MOAT: A Few Vulnerabilities Worth Discussing (BATS:MOAT)

When markets are jittery, without certainty on the horizon and countless risks fraying investors’ nerves, sticking with the most resilient stalwarts that are properly priced or are even offering some margin of safety, trading with a discount to their intrinsic values, certainly makes sense as, given the robustness of their business models, they should easily weather an environment where inflation is not fully tamed even by a few interest rate hikes, while low multiples offer some protection against the continuous evaporation of the growth premia across the board. For the long term, regardless of the monetary policy trajectory, such an equity portfolio also looks doubtlessly alluring, even with the potential to deliver alpha.

Today, we will be discussing the VanEck Morningstar Wide Moat ETF (MOAT), a fund with an unconventional approach to value investing overseeing around $7 billion in net assets. In the past, its strategy proved to be relatively successful, with the CAGR delivered over the May 2012 – January 2022 period being slightly above the S&P 500 ETF’s (IVV), 15.5% vs. ~15%, even despite its much higher expense ratio of 46 bps.

Still, the fund’s focus on undervalued companies has not protected it from a rough start to 2022, though its YTD losses are marginally less deep compared to IVV. By contrast, the pure-value component of the S&P 500 (RPV) is in green.

In the article, we will be taking a closer look at MOAT’s strategy, the current portfolio composition, and exposure to key factors including value, growth, and quality, which will be assessed using the Quant data; assuming its equity basket should be packed with wide-moat companies, its profitability characteristics also should be nothing short of exceptional. All these should allow us to arrive at a balanced conclusion if the fund is a Buy at the current levels or not.

Investment strategy

According to the prospectus, MOAT tracks the Morningstar Wide Moat Focus index, the one with a sophisticated proprietary strategy, which, in essence, revolves around filtering out stocks without “sustainable competitive advantages” and with too-generous valuations.

As explained in the rulebook, all the constituents of the Morningstar US Market index form the selection universe. At step one, companies with a wide moat (put simply, dominating competitive landscape) and fair value estimates provided by Morningstar’s Equity Research team are selected; buffer rules and sector capping are applied.

There is no doubt that this is not a straightforward task to find underappreciated wide-moat stocks. Competitive advantages typically undergird above-average returns on capital and thus command a premium valuation. A company with higher ROTC should have higher EV/EBITDA, higher ROE justifies higher P/E, etc., at least in theory. Another way of saying, creating a portfolio of wide-moat players without an additional value screen would be much easier.

At step two, 40 leaders with the lowest current market price/fair value ratio are picked for the index and then weighted equally. More details on the subportfolios and reconstitution schedule can be found in the rulebook linked above.

Returns the strategy was capable of delivering

The quick overview of the fund’s performance makes an impression that MOAT was capable of beating the market relatively consistently. At least, its CAGR of 15.5% delivered since May 2012 (MOAT was incepted on 24 April 2012) is a bit stronger compared to the bellwether ETF, with the best year (it was 2019, to be precise) also being more successful.

The downside is that its annual performance is rather patchy. Upon deeper inspection, MOAT did have a few rainy years, like 2015, when it finished deeply in the red while IVV eked out a small gain.

Oddly enough, MOAT failed to beat IVV not only in 2020, when racier high-multiple tech stocks from the bellwether index bolstered its returns but also in 2021, which was remarkable for its broad shift to value amid the capital rotation which was especially strong in the first half of the year and some softness in the long-duration equity league.

Overall, MOAT underperformed IVV five times, in 2013, 2014, 2015, 2020, and 2021. Risk metrics also do not look unambiguously superior as both Sharpe and Sortino ratios are lower, while the standard deviation is higher.

The verdict? The strategy certainly has merit but lacks consistency. I fairly have no reason to question that MOAT might be capable of outperforming IVV in the future, though investors should be prepared for periods of softness.

The portfolio

As of February 17, the fund was long 46 stocks, with the top ten accounting for ~29.4% of the net assets.

It is worth remarking that 37 stocks (~79% weight) from its portfolio are the S&P 500 constituents. Among those that are absent in IVV are Cheniere Energy (LNG), an energy infrastructure company and MOAT’s key investment with a 3.2% weight.

Only three members of the $1 trillion club can be found in the mix, namely Amazon (AMZN), Alphabet (GOOGL), and Microsoft (MSFT) as Apple (AAPL) failed to qualify. Thanks to MOAT’s smart-beta methodology, together they have just 7% weight.

Almost 43% are mega-caps (over $100 billion market caps). Large-caps have slightly north of 42%, with the rest of the portfolio allocated to medium-size companies. Compass Minerals International (CMP) is technically the only small-cap in MOAT, with a market value of ~$1.87 billion as of writing this article.

The chart below shows sectors allocations of IVV and MOAT, which clearly illustrates that in its current iteration, the fund overweights the consumer staples, industrials, and healthcare, while completely ignoring real estate and deploying a much lower share of the net assets to consumer discretionary, financials, and IT, though the latter is still its top sector with ~23%.

To have a deeper understanding if MOAT is tilted towards value, growth, or quality factors, I utilized the Quant data downloaded via the screener, as usual. Unfortunately, the results are rather mixed.

The table below summarizes the data for the fund’s key 25 holdings.

First and foremost, we see that 50% of the holdings are remarkably overvalued (D+ or worse); close to 28% have attractive Valuation grades (no less than B-), but it is still suboptimal. I believe the key culprit is MOAT’s tilt towards mega/large caps. Premium multiples are something to expect from the upper echelon of the market.

Exposure to growth is rather small, just 22.6%.

Quality should be simply nothing short of exceptional, as sustainable competitive advantages must be supportive of higher margins undergirded by cost advantages amongst other things. But unfortunately, 5 stocks in the mix (11.2%) score poorly here (D+ grades of worse), like Boeing (BA) and MercadoLibre (MELI), to name a few.

I decided to dig a bit deeper and created the scatter plot below. As you can see, though most players have strong EBITDA and net CFFO margins, there are a few with bleak profitability, while BA is cash-burning.

Final thoughts

The verdict? MOAT certainly deserves attention, though I am hesitant to assign it a Buy rating. There are a few reasons behind my moderate skepticism.

First, though the strategy did outperform IVV marginally, it is clear that it might face rainy years. Second, a substantial share of the portfolio is overpriced, as discussed above; this adds to risks. Third, quality is not faultless. Fourth, its dividend yield is simply insignificant, only marginally above 1%; for a fund focusing on underappreciated companies, that’s a bleak result. Fifth, fees are burdensome. MOAT is a Hold.