SMID-Cap Moats Lead in Market Rally

The Morningstar US Small-Mid Cap Moat Focus Index (the “SMID Moat Index”) managed to outpaced all three market cap segments of the U.S. stock market in January. The SMID Moat Index tends to provide mostly mid cap exposure along with some small cap exposure among those U.S. companies that benefit from sustainable competitive advantages.

Small caps led the way for the month followed by mid caps. Large caps generally participated least in the January market rally. Despite the SMID Moat Index’s relatively lower exposure to small caps, it outperformed them by 2.25% in January. In fact, for those “moat heads” out there, the SMID Moat Index even outmatched its big sister, the Morningstar Wide Moat Focus Index, which had an equally impressive month.

Banner January for SMID Moat Investing

1 Month Total Return as of 1/31/2023

Source: Morningstar. As of 1/31/2023. 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.

Stock Selection a Key Contributor to January Performance

The SMID Moat Index benefited most from its exposure to consumer discretionary, industrials and information technology companies, while no single sector, as a whole, posted negative returns within the index. With roughly 75% of its exposure in mid-cap stocks, the SMID Moat Index was highly influenced by stock selection within that market cap segment. Stock selection within smaller cap stocks, though less exposure, contributed nearly as prominently to January’s strong performance.

Notably, only five SMID Moat Index companies posted negative returns for the month: Baxter International, Kellogg Co., Hasbro Inc., Sirius XM Holdings and Zimmer Biomet Holdings.

Some of the leaders are lesser known, and most are in the car business, so let’s learn a little about their economic moat and valuations.

Top SMID Moat Companies in January

Adient (ADNT)

Adient PLC is an automotive seating business that was spun off from Johnson Controls in 2016 and has about 33% share of the global seating market, according to Morningstar. While auto parts may not be the most riveting area of the market, competitive advantages make sense here. Morningstar views seating as one of the stickiest areas of the supply chain because automakers need consistent quality that can be delivered with precision all around the world. Stated differently, automakers will generally pay for the right supplier rather than seek out the low-cost provider. In fact, Morningstar notes that it is common for incumbent seating suppliers to get the next generation of a vehicle program nearly 100% of the time.

Adient is assigned a narrow moat rating by Morningstar driven by intangible assets, cost advantage and switching costs. While its advantages are strong, it is assigned a narrow moat rather than a wide moat because of automaker customers’ growing global overcapacity and Adient's lack of immunity to the cyclical nature of the auto industry. Morningstar believes it’s more likely than not that Adient can generate economic profit for 10 years, but for the reasons mentioned, they cannot say that it is more likely than not that Adient can generate economic profit for 20 years.

Adient’s fair value estimate was increased from $64 per share to $68 in November 2022 to reflect continued operation improvement over time. Adient was a victim of the global chip shortages and high steel and chemical input costs which drove negative sentiment in recent periods, according to Morningstar. The company finished the month at a 30% discount to Morningstar’s fair value estimate.

Lithia Motors (LAD)

Lithia Motors is a publicly traded auto dealer that has created a differentiated business as the only public dealer to operate in rural markets. In fact, many Lithia brand stores have no competitors within 100 miles, according to Morningstar. The dealer, like some other publicly traded dealers, benefits from cost advantages and intangible assets. It also enjoys a lack of competition for many vehicle brands given its focus on rural areas. Morningstar believes public dealers enjoy several benefits over private dealers, such as centralized back-office operations and much higher volumes, which brings scale. They are also not dependent on any one vehicle brand as many have a diversified portfolio of dealerships.

Morningstar sees parts and service operations at Lithia as a strong advantage as well. Customers are prone to return to a dealer for service because of warranties or proximity to home and expertise to service a particular vehicle. Obtaining multiple quotes on a vehicle repair can be very time consuming. All of this leads to inelasticity of demand and stronger pricing power for dealers, according to Morningstar.

For the better part of the decade, Lithia has traded close to Morningstar fair value. Outside of the market selloff in March 2022, Lithia shares have not traded at such a steep discount to fair value in the last 10 years. Shares ended January at approximately a 40% discount.

Sensata Technologies (ST)

Staying on the automobile theme, Sensata Technologies is a supplier of sensors and electrical protection, predominantly for the automotive market. It has positioned itself well to participate in secular trends toward electrification, efficiency and connectivity, according to Morningstar.

Sensata‘s narrow moat rating is attributable primarily to switching costs. Its sensors and controls are often part of mission critical processes related to electric vehicle battery management systems, avionics systems and power grids. As Morningstar explains it, once a supplier’s component is designed into an end application, it is likely to remain in the product’s entire lifecycle—ranging from five to seven years in cars and more than 10 years in aerospace applications. Morningstar believes Sensata also boasts robust design and engineering abilities, exhibiting intangible assets that supplement its moat.

After closing January at under $53 per share, Sensata was over 25% discounted relative to its Morningstar fair value estimate.

Asbury Automotive Group (ABG)

ABG, like Lithia Motors, is a publicly traded auto dealer and benefits from similar cost advantages and intangible assets. ABG operates nearly 150 dealerships and generates the overwhelming majority of its revenue from the luxury automobile segment. This makes it slightly more recession proof, as customers of luxury brands tend to have higher-than-average incomes and can often afford new cars and maintenance through economic cycles.

Morningstar raised its fair value estimate substantially in April 2022 from $233 per share to $377 based on the company’s growth trajectory. Following a strong fourth quarter 2022, Morningstar has maintained its fair value estimate.

ICU Medical (ICUI)

ICU Medical is a comprehensive infusion and IV provider offering infusion consumables, infusion pumps and IV solution manufacturing. Morningstar believes its unrivaled scale in consumables allows ICU to offer rock-bottom prices that competitors would be hard-pressed to beat and gives them confidence in the firm's ability to generate excess returns over the coming decade. ICU Medical also benefits, to a lesser degree, from switching costs in its infusion systems segment.

Like medical technology firms that benefit from intellectual property and regulatory factors that limit competition, only a handful of competitors in ICU’s markets possess meaningful scale. As Morningstar explains, infusion consumables are the relatively commodity like parts that are used in IV administration. They include a wide array of mostly plastic parts such as IV sets, IV connectors, closed system transfer devices, disinfecting caps and more. ICU Medical has the leading U.S. market share in this segment. Morningstar does not see this changing anytime soon, because ICU Medical is able to price its consumables at significant discount to market, attracting hospitals and other health providers.

After trading at a steep discount to fair value throughout much of 2022, ICU Medical is now trading near fair value.

Top Contributors and Detractors from SMID Moat Index

January 2023

Source: Morningstar. As of 1/31/2023. Past performance is no guarantee of future results. Not intended as a recommendation to buy or sell any of the securities mentioned herein.

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.

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