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By Jeremy Glaser and Paul A. Larson | 09-18-2012 03:00 PM

Wide-Moat Names Losing Their Discounts

Recent rebalancing of Morningstar's Wide Moat Focus Index shows that quality stocks aren't nearly as cheap as they were this time last year.

Jeremy Glaser: For Morningstar, I am Jeremy Glaser. We recently announced the changes to our Wide Moat Focus Index. I'm here today with Paul Larson, our chief equity strategist and also the editor of Morningstar StockInvestor, to see what companies have been added to the most undervalued wide-moat names and which have been taken off.

Paul, thanks for joining me.

Paul Larson: Thanks for having me.

Glaser: So, let's talk a little bit more about how this index is constructed? What's in it? Can you just give us some color around that?

Larson: Sure thing. Well, with the Wide Moat Focus Index, the first that we do is we focus on the wide-moat names. What we do is we take roughly the 2,000 securities that we cover globally and we only look at the wide moat, which about 10% of our coverage universe attains that wide-moat rating.

Another thing that we do for this particular index is we exclude foreign firms--so we're only looking at U.S. firms--and then we also exclude master limited partnerships because they don't fit into an index and structured product structure all that well. So we're basically looking at wide-moat, U.S.-based corporations, and at this particular rebalance and reconstitution, that was 116 stocks. Then what we do with this 116 is we rank order that cohort by the price/fair value ratio, and we have taken the 20 cheapest stocks of that 116. And those are the stocks that are in the Wide Moat Focus Index.

Regarding the rebalancing, when we do rebalance from the current index holdings, we are going to rebalance so that every position has a 5% weighting. So it's an equal-weighted index at the point of rebalancing.

Glaser: What was the cutoff for making this quarter's Wide Moat Focus Index?

Larson: Well, it's kind of interesting, and it's a reflection of the market that we've had in recent months that has actually risen quite dramatically, in that the cutoff is dramatically smaller than it was in previous times that we've rebalanced. There's only about 14% this time around whereas last time we did this in June, the cutoff was 22% where a stock had to trade at a price/fair value ratio of 0.78 or less to make it into the index.

This time last year it was an even larger discount, about a 29% discount fair value before these U.S.-based wide-moat stocks would make it [into the index]. But these days bargains are harder to find, and that's reflected in this much lower hurdle to get into the index.

Glaser: Of the seven companies that have been added, did any stand out to you as maybe a surprise that they had become so cheap or that were just interesting?

Larson: Sure. I think by far the biggest surprise is Facebook, which is going into the index. This is a company that had a lot of hype around its IPO. With benefit of hindsight we can see that the IPO was kind of a disaster. But at the point of the IPO when we were looking at the company despite all the problems with the IPO, the underlying company we've always said has had a wide moat and has very high returns on invested capital and benefits from the network effect.

So from a business-quality standpoint it's always been there, but it's only in recent weeks that the stock has gotten cheap also. We said at the point of IPO that it was worth $32 a share. Today we're still saying that Facebook's fair value is $32 a share. So there's a big difference between at the point of IPO when it was near $40 and today where it's closer to $20 in terms of where it stands on valuation.

Glaser: Certainly moving seven stocks out of a 20-stock index is a fair amount of turnover. Do you think that that's detrimental to performance over the long term? Certainly we've always been skeptical of high-turnover strategies in the past.

Larson: Yes, this index does indeed have high turnover, and it has always had high turnover. So, seven additions and seven deletions is entirely with its historical character. Despite that turnover, the index has performed quite handsomely. So even though one following this index may not be the most efficient from a tax standpoint, the performance numbers certainly compensate for that high turnover.

Glaser: Paul, thanks for the update.

Larson: Thanks for having me.

Glaser: From Morningstar, I'm Jeremy Glaser.

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