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Moat investing: why this is a smart approach

Moat investing: why this is a smart approach

Demand for passively driven investment vehicles that do not simply base portfolio allocation on market capitalisation alone is rapidly increasing.

Consequently, Smart Beta products have in recent years garnered popularity from investors looking to achieve superior returns.

Investors’ qualms with more traditional funds which simply track an index, is that those which only take into account market capitalisation risk delivering lower returns by being overweight in overvalued, or expensive stocks and underweight in cheaper stocks.

Investors are increasingly seeking funds which consider other characteristics besides size. Smart Beta index funds are based on specially weighted indices, which are compiled from, for example, dividend-strong equities, and by this approach seek an outperformance against the wider market. 

However, whilst smart beta products and factor investing strategies have performed well, they have not always delivered consistent returns. Smart Beta products generally only use one alternative indicator in the allocation process, such as value or growth.

Investors should not be blind to other alternative ‘smart’ products which not only seek to maximise returns but also use a systematic, multilevel and repeatable methodology to identify stocks which possess multiple characteristics and which therefore should enable outperformance on a relatively long-term basis.

Such products are more about ‘smart investing’ than Smart Beta. 

Morningstar has pioneered research into this area with its MOAT index. Moat Investing is based on a longstanding concept of Economic Moats, originally coined by Warren Buffett, which rates companies according to their projected future ability to earn above average returns on capital and retain sustainable competitive advantages in their sector.

Morningstar analyzes a broad stock universe to identify those companies which meet the criteria.

The five sources of structural competitive advantage are:

  • Intangible assets.
  • Cost advantages.
  • Switching costs.
  • Network effects.
  • Efficient scale.

It then awards a rating of none, narrow or wide moat to a company based on the duration of excess returns. 

Morningstar’s research analyses companies with even greater granularity. The Morningstar Wide Moat Focus Index, for example, focuses specifically on US equities with a wide moat and includes a broad range of around 40 US stocks.

Any stock in the Morningstar Wide MOAT Focus Index has been included as it is deemed to have long-term competitive advantages that simultaneously are favorably valued.

But in order to be included, only companies with Moats which are exceptionally sustainable, for example if a stock’s competitive advantage is expected to last for at least 20 additional years. 

However, being a US-based company with long-term competitive advantages alone is not enough for a stock to win inclusion in the Wide Moat Focus Index.

To be able to differentiate itself from the other US stocks in the MOAT universe, the stock of the company must also demonstrate a favorable valuation relative to Morningstar’s assessment of its intrinsic value.

The analysts at Morningstar estimate the long-term intrinsic value of a stock using a proprietary method, the so-called fair value estimate. 

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