Moat Investing Rises Above Magnificent Seven Dominance

Once again, September lived up to its historical standing as the worst month of the year for markets, with U.S. equities seeing one of their biggest monthly pullbacks of 2023. Investors faced a long list of worries during the month, including a more hawkish than expected tone from Federal Reserve Chair Jerome Powell, soaring oil prices, narrow equity market leadership of mega-cap tech, and the United Auto Workers union strike. Then on the final trading day of the month, concerns about a government shutdown weighed on the market even further.

The Morningstar Wide Moat Focus Index (the “Moat Index”) was not resistant to market troubles, finishing down 5.44% in September, while the S&P 500 Index declined 4.77%. However, year-to-date the Moat Index continues to lead the S&P 500 by over 400 basis points. Smaller-cap companies also saw a modest decline during the month, yet the Morningstar US Small-Mid Cap Moat Focus Index (the “SMID Moat Index”) weathered the storm better than both the small- and mid-cap broad benchmark indexes.

Moat Indexes Maintain YTD Lead

Source: Morningstar. As of 9/30/2023. Past performance is no guarantee of future results. Index performance is not representative of fund performance. It is not possible to invest directly in an index. Fund performance current to the most recent month end is available by visiting vaneck.com or by calling 800.826.2333.

The Growing Magnificent Seven Concentration Problem

The expanding dominance of the "Magnificent Seven" mega-cap technology stocks has raised eyebrows in financial circles, leading to growing concerns about concentration risk in the U.S. equity market. These behemoths, which include Apple, Amazon, Microsoft, Google, Nvidia, Tesla, and Meta have seen their market values soar, making them pivotal players in the stock market's performance. Today, the Magnificent Seven make up over 25% of the S&P 500 Index and have contributed more than 70% of the index’s YTD returns¹.

While their spectacular rise underscores the transformative power and profitability of technology in today's digital age, it also poses a potential risk. If any of these companies were to falter, the ripple effect on the broader market could be significant. Diversification is a cornerstone of risk management in investing, and the increasing reliance on a handful of stocks for market returns challenges this foundational principle.

The equal-weighted Moat and SMID Moat strategies offers investors a potential solution to this growing concentration risk. By allocating equal importance to each stock, these approaches inherently reduce the influence of mega-cap tech giants, promoting diversification and potentially offering a buffer against the volatility of a few dominant players. And investors shouldn’t take this to mean reduced return potential either, as the Moat Index has actually outperformed the S&P 500 so far this year—despite its structural underweight to the Magnificent Seven.

September Index Reconstitution

Both the Moat and SMID Moat Indexes underwent quarterly reviews on September 15, 2023. Each quarter they systematically target the most attractively priced U.S. moat companies within their respective universes. Below are a few takeaways from the September reviews and how the indexes are positioned heading into the remainder of the year. Full results of the most recent quarterly reviews are available here: Moat Index and SMID Moat Index.

Moat Index Highlights

Growth Exodus Led by Technology

The Moat Index saw its technology exposure increase to the largest overweight in quite some time at the end of 2022, following the drastic declines in valuations for the sector that year. Now, with the incredible rally that many of these companies experienced in the first half of the year, their valuations have become less attractive. During the September review, the Moat Index continued its shift away from growth stocks, which began in June 2023, to more of a blend/value posture.

The technology sector saw the largest reduction in exposure, signaling growth as an overvalued segment of the U.S. market. Tech stocks are now the largest underweight in the Moat Index, about 12% relative to the S&P 500 Index. This technology sector void was filled by companies from more value-oriented sectors such as industrials (Honeywell, RTX Corp.), financials (Charles Schwab, MarketAxess) and consumer staples (Estee Lauder, Campbell Soup).

Source: Morningstar. As of 9/15/2023.Not intended as a recommendation to buy or sell any securities mentioned herein. Index performance is not representative of fund performance. It is not possible to invest directly in an index.

Moat Index’s Magnificent Seven Exposure

The market has taken a liking to the new moniker representing the seven companies driving the vast majority of U.S. market returns: Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla. Amid stretched valuations this quarter, the Moat Index removed Meta Platforms leaving only Alphabet, Amazon, and Microsoft in the Moat Index at around a 5% weighting. Meanwhile, the Magnificent Seven have more than 25% exposure in the S&P 500 Index.

Valuations Remain Attractive

The weighted average price-to-fair value of the Moat Index fell from 0.81 to 0.77 following the September review, signaling a 23% discount to Morningstar’s fair value estimate. This is in contrast to the S&P 500 Index, which featured a weighted average price-to-fair value ratio of 0.96 as of the same date.

SMID Moat Index Highlights

Technology Companies Lead in Removals

This quarterly review the SMID Moat Index saw the removal of a number of technology companies. In all, seven technology names were removed, including Crane NXT, Blackbaud, Guidewire Software, Monolithic Power Systems, Verisign, and WorkDay. Nearly all of these removals were due to the Index’s valuation screen. However, Morningstar still sees some opportunity within the technology sector, as there were also a few new tech names added this quarter as well. These companies include the global IT services provider Cognizant Tech Solutions and Tyler Technologies, which provides a full suite of software solutions and services that address the needs of cities, schools, courts and other local government entities.

Value Exposure Decreased in Favor of Growth

Despite the SMID Moat Index’s removal of several technology companies, the style exposure within the Index still shifted slightly toward growth this quarter. The shift came primarily at the cost of value, which saw a reduction in exposure this quarter. This is in contrast to the larger-cap Moat Index, which saw the reserve shift in these exposures. Total growth exposure for the SMID Moat Index now stands at about 26%, but remains a minor underweight of about 3% relative to the broad SMID-cap universe.

Source: Morningstar. As of 9/15/2023. Not intended as a recommendation to buy or sell any securities mentioned herein. Broad SMID Index refers to the Morningstar US Small-Mid Cap Index, is a broad-based index intended to track the overall performance of U.S. small- and mid-cap companies according to Morningstar. Index performance is not representative of fund performance. It is not possible to invest directly in an index.

Consumer Discretionary and Health Care Additions

Companies belonging to the consumer discretionary and health care sectors were notable additions this quarter with 12 names between the two sectors added to the Index. DoorDash, Harley-Davidson and Wynn Resorts were among the consumer discretionary additions, while health care saw names added like Veeva Systems, DaVita, and Agilent Technologies. Both sectors are overweights in the SMID Moat Index relative to the broad SMID-cap universe.

SMID Moat Valuations Remain Attractive

The weighted average price-to-fair value of the SMID Moat Index fell from 0.77 to 0.75 following the September review, signaling a 25% discount to Morningstar’s fair value estimate. This is in contrast to the broad based Morningstar US Small-Mid Cap Index, which featured a weighted average price-to-fair value ratio of 0.96 as of the same date.

Accessing Moat Stocks

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.

^* ”Magnificent Seven” refers to the group of seven mega-cap tech stocks in the S&P 500 that consists of Alphabet, Amazon, Apple, Meta, Microsoft, NVIDIA and Tesla.

¹ Source: Morningstar Direct. As of 9/30/2023.