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We reveal a way to tap into Morningstar’s moat ratings system
Thursday 25 Apr 2019 Author: Daniel Coatsworth

Are you looking for undervalued and high quality companies that have the right characteristics to potentially fend off even the fiercest of rivals for at least 20 years?

If so, analysis from financial services firm Morningstar may be able to point you in the right direction.

Morningstar uses five sources of long term competitive advantage which, where present, may indicate a company has something called an ‘economic moat’. This term focuses on a company’s ability to maintain competitive advantages over rivals to protect market share.

The five sources are:

Intangible assets. These are brands, patents or valuable licences that explicitly keep competitors at bay.
Cost advantage. A firm that can provide goods or services at lower cost than its peer group has an advantage because it can undercut rivals on price. The firm may also wish to sell products and services at the same price but get a bigger profit margin than competitors.
Switching costs. It may not sound customer-friendly, but Morningstar says there is a competitive advantage in charging chunky exit fees to leave a company’s service. It stops customers leaving, unless they are offered a large improvement in either price or performance with a third party.
Network effect. Strong companies can get even stronger when more people use their product or service.
Efficient scale. This is when a market of limited size is effectively served by one or just a few companies. It’s not worth another party entering the market, because their participation would result in insufficient returns for all players.

UK STOCKS WITH WIDE MOATS

Morningstar has three categories for economic moats: no moat, narrow moat and wide moat. A narrow moat rating is given when it finds at least one source of competitive advantage and that economic profits are expected to be positive for at least 10 years.

A company is deemed to have a wide moat if Morningstar thinks economic profits will endure for at least 20 years.

Nine stocks in the FTSE 100 qualify for Morningstar’s wide moat category. These are AstraZeneca (AZN), British American Tobacco (BATS), Diageo (DGE), Experian (EXPN), GlaxoSmithKline (GSK), Imperial Brands (IMB), London Stock Exchange (LSE), Reckitt Benckiser (RB.and Unilever (ULVR).

If you invested in these companies over the last 10 years, you would have enjoyed an average total return of 298% versus 166% from the FTSE 100.

London Stock Exchange delivered the biggest total return over the last 10 years at 726% followed by Experian with a 440% total return.

Pharmaceutical colossus GlaxoSmithKline was the weakest performer in the group on a total returns basis, but still generated 123% over 10 years – not as good as the FTSE 100 but still respectable.

ADDING VALUATION METRICS TO THE EQUATION

The aforementioned selection process from Morningstar doesn’t take valuation into account so you would need to do further research looking at metrics such as price-to-earnings and price-to-book.

However, there is another way to use the moat approach which automatically takes into account valuation. Morningstar has created the Wide Moat Focus Index which contains the most undervalued companies – trading at the lowest current market price-to-fair value ratios – which qualify for its wide moat status.

None of the aforementioned nine London-listed companies feature in the index; instead, it is populated by US-listed stocks such as retailer Amazon, financial services group Charles Schwab and fast food giant McDonald’s. You can see the full list here.

UK investors can track the performance of the Wide Moat Focus Index via London-listed exchange--traded fund VanEck Vectors Morningstar US Wide Moat UCITS ETF (MOAT).

It has delivered 16.47% annualised trailing returns over the past three years versus 14.09% from the Russell 1000 total return benchmark index.

As of the end of March, the index – and therefore the ETF – has the largest weighting to the healthcare, technology and financial services sectors. The portfolio trades on an average of 14.77 times prospective earnings.

DOES THE MOAT SYSTEM PREDICT STOCK RETURNS?

In the 2014 book Why Moats Matter, Morningstar’s head of quantitative research Warren Miller said research had shown that wide moat stocks ‘exhibit less downside risk and less upside potential’.

In times of market fear or distress, wide moat stocks outperform no moat stocks, but then underperform when risk aversion subsides, according to Miller.

‘The evidence isn’t quite strong enough to claim that all wide moat stocks generate excess risk-adjusted returns, but we do find that undervalued wide moat stocks have done so,’ he added.

‘We think it’s safe to say that the moat rating is a valuable risk-management and security-selection tool, especially when used in conjunction with valuation-based metrics.’

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