10 Newest Stocks in the Wide-Moat Focus Index
The Morningstar Wide Moat Focus Index made room for some undervalued consumer defensive stocks in June.
Every quarter, we reconstitute one subportfolio of the Morningstar Wide Moat Focus Index. When we do this, we re-evaluate the index's holdings and add and remove stocks based on a preset methodology. This helps keep the index true to its aim of providing exposure to competitively advantaged (wide-moat) stocks selling at the lowest current market price/fair value ratios.
The index consists of two subportfolios with 40 stocks each, many of which are overlapping positions. The subportfolios are reconstituted semiannually in alternating quarters, on a "staggered" schedule. Because stocks are equally weighted within each subportfolio, the reconstitution process also involves right-sizing positions.
After the June reconstitution, half of the portfolio swapped out 10 positions. The index now holds 46 positions.
One discernible theme is that wide-moat consumer defensives look cheap. Companies like Procter & Gamble (PG), General Mills (GIS), Campbell Soup (CPB), Hershey (HSY), and PepsiCo (PEP) are known for producing trusted brands of household products such as diapers, cereal, and soft drinks. Firms such as these tend to have more predictable, steady cash flows, therefore their share prices tend to decline less during a market downturn compared with stocks of firms that are more sensitive to business cycles.
As our consumer sector equity analysts wrote at the end of the second quarter, as sales have continued to languish, consumer product firms are using mergers and acquisitions to drive growth. For instance, General Mills, one of the new positions in the portfolio, scooped up pet food manufacturer Blue Buffalo a few months ago.
Cost pressures also continue to weigh on consumer product firms. Even though these operators have focused on cutting costs and improving efficiency over the past few years, inflationary headwinds in the form of increased freight costs and rising commodity prices continue to eat into profits.
These pressures have helped create opportunities for long-term investors who want to build positions in these competitively advantaged names.
Likewise, utilities such as Dominion Energy (D) , which supplies energy primarily to consumers on the East Coast, and cable company Comcast (CMCSA), which benefits from a subscription model, benefit from steady cash flows that help protect them from market sell-offs. (Though Comcast's pay TV model has faced competitive pressures from various corners of late, equity analyst Neil Macker believes Comcast has a wide economic moat rating based on cost advantage and efficient scale inherent in its residential broadband business and cost advantage in its business services segment.)
On the flip side, 10 stocks were removed from the index.
Eight of the stocks were removed because their price/fair value ratios rose beyond our buy range.
There were two special cases among the removals this month: Monsanto was acquired by Bayer (BAYRY) for $128 per share on June 7. The Wide Moat Focus first added this position around $90 in September 2015; the stock gained over 40% over our holding period.
Stericycle (SRCL) was removed because we downgraded its moat to narrow. Equity analyst Matthew Young says the firm's core domestic med-waste operations still enjoy robust competitive advantages rooted in route density. However, changes in healthcare end markets over the past decade (namely consolidation of independent healthcare practices into larger hospital groups) have reached the point where Stericycle is seeing a large portion of its small-quantity account pricing materially bid down. Stericycle isn’t losing its footing against its small regional peers, but profitability concerns keep us from comfortably making the call that excess returns are more likely than not to remain for at least 20 years, the definition of a wide moat, Young said.
High-Quality Stocks in the Bargain Bin
The table below lists the 10 cheapest stocks in the index, ranked by price/fair value. The median stock in the Wide Moat Focus Index is trading at a weighted average price fair/value of 0.84. By comparison, the broad Morningstar US Market Index is fairly valued, trading at a weighted average price/fair value of 1.0.
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Karen Wallace does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.