Just like a moat surrounds and protects a castle, so does an economic “moat” surround and protect a firm.
According to Morningstar, “only companies with an economic moat — a structural competitive advantage that allows a firm to earn above-average returns on capital over a long period of time — are able to hold competitors at bay.”
An economic moat provides a margin of safety because if a firm can fall back on a structural competitive advantage, it’s more likely to recover from temporary troubles.
Brandon Rakszawski, product manager with Market Vectors ETFs, and Morningstar’s Michael Hodel held a conference call last week to discuss recent wide moat trends and the results of the Morningstar Wide Moat Focus Index quarterly review.
“Market Vectors Morningstar Wide Moat ETF was listed for trading in April 2012. Over the past two and a half years the ETF and its index’s underlying methodology has gained a great deal of acceptance,” said Rakszawski during the conference call, adding that the fund has attracted more than $250 million in net new flows year-to-date.
He said the fund’s assets under management stood at $850 million at the end of September.
Market Vectors Morningstar Wide Moat ETF’s underlying index, the Morningstar Wide Moat Focus Index, consists of the 20 securities in the Morningstar US Market Index with the most attractive prices (or highest ratios of fair value to their stock price as determined by Morningstar) and a sustainable competitive advantage (or wide moat).
Morningstar gives a narrow or wide moat rating to a firm if it has the prospect of earning above average returns on capital, some competitive edge that prevents these returns from quickly deteriorating and a competitive advantage inherent to its business.
And, of course, the wider the moat, the more sustainable the competitive advantage. Currently about 10% of the broad equity world analyzed by Morningstar receives a wide moat categorization.
Every quarter, the index reevaluates the moat ratings and valuations, and adds and removes companies accordingly. At the end of this past quarter, nine companies – Franklin Resources Inc., Blackrock Inc., Berkshire Hathaway Inc., MasterCard, Eaton Vance Corp., Bank Of New York Mellon Corp., Amgen Inc., Coca-Cola Co. and Costco Wholesale Corp. – were removed from the index, to which Rakszawski said “you’ll see a theme of financial doubt.”
“All nine of these companies were removed because their price to fair value was no longer one of the 20 cheapest at that quarterly rebalance determination date,” Rakszawski said.
Taking their place were nine predominately energy companies – Schlumberger NV, Lorillard Inc., National Oilwell Varco Inc., Monsanto Co., Exxon Mobil Corp., Qualcomm Inc., General Electric Co., Polaris Industries Inc. and Expeditors International of Washington Inc.
Hodel, who is an analyst on Morningstar’s equity and credit research team, talked about the success of the energy sector.
“Oil services has been a very stong sector for us with Schlumberger and National Oilwell performing particularly well,” he said. “Exelon, while it was a detractor in the last quarter, over the balance of 2014 has actually performed very well for us.”
Hodel also expanded on what makes companies like Schlumberger part of the Wide Moat Focus Index.
“Schlumberger continues to remain at the forefront of the oil field services industry, and the firm possesses one of the widest moats in the business,” Hodel said. “Our moat rating on that firm is really based on the breadth of the products and services the firm offers to its customers … in addition, the firm has one of the largest research and development efforts in the industry which continues to develop new intellectual property and new processes and new technology for the firm to offer to its customers.”
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