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What are we looking for?

Warren Buffett always talks about buying companies that have a competitive advantage in the market, or in other words, have a wide moat around them. Today, let's look for stocks with wide moats and see how they've performed lately. This should be especially useful as the market plunges during the Japan crisis.

More about today's screen

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Morningstar has set up what it calls the wide-moat focus index and has tracked how it has performed in recent years. These wide-moat stocks trade at the largest discounts to Morningstar's estimate of their intrinsic value. The index is equal weighted and balanced quarterly. There are no sector constraints.

How has the index performed?

As of Monday, the Morningstar wide-moat focus index was up 6 per cent, versus the S&P 500 total return benchmark up 3.5 per cent. Over three years, the wide-moat focus index was up 13.8 per cent, versus 2.5 per cent for the benchmark.

For five years, the wide-moat focus index was up 9 per cent, versus 2.1 per cent for the benchmark.

Why has it outperformed?

Morningstar analyzed the performance of the wide-moat focus index and ruled out a number of reasons why it has done so well.

It found that it has tended to be fairly diversified in the past, so it hasn't outperformed because of concentration in a market-beating sector. The index has had somewhat more volatility than the S&P 500 through various tests, but Morningstar concluded that the index hasn't outperformed by loading up on risk either.

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Morningstar also crunched the numbers and found that the wide-moat focus index of 20 stocks beat a generic list of all moat stocks. That means looking for the cheapest moat stocks added excess return.

"The outperformance of the wide-moat focus index was not due to excessive risk-taking, nor to size or style tilters, nor to sector weighting," said Morningstar director of equity research Patrick Dorsey in a report. "The wide-moat focus strategy has produced excellent performance … because we have done a good job of identifying undervalued wide-moat stocks."

He concluded that the main reason the strategy has performed well is the market's focus on the short term and Morningstar's focus on long-term cash flow analysis for the strategy.

"Behavioral biases which push investors to chase short-term gains are not going away," he said. "It appears, then, that beating the market requires neither inside information, nor a black-box quantitative model, nor a co-located server. It merely requires discipline and patience. Thankfully for active investors, these are scarce commodities on Wall Street."

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