Moat Index: All Eyes on Trade Negotiations

27 August 2019

July was a strong month for the Morningstar^®Wide Moat Focus Index^TM (“Moat Index”). It outperformed the S&P 500^®Index by over 1.5% (2.97% vs. 1.44%, respectively). The outperformance was driven in large part by its technology sector exposure, specifically semiconductor stocks, which have been heavily influenced by ongoing U.S.-China trade negotiations. Several health care stocks and consumer staples firms such as Kellogg (K) and The Hershey Co. (HSY) also boosted the Moat Index’s relative performance in July. Modest exposure to the energy and utilities sectors were the only detractors from Moat Index performance for the month.

Trade Tension Implications for Semiconductor Moat Stocks

There are three types of semiconductor-related firms in the Moat Index:

Chip equipment makers: Applied Materials (AMAT) and KLA Corp (KLAC)
Processor makers: Intel (INTC)
Analog and mixed signal products providers: Microchip Technology (MCHP)

Each of these firms were added to the Moat Index at various times beginning in December 2017, as Morningstar assessed them to be undervalued for slightly different reasons, according to Brian Colello, director of technology, media and telecom equity research at Morningstar. The onset of U.S.-China trade war headlines and certain company-specific factors led each of these companies’ stock prices to suffer in the fourth quarter of 2018, and trade tensions continued to weigh on these firms into the start of 2019.

Following a tough start to the year, these companies’ stock prices recovered into early May before falling again with the announcement of the second round of tariffs. A recovery was in the works through June and July on the assumption that a deal could be worked out, then fell sharply at the end of July and faced volatility in August based on headlines in the ongoing trade saga.

Chip equipment has started to see a recovery in demand since the start of the year, Colello notes, with most large-cap chip equipment names exceeding earnings expectations recently. The stocks subsequently recovered as well, pointing to a positive outlook for AMAT and KLAC.

INTC also exceeded Morningstar’s expectations on earnings when reporting second quarter results in late July. Though demand from PC makers wavered ahead of tariffs, average selling prices for chips were strong and the company is starting to recover from prior manufacturing mishaps.

MCHP added to the trend of earnings outperformance in early August after being one of the first to see a downturn in demand from China. MCHP sells to 120,000 customers and has broad, diversified exposure across end markets and geographies. However, the company indicated recently that they’ve seen the worst of the downturn, despite the current trade rhetoric between the U.S. and China being even worse than in months past. No one knows how (or if) a trade deal will be reached, so there is no way to predict a full recovery, but MCHP is seeing modestly higher orders than before and believe that chip inventory is about as low as it can go. This was one of the first green shoots Colello’s team heard from this sub-industry this earnings season.

Looking ahead, Colello notes that all eyes are on U.S.-China trade negotiations, for better or worse. He would expect additional weakness if a deal appears increasingly unlikely, but a snapback if we see improved negotiations that might lead to a rebound in demand.

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