MOAT Delivers Quality with a Forward-Looking Edge

29 June 2023

Read Time 6 MIN

Want quality exposure? Explore how the Morningstar Wide Moat Focus Index combines quality, valuations and a forward-looking perspective to historically outperform quality and factor indexes.

This year, investors have poured over $14B into U.S. equity ETFs that target exposure to the quality factor, according to Morningstar. Much of that investment coincided with the weeks following the failure of Silicon Valley Bank, but notable inflows continued in April and May. As uncertainty abounds, investors appear to be seeking well-positioned companies that can withstand market turmoil.

This is not that surprising. The S&P 500 Index is notably difficult for U.S. large-cap active managers to outperform in both strong and weak markets. Therefore, logically, investors may look to index-based strategies targeting specific factors that may provide a desired return profile in the current environment. A similar thought process led low volatility strategies to become very popular in the years following the 2008 Global Financial Crisis, and more recently drew investors to value-oriented strategies as those companies finally proved attractive relative to growth companies for the first time in many years.

But are investors getting what they want from quality equity ETFs? More to the point, what is it that investors are actually looking for from these strategies?

What Is Quality?

Measuring the quality of a company from an equity investor perspective can be nuanced. Most academics and practitioners agree that quality is the least agreed-upon factor. Generally, however, several characteristics are commonly associated with quality:

  1. High and/or Stable Profitability: Profitable companies are typically considered to have well-run business models and control of their costs. Common measures of profitability are return on equity, cash flow returns on investment or free cash flow yield.
  2. Profitability Growth: Better yet, companies that are increasing their profitability can signal improving demand, economies of scale or lack of suitable competition. Earnings per share growth is often the go-to metric for measuring profit growth.
  3. Low Leverage: Companies with lower debt burdens may correlate with stronger balance sheets and lower macroeconomic risks. Debt to capital is a common measure of leverage.

What Is a Quality Outcome?

From an outcome perspective, these quality characteristics would be expected to facilitate upside participation when markets are appreciating, as well as to help mitigate losses when markets enter a rough patch. That hasn’t always been the case, as seen in recent periods of market turmoil. In 2022, when many investors were seeking quality company exposure, many were left with more downside and lower overall returns. Similarly, in late 2018 as geopolitical turmoil pushed markets negative, so-called quality companies underperformed.

Quality Downside Risk Mitigation Notably Lacking
  2022 2018
  Total Return Max Drawdown Total Return Max Drawdown
MSCI USA Sector Neutral Quality Index -20.28% -27.78% -5.64% -20.51%
S&P 500 Index -18.11% -24.49% -4.38% -19.36%
Difference -2.17% -3.29% -1.25% -1.14%

Source: Morningstar. Max drawdown represents the largest decline within the stated time period. Past performance is no guarantee of future results.

Similarly, quality stocks have been inconsistent in rising markets. Their strong financial health and profitability profile hasn’t always benefited investors relative to the S&P 500 Index. The MSCI USA Sector Neutral Quality Index has an upside capture ratio of less than 100, indicating that it participated less in periods when S&P 500 returns were positive.

This means that many investors seeking quality companies via factor indexes may not experience the protection they desire and also may potentially miss out on market recoveries. Factor investing can be a powerful tool, but it is constructed through a backward-looking lens and factors can be extremely difficult to time.

Forward Looking Approach to Quality Investing

I would argue Morningstar’s moat investing philosophy represents a more practical approach to identifying high quality companies. Their economic moat framework considers quantitative inputs—such as returns on invested capital and costs of capital—to determine the staying power of a company’s competitive advantages, but it also relies heavily on forward-looking qualitative assessments by analysts. Morningstar’s equity research team can reflect, in real time, their view on which companies possess the most sustainable advantage—those with true staying power. Their moat framework looks out decades into the future to make that determination. Conversely, factor-based strategies will use historical inputs from a company’s balance sheet and income statement to assemble a portfolio. Morningstar has created the Morningstar Wide Moat Focus Index to capture those companies that are high quality today and expected to remain high quality many years into the future.

Equally important to the Morningstar Wide Moat Focus Index’s success is getting valuations right. Remember, factors are very difficult to time. A single factor ETF may perform very well in certain environments, but not others. The same can be said about wide moat companies. The Morningstar Wide Moat Focus Index uses Morningstar’s forward-looking valuation process to determine what moat-rated companies to own each quarter. The Index selects the most attractively priced relative to Morningstar analysts’ fair value estimate for the company. This focus on paying a fair price for exposure to high quality companies has allowed the Index to provide risk mitigation in difficult markets and exploit mispricing in order to participate in the upside.

Moat Investing: Quality Outcomes in Drawdowns and Recoveries

Moat Investing: Quality Outcomes in Drawdowns and Recoveries

Source: Morningstar. Max drawdown represents the largest decline within the stated time period. Past performance is no guarantee of future results.

Looking at more than 15 years of data, the Morningstar Wide Moat Focus Index has offered the long-term high-quality outcomes expected by investors seeking out financially strong businesses. Its use of valuations to select among high quality companies with moats has resulted in impressive risk-adjusted returns, while offering both higher participation on the upside and buffering on the downside.

High-Quality Risk/Reward Profile (4/2007 – 3/31/2023)
  Return Standard Deviation Sharpe Ratio Sortino Ratio Up Capture Down Capture
Morningstar Wide Moat Focus Index 12.59 18.77 0.68 1.16 109.29 85.70
MSCI USA Sector Neutral Quality Index 9.83 16.55 0.60 0.93 98.73 91.03
S&P 500 Index 9.04 17.27 0.54 0.81 100.00 100.00

Source: Morningstar. Data calculated with quarterly returns. Past performance is no guarantee of future results.

Morningstar’s Moat Investing Outperforms Factors

Quality is certainly not the only single factor investment strategy out there. Many others have been identified in an academic setting and further developed into commercial applications by way of indexing. Again, timing these factors is very difficult. Morningstar’s systematic process of identifying high quality companies at attractive prices has allowed it to outperform the major style factors over many time periods, short-term and long.

Moat Investing Outpaces Factors Over Many Time Periods

Moat Investing Outpaces Factors Over Many Time Periods

Source: Morningstar. Data as of 6/20/2023. Minimum Volatility represents the MSCI USA Minimum Volatility Index; Momentum represents the MSCI USA Momentum SR Variant Index; Quality represents the MSCI USA Sector Neutral Quality Index; Size represents the MSCI USA Low Size Index; Value represents the MSCI USA Enhanced Value Index. Past performance is no guarantee of future results.

Moat Investing: A Better Approach to Quality

The turbulence of the last year has led to a discernible emphasis on quality as a beacon in uncertain markets. The effectiveness of these strategies, however, is up for debate. While traditional quality factor strategies offer some allure, they have often underperformed in the face of market stress and recovery due to their retrospective nature.

A potentially more viable alternative is Morningstar’s moat investing philosophy which, by incorporating both quantitative and qualitative forward-looking evaluations, redefines the approach to quality investing. The Morningstar Wide Moat Focus Index stands out in this realm, delivering impressive risk-adjusted returns by centering on attractively priced, high-quality companies.

Source for all data unless otherwise noted: Morningstar.

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