By Coulter Regal, CFA
Associate Product Manager
Instead of a broad approach to small– and mid–cap stocks, we believe a strategy using Morningstar’s equity research to identify moat stocks in this space may be a better approach for investors.
Small– and mid–cap (SMID) stocks are an attractive segment of the U.S. equity market, having historically provided greater return potential than large–caps. However, investors should be mindful when making an allocation due to the large universe of SMID–cap stocks and the lack of available research on these smaller and lesser–known companies relative to large–caps.
Within this universe, a strategy that selectively identifies stocks may be more prudent than a broad–based market approach. Leveraging Morningstar’s rigorous equity research, the VanEck Morningstar SMID Moat ETF (SMOT) provides thoughtful exposure to SMID–cap stocks, targeting companies with long–term competitive advantages, known as moats, and attractive valuations.
Powered by Morningstar’s Equity Research
There are about five times as many SMID–cap stocks as there are large–cap stocks. However, the average SMID–cap stock has fewer than eight analysts covering it, compared to roughly 21 analysts for the average large–cap stock.
The Morningstar® US Small–Mid Cap Moat Focus IndexSM (the “Index”) targets small– and mid–cap moat companies with attractive valuations and is powered by Morningstar’s equity research. Morningstar’s team of more than 100 analysts covers over 1,500 companies globally. More than 200 asset managers and 75,000 financial advisors rely on Morningstar’s research. All of Morningstar’s equity analysts follow a single, consistent research methodology to identify companies with long–term competitive advantages and assign a fair value estimate based on future cash flows. SMOT provides access to this rigorous and forward–looking equity research by seeking to track the Morningstar US Small–Mid Cap Moat Focus Index.
Morningstar’s Robust Equity Research Team and Resilient Process
Source: Morningstar. See disclaimers and descriptions at bottom of page.
Economic Moats: Competitive Advantages Built to Last
An economic moat is a durable competitive advantage that allows a firm to keep competitors at bay and generate economic profits over an extended period. To help investors identify companies that possess an economic moat, Morningstar’s equity research team assigns one of three economic moat ratings: wide, narrow, or none. There are two major criteria that must be satisfied for a company to earn a moat rating of narrow or wide.
First, the company must be likely to generate returns on invested capital above its weighted average cost of capital for at least the next 10 years in the case of narrow moats, and at least 20 years for wide moats. Second, it must possess one of the five economic moat sources that Morningstar has identified: switching costs, intangible assets, network effect, cost advantage and efficient scale. Each source of moat is a driver of structural competitive advantage that can help a company protect its profitability well into the future.
The Morningstar US Small–Mid Cap Moat Focus Index exclusively targets these narrow and wide moat SMID–cap companies, giving investors confidence that only companies with sustainable competitive advantages are selected for inclusion.
The Five Sources of Moats
Source: Morningstar. See disclaimers and descriptions at bottom of page.
A Focus on Valuations
Equally important to identifying companies with economic moats is ensuring you do not overpay for them. Beyond identifying economic moats, Morningstar’s analysts also create fair value estimates for companies based on a three–staged discounted cash flow model that incorporates their in–depth knowledge and expectations for future growth. This forward–looking valuation assessment reflects long–term cash flow forecasts, which many traditional valuation metrics, like price/earnings, may not be as well–equipped to capture.
Over time, a company’s stock may trade above or below Morningstar’s fair value estimate, which may create potential opportunities to invest in a company at a discount to fair value. This fair value estimate is one of the primary inputs driving stock selection within Morningstar’s Index. The Index targets those small– and mid–cap moat companies that are trading at the greatest discount to Morningstar’s estimated fair value, while avoiding those that are potentially overvalued.
Access SMID–Cap Moat Stocks with Confidence
The VanEck Morningstar SMID Moat ETF (SMOT) aims to make sense of the large and less researched small– and mid–cap space by offering investors a focused and selective strategy powered by Morningstar’s robust equity research. SMOT seeks to replicate as closely as possible, before fees and expenses, the price and yield performance of the Morningstar US Small–Mid Cap Moat Focus Index.
Originally published by VanEck on October 6, 2022.
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Important Disclosures
Source for all data unless otherwise noted: Morningstar.
Morningstar US Small–Mid Cap Index consists of US stocks representing the bottom 27 percent capitalization of the investable universe.
The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. Certain statements contained herein may constitute projections, forecasts and other forward looking statements, which do not reflect actual results, are valid as of the date of this communication and subject to change without notice. Information provided by third party sources are believed to be reliable and have not been independently verified for accuracy or completeness and cannot be guaranteed. The information herein represents the opinion of the author(s), but not necessarily those of VanEck.
An investor cannot invest directly in an index. Returns reflect past performance and do not guarantee future results. Results reflect the reinvestment of dividends and capital gains, if any. Certain indices may take into account withholding taxes. Index returns do not represent Fund returns. The Index does not charge management fees or brokerage expenses, nor does the Index lend securities, and no revenues from securities lending were added to the performance shown.
The Morningstar® US Small–Mid Cap Moat Focus IndexSM was created and is maintained by Morningstar, Inc. Morningstar, Inc. does not sponsor, endorse, issue, sell, or promote the VanEck Morningstar SMID Moat ETF and bears no liability with respect to that ETF or any security. Morningstar® is a registered trademark of Morningstar, Inc. Morningstar® US Small–Mid Cap Moat Focus IndexSM is a service mark of Morningstar, Inc.
The S&P 500® Index is a product of S&P Dow Jones Indices LLC and/or its affiliates and has been licensed for use by Van Eck Associates Corporation. Copyright © 2021 S&P Dow Jones Indices LLC, a division of S&P Global, Inc., and/or its affiliates. All rights reserved. Redistribution or reproduction in whole or in part are prohibited without written permission of S&P Dow Jones Indices LLC. For more information on any of S&P Dow Jones Indices LLC’s indices please visit www.spglobal.com/spdji/en/. S&P® is a registered trademark of S&P Global and Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC. Neither S&P Dow Jones Indices LLC, Dow Jones Trademark Holdings LLC, their affiliates nor their third party licensors make any representation or warranty, express or implied, as to the ability of any index to accurately represent the asset class or market sector that it purports to represent and neither S&P Dow Jones Indices LLC, Dow Jones Trademark Holdings LLC, their affiliates nor their third party licensors shall have any liability for any errors, omissions, or interruptions of any index or the data included therein.
An investment in the VanEck Morningstar SMID Moat ETF may be subject to risks which include, among others, equity securities, small– and medium–capitalization companies, consumer discretionary sector, financials sector, health care sector, industrials sector, information technology sector, market, operational, index tracking, authorized participant concentration, new fund, absence of prior active market, trading issues, passive management, fund shares trading, premium/discount and liquidity of fund shares, non–diversified, and concentration risks, all of which may adversely affect the Fund. Small– and medium–capitalization companies may be subject to elevated risks.
Investing involves substantial risk and high volatility, including possible loss of principal. An investor should consider a Fund’s investment objective, risks, charges and expenses carefully before investing. To obtain a prospectus and summary prospectus for VanEck Funds and VanEck ETFs, which contain this and other information, call 800.826.2333 or visit vaneck.com. Please read the prospectus and summary prospectus for VanEck Funds and VanEck ETFs carefully before investing.
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