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The Wide Moat Focus Index Adds 11 New Holdings

The Morningstar Wide Moat Focus Index made room for some undervalued consumer defensive stocks in March.

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Every quarter, we reconstitute one subportfolio of the Morningstar Wide Moat Focus Index. When we do this, we re-evaluate the index's holdings and add and remove stocks based on a preset methodology. This helps keep the index true to its aim of providing exposure to competitively advantaged (wide-moat) stocks selling at the lowest current market price/fair value ratios.  

The index consists of two subportfolios with 40 stocks each. The subportfolios are reconstituted semiannually in alternating quarters, on a "staggered" schedule. Because stocks are equally weighted within each subportfolio, the reconstitution process also involves right-sizing positions. 

The Adds
After the March reconstitution, half of the portfolio swapped out 11 positions. The net result is that the index now holds 52 positions.

One discernible theme is that wide-moat consumer defensives look cheap. Companies like  Procter & Gamble (PG),  General Mills (GIS),  Campbell Soup (CPB),  The Hershey (HSY) , and  PepsiCo (PEP) are known for producing trusted brands of household products such as diapers, cereal, and soft drinks. Firms such as these tend to have more predictable, steady cash flows; therefore, their share prices tend to decline less during a market downturn compared with stocks of firms that are more sensitive to business cycles. 

As director of consumer sector equity research Erin Lash wrote, although consumer defensive firms have been laser-focused on driving efficiencies, these efforts to extract costs have failed to offset languishing top-line trends. 

"This has been evidenced in soft volumes (compared with historical levels) combined with price/mix that has generally still been under pressure." 

Lash also points out that the growth of the hard discounters in Europe, Australia, and increasingly in the U.S., and the emergence of the e-commerce channel, are lowering barriers to entry in the consumer defensive space and intensifying price competition. Meanwhile, consumers are looking for alternatives to the big brands, either seeking better value from unbranded alternatives, or trading up to more niche, artisan products such as craft beer, she said.

These competitive pressures have helped create opportunities for long-term investors who want to build positions in these competitively advantaged names.

Likewise, utilities such as  Dominion Energy (D) , which supplies energy primarily to consumers on the East Coast, and cable company  Comcast (CMCSA), which benefits from a subscription model, benefit from steady cash flows that help protect them from market sell-offs. (Though Comcast's pay TV model has faced competitive pressures from various corners of late, equity analyst Neil Macker believes Comcast has a wide economic moat rating based on cost advantage and efficient scale inherent in its residential broadband business and cost advantage in its business services segment.) 

The Drops
On the flip side, 11 stocks were removed because their price/fair values rose beyond our buy range. 

There weren't many broad themes among the companies that were removed owing to high price/fair value ratios--mostly just strong individual performance. For instance,  CBRE Group's (CBRE) fourth-quarter results exceeded management's guidance and Morningstar analyst Brad Schwer's expectations. 

"Revenue and earnings reached all-time highs in 2017 as the global economy continued to grow," Schwer said.

 Bristol-Myers Squibb (BMY) has benefited from two positive developments in the past few months. First, the pharmaceutical firm reported slightly better-than-expected fourth-quarter results. Also, Bristol reported positive combination-therapy data in a recent non-small cell lung cancer (NSCLC) study. 

Healthcare sector director Damien Conover said this positive data "[supports] our expectation Bristol will gain close to a quarter of the $12 billion NSCLC market. We don’t expect any major changes to our fair value estimate following the data, but the continued strength of Bristol’s positioning in immuno oncology helps reinforce the company’s wide moat."

 Veeva Systems (VEEV), which provides customer relationship management software for the life sciences industry, rose around 33% in the past three months after it reported a strong fourth quarter, with an impressive 23% increase in revenue.

We removed  Patterson Companies (PDCO) because we recently downgraded our moat rating to narrow from wide due to concerns that Patterson's competitive position in the dental wholesaling market has significantly deteriorated.

"We believe Patterson faces significant pressure from alternative sourcing options for dental consumable products (fillings, gauze, latex gloves, disinfectants, swabs)," said senior equity analyst Vishnu Lekraj. "From what we can gather, there has been increased competition from online-based wholesale players that can source consumables from the cheapest suppliers nationwide."

High-Quality Stocks in the Bargain Bin
The table below lists the 10 cheapest stocks in the index, ranked by price/fair value. The median stock in the Wide Moat Focus Index is trading at a weighted average price fair/value of 0.81. By comparison, the broad Morningstar US Market Index is close to fairly valued, trading at a weighted average price/fair value of 0.95 .

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Karen Wallace does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.