Beware Fund Company Marketing Claims
MOAT is a perfect example of why investors need to do their own diligence. MOAT tracks Morningstar® Wide Moat Focus IndexSM (MWMFTR). The website and fact sheet for MOAT state:
“Moat = Sustainable Competitive Advantage: Morningstar equity analysts use a time-tested proprietary process to determine if a company has an economic moat”
The MWMFTR index is intended to “offer exposure to the 20 most attractively priced companies with sustainable competitive advantages according to Morningstar’s equity research team.”
Most investors assume that a big, well-respected company like Morningstar (NYSE:MORN) has an equity research team that knows how to perform the appropriate analysis to identify the traits detailed above. Why would the firm claim to do so if it didn’t have those capabilities? Beware: this line of reasoning got many investors in trouble by trusting Wall Street research during the tech bubble.
The problem is that investors really have no way of validating the claims that Morningstar or Wall Street make about the rigor of their research. The subjective nature of stock research means there is no official standard methodology for measuring “moats” or competitive advantage. Anyone can use those words to lead investors to believe that they do research like Warren Buffett and Charlie Munger, the guys who coined the term moat as it relates to stocks. Maybe Morningstar hopes that using the same terminology can convince investors that their research is like Warren Buffet’s.
After reviewing MOAT’s holdings, I question Morningstar’s “moat” measurement and the rigor of their stock research. In my opinion, MOAT may not actually hold wide moat stocks.
Digging Into the Holdings
When analyzing MOAT’s holdings, one of the tools I use is my dynamic discounted cash flow model, which is designed to measure the “moat” by quantifying market expectations for a company’s competitive advantage period. Of course, I am subjectively asserting that my “moat” model is better than Morningstar’s model, which is a bit of the pot calling the kettle black. The key difference in my assertion is that I will back it up by showing you my model and invite you to see the inner workings of my analysis so that you can judge its rigor for yourself. Morningstar’s ratings are based on a “proprietary process” that is not as open to investors.
Of the 20 stocks in MOAT, only seven get my Attractive or better rating. Five earn my Dangerous or Very Dangerous rating.
Holes in MORN’s Models?
To highlight where I think MORN’s models could be inaccurate, I point to Express Scripts (NYSE:ESRX). Per my April 1, 2013 Danger Zone call, ESRX gets my Very Dangerous rating because the company exploits funky merger accounting to artificially boost earnings while burying several hidden liabilities in the footnotes
Conversely, Morningstar has a bullish opinion on ESRX as detailed in this article and calculates a fair value of $89/share for the stock. It seems to me that Morningstar’s research overlooks details in the financial footnotes or, worse, does not incorporate them into their analysis. I cannot be sure.
Relying on reported accounting values, as Morningstar appears to do, is dangerous and can lead to inaccurate conclusions like the one I think Morningstar has for ESRX.
My fair value for ESRX is closer to $14/share and is based on the firm’s economic book value (EBV). You can review my EBV calculation here– see the “Current” column. My model also shows the impact of hidden liabilities we unearth from footnotes on the valuation of the stock.