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By Jeremy Glaser and Elizabeth Collins, CFA | 10-02-2013 01:00 PM

Wide Moat Focus Index Unfriends Facebook

It's all aboard for CSX, among others, in the index's quarterly rebalancing.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. We recently rebalanced the Morningstar Wide Moat Focus Index. I'm here with Elizabeth Collins, the chair of our economic moat committee, to look at some of the changes.

Elizabeth, thanks for joining me.

Elizabeth Collins: Thanks for having me, Jeremy.

Glaser: Can you tell us little bit about what the Wide Moat Focus Index is and how we decide on which 20 stocks go in it?

Collins: Sure. The way to think about the Wide Moat Focus Index is that it is a combination of quality and value, and we think that both things are important here at Morningstar. Basically, it picks stocks from our universe of wide-moat companies. These are companies that we think have sustainable competitive advantages that will protect economic profits for 20 years or more. Then it takes the 20 cheapest companies every quarter based on what our analysts think the companies are worth relative to where the stock price is trading.

Glaser: Let's look at some companies that came out of the index this quarter. What were some of the notable departures?

Collins: I think that the most notable departure is that Facebook left the index at the end of the quarter. At the beginning of the quarter, this was a situation where our analyst and our team saw a wide-moat company with a significant potential for long-term earnings growth. And at the beginning of the quarter, the market definitely disagreed. There were concerns about whether or not Facebook users were getting Facebook fatigue--they weren't willing to spend enough time on Facebook, and they weren't engaged enough.

The other main concern of the market was that Facebook wouldn't be able to monetize their network through advertising, both at the desktop platform and on the mobile platform. But our analyst thought that these two problems were being overemphasized by the market. And when they reported last quarter, they indicated two very important things; number one, engagement trends were very encouraging. People are not getting Facebook fatigue--they are spending enough time on Facebook, maybe not enough time for what else they are doing, but anyway. So, people are spending enough time on Facebook in order for it to be a valuable platform for advertisers.

The second thing that was indicated in the most recent quarter was that the mobile platform is doing nearly as good as the desktop platform at monetizing things for Facebook. So, advertisers are seeing the value in advertising on mobile Facebook as well. By the end of the quarter, the stock price had appreciated to a level well above our analyst's estimate of intrinsic value, which means it wasn't cheap enough for our index anymore.

Glaser: Of all the stocks that departed--were they all due to market movements, or were there any that the analysts changed the opinion of the moat or changed the opinion of the valuation?

Collins: There were some cases where the analysts have changed their opinions of the companies. One example there would be Vulcan Materials, where I actually happen to be the analyst covering that company because my other role is to lead the basic materials team. In that case, I did lower my fair value estimate a tiny bit based on a change in our cost of equity methodology. I just think that it's wiser to use a higher cost of equity for Vulcan Materials because they have high revenue cyclicality. That's not offset by their low degree of operating leverage or modest financial leverage and that lowered the fair value estimate a little bit. And so it didn't make the cut for the 20 cheapest wide-moat companies at the end of the quarter. While Vulcan Materials was in the index over the quarter, it didn't meet the S&P 500, but it almost got there. It slightly underperformed the S&P 500.

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