MOAT: Have You Considered Using An ETF To Find Companies With Moats?

By | October 28, 2015

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Summary The sector allocations were a bit surprising to me. Industrials were heavily weighted while utilities and health care were not. The fund has a 15% turnover ratio, which seems within reason for the strategy. The idea of holding attractively priced companies with solid economic moats makes sense, but applying that strategy as an ETF is problematic. The sheer size of the ETF would be a huge problem for acquiring shares in smaller companies with the equal weighting philosophy. Larger companies will receive significantly more coverage and the market should be more efficient. Investors should be seeking to improve their risk adjusted returns. I’m a big fan of using ETFs to achieve the risk adjusted returns relative to the portfolios that a normal investor can generate for themselves after trading costs. One of the funds that I’m researching is the Market Vectors Wide Moat ETF (NYSEARCA: MOAT ). I’ll be performing a substantial portion of my analysis along the lines of modern portfolio theory, so my goal is to find ways to minimize costs while achieving diversification to reduce my risk level. Expense Ratio The net expense ratio for MOAT is .49%. I tend to be very frugal with my expense ratios, so I like to see those low levels. When I’m looking at a simple market cap weighted broad market or total market ETF I would expect to see single digit expense ratios. On the other hand, this portfolio would require analysis on the individual companies so higher expenses would be expected. Sector The following chart breaks down the sector allocations: I don’t love huge allocations to consumer discretionary, but I can believe that they would make sense for a portfolio based on having economic moats since there should be some material differentiation in the products provided by the companies. On the other hand, seeing industrials at almost 25% is quite a surprise to me. Perhaps their concept of a moat is different from mine, but they clearly don’t weight utilities high despite the utilities having regulated monopolies. I would think a monopoly that was protected through regulation would have a fairly solid economic moat. In a similar manner I would have expected stronger allocations to health care because the patent system provides long lasting economic moats. Largest Holdings The following chart shows the largest holdings for the fund from the end of the third quarter: I pulled up the daily list of holdings to verify that they were not materially changed. Since the goal here is to buy companies with durable economic moats, I would expect the allocations to remain similar with some small variations as shares go up and down in value causing them to trade places on the list. (click to enlarge) I had to pull the fund up on Schwab to find the turnover ratio, which was listed at 15%. All in all that suggests the portfolio would be turned over about once every 6 to 7 years. That isn’t too bad. The reason for the turnover seems to be that the portfolio is designed to be allocated as an equal weight portfolio across the “most attractively priced” companies that have been classified as having large moats. If the case is based on most attractively priced, then it starts to seem strange that the companies are not moving up in price enough to force the positions to be turned over the next time the index is updated. Conclusion There is nothing wrong with the concept of selecting stocks based on finding reasonably priced companies that have economic moats to prevent competition from eroding their profits. The strategy makes a great deal of sense and investors selecting individual companies would be wise to consider the influence of future competition on the success of their investment. A challenge for an ETF attempting to follow the same strategy is that it could require some fairly significant capital flows if the ETF becomes larger. The need to completely remove companies and buy up a 5% allocation in another company would risk moving market prices if the ETF were large and their strategy included fairly small companies. While moats may be much more common for established companies that rule their space, that doesn’t mean there won’t be very attractively priced smaller companies that are flying under the radar. The nature of needing to be able to suddenly buy up around $30 million to $40 million would be a difficulty for companies with a market capitalization lower than $1 billion since it could require purchasing at least 3% of the company. This will probably force the ETF to only consider larger companies. The concept makes sense, but execution of the strategy seems like a logistical nightmare unless the investment universe is significantly restricted to limit the list of potential investments to medium and larger companies. Once those restrictions are in place, it seems much more difficult to find and select the best securities because larger capitalization companies attract substantially more analyst attention and should generally be priced be more efficiently. Scalper1 News

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