What are we looking for?
ETFs that hold companies with wide economic moats.
Among the many impressions made on the investment world, the Oracle of Omaha – also known as Warren Buffet – popularized a term that Morningstar has written into the very core of how we value individual stock investments: the economic moat. Analogous to the stronghold defence mechanism used in medieval times, moats act as competitive barriers to entry into the sector a business operates in.
Morningstar defines fives unique sources of economic moats: (1) Switching costs are those obstacles that keep customers from changing from one product to another, (2) 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, (3) Intangible assets are things such as patents, government licences and brand identity that keep competitors at bay, (4) 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, (5) Efficient scale benefits companies operating in a market that only supports one or a few competitors, limiting rivalry.
Companies with wide moats are those which Morningstar predicts will maintain competitive advantages for more than 20 years, while those with narrow moats are predicted to maintain advantages for 10 years. In financial terms, these companies are expected to produce a return on invested capital in excess of their cost of capital (an increasingly relevant measure given that the cost of capital has increased alongside recent interest-rate hikes).
ETFs 101: What are exchange-traded funds?
Today, I use Morningstar Direct to screen for actively managed Canadian-listed ETFs and mutual funds sold through discount brokerages (without embedded advice costs) that hold a high weighting in narrow or wide moat stocks. Moreover, I used Morningstar’s fund-level ratings to find funds that have beaten their category peers on an after-fee risk-adjusted basis, and that we expect to do so in the future. I used the following limits for today’s screen:
- A four- or five-star Morningstar Rating for Funds, indicating that the fund has historically outperformed respective category peers after fees, on risk-adjusted basis. Our data shows that although the star ratings are backward-looking, funds in aggregate that have received five stars outperform those that have received four stars, three stars, etc., in periods after receiving the rating. In other words, it’s more likely that a fund manager with a track record of outperforming peers will continue to outperform in the future, as compared with those that have historically underperformed peers.
- Morningstar Medalist Rating of gold, silver, or bronze, isolating funds that Morningstar believes will produce excess after-fee returns in the future, based on our analysis of people (quality of the management team), parent (stewardship of the fund company) and process (robustness of investment decision making).
Only actively managed funds were included in this search, implying that the portfolio manager has made a conscious decision to invest in these companies, as opposed to an index or passively managed fund, which selects stocks based on a predetermined set of rules.
What we found
The funds that met the above requirements are listed in the accompanying table, which includes management expense ratios, categories, Morningstar ratings, trailing returns, inception dates and percentage exposure to wide, narrow and no-moat stocks. It’s important to note that both ratings from Morningstar are measured relative to category peers and hence consideration of the category should be taken before looking at the ratings. Only the Top 20 funds are displayed in the table after sorting the universe of qualifiers by their exposure to wide and narrow moat stocks.
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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