(11/29/13) Wide Moats

Stocks with strong competitive advantages that protect their profitability from competition—a ‘moat’ if you will—tend to be resilient performers over the long-term, observes Mark Salzinger, editor of No-Load Fund Investor.

Morningstar has incorporated the ‘moat’ concept into its stock research, which Market Vectors has used, in turn, as the basis for its Market Vectors Wide Moat ETF (MOAT), which has generated strong performance.

The term moat—in reference to competitive advantage—is attributed to Warren Buffett, who used it to describe the characteristic leadership traits of companies in which he prefers to invest. Morningstar identifies five types of these sustainable competitive advantages:

1) Intangible assets (such as valuable brand names);

2) Switching costs (how disruptive or expensive it would be for a customer to switch to a competitor's product or service);

3) Network effect (which means that the more people who use a product, the more value it has, as in a financial exchange, or a social media site);

4) Cost advantage (which can favor companies that operate at the lowest costs or have operations that would be prohibitively expensive for a competitor to duplicate);

5) Efficient scale (meaning that there is sufficient capacity to meet demand, but not so much that companies have 'commoditized' themselves [e.g., PC manufacturers], thus allowing them to have limited control over pricing).

Companies that have the most favorable combination of competitive factors in their operations earn a wide moat rating from Morningstar.

MOAT's portfolio is equal-weighted, and any stock Morningstar analyst's cover is eligible. Of the more than 1,200 stocks that Morningstar covers, about 220 recently got a wide moat rating.

The portfolio is well-diversified by sector. Healthcare is the largest, with about 20%. Technology, financials, and industrials each account for about 15%, while utilities, energy, and consumer staples get about 10% apiece. Consumer discretionary stocks take up the remaining 5%.

Since its April 2012 inception, MOAT has gained 33.4%, versus 29.2% for the S&P 500 (SPX). Morningstar created and has tracked the index on which MOAT is based—the Morningstar Wide Moat Focus Index—since 2007.

Over the five years ended September 30, 2013, the Wide Moat Focus Index would have generated a 15.1% annualized return, versus 10.0% for the S&P 500.

Note for risk-averse investors: the index has also been considerably more volatile, with a standard deviation (a measure of the severity of price swings) over the five-year period that is more than 38% greater than that of the S&P 500.