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By Matthew Coffina, CFA | 09-23-2014 01:00 PM

9 New Names Join the Wide Moat Focus Index

Some energy names and out-of-favor companies joined the index, but, in a sign of the times, few deeply discounted stocks.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I am joined today by Matt Coffina. He's the editor of Morningstar StockInvestor newsletter. We're going to take a look at the Wide Moat Focus Index and some recent constituent changes.

Matt, thanks for joining me.

Matt Coffina: Thanks for having me, Jeremy.

Glaser: First, let's take a look at what the Wide Moat Focus Index is. Can you explain a little bit about the methodology that goes into creating it?

Coffina: So, this is an index that includes the 20 cheapest wide-moat stocks based on Morningstar's price/fair value ratio. So, basically, we look at the whole group of companies that have wide economic moats according to our analysts. There are about 175 companies like that with U.S. listings. Then, we sort them all by price/fair value ratio and just simply take the top 20 in terms of the ones that our analyst thinks are undervalued.

Glaser: How has this strategy performed over time, both over the long term and also more recently?

Coffina: Year to date, the strategy is just a little bit ahead of the S&P 500--maybe about 30 basis points. It's a similar story over the trailing five years now; it's only slightly ahead of the S&P 500. And I'd say that's really because it's been a difficult environment for a strategy like this with a very strong bull market. Going back five years, you're starting toward the financial crisis now--in which case, a lot of lower-quality, more cyclical, more heavily indebted kinds of companies really had a huge runup over the last five years. So, it's been a relatively difficult environment for this kind of strategy, and it has still kept up with the S&P 500 or slightly outperformed it. If you go back further before the financial crisis--to 7-, 8-, 10-year returns--then we're significantly ahead of the benchmark.

Glaser: This index is rebalanced every quarter. How many changes were there? Was it a particularly high turnover quarter?

Coffina: It was a high turnover quarter. So, we have nine additions to the index out of 20 total names this quarter. And this is one of the downsides to this strategy--it's a relatively high turnover strategy. Historically, we've averaged about 120% to 150% turnover per year, and that's largely because, again, it's just a strict quantitative cutoff. So, if a stock is trading at a price/fair value ratio of 0.90 this month, it made into the index; [but if its price/fair value ratio is] 0.91, it would not make it into the index. So, very small valuation differences can sometimes make the difference between whether a stock is included or not.

In our Tortoise and Hare strategies from the Morningstar StockInvestor newsletter, we have much lower turnover. That's one advantage of that kind of approach. But I do think we give up a little bit in terms of total returns by pursuing a lower-turnover strategy. So, we're not constantly rebalancing to Morningstar's best ideas of the moment. This also makes this strategy relatively well suited to an ETF structure, where you don't have to worry about the capital gains implications.

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