Wide Moat Focus Index Unfriends Facebook

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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Glaser: Let's look at some of the names that came into the index that are potentially good investment ideas right now. One was Spectra Energy. Can you tell us little bit about that story?

Collins: This is a pipeline company, and at Morningstar we think that pipelines have wide economic moats that will protect profits for two decades or more. That is because of the efficient scale phenomenon. Once you build a pipeline to transport oil or gas between Point A and Point B, it doesn't make any economic sense for another pipeline to be built along that same corridor, because the capacity utilization factors for both competitors would fall, and there would be a price war, so to speak. That would result in substandard economic profits for both players.

So, the efficient scale phenomenon protects pipeline operators like Spectra Energy. We didn't talk about it yet specifically, but the wide-moat investing philosophy is something that we came up with after hearing about Warren Buffett, the famed investor, and his idea about investing in companies with sustainable competitive advantages. And in fact, our energy team and utilities team just did a research piece on how to replicate Berkshire Hathaway's investment in MidAmerican Energy, which investors can't do by themselves.

But Spectra Energy happens to be one of the companies that you would add to a portfolio if you are trying to replicate MidAmerican Energy. ITC Holdings is another one, which also happens to be part of the Wide Moat Focus Index newly this quarter.

Glaser: Can you talk just little bit about ITC then?

Collins: Sure. ITC Holdings is much like a pipeline company. But instead of transporting oil or gas, they are transporting electricity. And then the same type of economic moat applies in the idea that once you build the transmission line between Point A and Point B, it won't make sense to build another transmission line because utilization would suffer for both players.

Glaser: CSX was added, which recently was upgraded to a wide moat. Can you tell us why that moat was upgraded and why we think it is cheap today?

Collins: Sure. Well, we've always thought that the railroads in North America, in particular, had insurmountable barriers to entry. It would be really hard for anybody to enter this market. They are protected by a number of barriers to entry. And in the past we had awarded these six Class I railroads in North America narrow economic moats.

We hesitated in the past from giving them wide economic moats because their economic profit generation wasn't strong enough that we had enough confidence that the economic profits would be positive 20 years from now. Even a slight change in economic conditions or operating efficiency assumptions would have meant that they weren't meeting their cost of capital. But the railroad operators have made a lot of progress in recent years on lowering their cost structure, and that means that our outlook for profitability from these six railroads has really improved and we now have enough confidence to say that they'll be generating economic profits 20 years from now, and that increased level of confidence because of their increased economic profit potential means that we now think that they are worthy of the wide economic moat rating. CSX happens to be the cheapest one; it made the cut at the last rebalancing.

Glaser: How has this strategy worked over time? What did the performance numbers look like?

Collins: We've been happy to see that the Wide Moat Focus Index has been doing a good job beating the S&P 500, and it's happened that that's also been the case this year, even in a year when the S&P 500 had a really good year and it's been hard to beat. Part of the last quarter's success had to do with Facebook. We were glad to get that company in the index, and then market sentiment changed on Facebook during the course of the quarter. And Facebook got sold out of the index, but it helped our performance this year.

Glaser: Elizabeth, thanks for the update on the index today.

Collins: Thank you.

Glaser: For Morningstar, I'm Jeremy Glaser.