UNH - Wide Moat ETF Rebalance: No Room For Apple And Tesla; Nvidia Removed; Pfizer Kellogg Added

2023-04-10 14:32:24 ET

Summary

• The VanEck Morningstar Wide Moat ETF invests in U.S. companies that possess wide economic moats per Morningstar's methodology.
• We discuss the reasons for the omission of Apple, Tesla, and UnitedHealth from MOAT.
• Meanwhile, the recent reconstitution saw the inclusion of Pfizer and the increased weighting of Kellogg, two defensive stocks available at a sizable discount to fair value according to Morningstar.
• Eight stocks, including Boeing, MercadoLibre and Nvidia, were trimmed or removed on valuation grounds.
• The discounts to fair value are seen to be sizable in Big Tech according to Morningstar's estimates.

The VanEck Morningstar Wide Moat ETF ( MOAT ) has shown good performance so far this year, outperforming the S&P 500 by about 5%.

This outperformance tends to validate the stock-picking methodology of this semi-passive ETF, given that its sector weightings do not differ much from those of the S&P 500 (here, SPY ):

This breakdown, in fact, resembles that of the S&P 500 at large:

It's worth noting that most of the S&P 500's main holdings are also included in MOAT. This shows that the outperformance comes mostly from how MOAT manages the weightings (usually no higher than 3% per constituent, ideally 2.5%) and actively rebalances the portfolio in search of stocks trading at a discount.

Out of the list above, Apple ( AAPL ), Tesla ( TSLA ), UnitedHealth ( UNH ), Nvidia ( NVDA ) are not in MOAT, but it's worth noting that Nvidia was included until March and only recently removed based on valuation.

It is somewhat surprising to see a stock like Apple omitted from an ETF focused on economic moats, but one has to keep in mind that Morningstar picks MOAT's constituents based on their relative valuation, not just their fundamentals. In the case of Apple, Morningstar's analysts acknowledge the durable competitive advantage - a wide moat means that the company is likely to keep its edge for at least another 20 years - provided by iOS in particular (which helps the company capture a premium on its devices). However, Morningstar has a fair value of only $150 for the stock, hence the exclusion from MOAT on valuation grounds.

Meanwhile, Tesla enjoys only a narrow moat according to Morningstar, which explains the omission from the ETF despite a fair value estimate of $225 per share . The narrow moat means that Tesla has a competitive advantage, but that the protection this moat provides may not exceed 10 years, as competitors raise their game. The story is the same with UnitedHealth, which has seen the likes of CVS Health and Cigna emulate its integrated business model, and, therefore, erode the competitive advantage.

The MOAT ETF: How It Works

Note: Investors already familiar with the MOAT ETF and Morningstar's methodology may want to skip this part and move directly to the March rebalance section.

Per VanEck , the VanEck Morningstar Wide Moat ETF seeks to track, before fees and expenses, the price and yield performance of the Morningstar® Wide Moat Focus Index. The index provides exposure to U.S. companies with Morningstar® US Economic Moat ratings of Wide that are trading at the lowest current market price to fair value ratios. The index has a staggered rebalance in which it is divided into two sub-portfolios, each with 40 stocks. One sub-portfolio reconstitutes in December and June; the other in March and September.

MOAT, is, obviously, focused on large caps. Also worth mentioning is the high P/E and Price/Book ratios (see below), which remind us that moat investing is not synonymous with value investing in the traditional sense (though there are some common traits). Instead, the focus is primarily on the sustainability of the competitive advantage, which some growth companies do possess.

The ETF, being based on the Morningstar® Wide Moat Focus Index , includes only U.S. stocks and, as the name suggests, only companies that possess wide economic moats. But what exactly does Morningstar mean by "economic moat"? As per VanEck :

Economic Moat ratings represent the sustainability of a company's competitive advantage. Wide and narrow moat ratings represent Morningstar's belief that a company may maintain its advantage for at least 20 years and at least 10 years, respectively. An economic moat rating of none indicates that a company has either no advantage or an unsustainable one. Quantitative factors used to identify competitive advantages include returns on invested capital relative to cost of capital, while qualitative factors used to identify competitive advantages include customer switching cost, cost advantages, intangible assets, network effects, and efficient scale.

March Rebalance: The Removed Constituents

The recent reconstitution - performed mid-March and affecting the sub-portfolio whose previous rebalancing was in September - saw the removal of eight stocks:

(see VanEck's full document here )

None of these names were removed due to a downgrade to their economic moat, but, rather, on valuation grounds (again, on a relative basis: more attractive new entrants were found). Such is the case of Boeing ( BA ), which Morningstar considers to be facing execution and supply risks . The main reason for trimming Boeing, though, was the stock's strong run since last summer, which made its valuation less attractive. Nvidia is another notable removal from the index, also as a result of the stock's run-up over the past six months. MercadoLibre ( MELI ), whose share price also appreciated during the period, exited the sub-portfolio for the same reason.

Clearly, the removal of these stocks is the result of the bull thesis materializing (thus closing the discount) rather than Morningstar changing their mind regarding these companies' fundamentals.

March Rebalance: The New Entrants

The eight stocks removed gave way to another eight wide-moat companies:

The discounts to fair value are seen to be around 20% (leaving 25% upside potential for the stocks, as of mid-March). The inclusion of Kellogg ( K ) may seem surprising as Morningstar's analysts do not seem convinced with the company's decision to spin off its North American cereal and plant-based alternative arms. However, the perceived wide moat and the discount to fair value warranted inclusion.

Another defensive stock in which Morningstar sees value is Pfizer ( PFE ). The pharmaceutical company should see some of its new drugs - including already approved cancer drugs from the Seagen acquisition such as Adcetris, Padcev, and Tukysa - help offset generic competition and drive growth in coming years.

Those Waiting On The Sidelines

As always, VanEck provides a list of stocks that could be included as part of the next reconstitution, should their valuations warrant it at the time. Berkshire Hathaway ( BRK.A , BRK.B ), already a part of the other sub-portfolio, tops the list.

(see this document for full detail)

Takeaway

The MOAT ETF got off to a strong start in 2023, with its outperformance year-to-date vs. the broader market confirming the relevance of its semi-active management. The strategy that consists in picking names perceived as most undervalued within a universe of stocks with strong competitive advantages continues to pay off.

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