Kings of the castles: why moat, price and process matter for stock selection

Can a monopoly be good for investors? Assuming the monopoly isn’t exploitative, companies with a commanding position in their respective industries that are not trading at too high a premium to the market are the ones to hold for the long-term, according to the author of this recent Wall Street Journal article, Playing Monopoly Pays Off for Investors.

Monopoly or not, the idea of investing in companies with defensible businesses or “moats” that protect them and investing in these companies at the right price is not a new concept. Long a basic tenet of successful investors like Warren Buffett, moat investing provides a simple guideline for how investors should approach their portfolios.

Easier said than done

The difficulty of abiding by this maxim, especially if you aren’t a securities analyst, is first identifying the moat stocks worthwhile of including in your portfolio, and secondly, regularly reevaluating whether those companies remain worthy of inclusion.

Successful companies earning excess profits are competitive targets for rivals, and technological innovation has the potential to disrupt the norms in any industry. More important, however, than a company’s competitive position is its valuation. As the author asserts, “overpaying for a stock is an even bigger threat to future returns than competition.” Do you have a process for assessing the proper valuation of a company in the context of its future prospects? Things change, and reassessments and reallocations may be necessary to keep a portfolio relevant.

Moat stocks: Process is a success factor

With over 100 analysts globally helping to identify dominant players in different industries, perhaps the most powerful attribute of Morningstar’s process is the price-to-fair value metric. This forward-looking assessment provides a view of the current valuation of a company in the context of its future prospects and helps increase the probability of finding mispriced stocks.

As an example of how this process can play out, consider Campbell Soup, General Mills, and Kraft Heinz, several of the companies mentioned in the article. These are food and drink companies that have had to fend off assaults on their moats by technological disruption in distribution and brand-building. Campbell Soup and General Mills are currently “wide moat” companies, according to Morningstar, meaning they expect the firms’ returns on invested capital to remain above its cost of capital over the next 20 years. However, according to Morningstar’s price-to-fair value metric, their stock prices had been overvalued since early 2016. Not until their price fell below fair value earlier this year did Morningstar select the stocks for inclusion in the Morningstar Wide Moat Focus Index^SM .

Companies may also have “narrow moats” meaning their competitive advantages could reasonably be expected to defend them for at least 10 years. Kraft Heinz sported a narrow moat until August 2018, and would not have been in the Wide Moat Focus Index to begin with. Now, lacking a meaningful edge from scale and no significant pricing power, it no longer has a moat. Things change.

Overall, the Morningstar process has historically demonstrated the ability to provide long-term excess returns. The Morningstar Wide Moat Focus Index, for instance, has outperformed the broad market by 3.65% annually through July 2018 since its inception in February 14, 2007. Over that time period, it has also outperformed the broad market 81% of the time over 3-year rolling periods and 94% of the time over 5-year rolling periods.¹

A moat for your castle

Today, there’s no shortage of strategies for equity investing to confuse even seasoned financial professionals, be they factors that distill stock selections into various definitions of quality, momentum, volatility, etc., or some gimmicky weighting scheme that rearranges exposures and potential returns. The idea of “buying good companies at a good price” is easy to understand in concept, and with funds following Morningstar’s moat index methodology, putting it into practice can be easier than managing it yourself.

VanEck offers an ETF based on the moat philosophy, the VanEck Vectors Morningstar Wide Moat ETF (MOAT).