MOAT ETF: Question & Answer

Moat investing is based on a simple concept: invest in companies with sustainable competitive advantages. Morningstar builds on this philosophy by seeking out moat stocks trading at attractive valuations relative to their equity research team’s forward-looking estimate of fair value. This approach has stood the test of time, with the live track record for the Morningstar^® Wide Moat Focus Index^SM (“Moat Index”) exceeding 15 years. This blog is intended to address frequently asked questions about Morningstar’s moat investing philosophy and the VanEck Morningstar Wide Moat ETF (MOAT).

• How is Morningstar’s equity research incorporated into the Moat Index?
• How does Morningstar identify moat companies?
• How does Morningstar determine the width of moat and what makes a particular advantage short vs long term?
• Is MOAT an actively managed ETF?
• What has most influenced the Moat Index’s performance historically?
• How frequently does the Moat Index rebalance?
• What style exposure does MOAT offer?
• Does MOAT pay capital gains?
• How does MOAT fit in a portfolio?

How is Morningstar’s equity research incorporated into the Moat Index?

The Moat Index is fueled by Morningstar’s forward-looking, rigorous equity research process, driven by over 100 analysts globally. All of Morningstar’s equity analysts follow a single, consistent research methodology. Morningstar’s economic moat rating serves as the cornerstone of Morningstar’s equity research philosophy. The goal is to determine which companies have competitive advantages that will lead to returns on invested capital in excess of the companies’ weighted cost of capital. Just as important is determining how long those companies can maintain their advantages. The exclusive group of wide moat rated companies are expected to maintain their competitive advantages for more than 20 years into the future.

Morningstar considers a company’s economic moat rating when forecasting future cash flow and discounting those future cash flows to arrive at a current intrinsic per share value for each company. Their valuation process does not take shortcuts, and cash flows are regularly forecasted well into the future.

The Index leverages Morningstar’s economic moat ratings and fair value estimates to systematically assemble the Index’s portfolio each quarter.

How does Morningstar identify moat companies?

Morningstar has identified five attributes that may contribute to a company’s moat: switching costs, intangible assets, network effect, cost leadership and efficient scale. Companies may demonstrate one or a combination of these five sources of moat. Evaluating companies against these attributes are a key part of how Morningstar’s equity research team gauges the strength of a company’s competitive advantage. This assessment results in one of three economic moat ratings: none, narrow or wide. A wide moat rating is assigned to a company that is likely to sustain its competitive advantage for at least the next 20 years, while a narrow moat rating means a company is likely to do so for at least 10 years. A company with no moat has either no advantage or one expected to dissipate relatively quickly.

A wide economic moat rating from Morningstar’s equity analysts is rare. Morningstar’s equity coverage universe skews toward companies with economic moats, yet only 10-15% of those companies receive the elusive wide moat rating. That percentage would likely be far lower for a more comprehensive group of U.S and global companies. Stated differently, it is very difficult to find companies that possess the attributes Morningstar requires to assign a wide moat rating and therefore very few receive that designation.

How does Morningstar determine the width of moat and what makes a particular advantage short vs long term?

This determination involves a number of considerations, both qualitative and quantitative. From a qualitative perspective, Morningstar consider the nature of the company’s competitive advantage and how effectively it will persist given the industry in which the company operates. For example, a tech company may have a strong competitive advantage, but it receives a narrow moat rating because industry in which it operates is subject to a rapid pace of technological change and the risk of disruption is far higher in the tech industry than other industries. Conversely, consider a packaged goods company with an incredible brand that produces unhealthy snack food may receive a wide moat rating. The pace at which this company’s brand equity is likely to fade is far slower than the pace of technological change and disruption in the certain areas of the tech space. Ultimately, certain sectors and industries are far more conducive to economic moats than others.

The next consideration is more quantitative in nature. Morningstar looks at a company’s current and projected returns on invested capital (ROIC) vs. its weighted average cost of capital (WACC) in order to determine what would have to happen for that ROIC to converge downward with its WACC. Once a company’s ROIC and WACC are at parity, economic profits are no longer earned. In some cases, even when a company is in secular decline, its ROIC might be so high that it would take decades for that ROIC to realistically decline down to the company’s WACC. This may apply to tobacco companies or possibly the packaged goods company example above. However, when the spread between ROIC and WACC is thinner, Morningstar requires more conviction in the durability of the competitive advantage before assigning a wide moat rating to the company. Ultimately, the durability of economic profits matters far more than the current magnitude of economic profits when determining the “width” of a company’s economic moat. However, a high magnitude of economic profits does leave the company more margin for error before economic profits would realistically disappear.

Each industry has its own “economic moat framework” each analyst should consider when determining appropriate economic moat ratings.

Is MOAT an actively managed ETF?

No, MOAT is an index-based ETF. MOAT seeks to replicate, before fees and expenses, the price and yield performance of the Moat Index. The Index is unique in the world of index investing because it leverages Morningstar’s 100+ person equity research team to systematically identify what Morningstar equity research analysts considers attractively priced companies with sustainable competitive advantages.

What has most influenced the Moat Index’s performance historically?

This long-term, core investment approach has resulted in excess returns relative to the broad U.S. equity markets since 2007, and often displays excess returns following periods of sizable market declines. The Moat Index’s focus on companies with competitive advantages and attractive valuations results in a dynamic portfolio that has potential to outperform on both the upside and down side. Historically, the Index has benefited primarily from strong stock selection as opposed to sector, size or style over/underweights.

How frequently does the Moat Index rebalance?

The Index employs a staggered rebalance methodology whereby the Index is divided into two equally-weighted sub-portfolios, and each is reconstituted and rebalanced semi-annually on alternating quarters. Adjustments to one sub-portfolio are performed on the third Friday of March and September, and adjustments for the other sub-portfolio are performed on the third Friday of June and December. Due to the staggered rebalance methodology, Index constituents and weights may vary between sub-portfolios.

What style exposure does MOAT offer?

MOAT has historically provided a large blend exposure to U.S. equities. Morningstar’s valuation methodology allows the Moat Index to target opportunities among wide moat stocks regardless of style exposure. Therefore, both the Index and MOAT have seen their style exposure drift between growth and value through time.

Does MOAT pay capital gains?

As a regulated investment company, MOAT must pass through income and capital gains to shareholders each year. Despite turnover in excess of typical index-based U.S. equity ETFs, MOAT has never paid a capital gain distribution. This has held true despite its 2012 launch corresponding with the early years of a sustained bull market in U.S. stocks.

How does MOAT fit in a portfolio?

MOAT offers investors a diversified portfolio of U.S. equities that can serve as a core portfolio building block. Investors should consider MOAT for long-term exposure as opposed to opportunistic tactical market exposure. The Moat Index has historically had more success relative to broad beta indexes over longer-periods of time than short time periods.