Moat Investing: Don’t Ignore Valuations

The September Effect, referring to the historically weak stock market returns observed during the month, once again proved statistically significant. Negative sentiment and volatility plagued the U.S. equity markets this September, leading to sizeable declines in the U.S. equity market and fresh lows for the S&P 500^®Index.

The Morningstar^® Wide Moat Focus Index^SM (the “Moat Index” or “Index”) was not immune to the turbulence this month and mainly performed in line with the S&P 500 Index (-9.90% vs. -9.16%, respectively). However, year–to–date the Moat Index maintains its outperformance (-20.82% vs. -23.87%, respectively) as of September 30, 2022.

Valuations: An Important Consideration

During volatile periods in the market, oftentimes, investors will look to seek shelter in companies that exhibit a quality factor tilt with the expectation that they will prove more resilient. Screening for quality companies, or the frequently equated wide moat companies, is undoubtedly an important consideration; however, it should not be the only one.

The quality factor, represented by the Russell 1000 Quality Factor Index, has actually underperformed the S&P 500 Index this year by roughly 200 basis points as of September. The story is similar when looking at an index of just wide moat companies with no consideration for valuations. While the expectation is that these quality companies will outperform in the long–run, if history repeats, recent underperformance highlights the importance of looking at more than just quality.

Surprisingly, U.S. companies that Morningstar analysts deem “moatless” (i.e., lacking a competitive advantage or possessing a fleeting advantage) have actually outperformed their wide moat peers through the first nine months of 2022.

Source: Morningstar.

Layering a valuation–based selection screen on top of the universe of wide moat companies is how the Moat Index sets itself apart in various market environments. According to Morningstar, the performance of the Moat Index, which targets the wide moat stocks trading at the greatest discounts to fair value, helps illustrate this. The Moat index has outperformed various proxies for quality by 500 basis points or more so far this year.

Key Takeaways from the Moat Index’s Q3 Review

The Moat Index underwent its regularly scheduled quarterly review on September 16, 2022. Below are a few key takeaways from the review.

Index Valuation Remains Near Five–Year Lows

As of September 30, 2022, the reconstituted Moat Index exhibited a weighted average Price/Fair Value ratio (“P/FV”) of 0.66, signaling a roughly 34% discount to Morningstar’s assessment of fair value. This is in contrast to the S&P 500 Index, which featured a weighted average P/FV ratio of 0.85 for the same date. For context, the Morningstar Wide Moat Index’s five–year average P/FV was 0.87, and S&P 500 Index’s was 1.03, and they dropped as low as 0.62 and 0.77 over the last five years, respectively, in March 2020.

Style Exposure and Sector Shifts

Similar to both the March and June reviews, the Index’s growth style exposure again saw an increase representing valuation opportunities among wide moat growth stocks following the volatility of the past several months. The increase in growth exposure was largely at the expense of value, which declined for the third time this year. Style exposure in the Moat Index is now the closest to the S&P 500 Index’s in quite some time.

Source: Morningstar. As of 9/16/2022.

From a sector perspective, following the removal of several consumer staples names (Kellogg, Philip Morris, and Campbell Soup Co), the sector is now the largest underweight relative to the S&P 500. The greatest overweight remains the industrials sector. Technology stocks continue to represent an increasingly large portion of the Moat Index and are now nearly 5% overweight the S&P 500 Index; 4 of the 10 additions at this quarterly reconstitution were tech stocks.

Moat Downgrade Removes Intel

Changes to a company’s moat rating are not a common event. The competitive advantages required to obtain a wide moat rating within Morningstar’s framework are difficult to obtain and durable in nature. However, despite being generally sticky, moat ratings can and do change on occasion.

This quarter’s reconstitution of the Moat Index saw the moat downgrade and thus the removal of Intel. Intel’s downgrade is the first to impact the Index since December 2021, when Cerner was last removed following its downgrade. Morningstar's reasoning for Intel’s downgrade is noted below.

Morningstar Commentary – July 29, 2022:

“We are lowering our moat rating for Intel to narrow from wide, as we are no longer certain that the firm can generate excess returns on capital over the next few years. We still believe Intel possesses cost advantages realized in the design and manufacturing of its cutting–edge microprocessors and intangible assets related to its x86 instruction set architecture license and chip design expertise. However, we believe Intel's cost advantage has eroded, as it faced significant product delays associated with its various 10–nanometer process technologies. Intel's x86 rival, AMD, and its foundry partner, Taiwan Semiconductor Manufacturing, or TSMC, have combined to leapfrog Intel in cutting–edge processors. In turn, in recent years, Intel has lost market share, conceded on pricing, and faced a sharp decline in gross margins and returns on invested capital. We believe that it is more likely than not that Intel can close the gap with TSMC/AMD and generate excess returns on capital over the next decade, but this is no longer a certainty, and we concede that Intel's manufacturing inferiority to TSMC/AMD will persist for the next year or two and perhaps longer.”

VanEck Morningstar Wide ETF (MOAT) seeks to replicate as closely as possible, before fees and expenses the price and yield performance of the Morningstar Wide Moat Focus Index.