ZBH - MOAT: Fortify Your Portfolio With Quality Companies

2023-06-14 02:38:07 ET

Summary

• The VanEck Morningstar Wide Moat ETF offers investors exposure to high quality businesses with sustainable competitive advantages and a track record of success.
• MOAT has outperformed the S&P 500 on a total return basis since its inception in 2012.
• The fund and its underlying holdings are well-positioned to thrive during various stages of the businesses cycle and economic environments.

The best companies are those that can generate consistent revenue and profit growth over the long run. These companies accomplish that feat by structuring their businesses to protect them from competitors while allowing the company to extract higher revenue and profit than would be otherwise possible. While most companies strive for those outcomes, few can achieve them, and even fewer are able to sustain them.

The strategy managed by the VanEck Morningstar Wide Moat ETF ( MOAT ) is based on screening for companies that have achieved those outcomes and are expected to continue doing so. The management of the fund is rules-based and holds positions in companies that possess at least one of five competitive advantages capable of creating a moat. Those five sources are: High switching costs, possession of unique, valuable, and/or legally protected intangible assets, network effect benefits, production cost advantages, and operating at an efficient scale for its market.

Combined, these characteristics protect companies’ ability to grow revenue while maintaining robust margins and sometimes even discouraging new entrants into the market. This is a powerful combination and one that can serve companies and their investors well over the long run.

The strategy has been effective in achieving its objectives, selecting stocks that have performed well relative to the broader market. The fund has outperformed the S&P 500 on a total return basis since its inception in 2012, as well as over most shorter trailing periods.

Portfolio Management Methodology

As this is a rules-based strategy, it is important to understand the methodology used to manage the fund. The fund seeks to track the Morningstar Wide Moat Focus Index . The purpose of the index is to provide exposure to companies benefiting from a wide economic moat that can be purchased at attractive valuations.

To track the index, the fund is reconstituted on a regular schedule. The portfolio is divided into two “sub-portfolios”, each with 40 stocks. One sub-portfolio rebalances, or reconstitutes, in December and June. The second one is reconstituted in March and September. To determine what stocks are removed or added to the index, the strength of the moat of each company and current valuation are evaluated, as are any other material factors. Moats are rated based on how wide or narrow they might be in terms of providing each company with a competitive advantage and for how long. Narrow moats may only be sustainable for 10 years while wide moats persist for at least 20 years.

The result of the criteria and methodology used is a portfolio diversified by company sizes, styles, and sectors. The fund currently holds about 50 equity positions, effectively all in the U.S.

Portfolio Positions

To illustrate how this process works, it is helpful to look at each source of competitive advantage and the type of company that benefits from that source.

High switching costs means companies can lock in customers due to prohibitive, or near prohibitive, expenses and effort required to switch to another supplier or provider. Companies that are successful in creating this relationship and ecosystem can charge more for their goods and services as the cost of switching to another supplier would offset any potential benefit. Companies that possess these characteristics include certain software companies or those that manufacture specialized products, or products that require specialized training to use. Companies in the software and cloud space that exhibit this strength, and are currently in the portfolio, include Salesforce ( CRM ) and ServiceNow ( NOW ), among others. On the product side, the portfolio holds position in Boeing ( BA ) and Zimmer Biomet Holdings ( ZBH ).

Intangible assets including brand value, patents, copyrights, and other legal protections prevent copycats and protect incumbents from competitive threats. An example of a company that benefits from an intangible asset would be a pharmaceutical company like Pfizer ( PFE ). The company, like most major pharmaceutical companies, spends billions on R&D, branding and marketing, and distribution to deliver drugs around the world. The formula for each drug not only requires FDA approval, but in each case is protected through patents, creating a monopoly, albeit only for a limited time and for each drug separately.

Network effects in which the value of a good or service increases as the number of users increases is another powerful factor that can create a moat. Using Microsoft ( MSFT ) Office is valuable because most people and businesses can communicate and share files seamlessly as users on both ends have the same software. There are no compatibility issues. Facebook and Instagram ( META ) are valuable because other people use the platforms. If friends, family, “influencers”, or other parties of interest weren’t on the platforms, then they would have no value to you.

