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Stocks that Always Outperform the Rest of the Market

Companies with an economic moat, or competitive advantage over their peers, routinely outpeform over the long term - and if you add a value bias you are onto a winner

Michael Holt, CFA 3 June, 2015 | 2:03PM

In 2007, Morningstar created the Wide Moat Focus Index based on the 20 most undervalued wide-moat stocks in our US equity coverage universe. To construct the Wide Moat Focus Index, we start with all U.S.-based and U.S.-traded corporations with a wide moat rating.

We then sort on market price relative to Morningstar fair value estimates and include the 20 securities trading at the largest discount to fair value. These holdings are weighted equally, and the index is rebalanced and reconstituted quarterly.

Based on actual moat ratings assigned starting in 2002, Morningstar was able to create hypothetical results going back to late 2002. For 2007 to the present, the results are based on the index's actual performance. Since inception, the index has outperformed the S&P 500 annually by more than 5% annually.

Based on attribution analysis, the majority of excess returns throughout the history of the Wide Moat Focus is explained by stock selection. As such, we believe that our economic moat framework, which helps identify undervalued stocks, is the foundation for such outstanding performance.

Further, the Wide Moat Focus Index has performed well over more than a decade that has seen many market conditions, including boom-bust cycles, in the commodity and housing markets. The Wide Moat Focus Index's strong performance through several major market fluctuations suggests a robust ability to remain disciplined, selecting undervalued stocks under a variety of conditions.

Selecting undervalued securities, it's not only firms with strong competitive positions that are fundamental to the Wide Moat Focus. Exhibits 1 and 2 present performance of both the Wide Moat Focus and the Wide Moat portfolios over a variety of time periods. The Wide Moat Index is a market-cap weighted portfolio of all wide-moat rated stocks across Morningstar's coverage universe. Of particular note, wide moat stocks typically generate lower returns than the broader stock market, with generally lower volatility as well.

Recent index performance has been subpar, but we'd note that periods of underperformance are common, to be expected, and—most critically—often necessary given our methodology. Simply put, periods of underperformance sow the seeds of future success.

Over the past decade, six of the top contributors to annual performance had been a major underperformer the year prior. The Wide Moat Focus index is designed to patiently wait for company fundamentals to be borne out in valuation, and often this takes a long time.

Sometimes fortune smiles more quickly. Of the four remaining top contributors, two were IPOs; MasterCard in 2006 and Facebook in 2013. Which we identified out of the gate as both deserving of a wide economic moat rating and seriously mispriced. The remaining two firms saw M&A activity quickly drive their share prices toward fair value.

The precipitous drop in oil prices and resulting hit to energy stocks has fuelled most of the Wide Moat Focus' underperformance of late. Exhibit 4 provides a look at the leading contributors to and detractors from the Wide Moat Focus Index's performance over the past 12 months.

While energy has been a drag on performance, we believe that investor fear around the sector today will help generate strong performance in the future. Of particular note, three of the index's current six energy holdings; Williams, ONEOK, and Spectra, are pipelines with relatively modest commodity price exposure that have been thrown out with the industry anyway.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author

Michael Holt, CFA  Michael Holt, CFA, is a senior stock analyst with Morningstar.

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