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3 Additions to the Wide Moat Focus Index

We take an in-depth look at the new constituents of Morningstar's index of competitively advantaged firms trading at favorable prices.

In September, three new stocks made their way into the Morningstar Wide Moat Focus Index.

There are only two qualifications for inclusion in the Wide Moat Focus strategy: Companies must have an economic moat rating of wide (meaning we think they have advantages that will fend off competitors for at least 20 years), and their shares must be among those trading at the steepest discount to their fair value estimates in our coverage universe. (Our fair value estimates are determined through independent research by the Morningstar Equity Research team.)

The index consists of two subportfolios of 40 stocks each, which are reconstituted semiannually, but with staggered rebalancing quarterly. One of the subportfolios reconstituted in September, at prices as of Sept. 6.

Owing to the new portfolio construction methodology introduced last quarter, turnover was much lower this quarter than it has been historically, which is as intended. Half of the portfolio remained unchanged, holding the same 40 stocks as at the June rebalance. The other half of the portfolio swapped out three positions:

The following are the new stocks in the Wide Moat Focus Index. See all the positions in the index here.

Bristol-Myers Squibb

BMY

4 stars Price/Fair Value: 0.70

A broad lineup of patent-protected drugs, an entrenched salesforce, and economies of scale support Bristol's wide economic moat, says Morningstar sector director Damien Conover. Importantly, he points out that Bristol has created a strong pipeline and is adept at partnering with other firms to share the development costs and diversify the risks of clinical and regulatory failure. One such partner, Pfizer, is helping Bristol develop and market Eliquis, a drug that Bristol discovered internally and which has blockbuster potential in arterial fibrillation. While the company faces significant patent losses that continue through 2017, Conover expects its next generation of drugs to fill the patent holes over the next decade. A pivotal drug for Bristol is cancer drug Opdivo, which is in late-stage development. Opdivo could potentially revolutionize cancer treatment, in Conover's view. It should develop into "a multibillion-dollar opportunity based on solid efficacy, combination potential with other drugs, and strong pricing power," he said.

Deere & Co

DE

4 stars Price/Fair Value: 0.90

The John Deere brand is built on industry-leading agricultural research and development spending and an unmatched North American agricultural dealer network, says Morningstar senior equity analyst Kwame Webb. He believes that John Deere has carved a wide economic moat based on a combination of intangible assets. The first is its strong brand. Most Americans are familiar with John Deere's green and yellow leaping deer logo; generations of North American farmers view the brand as a symbol of high quality and prestige, Webb says. Deere's second competitive advantages is its network effect. Throughout North America, Deere has 1,539 agricultural equipment dealers. Webb points out that the strength of this dealer network is important for three reasons: new equipment sales, continuing product service, and used-equipment resale. He says outside of North America, Deere's brand is weaker; however, it is aggressively deploying resources into markets such as Brazil, where it has grown to 20% of the new tractor sales from 8% over the past decade.

Lowe's

LOW

4 stars Price/Fair Value: 0.84

Lowe's is the second-largest home improvement retailer in the world, with annual revenue of more than $59 billion. That scale enables consolidated purchasing power, which leads to a low-cost position, says Morningstar equity analyst Jaime Katz. In addition, an automated distribution network puts vendors, distribution centers, and stores on one IT platform, which helps drive operational efficiency. The Lowe's logistics system permits large-scale purchase orders at a discount, which gives it a low-cost edge, she says. The firm retains some of the cost savings, and it passes the remainder on to its customers in the form of low everyday prices. In Katz's view, these competitive advantages generate positive economic returns and support a wide economic moat for Lowe's. Going forward, while Katz thinks value improvement and product differentiation initiatives should continue to decrease unit costs, she also thinks long-term growth will come from expansion into underpenetrated domestic markets (such as cities), international locales (boosted by its acquisition of Canadian home-improvement retailer Rona in Canada), and broader professional penetration.

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