StockInvestor editor Paul Larson details recent changes to Morningstar's Wide Moat Focus Index, noting how the rally in wide-moat names could have them more fairly priced than lower-quality stocks.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. We recently made some changes to our Wide Moat Focus Index. I'm here with Paul Larson, the chief equities strategist and also the editor of Morningstar StockInvestor, to see which wide-moat stocks have entered the index and which ones have left.
Paul, thanks for joining me today.
Paul Larson: Glad to be here.
Glaser: Can you tell us a little bit about what the Wide Moat Focus Index is and what it holds?
Larson: Sure. Well, the Wide Moat Focus Index is an index that holds exclusively wide-moat stocks. When we are constructing the index, we take our cohort of wide-moat-rated stocks and we limit it to those that trade in the United States. And we also exclude master limited partnerships because those don't really fit into the index structure so well.
Our beginning cohort is 114 companies this time around. We take those wide-moat U.S.-traded stocks, and we rank order them on the price/fair value ratio. And to create this index, we simply take the 20 cheapest stocks among that rank order and equal weight the index. We rebalance and reconstitute it every three months, and that's the index in a nutshell.
Glaser: So, there are six names that are entering in this time. What are some that are notable?
Larson: One of the notable names that's going in is Berkshire Hathaway, and this company has been in the news lately regarding a one-time buyback that the company made as well as raising the limit that it would be willing to repurchase shares. But ahead of that news, we raised our fair value estimate by $10. So, our fair value estimate is $110 on the B shares, and that made it, in that rank order, trading at enough of a discount to make it into the index this time around.
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Glaser: And how about another name?
Larson: Another one that's making it in is a company called, Express Scripts. And our fair value has not changed for this particular firm, but the stock fell off after recent earnings. But we still think that this company has a wide economic moat. It has outstanding management; actually, the CEO is one of our finalists for the CEO of the Year award for [2012]. And this is also a company that I own personally as well as in the [StockInvestor] Hare portfolio. So, this is a name that is really one of our best ideas right now.
Glaser: For everything that comes in, something has to go out. Of the stocks that left, [was it] due to reductions in fair value estimates, or was it because the stock price has performed so well over the last three months?
Larson: Well, those are the two reasons why they can go out, but most of them thankfully are going out simply because the stocks have appreciated over the last three months. For only one of the names have we seen a fair value reduction and the stock subsequently leaving the index, and that would be Caterpillar. We cut that by $5, and our new fair value estimate is $106.
But of all the rest of the names that are leaving the index, our fair value estimates are the same, but the stocks have risen fairly significantly. So, they are no longer at a sufficient discount to that fair value estimate to continue in the index. Two names come to mind: One is Lowe's, the home-improvement firm, and then also, Facebook falls into the same bucket.
Glaser: So, with six out of 20 stocks turning over, this seems like a pretty high turnover strategy. Is that a fair characterization or is this just one-time blip?
Larson: This is entirely in character with what the index has done since inception, and we can track this formulaic approach to creating the index back roughly a decade now. The index historically has had annual turnover on the order of 150%. So, with this particular time, we are turning over 30% of the index, and again, that's entirely in character with what we've seen.
Glaser: The index just holds the 20 cheapest stocks. They don't [necessarily have Morningstar Ratings for stocks of 5 stars]. What do you see in terms of valuation? Have valuation levels become richer?
Larson: Well, it's certainly become easier to make it into the Wide Moat Focus Index. This particular time the cut-off to make it into the index was 0.84 on the price/fair value metric, or you can say a 16% discount to fair value is all that the wide-moat stock needed to trade at in order to make it in [the index].
This time last year it needed to trade at 0.77 or below on the price/fair value scale. It's easier to make it in last time than it has been historically, and frankly, this is because wide moat stocks have done, as a group, relatively well in 2012. Actually, we're in a relatively rare time where wide-moat stocks are actually trading at a higher median price/fair value ratio than some of the lower-quality stocks in our coverage universe. That has rarely happened in the history [of the index].
Glaser: Paul, thanks for sharing your thoughts today. I will definitely catch up with you in three months when the index changes again.
Larson: It will be interesting to see what names go in and go out.
Glaser: For Morningstar, I'm Jeremy Glaser.
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