What are we looking for?
Canadian-domiciled exchange-traded funds holding wide moat stocks that have outperformed peers.
At the risk of belabouring the well-known advice to “play the long game” when investing, readers are reminded that this year’s dismal returns on equities, while not pleasant, are also not unique. My colleague, Dr. Paul Kaplan, exemplified this through his study of past bear markets in various countries around the world. He found that in Canada, bear markets (defined as a decline in the main stock index of 20 per cent or more from the most recent peak) occur on average once every 6.5 years when observing the S&P/TSX Composite Total Return Index.
So what to do about it?
The approach that Morningstar subscribes to is to invest in quality companies with “economic moats,” the term popularized by Warren Buffett. Companies with moats exhibit competitive barriers to entry that provide a unique ability to produce return on invested capital above and beyond the company’s cost of capital.
Morningstar has identified five sources of moat.
- Switching costs are those obstacles that keep customers from changing from one product to another.
- The network effect occurs when the value of a good or service increases for both new and existing users as more people use that good or service.
- Intangible assets are things such as patents, government licences and brand identity that keep competitors at bay.
- A company with a cost advantage can produce goods or services at a lower cost, allowing them to undercut their competitors or achieve higher profitability.
- Efficient scale benefits companies operating in a market that only supports one or a few competitors, limiting rivalry.
Companies with wide moats are predicted by Morningstar to maintain competitive advantages for more than 20 years, while those with narrow moats are predicted to maintain advantages for 10 years. Today, I use Morningstar Direct to screen for Canadian-listed equity ETFs that hold a large percentage of wide or narrow moat stocks, noting that we are looking at the portfolio-level average moat rating, provided for ETFs that have 50 per cent or more of their holdings covered by Morningstar stock analysts. To qualify, ETFs must also have received a five-star rating, which signifies that the fund has outperformed others in its category on a risk-adjusted basis, after fees.
What we found
The ETFs that met the above requirements are listed in the accompanying table, alongside their category, fees, ratings, dividend yield, percentage of wide/narrow moat stocks, trailing performance, inception dates and asset allocation. Investors are urged to consider the category to which each fund belongs to get an understanding of where the fund fits in their overall asset allocation.
This article does not constitute financial advice. Investors are encouraged to conduct their own independent research before purchasing any of the investments listed here.
Ian Tam, CFA, is director of investment research for Morningstar Canada.
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