StockInvestor editor Matt Coffina reviews the recent additions and subtractions to Morningstar's Wide Moat Focus Index as well as his current favorites among index constituents.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm joined today by Matt Coffina. He is editor of Morningstar StockInvestor newsletter, and we'll take a closer look at the Wide Moat Focus Index and see what happened in the latest quarterly rebalancing.
Matt, thanks for joining me today.
Matt Coffina: Thanks for having me, Jeremy.
Glaser: First off, can you talk to us a little bit about what the Wide Moat Focus Index is? How are stocks selected to go into it?
Coffina: This is an index that includes 20 stocks covered by Morningstar analysts, and we only include companies that our analysts believe have a wide economic moat, so that will be a very strong sustainable competitive advantage. And then we rank those companies based on the price/fair value ratio, and then the 20 companies with the lowest price/fair value ratio would be the ones that make it into the index. Basically, we're looking for very high-quality, relatively cheap stocks. We rebalance the index quarterly, and it excludes certain issues, for example, foreign stocks and master limited partnerships.
Glaser: You mentioned this index is only holding the 20 cheapest wide-moat stocks. How has that definition of cheap changed over the past couple of years? Have you seen big changes in valuations among wide moats?
Coffina: As the market has run up, as you might expect, the hurdle has gotten lower and lower for getting into the Wide Moat Focus Index. In the most recent rebalancing, the least cheap stock in the index was MasterCard, which at the time of rebalancing had a price/fair value ratio of 0.93, so only a 7% discount to fair value for the least cheap stock in the index this time around.
That's really just a sign of the times. There's very few cheap stocks out there. Not only do our analysts think that the market as a whole is fairly to fully valued, but it's very homogenously valued. You see very few stocks trading at deep discounts to fair value in the current environment, and that's just sort of the environment that we're in.
Glaser: Briefly looking at stocks that left the index, what was the major reason? Was it that analysts changed their opinion, that the companies became less valuable, or was it mainly just that the prices ran up so much, they just didn't look like a bargain anymore?
Coffina: There weren't any moat downgrades among index participants, which means that all of the stocks that left the index was because of valuation. And by and large, that was because the stocks had run up closer to our fair value estimate, at least closer than the stocks that came out of the index.
So, some names that came out this time around, there were seven of them. They included, General Electric, Schlumberger, CH Robinson, Expeditors International of Washington, Spectra Energy, National Oilwell Varco, and Philip Morris International. There really weren't any notable fair value estimate reductions on this list. It was much more that the stocks ran up toward our fair value estimate and the stocks no longer qualified among the 20 cheapest wide moats.
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Glaser: Looking at the stocks that came in to replace those, could be some ideas for investors today. Can you talk about a few that you think could be interesting?
Coffina: There were seven additions to the index this time around, again, mostly due to valuation. I would say more due to stock price weakness of these particular issues, rather than fair value estimates that have been rising.
The new names would be Amazon, Amgen, Intercontinental Exchange, Eaton Vance, Bank of New York Mellon, Costco, and MasterCard. And the cheapest of these would be Amazon, trading at a price/fair value ratio of 0.82 at the time of rebalancing. This is probably a relatively controversial call.
The key assumptions that our analyst is making in deciding that Amazon is undervalued is, first, that the company's operating margin is going to reach about 4.5% five years from now, rising to 8.5% in 10 years, versus the company is only making about a 1% operating margin today. So we really have to have some confidence in the management here and that the investments that they're making today are really going to pay off in the long run, and that at some point Amazon is going to be a big profitable company.
The company has a great track record of revenue growth, but it hasn't really shown much history of profitability. And I think it's sort of an open question as to whether that's because it's not as good of a business as you might expect it to be, or whether management really is just making these investments for the future and they're going to pay off in the long run.
Personally, I think the 18% discount to fair value is at least intriguing, but for our purposes, I'd rather have a wider discount to fair value given the uncertainty about that long-run profitability.
MasterCard, I mentioned was the least cheap stock entering the index, but this is a company that's a very longtime favorite of StockInvestor. It's a company that I think can grow earnings per share at a midteens rate for the foreseeable future, and it's trading at a reasonable valuation. Not a deep discount to fair value, but a wonderful business at a reasonable price.
Of the other additions to the index, none of them really stand out as being all that cheap or all that compelling from an investment standpoint. They're all trading at about 10% discounts to fair value, which again is a sign of the times and the fact that there just aren't that many cheap high-quality companies out there.
For StockInvestor's purposes, I actually like some of the existing holdings in the index more, the ones that carried over from the prior quarter, more than the ones that were added this time around.
Glaser: What are some of those names in the existing portfolio that you like?
Coffina: A few of the cheaper names that are in the portfolio already would include eBay. They've had a lot of negative news lately, but really more minor issues that I don't think is going to impact the company's economic moat or its valuation over the long run. And that stock is looking cheaper and cheaper as the earnings continue to grow. They're very consistent, double-digit top- and bottom-line grower. And investors really don't seem to appreciate the business. They give a lot more credit to Amazon, which doesn't have the same demonstrated record of profitability as eBay, and eBay really gets overlooked, I think.
Express Scripts would be another name. The free cash flow yield is around 8%, which really creates a very low hurdle rate for future total returns. If the company can grow operating income, even 2% or 3% a year, we could be looking at a double-digit total return pretty easily; the price/earnings multiple is in the low teens. So Express Scripts is a company that I like a lot on valuation.
EBay, they've had their issues over the years, a lot of negative news recently, but I think still very attractive valuation for long-term investors.
Glaser: Matt, thanks for your update on the index today.
Coffina: Thanks for having me, Jeremy.
Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.
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