Eric Dutram: The first half of 2012 has been very volatile for the world stock markets, given slowing U.S. economic growth and worsening European debt problems. With the announcement of another round of quantitative easing (or QE3) by the Federal Reserve to spur economic growth, the markets have surged to a new high, suggesting more upside potential in the year ahead as the full impact of this program is felt (read: Are the Troubled European ETFs Back on Track?).
Investors looking to put more in the market could tap the current opportunity by investing in wide moat stocks. These stocks have easily beaten the S&P 500 since the inception of the wide moat concept in exchange-traded product form in late 2002 and have outperformed the S&P 500 by at least 5% over the last three to five years.
Given their robust track record, these stocks have been the biggest gainer from QE1 and QE2, beating the broader market returns. As a result, we expect these stocks to benefit from the QE3 implementation as well (read: Commodity ETFs in Focus as Fed Unleashes QE3).
Concept of Wide Moats
The term was widely used by the famous investor, Warren Buffett, who describes “wide moats” as sustainable competitive advantages that enable companies to produce outsized returns over time. In other words, a wide moat offers solid returns, ensuring safety of income, as it is harder for the rivals to overcome the companies with these advantages.
Generally, the competitive advantages can be in any form such as brand power, high switching costs, network effects, cost advantages or efficient scale. Any of these factors, or better yet a combo of them, look to make it very difficult for new entrants to steal share and unseat firms
The wide moat companies not only warrant rapid growth but also preserve value via returns on invested capital (ROIC) over the long term. These companies are well positioned compared to rivals, especially if they possess other strengths such as huge liquid cash reserves or strong balance sheet.
Wide Moat ETFs in Focus
Investors could play the wide moats in the ETF form that provides ample flexibility as well as tax and diversification benefits when compared to individual stocks or mutual funds (see more ETFs in the Zacks ETF Center). The funds honing in on the stocks that have wide competitive moats are doing better than the other funds in the space.
Investors have only two options in the wide moat ETF space to choose from, each having different structures, both of which we have briefly highlighted below:
Market Vectors Morningstar Wide Moat Research ETF (NYSEARCA:MOAT)
Launched by Van Eck, this fund has recently made its debut in the space in April 2012 (read: Van Eck Launches Morningstar Wide Moat Research ETF (MOAT)). It seeks to match the price and yield of the Morningstar Wide Moat Focus Index, before fees and expenses. The index has been generating exceptional returns relative to the overall market.
The fund provides exposure to 20 U.S. securities that have sustainable competitive advantages. None of the stocks occupies more than 6% of the share in the basket, suggesting higher diversification benefits.
Some of the top wide moat companies include Lowe’s, C.H. Robinson Worldwide, and Compass Minerals International. Large caps account for a hefty 80% of the assets while mid caps take the remaining portion of the basket (read: Three ETFs with Incredible Diversification).
The product is heavily weighted towards information technology and financial sector that combined make up for roughly 41% share. Other sectors – materials, industrials, energy, health care, utilities and consumer discretionary – occupy the next places in the basket.
The fund has attracted about $64.3 million of assets under management thanks to good liquidity. The ETF trades in volumes of more than 48,000 shares per day and charges a relatively higher fee of 0.49% compared to the category average of 0.46%. The fund has delivered impressive returns of about 7.6% since its inception, which is higher than the S&P 500 returns of just over 5%.
Elements Morningstar Wide Moat Focus ETN (NYSEARCA:WMW)
Launched in October 2007, this is the oldest moat product tracking the Morningstar Wide Moat Focus Total Return Index. The index provides equal-weighted exposure to 20 attractively priced companies that have sustainable competitive advantages.
The fund is similar to its Market Vector counterparts from an individual security perspective with technology as the top sector. Materials, financial, industrial, real estate, energy, health care, consumer cyclical and utilities take the next remaining spots in the basket. The ETN largely focuses on large cap firms (64%) followed by mid caps (21%) and small caps (15%).
The product has failed to catch the investors’ interest as AUM is below $8 million despite having been on the market for nearly five years. The fund is quite expensive, charging 75 bps in fees per year from investors.
A great deal of the lack of interest could be due to the ETN structure as it is a debt security instead of a product that actually holds the underlying securities. Additionally, it is less liquid, trading in volumes of only 9,000 shares per day on average that increases the cost of this fund further in the form of a wide bid/ask spread (read: Use Caution When Trading These Three Illiquid ETFs).
Nevertheless, WMW is no weakling in terms of delivering outstanding returns to investors. The fund has delivered exceptional gains of 17.3% so far this year, outpacing the S&P 500 returns in the same time frame.
In addition, the product has gained over 49% since its inception while S&P 500 lost around 5% over the same period, suggesting that even over long time periods, there is something to this wide moat strategy (read: The Five Best ETFs over the Past Five Years).
In 1978, Len Zacks discovered the power of earnings estimates revisions to enable profitable investment decisions. Today, that discovery is still the heart of the Zacks Rank, a peerless stock rating system whose Strong Buy recommendation has an average return of 26% per year.