Fair Value, Rinse, Repeat: A Key to Moat Investing
Brandon Rakszawski, Senior ETF Product Manager
February 12, 2019
For the Month Ending January 31, 2019
The Morningstar® Wide Moat Focus IndexSM (MWMFTR, or "U.S. Moat Index") started the year strong, posting a return of 9.45% in January, which represents a notable outperformance of the broad markets as represented by the S&P 500 Index (8.01%) and Morningstar US Large Cap Index (7.59%).
Target Attractive Valuations and Repeat
A key to the U.S. Moat Index’s success is getting valuations right. Morningstar’s equity research team adopts a forward-looking approach that includes forecasting a company’s future free cash flows to determine its current fair value estimate. The index’s methodology is designed to allocate to moat companies that appear most attractively priced at each quarterly index review. The assumption is that the market will realize the intrinsic value of these companies and bring their market price more in line with Morningstar’s view of fair value.
Several companies in the index proved that assumption correct in January. Facebook (FB) was added to the index in September and December of 2018. The stock began to appear attractively priced after a July sell-off that was triggered by earnings estimate revisions and ongoing privacy concerns with the social network. By the end of January, FB was the top contributor to the U.S. Moat Index’s performance for the month, after beating fourth-quarter consensus estimates.
Facebook: 1 Year Price and Fair Value as of 1/31/2019
Source: Morningstar. Past performance is no guarantee of future results. For illustrative purposes only. Not a recommendation to buy or sell any security. Visit vaneck.com to view daily ETF and index holdings.
Compass Minerals (CMP) was also among January’s top performers following a difficult fourth quarter. Morningstar analysts have lowered its fair value estimate for CMP several times over the past three years but recently held steady at $81 per share. CMP finished the month trading around $52 per share, representing significant upside potential according to Morningstar’s valuation research.
Only five of the U.S. Moat Index’s 49 constituents posted negative returns for the month. The top detractors from performance were two healthcare companies: Medtronic PLC (MDT) and Bristol-Myers Squibb Company (BMY). BMY sold off at the beginning of January after announcing the acquisition of Celgene. It recovered slowly throughout the month and finished January with a roughly 4% loss in share price. Morningstar analysts believe the acquisition creates value and expands BMY’s pipeline.
Moat Index’s Stock Selection Battles Back
The U.S. Moat Index’s outperformance of the Morningstar US Large Cap Index in 2018 (-0.74% vs. -3.44%, respectively) was driven exclusively by beneficial sector over- and underweights (i.e., allocation effect1). In fact, stock selection (i.e., selection effect2) was detrimental to relative returns in 2018.
January saw a complete reversal of this. The outperformance posted by the U.S. Moat Index was driven by strong stock selection which is more in line with the index’s historical driver of outperformance.
1Allocation effect is the portion of portfolio excess return attributed to taking different group bets from the benchmark. (If either the portfolio or the benchmark has no position in a given group, allocation effect is the lone effect.) A group’s allocation effect equals the weight of the portfolio’s group minus the weight of the benchmark’s group times the total return of the benchmark group minus the total return of the benchmark in aggregate.
2Selection effect is the portion of portfolio excess return attributable to choosing different securities within groups from the benchmark. A group’s selection effect equals the weight of the benchmark’s group multiplied by the total return of the portfolio’s group minus the total return of the benchmark’s group.
The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. Certain statements contained herein may constitute projections, forecasts and other forward looking statements, which do not reflect actual results, are valid as of the date of this communication and subject to change without notice. Information provided by third party sources are believed to be reliable and have not been independently verified for accuracy or completeness and cannot be guaranteed. The information herein represents the opinion of the author(s), but not necessarily those of VanEck.
This commentary is not intended as a recommendation to buy or to sell any of the sectors or securities mentioned herein. Holdings will vary for the MOAT ETF and its corresponding Index. For a complete list of holdings in the ETF, please click here https://www.vaneck.com/etf/equity/moat/holdings/.
An investor cannot invest directly in an index. Returns reflect past performance and do not guarantee future results. Results reflect the reinvestment of dividends and capital gains, if any. Certain indices may take into account withholding taxes. Index returns do not represent Fund returns. The Index does not charge management fees or brokerage expenses, nor does the Index lend securities, and no revenues from securities lending were added to the performance shown.
Fair value estimate: the Morningstar analyst's estimate of what a stock is worth.
Price/Fair Value: ratio of a stock's trading price to its fair value estimate.
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The Morningstar Wide Moat Focus Index consists of U.S. companies identified as having sustainable, competitive advantages and whose stocks are attractively priced, according to Morningstar.
S&P 500® Index: consists of 500 widely held common stocks covering the leading industries of the U.S. economy.
Morningstar® US Large Cap IndexSM tracks the performance of U.S. large-cap stocks that represent the largest 70 percent capitalization of the investable universe.
Effective June 20, 2016, Morningstar implemented several changes to the Morningstar Wide Moat Focus Index construction rules. Among other changes, the index increased its constituent count from 20 stocks to at least 40 stocks and modified its rebalance and reconstitution methodology. These changes may result in more diversified exposure, lower turnover, and longer holding periods for index constituents than under the rules in effect prior to this date.
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