Fair Value, Rinse, Repeat: A Key to Moat Investing

15 February 2019

For the Month Ending January 31, 2019

The Morningstar^® Wide Moat Focus Index^SM (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.

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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.

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Effective December 17, 2021 the Morningstar® Wide Moat Focus IndexTM has been replaced with the Morningstar® US Sustainability Moat Focus Index.
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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