What are we looking for?
Companies with moats.
No, we're not shopping for a castle. The moats we're hunting are sustainable competitive advantages that can allow a firm to defend its business from competitors and expand its territory.
How we did it
Craig McGee, senior consultant at Morningstar Canada, delved into the Morningstar CPMS database to find U.S. companies that have long-lasting competitive advantages as well as growing earnings and improving expectations.
He restricted his search to those firms classified as having a wide economic moat by Morningstar's research analysts.
The Economic Moat Rating is Morningstar's assessment of a firm's ability to earn returns consistently above its cost of capital in the future, usually by virtue of some competitive advantage.
He looked for the 20 stocks with wide moats and the best combination of:
-five-year annualized growth rate of earnings per share;
-one-year total return;
-upward revisions over the past 90 days to analysts' consensus forecast for earnings per share.
More about Morningstar
Morningstar Inc. provides independent investment research in North America, Europe, Australia and Asia.
Its investment research tool, Morningstar CPMS, provides quantitative North American equity research and portfolio analysis to institutional clients and financial advisers.
CPMS data cover more than 95 per cent of the investable North American stock market.
What history says
To test the theory that wide moats result in superior returns, Mr. McGee looked at how his strategy would have worked from June 30, 2004, to Dec. 31, 2011.
He calculated how an investor would have fared by selecting the 20 best stocks according to the criteria above, then removing them if they were no longer considered to have a wide moat or if consensus estimates fell by over 15 per cent.
The strategy posted an annualized total return of 12.6 per cent while the S&P 500 came in at 4.5 per cent over the same period.
Investors should keep in mind that moats can disappear if new technology or new competitors reshape an industry. But Mr. McGee's test suggests that having a wide moat is a good strategy whether you're building a portfolio or a castle.