Quality Amid Turmoil: Moat Stocks Show Strength as Q1 Ends

The first quarter of the year is officially complete, and it ended in dramatic fashion with a sudden and unexpected bank crisis. The collapse of several U.S. regional banks, including Silicon Valley Bank, and the fall of Switzerland’s Credit Suisse took the markets on a volatile ride to end the quarter. After two weeks of relative market chaos, coordinated efforts by regulators and the big banks to backstop the industry calmed markets.

Despite this crisis, large cap U.S. equities ended the March session up, with a modest gain of 3.67% for the S&P 500 Index during the month. However, smaller cap stocks proved less tolerant, with the S&P SmallCap 600 Index down over 5% during the same period. Notably though, moat stocks outperformed broad benchmarks during the month in both the large cap and small/mid cap segments.

The Morningstar Wide Moat Focus Index (the “Moat Index”) gained 4.68% in March, ahead of the S&P 500 Index by 100 basis points. The Morningstar US Small-Mid Cap Moat Focus Index (the “SMID Moat Index”) was down 2.74% during the month, but still demonstrated some resilience compared to the broader universe of small and mid-cap stocks. Year to date, both Moat Indexes maintained their lead versus the respective broad market benchmarks.

U.S. Equity Performance: Moat Indexes Lead Respective Broad Markets

Source: Morningstar. As of 3/31/2023. Past performance is no guarantee of future results. Index performance is not illustrative of Fund performance. Fund performance current to the most recent month end is available by visiting vaneck.com or by calling 800.826.2333. Indexes are unmanaged and are not securities in which an investment can be made.

Moat Indexes Avoided Failed Banks

The recent U.S. banking failures had only a limited impact on both the Moat and SMID Moat Indexes, as neither index had exposure to the failed banks. The Moat Index does however have exposure to two diversified national banks. Wells Fargo & Co. (WFC), which has long been an Index component, and U.S. Bancorp (USB), which saw its position in the Index increase this quarter due to attractive valuation.

In the SMID cap segment, where regional banks are more prevalent, the SMID Moat Index had exposure to only one regional bank, Comerica Inc. (CMA), during the onset of the banking crisis. Notably, following much of the turmoil in smaller banks, the SMID Moat Index added two more regional banks given their attractive valuations as part of the March 17 reconstitution. Both M&T Bank Corp (MTB) and Huntington Bancshares (HBAN) entered the SMID Moat index after their share prices had declined by more than 20%. Morningstar analyst Eric Compton, who covers the banking sector, believes much of the selloff in banks is overdone and that sector is currently undervalued. Below are Eric’s comments regarding US Bancorp and Comerica.

Morningstar Analyst Comments | by Eric Compton April 3, 2023

Comerica is one of the smaller regional banks we cover. As such, we think the upside could be greater. The bank trades at one of the steepest price/fair value discounts in our coverage, even after we've baked in additional headwinds from funding costs and deposit outflows. Comerica is also the only narrow-moat-rated regional bank among the regionals that have sold off the most this year. As such, we view Comerica as our “higher risk, higher reward” regional pick for long-term investors. If the deposit base remains even remotely intact after first-quarter earnings, we would expect to see a rerating higher.

We also like U.S. Bancorp, which has sold off like some of the regionals but is where we see the risk of deposit outflows as being lower given that the bank is the largest regional bank in the U.S. This is our “lower risk” mega-regional pick.

March Index Reconstitution

Both the Moat and SMID Moat Indexes underwent quarterly reviews on March 17, 2023. Each quarter they systematically target the most attractively priced U.S. moat companies within their respective universes. Below are a few takeaways from the March reviews and how the indexes are positioned heading into the second quarter. Full results of the most recent quarterly reviews are available here: Moat Index and SMID Moat Index.

Moat Index Highlights

Valuations Drive Profit Taking in Tech

The Moat Index previously saw its tech exposure increase to the largest overweight in quite some time over the last few quarters of 2022. Exposure came primarily from chip and equipment companies and enterprise software companies. With the rally that many of these companies experienced to begin the year, their valuations became too pricey, allowing the Index to lock in gains in a fairly short period of time. Technology exposure in the Moat Index is now closer to market weight.

Disciplined Valuation Approach Allowed Semiconductor Companies to Make an Impact

Source: Morningstar. As of 3/17/2023. Past performance is no guarantee of future results. Not intended as a recommendation to buy or sell any securities mentioned herein.

Growth Exposure Reined In

After several quarters of increasing growth exposure based on valuation opportunities among oversold growth-oriented stocks, the Moat Index’s growth exposure decreased this quarter. The modest reduction in growth stocks was equally redistributed to value stocks and core/blend stocks. Core stock exposure is now the largest style followed by growth and then value. Growth and value stocks are both slight overweight relative to the S&P 500 Index, while core/blend exposure is underweight.

Source: Morningstar. As of 3/17/2023.Not intended as a recommendation to buy or sell any securities mentioned herein.

Valuations Remain Attractive

The weighted average price-to-fair value of the Moat Index fell from 0.78 to 0.74 following the latest review, signaling a 26% discount to Morningstar’s fair value estimate. This is in contrast to the S&P 500 Index, which featured a weighted average price-to-fair value ratio of 0.89 as the same date.

SMID Moat Index Highlights

Growth Exposure Increases, But Remains an Underweight

Contrary to the Moat index, which saw growth exposure reined in this quarter, the SMID Moat Index’s review led to increased growth exposure by nearly 5% relative to last quarter. It is worth noting that growth is much less dominant in the SMID universe compared to the large cap space. Even after this quarter’s increase, the SMID Moat Index has just under a 20% exposure to growth while the Moat Index sits at about 35%. Additionally, despite the increase, the SMID Moat Index still remains underweight growth compared to the broad SMID universe, which has about 25% exposure.

SMID Moat Sector Shifts and Relative Weights

This quarterly review the SMID Moat Index saw a notable increase to technology names with the addition of several tech names including Guidewire Software (GWRE), Paycom Software Inc. (LTHM) and Garmin Ltd. (GRMN), among others. The technology sector weighting increased from about 16% to 20% following the index review. On the other end of the spectrum, the Industrials, Healthcare, Financials and Communication services sectors all saw slight decreases in weighting.

In terms of exposure to Financials and the banking industry, the SMID Moat Index is underweight the Financials sector by about 5% and underweight the banking industry by about 2.5% relative to the broad SMID stock universe represented by the Morningstar US Small-Mid Cap Index.

SMID Moat Valuations Remain Attractive

The weighted average price-to-fair value of the SMID Moat Index was 0.74 following the quarterly review, signaling a 26% discount to Morningstar’s fair value estimate. This is in contrast to the Morningstar US Small-Mid Cap Index, which featured a weighted average price-to-fair value ratio of 0.90 as of the same date.

Accessing Moat Stocks

VanEck Morningstar Wide ETF (MOAT) seeks to replicate as closely as possible, before fees and expenses the price and yield performance of the Morningstar Wide Moat Focus Index.

VanEck Morningstar SMID Moat ETF (SMOT) seeks to track as closely as possible, before fees and expenses, the price and yield performance of the Morningstar US Small-Mid Cap Moat Focus Index.