Why Are Wide-Moat Stocks Underperforming?

Susan Dziubinski: Hi, I'm Susan Dziubinski at Morningstar. At Morningstar we're fans of companies with wide economic moats. Such high-quality firms have competitive advantages that allow them to effectively fight off competitors. And because of those competitive advantages, wide-moat stocks often hold up better during market downturns. So, how are they doing so far in choppy 2022? I'm here with Morningstar's chief U.S. market strategist Dave Sekera to find out.

Dave, first let's unpack this premise that wide-moat stocks should theoretically outperform in tough markets. What's the thinking behind that?

Dave Sekera: Hey, Susan. Yes, at Morningstar, we certainly do focus on those firms with wide economic moats, really due to their demonstrated ability to be able to generate excess returns over long time periods. However, I think you also need to be careful to separate the difference between the operating performance of a company and the performance of its stock, especially over short time periods. From an operating standpoint, firms with an economic moat will typically perform better during times of economic turbulence. However, operating performance is really only one part of the investment decision, as valuation is really the other part. In our valuation methodology, we do include our moat rating in determining what we think the fair value, or the intrinsic value, of a company is. A company that has an economic moat will have a higher valuation as compared to those companies that don't have an economic moat. Now, the performance of a stock will depend not only on the quality of the underlying business and its performance, but also the performance of the stock is really in relation to the price that you pay for that stock, as compared to its intrinsic value based on our forecasts.

Dziubinski: Let's talk a little bit about wide-moat stock performance. So far this year, as a group how have wide-moat stocks performed against, say, the broader market.

Sekera: Well, the Morningstar Wide Moat Index itself has underperformed the U.S. market, I think by a little bit less than 1%, last time I checked. And so when I do an attribution analysis on the wide-moat index as compared to the broad market, the one thing I would note is, because it's a subset of the broad market, it's a lot more concentrated, especially when we look at the top 10 names of the moat index. And what I noticed that thus far over this year, over this two-month time frame, several of the larger positions have had an outsize negative impact on at the moat index. So, for example, Nvidia, which we rated 2 stars coming into this year, has dropped by over 20%, more than double the rest of the market has dropped.

There's also a number of other technology stocks in the moat index. And as you know, technology was one of the most overvalued sectors coming into this year. And so as that entire sector has been selling off, it's really kind of pulled everything down within the technology sector along with it. And then, finally, another outlier I'd highlight is Meta Platforms, the parent of Facebook, and that stock has dropped almost 40% this year. Now, from our point of view, we think that the market has actually really overreacted to the downside on Meta Platforms. And based on our 5-star rating, we think it actually has a lot of substantial upside potential from here.

Now, the other thing I would note is that when you take evaluation into account, I would highlight the wide-moat-focused index has significantly outperformed the broad U.S. market thus far this year, by about 4%. So, the difference is that the wide-moat index is just a composite of all the wide-moat stocks weighted by market cap that we follow. Whereas the wide-moat-focused index is a composite of the 40 most undervalued stocks that we cover, as measured by our price/fair value metric.

Dziubinski: Dave, you alluded to technology sort of coming into the year overpriced and some specific wide-moat stocks that have had really tough performance this year. Is there anything else contributing to that group underperforming the wide-moat index? And then, conversely, what types of wide-moat stocks have been doing better? Is it strictly those that have been undervalued?

Sekera: The wide-moat stocks in the nontechnology sectors really have generally held up better thus far this year. So, when I look at some of the larger contributors in the wide-moat-focused index, like Johnson & Johnson, Procter & Gamble, JPMorgan, they've all dropped much less than the market thus far this year. And, in fact, Berkshire Hathaway is actually up for this year.

Dziubinski: What's the takeaway for investors, Dave? Is it an issue of that valuation will always trump moat?

Sekera: Well, in the short run, we always note that the price of a stock does not always equal the value of that stock. So again, price can always be influenced by short-term factors. You'll think about things like news flow with Ukraine in the headlines right now and how that impacts market sentiment. But, in our view, we think that stock prices over the long term will always converge toward their intrinsic value. In my mind, the key is really that economic moat and valuation are intertwined. So, firms with an economic moat will have a higher value than those without an economic moat, but the performance will be based on the price you pay today as compared to that intrinsic value of the stock.

That's why you'll also see examples of stocks with a wide moat that might be rated 1 or 2 stars when they're trading too far above their intrinsic value. And sometimes you'll even see a no-moat stock that can trade with 4 or 5 stars, because it's trading at a great enough discount from its fair value. In my mind, I always find that the best investment opportunities are those where you can find that combination of a high-quality business with a wide economic moat that's trading at a discount to its fair value.

Dziubinski: That sounds like a pretty good recipe, Dave. Thank you very much for your time today and your perspective. We appreciate it.

Sekera: All right, thank you.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thanks for tuning in.

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