Businesses that have a cost advantage can either boost profits by selling at the same price as competitors or gain market share profitably by lowering their price below competitors. These are often businesses with increasing economies of scale that result in a natural monopoly market structure. Think Walmart ( WMT ) or Amazon ( AMZN ) within retail. Their economies of scale allow them to profitably sell goods for low prices and, especially in Amazon’s case, ship them virtually anywhere to anyone because of the scale and efficiency of their corporate infrastructure. Closely related to cost advantages is the ability to operate at an efficient scale for its target market. Companies that fit that description include railroads and utilities. Dominion Energy ( D ) is an example of a portfolio position that benefits from operating at an efficient scale.

The above provides insight into the types of companies that qualify for inclusion in the index, and ultimately in MOAT. Digging a little deeper into the top holdings we see how the creation of a moat can translate into tangible results.

Gross Margins and Capital Efficiency of Portfolio Companies

Companies that meet the criteria described above should be expected to generate significant gross margins through various points in the business cycle. Furthermore, as a result of strong margins and effective management of their businesses, the returns on equity should also be robust.

The gross margins of the top five holdings have been high, stable, and/or increasing over time. Any apparent trend higher or lower should be looked at in a broader context. We see that Microsoft’s gross margin declined from 2011 through 2016, bottoming around 60% before slowly inching its way higher. Salesforce and Alphabet have been experiencing shallow declines in gross margins over the last several years. If this trend were to continue or worsen, then that might be a cause for concern, but maintaining levels in the 50-70% range implies that business is healthy and pricing power intact.

Companies that enjoy competitive advantages that create high margins tend to throw off a lot of cash. To evaluate the management of a business, capital allocation decisions are critical. A simple measure of this is looking at return on equity. If management decides to retain cash instead of returning it to shareholders, then it is expected to generate high returns. The trend across the largest holdings has been higher for the better part of a decade, although there has been some erosion since the beginning of last year. Like with margins, if this were to develop into a long-term trend, then that might be a cause for concern.

Two companies stand out in the chart below: Salesforce and Amazon. They generate substantially lower returns on equity, and their ROEs have spent much of the last decade hovering around 0%. For Salesforce, this is driven by high SG&A, R&D, and interest expenses that hit net margins while the growth in goodwill has pushed assets, and equity, higher. Fortunately, the total debt has been falling for the last two years.

Amazon has also seen SG&A and R&D expenses rise faster than revenue over the last decade while assets and shareholder equity have exploded higher over that period.

In both cases, balance sheets are strong and have grown quickly as has spending on people and R&D, resulting in muted ROE estimates. However, spending in these areas, particularly for Amazon, might be better characterized as an investment in the business that is expected to generate future growth. Regardless, these are two of 50 positions in the portfolio, which means any business specific risk is partially offset by the other holdings.

Risks

As discussed above, there are risks that can be attributed to individual holdings in the portfolio. However, these are mitigated by the portfolio management process with regular rebalancing as well as relatively modest position sizes. For Salesforce and Amazon, for example, each position represents about 3% of portfolio value.

There are also risks associated with what is added and removed from the portfolio. Although this is a rules-based strategy, it is possible that changes to the portfolio could create increased volatility and/or underperformance.

These risks, however, seem manageable given the diversification within the fund and the typical high quality of the holdings. Moats protect revenue and gross margins, and businesses with these qualities are generally high quality and suitable as long-term holdings.

How It Fits In Portfolios

Investors can view this fund as part of their core U.S. equity holdings, and size it according to their target strategic allocation. As mentioned above, it provides diversification across sizes, styles, and sectors within its 50-position portfolio. With a yield of about 1%, total returns are dominated by capital appreciation. This in itself is not a negative, but investors should be aware that the fund has historically exhibited slightly higher volatility relative to other blended and rules-based strategies. That said, returns have also been higher, so on a risk-adjusted basis it has outperformed its peer group.

Final Thoughts

A position in MOAT offers investors exposure to high quality businesses with sustainable competitive advantages and a track record of success. Even within a portfolio of 50 names, the allocation across company sizes, styles, and sectors offers diversification benefits. It also offers exposure to businesses that are proven to perform during various stages of the businesses cycle and economic environments. I view this as a core position that can represent a substantial percentage of investor U.S. equity allocations. As always, these suggestions should be considered within the broader context of strategic asset allocations as well as personal needs and constraints. Any overweight or underweight positions need to be considered carefully to understand the impact on long-term total returns. Thank you for reading. I look forward to seeing your feedback and comments below.

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