So far, so good this year for the Morningstar Wide-Moat Focus Index: It’s up nearly 17% for the year to date as of this writing, which is about on par with the broader market’s gains.
The index, which focuses on the least expensive high-quality stocks in our coverage universe, consists of two subportfolios containing 40 stocks each, many of which are overlapping positions. The subportfolios are reconstituted semiannually in alternating quarters, on a "staggered" schedule. We re-evaluate the index's holdings and add and remove stocks based on a preset methodology. Because stocks are equally weighted within each subportfolio, the reconstitution process also involves right-sizing positions.
After the most recent reconstitution on March 15, half of the portfolio added four positions and eliminated four names. The index now holds 46 positions.
The four stocks removed during the reconstitution-- Procter & Gamble PG, PepsiCo PEP, Starbucks SBUX, and ServiceNow NOW--were let go because their price/fair values fell outside of our buying range.
Here’s a little bit about each of the new additions.
The largest construction and mining equipment manufacturer, Caterpillar CAT owns the most valuable heavy equipment brand in the world, notes analyst Scott Pope. Although it operates in many highly competitive segments of the heavy equipment industry, the company’s investments in optimal product design and brand development have given it a leg up on the competition. So has the host of technology solutions it offers, such as fleet management systems, equipment management analytics, and autonomous machine capabilities, adds Pope. The strength of its brand and extensive global dealer network fortify its wide moat.
“We view Caterpillar as the best-run company in the heavy equipment market and especially like its focus on total cost of ownership,” Pope notes. We pin Caterpillar’s fair value estimate at $168; share are trading 15% below that as of this writing.
One of the more established firms in automation, Emerson Electric EMR has a long runway for positive organic growth, says analyst Josh Aguilar. According to 2017 data, the total addressable automation market tips $204 billion, with about $140 billion in devices, $40 billion in control and safety systems, and $20 billion in asset management. Emerson only has 6%, 5%, and 2% share participation in each respective category, says Aguilar. The firm also operates commercial and residential solutions. Both businesses have earned prolonged periods of excess economic returns.
“We think the cash flows from Emerson’s rich pedigree of household-name brands ultimately go to support the firm’s dividend, which continues growing in an upwards fashion for over 60 years,” he observes. We estimate that Emerson is worth $83 per share; shares are trading 12% below our fair value estimate.
Creating solutions for property and casualty insurers, Guidewire Software GWRE has prospered as its modern software systems replace clunky, decades-old mainframes, says senior analyst Ali Mogharabi. Guidewire’s applications increase underwriting and billing efficiency, shorten the claims cycle, and limit claims leakage, which lead to cost savings for its clients. Given the lengthy implementation process (anywhere from 12 to 36 months), many customers see Guidewire as a long-term strategic partner--which contributes to the firm’s high switching costs, he says.
“Guidewire’s growing presence at the top of the market, the expanding number of customers using its nascent cloud platform, international expansion (particularly in Europe), and upsell opportunities give us confidence that the firm still has a runway for growth,” argues Mogharabi. Shares are trading at a 9% discount to our $114 fair value estimate.
Packaged foods leader Kellogg K recently made headlines when it announced the sale of its cookies, fruit snacks, cones, and pie crust businesses (including brands such as Keebler, Mother’s, Famous Amos, and Stretch Island) to Ferrero for $1.3 billion. The sale allows the firm to increase support for its core offerings, such as Pringles, Cheez-Its, and Pop-Tarts, says sector director Erin Lash. We forecast Kellogg will spend around 8% of sales, or about $1.2 billion annually, on R&D and marketing, which should ensure it weathers competitive pressures. We also expect further investments in its manufacturing platform over the near term, she adds.
“We’re maintaining our wide moat rating for Kellogg, which reflects our confidence surrounding its ability to generate returns above its cost of capital (even under a more bearish set of assumptions) over the next two decades, stemming from both intangible assets and a cost edge,” says Lash. We assign a $78 fair value estimate for Kellogg; shares are trading 25% below that.
Lastly, here are the 10 stocks in the index trading at the largest discount to our fair value estimate as of this writing. Two of the names-- AmerisourceBergen ABC and Cardinal Health CAH--experienced moat downgrades to narrow from wide after the most recent reconstitution and will be removed from the index during the next reconstitution.
Disclosure: Morningstar, Inc. licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.