What are we looking for?
Peer-beating exchange-traded funds that hold companies with wide moats.
The screen
From the perspective of an equity investor, Wednesday’s Bank of Canada rate hike means the cost of debt for companies increases, which puts pressure on management to generate enough earnings to service both debt obligations and continue to provide returns to shareholders. A common measure used to compare a company’s bottom line against both its debt and equity obligations is return on capital. As long-term value investors, we at Morningstar believe that a core determinant of a company’s ability to generate said return on capital in excess of its cost of capital (which is driven by interest rates) are competitive barriers to entry, or “economic moats.” Morningstar identifies five sources of economic moat:
- Switching costs are those obstacles that keep customers from changing from one product to another.
- The network effect occurs when the value of a good or service increases for both new and existing users as more people use that good or service.
- Intangible assets are things such as patents, government licences, and brand identity that keep competitors at bay.
- A cost advantage – a company can produce goods or services at a lower cost, allowing them to undercut their competitors or achieve higher profitability.
- Efficient scale benefits companies operating in a market that only supports one or a few competitors, limiting rivalry.
Companies with wide moats are predicted by Morningstar to maintain competitive advantages for more than 20 years, while those with narrow moats are predicted to maintain advantages for 10 years.
For investors who also believe holding wide-moat stocks will help companies endure interest rate hikes, this week I use Morningstar Direct to screen for Canadian-listed ETFs that hold a high weighting in narrow or wide moat stocks. Moreover, I used Morningstar’s star rating to find funds that have beaten their category peers on an after-fee, risk-adjusted basis.
What we found
The ETFs that met the above requirements are listed in the accompanying table, alongside their category, fees, ratings, percentage of wide/narrow moat stocks, trailing performance and inception dates. Readers will quickly notice that many qualifiers are run-of-the-mill index ETFs. It is worthwhile noting that most of the indexes on which these funds are based are weighted by market capitalization, hence Morningstar’s analysis on the largest companies in the index will have a significant bearing on the moat percentage listed in table.
This article does not constitute financial advice. Investors are encouraged to conduct their own independent research before purchasing any of the investments listed here.
Ian Tam, CFA, is director of investment research for Morningstar Canada.
Ian Tam, CFA