Ideas From the Wide Moat Focus Index

We recently rebalanced the Morningstar Wide Moat Focus Index. As a reminder, this index contains the 20 cheapest wide-moat stocks based on price/fair value ratios. It is equal-weighted and rebalanced quarterly. It is also the basis for Market Vectors Wide Moat ETF (MOAT).

The Wide Moat Focus Index has performed exceedingly well to date, with annualized total returns of 33.5%, 12.7%, and 13.3%, respectively, over the trailing one-, five-, and 10-year periods through the end of May. (The index was created in August 2007, so 10-year return data before then is back-tested.) These results trounced the total returns of the S&P 500, which were 27.3%, 5.4%, and 7.6% over the same time periods.

Since Morningstar StockInvestor follows a similar strategy to the Wide Moat Focus Index--buying companies with very strong competitive advantages when they are trading for discounts to their intrinsic values--I find the regular index rebalancing to be a useful source of ideas. Below are the eight companies that were recently added to the index, along with my take on each.

Facebook (FB)     
Price: $24.70
Fair Value Estimate: $34
Matt's Take: Facebook has given investors plenty of heartburn in its short life as a public company. After an initial public offering at an inflated price of $38 per share, the stock fell to the high teens in less than six months and has had a bumpy ride between those values ever since. Morningstar's fair value estimate hasn't been nearly so volatile during this time. We initiated coverage of Facebook at the IPO with a fair value estimate of $32, and we raised it to $34 after a strong first-quarter earnings release earlier this year. Facebook returned to the Wide Moat Focus Index as a result of recent share price weakness, combined with our higher appraisal. Despite the relative stability of our fair value estimate, I would not downplay the difficulty in valuing a company like Facebook, with its rapid growth and uncertain future margins. The stock is trading for about 43 times this year's adjusted earnings and 32 times forward earnings. Rapid growth can justify a very high P/E multiple--investors who paid more than 100 times earnings for
 Google (GOOG) in 2004 have done very well--but if Facebook's growth were to slow more than we expect, the likely reaction of investors wouldn't be pretty. I would characterize Facebook as a high risk/high potential reward situation.

Franklin Resources (BEN)
Price: $138.45
Fair Value Estimate: $185
Matt's Take: Franklin Resources' wide moat is founded on its sticky customer relationships and well-known asset management brands such as Templeton and Mutual Series. Investors would often do well to skip mutual funds and instead invest in the companies that sell them: Asset managers' revenue is directly tied to the performance of financial markets, but a well-run firm can grow earnings even faster over time by gathering new client assets and leveraging fixed costs. I prefer asset managers that are well-diversified across product categories (so they are protected when one asset class falls out of favor), have a large institutional client base (institutions tend not to chase performance as much as retail investors, making the assets stickier), and that display exemplary stewardship. Franklin is reasonably well diversified, with 39% of managed assets in equities, 44% in fixed income, and 16% in hybrid funds. However, its distribution is tilted toward retail investors, and management only receives our standard stewardship rating. 

 Oracle (ORCL) 
Price: $30.14    
Fair Value Estimate: $38
Matt's Take: We recently cut our fair value estimate for Oracle by $1 per share, following a second consecutive quarter of disappointing sales growth. The more I think about it, the more Oracle looks like a bargain, trading at just 10.4 times consensus earnings estimates for this year. Surprisingly, this is a meaningful discount to  Microsoft (MSFT), which is trading at about 12.4 times earnings even though I would argue that Microsoft is facing greater external threats than Oracle. While there's little doubt that Oracle's business has matured and that growth will be slower going forward, it doesn't take a lot of growth to justify a P/E multiple of 10.4. I expect that Oracle can still grow its top line by 4%-5% over the long run, which should translate to a similar level of operating income growth assuming relatively stable margins. Considering the current valuation, it shouldn't be too hard for Oracle to get the rest of the way to double-digit earnings per share growth through share repurchases. On top of that, the recently raised dividend provides a yield of 1.6%.

 Qualcomm (QCOM)      
Price: $60.80
Fair Value Estimate: $75
Matt's Take: Qualcomm owns thousands of patents surrounding CDMA technology, a communications standard that is central to 3G wireless networks. Qualcomm licenses the technology to practically every handset maker, which allows the firm to collect 3%-5% of the price of every handset unit sold with minimal incremental costs. While the company doesn't have quite as strong a position in 4G intellectual property, 4G handsets will need to be backward-compatible with 3G technology for at least the next decade, allowing Qualcomm to maintain its lucrative royalty stream. Qualcomm has also leveraged its CDMA expertise to become a key supplier of semiconductors to handset makers. The shift toward more sophisticated smartphones provides a tailwind, as these handsets require more expensive and powerful chips. The semiconductor business is hypercompetitive, but Qualcomm has established itself as a supplier of choice for leading handset makers like
 Apple (AAPL).    

 EBay (EBAY)     
Price: $53.02   
Fair Value Estimate: $63
Matt's Take: EBay offers a rare combination of a wide moat, an improving competitive position (positive moat trend), and exemplary stewardship. The company's addition to the Wide Moat Focus Index was primarily due to a pair of fair value estimate increases in March and April. I think eBay is uniquely positioned to act as an impartial facilitator of online commerce--connecting retailers and consumers without competing with them. The network effect is strengthening as eBay attracts more users to its marketplaces and PayPal. Aggressive investment in mobile capabilities is a near-term headwind to margins, but should solidify eBay's economic moat over the long run.   

Schlumberger (SLB)      
Price: $73.31
Fair Value Estimate: $87
Matt's Take: Oil and natural gas aren't getting any easier to find and extract, and Schlumberger has unique technological expertise that makes it a key partner on hard-to-drill wells. The company enables exploration and production companies to exploit energy resources safely, efficiently, and at a lower total cost than they could without its services. Furthermore, Schlumberger's broad international presence and independent service-provider model make it an ideal partner for national oil companies that want to retain ownership of their resources while still benefiting from best-in-class technology.

 Maxim Integrated Products     
Price: $27.65  
Fair Value Estimate: $33
Matt's Take: Maxim is a leader in the design and production of analog chips. Analog chips are used to convert real-world inputs, like sound and temperature, into digital signals (1's and 0's). We think the market for analog chips is significantly less competitive than the markets for most semiconductors, due to the need for specialized design expertise, differentiation between chips, longer product cycles, and less rapid innovation. This is reflected in Maxim's relatively stable pricing and favorable profitability. On the other hand, much of Maxim's incremental growth is likely to come from high-volume consumer electronics, where competition is more intense than in industrial applications.

 Amgen (AMGN)      
Price: $96.82   
Fair Value Estimate: $114
Matt's Take: Amgen is another large-cap biotech that received a fair value estimate boost when we lowered our cost of equity assumption to 8% from 10%. The same underlying factor brought  Novo Nordisk (NVO) and  Gilead Sciences (GILD) to my attention. I prefer either of those companies to Amgen, considering their improving competitive positions (that is, positive moat trends). In contrast, Amgen has a negative moat trend, the result of generic and branded competition and reimbursement pressure facing its aging portfolio of blockbuster biologic drugs, such as Aranesp, Epogen, Neulasta, Neupogen, and Enbrel. However, the pipeline continues to improve, and if Amgen can stabilize its competitive position I would take another look.

Stock data as of July 2.

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