Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I am joined today by Matt Coffina. He's the editor of Morningstar StockInvestor newsletter. We're going to take a look at the Wide Moat Focus Index and some recent constituent changes.
Matt, thanks for joining me.
Matt Coffina: Thanks for having me, Jeremy.
Glaser: First, let's take a look at what the Wide Moat Focus Index is. Can you explain a little bit about the methodology that goes into creating it?
Coffina: So, this is an index that includes the 20 cheapest wide-moat stocks based on Morningstar's price/fair value ratio. So, basically, we look at the whole group of companies that have wide economic moats according to our analysts. There are about 175 companies like that with U.S. listings. Then, we sort them all by price/fair value ratio and just simply take the top 20 in terms of the ones that our analyst thinks are undervalued.
Glaser: How has this strategy performed over time, both over the long term and also more recently?
Coffina: Year to date, the strategy is just a little bit ahead of the S&P 500--maybe about 30 basis points. It's a similar story over the trailing five years now; it's only slightly ahead of the S&P 500. And I'd say that's really because it's been a difficult environment for a strategy like this with a very strong bull market. Going back five years, you're starting toward the financial crisis now--in which case, a lot of lower-quality, more cyclical, more heavily indebted kinds of companies really had a huge runup over the last five years. So, it's been a relatively difficult environment for this kind of strategy, and it has still kept up with the S&P 500 or slightly outperformed it. If you go back further before the financial crisis--to 7-, 8-, 10-year returns--then we're significantly ahead of the benchmark.
Glaser: This index is rebalanced every quarter. How many changes were there? Was it a particularly high turnover quarter?
Coffina: It was a high turnover quarter. So, we have nine additions to the index out of 20 total names this quarter. And this is one of the downsides to this strategy--it's a relatively high turnover strategy. Historically, we've averaged about 120% to 150% turnover per year, and that's largely because, again, it's just a strict quantitative cutoff. So, if a stock is trading at a price/fair value ratio of 0.90 this month, it made into the index; [but if its price/fair value ratio is] 0.91, it would not make it into the index. So, very small valuation differences can sometimes make the difference between whether a stock is included or not.
In our Tortoise and Hare strategies from the Morningstar StockInvestor newsletter, we have much lower turnover. That's one advantage of that kind of approach. But I do think we give up a little bit in terms of total returns by pursuing a lower-turnover strategy. So, we're not constantly rebalancing to Morningstar's best ideas of the moment. This also makes this strategy relatively well suited to an ETF structure, where you don't have to worry about the capital gains implications.
Glaser: So, what were the nine firms that were added this quarter?
Coffina: The new additions this quarter were Schlumberger (SLB), Lorillard (LO), National Oilwell Varco (NOV), Monsanto (MON), Exxon Mobil (XOM), Qualcomm (QCOM), General Electric (GE), Polaris (PII), and Expeditors International of Washington (EXPD).
Glaser: So, a reasonably diverse list. Do you see any common themes as to why these have become cheap enough to be added?
Coffina: There a few themes, I think. A couple of these companies are experiencing company-specific issues. For example, Lorillard is trying to be acquired by Reynolds American (RAI). We are relatively optimistic about that deal. We think it's going to go through. But right now, Lorillard's stock price is right about halfway between the acquisition value and what we think the company is worth on a standalone basis. So, it's really sort of a merger-arbitrage kind of situation.
Qualcomm--they've had some issues enforcing their intellectual property in China, and there are investor concerns about what that might mean for their licensing business. But we think that that will be resolved and that it won't be a material issue.
There are also a few energy names in that list: Schlumberger, National Oilwell Varco, and Exxon. The energy sector is probably one of the few that's out of favor at the moment. Oil prices have been weak. There are concerns about the global economic outlook, especially in developing countries. So, that's pressured the energy sector as a whole.
Glaser: How about Polaris? How did that end up in the index?
Coffina: That's the only name on this list that recently had a moat upgrade. So, we raised the economic moat rating to wide. And we think that Polaris has a wide moat based on its branding advantage. It has a very long history of leadership in the power-sports-equipment industry. They make things like snowmobiles or all-terrain vehicles, and so we think that branding advantage within that niche is similar to Harley-Davidson (HOG) in motorcycles, which gives this company very high returns on capital despite being what you would think is a relatively capital-intensive business.
Glaser: Finally, when you look at what the threshold is to actually enter into this index this quarter, what does that tell you about the broader market valuation?
Coffina: The cutoff this time around was 0.90. So, we continue to be in a relatively fully valued market--not a whole lot of opportunities, very few [5-star rated companies]. There is actually not a single wide-moat, 5-star [rated company] in our coverage universe right now. So, all it took was a 10% discount to fair value to make the index--which, again, I think is more a sign of the times than anything else. There just aren't that many opportunities to be found right now.
Glaser: Matt, I certainly appreciate your update on the index today.
Coffina: Thanks for having me.
Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.
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