How to Find Stocks Primed to Beat the Market

Morningstar
equity
strategist Allen
Good,
explains:
“To
find
stocks
that
are
most
likely
to
outperform,
the
key
is
to
combine
high
quality
with
attractive
price.”

But,
an
economic
moat
in
itself
won’t
result
in
outperformance,
he
says.

The
‘Magnificent
Seven’
and
Moat
Stocks

This
dynamic
can
even
be
seen
in
the
stock
market
rally
of
the
past
year.
Much
of
the
attention
has
been
on
the
stocks
known
as
the
Magnificent
Seven:
Nvidia (NVDA),
Meta
Platforms (META),
Apple (AAPL),
Amazon.com (AMZN),
Microsoft (MSFT),
Alphabet (GOOGL),
and
Tesla (TSLA).
Six
of
these
stocks
have
wide
moats
–
the
exception
is
narrow-moat
Tesla.
At
the
start
of
2023,
five
of
the
six
wide-moat
Magnificent
Seven
stocks
were
in
the
Wide
Moat
Focus
Index,
with
a
total
weight
of
11%.
As
they
rallied,
Nvidia
and
Meta
were
booted
from
the
index,
while
Amazon
and
Microsoft
saw
a
decrease
in
weight.
But
these
stocks
continued
to
soar,
causing
the
index
to
lag.

Over
the
past
year,
wide-moat
stocks
have
performed
very
well.
The Morningstar
Wide
Moat
Composite
Index
–
which
tracks
all
the
stocks
in
the
US
market
with
wide
moats,
regardless
of
their
valuations
–
gained
30.3%.
This
outpaced
the
US
Market
Index,
which
gained
19.9%.
The
Wide
Moat
Focus
Index
did
not
see
quite
the
same
success,
gaining
only
16.4%.
Still,
it’s
outperformed
narrow-moat
and
no-moat
stocks
over
this
time.
Narrow-moat
stocks
were
up
12.9%,
and
stocks
without
moats
were
up
1.9%.

1-Year
Performance
by
Moat
Index

Source:
Morningstar
Direct,
Morningstar
Indexes, February
12,
2024

Long-Term
Outperformance
for
Undervalued
Wide
Moat
Stocks

Despite
underperforming
the
market
over
the
past
year,
Andrew
Lane,
director
of
equity
research
for
index
strategies
at
Morningstar
explains
that
if
you
go
back
to
when
the
Wide
Moat
Focus
Index
launched
in
2007,
“it
has
hugely
outperformed”.

Over
the
past
20
years,
the
index
has
risen
1,070.81%,
gaining
twice
as
much
as
the
US
Market
Index,
which
rose
547.50%.
Undervalued
wide-moat
stocks
also
outpaced
the
overall
group
of
wide-moat
stocks
during
this
period;
the
Wide
Moat
Composite
Index
has
risen
562%.

Ioannis
Pontikis,
senior
equity
analyst
at
Morningstar
says:
“Investing
at
the
intersection
of
quality
and
value
has
worked
really
well.”

To
understand
why
undervalued
stocks
with
moats
have
done
so
well,
it’s
worth
looking
at
both
the
moat
rating
itself
and
how
Morningstar
analysts
determine
valuations.

What
are
Moat
Stocks?

Long-lasting
competitive
advantages
–
represented
by
economic
moats
–
play
a
big
role
in
how
companies
generate
excess
returns
on
capital.
A
moat
reflects
the
degree
to
which
a
company
has
durable
competitive
advantages.
A
company
with
a
moat
can
fend
off
competition
and
earn
high
returns
on
capital
for
years
to
come.
To
determine
whether
a
company
has
a
moat,
Morningstar
analysts
look
at
its
network
effect,
switching
costs,
intangible
assets,
cost
advantage,
and
efficient
scale.

Companies
with wide
moats are
expected
to
maintain
their
competitive
advantages
for
more
than
20
years.
Just
156
of
the
1,321
companies
in
the
US
Market
Index
(12%)
have
a
wide
moat
rating.
Meanwhile,
31%
have narrow
moat
ratings,
meaning
they
should
be
able
to
fend
off
rivals
for
10-20
years.
The
remaining
57%
of
these
firms
have
no
moat;
our
analysts
either
don’t
cover
them
or
think
they
have
no
durable
competitive
advantage.

The
Benefits
of
Moats
and
Attractive
Stock
Prices

Though
a
company
may
be
generating
meaningful
returns
on
invested
capital,
those
fundamental
returns
may
not
raise
its
stock.
For
a
stock’s
price
to
appreciate
meaningfully,
it
generally
has
to
start
from
an
attractive
valuation.

“If
you
buy
at
the
top,
it’ll
be
almost
impossible
to
earn
returns
on
your
investment,
no
matter
how
high-quality
the
company,”
Good
says
–
but
a
moat
has
historically
meant
that
when
prices
are
moving
higher,
a
stock
has
a
better
chance
of
outperforming
over
a
long
period.

“An
economic
moat
adds
an
element
of
quality
to
a
company.
Cash
flow
is
expected
to
compound
at
a
higher
rate
for
a
longer
time,
risk
of
bankruptcy
is
lower,
and
R&D
investment
is
more
productive,”
Good
says.
“But
it’s
the
combination
of
quality
and
valuation
which
ultimately
impacts
the
long-term
stock
price.”

High-Quality,
Stable
Stock
Prices

Stocks
with
moats
have
also
tended
to
see
smaller
price
swings
than
no-moat
stocks.
As
measured
by standard
deviation
–
a
common
barometer
for
volatility
–
over
the
past
five-,
10-,
and
15-year
periods,
wide-moat
stocks
have
had
lower
volatility
than
narrow-moat
stocks
and
the
broader
equity
market.
No-moat
stocks
have
shown
the
highest
volatility.

That
lower
volatility
could
be
seen
during
the
recent
bear
market.
But
it
also
means
investors
may
get
somewhat
smaller
returns
in
bull
markets.
As
Good
explains,
stocks
of
companies
with
economic
moats
have
tended
to
outperform
in
downcycles
and
underperform
in
the
upcycle.

However,
he
adds:
“their
strong
showing
during
downcycles
ultimately
results
in
long-term
outperformance.”

Which
Stocks
Have
Led
the
Wide
Moat
Focus
Index?

Top
contributors
to
the
Wide
Moat
Focus
Index’s
outperformance
come
from
a
variety
of
sectors,
including
technology,
healthcare,
financial
services,
industrials,
and
consumer
defensives.

Over
the
past
five
years,
the
semiconductor
equipment
supplier
Applied
Materials (AMAT),
which
rose
345.2%,
and
the
liquified
natural
gas
company
Cheniere
Energy (LNG),
which
gained
155.5%,
led
returns
for
the
index.
Applied
Materials
is
also
the
top
contributor
over
the
trailing
10-year
period,
gaining
over
1,000%.

The
list
of
leaders
for
undervalued
wide-moat
stocks
is
markedly
different
from
that
of
the
broader
equity
market.
Over
the
past
five
years,
leaders
in
the
US
Market
Index
have
included
Apple,
Microsoft,
Nvidia,
Amazon,
Meta,
and
Alphabet.

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