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The Morningstar Wide Moat Focus Index (the “Moat Index” or “Index”) undergoes its systematic quarterly review on 18 June 2021 whereby it will reposition one of its two sub-portfolios to reflect 40 of the most attractively priced wide-moat companies according to Morningstar’s equity research team. I’ve written previously about the Index’s shift away from growth-oriented companies throughout 2020 to more of a value posturing. This, in part, led to the first calendar year of underperformance since 2015, relative to the S&P 500 Index.
However, the focus on valuations within the Index has since rewarded investors with outperformance of nearly 6% relative to the S&P 500 Index (18.42% vs. 12.62%, respectively) for the year through May.
As we approach the next quarterly review, let’s have a look at some of the leaders and laggards from the March 2021 Moat Index review. Each of the following companies were added to the sub-portfolio under review effective after the close of markets on 19 March 2021. Some have impressed, while others have yet to do so. All told, six of the nine additions to the Index are ahead of the S&P 500 Index from the day they were added through 9 June 2021.
Northrop Grumman Corp. (NOC)
Northrop Grumman was added to the Index’s sub-portfolio at a discount of approximately 7% to its fair value on 19 March 2021. The defense contractor had traded below its fair value consistently from October 2020 to that time. In fact, the company was also added to the Index’s other sub-portfolio at its December 2020 review at a slightly steeper discount to fair value. Northrop’s wide economic moat stems from intangible assets related to product complexity and long contract life spans paired with switching costs associated with the mission-criticality of product, extended product cycles, a lack of viable alternative products, and the substantial time investment required for switching. Northrop reported strong first quarter results in late April, driving its price higher to where it now trades at approximately 10% above fair value, according to Morningstar.
Alphabet Inc. (GOOGL)
Alphabet has found its way into the Moat Index several times before, though it hasn’t traded very far from fair value historically and has represented a far lower weighting in the Index than most other U.S. equity indexes and strategies. Most recently it was added to the Index in both December 2020 and March 2021, entering at 22% discount to Morningstar’s fair value at the latter review. Despite Alphabet’s strong run since March, the company remains attractively priced according to Morningstar, following an increase to its fair value estimate in April 2021 from $2,605 per share to $2,925 per share. Alphabet benefits from intangible assets and network effect. Morningstar believes its intangible assets are related to its overall technological expertise in search algorithms and machine learning as well as its access to and accumulation of data deemed valuable to advertisers. Add to that the obvious brand associated with “Googling” something. Alphabet’s network effect is created from its ability to collect data through an extensive network and, in turn, offer the best return on investment for advertisers, further building its network of advertising customers.
Tyler Technologies Inc. (TYL)
Tyler Technologies is a lesser known wide moat company that offers software solutions and services to municipalities. These solutions include enterprise resource planning and court management systems, among others. Morningstar believes Tyler earns its wide moat rating from high customer switching costs and, to a lesser extent, intangible assets. Because Tyler provides core systems that enable normal operation of government units and governmental contracts tend to be long-tail in nature, Morningstar believes Tyler’s customer retention will be extremely high moving forward. Morningstar also posits that Tyler benefits from building up a portfolio of software that would be difficult for a startup, or even an established software vendor without government expertise, to replicate. Tyler has been assigned a wide moat rating by Morningstar since early 2019 but was first added to the Moat Index in March 2021 when it first displayed valuations attractive enough for addition to the Index. Tyler completed the acquisition of NIS, a leading digital government solution and payments company in April 2020, and Morningstar has maintained its fair value of $475 and continue to see shares as undervalued as of this writing.
ServiceNow Inc. (NOW)
ServiceNow was a strong performer for the Moat Index at different times in the last few years and saw its exposure reduced and eventually removed in December 2020 as its shares traded at or above its Morningstar-assigned fair value. With shares falling along with many other software names in the early part of the year, ServiceNow found its way back into the Index in March 2021 at an 18% discount to Morningstar’s fair value estimate. ServiceNow is a software as a service company focused primarily on the IT function for enterprise customers. It has offerings for HR, customer service, and security operations as well. Like Tyler Technologies, Morningstar cites high customer switching costs as a source of ServiceNow’s wide moat. Though it was founded in 2004, it already controls approximately 40% of the IT service management market, according to Morningstar.
We’ll learn which companies make the cut on 18 June. More to follow.
VanEck Vectors Morningstar US Wide Moat UCITS 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.
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