Are investors better off blowing off wide-moat stocks?

Are investors better off blowing off wide-moat stocks?

Are investors better off blowing off wide-moat stocks?

Adherents of value investing fervently follow most, if not all, of the words of wisdom issued by Warren Buffett. Among those is his advice to pick stocks of companies with wide and sustainable “economic moats,” which describes an industry presence so strong that competitors find it difficult to steal any part of its market share.

One doesn’t have to be familiar with the Oracle of Omaha to see the sense behind the strategy, if not come up with it themselves. In fact, the notion smacks of conventional wisdom — and conventional wisdom, like Buffett himself, can be questioned and attacked.

Recent research conducted jointly by Morningstar analysts and Roger Ibbotson, an emeritus finance professor at Yale, indicates that such wide-moat stocks often don’t deliver the best returns, reported The Wall Street Journal. The issue, the researchers found, is that wide-moat stocks tend to be cursed with popularity, which makes them prone to overpricing as more investors pile into them.

Similarly, companies with valued brands and glowing reputations tend to attract droves of investors, as almost all are convinced that those attributes make for terrific investments. Massive demand leads to bid-up prices, eventually resulting in depressed returns.

“Great companies don’t always make great investments,” said Thomas Idzorek, chief investment officer, retirement, for Morningstar Investment Management. According to the Journal, Idzorek was among the Morningstar researchers who worked with Ibbotson on a new asset-pricing model. Rather than just focusing on risk and return, it incorporates an array of characteristics that investors pay attention to. By doing that, the model seeks to capture the effects of investor behaviour on asset prices.

Accounting for investor behaviour could explain a recent puzzling finding by Morningstar. The firm compared the returns of portfolios made up of three different types of companies: wide-moat, narrow-moat, and no-moat. The categories are based on competitive factors such as a company’s pricing power and intangible assets like brand equity. From a behavioural perspective, a wide economic moat would be more desirable to investors than a narrow one, and the absence of a moat would be undesirable.

Morningstar created equal-weight and market cap-weighted portfolios, each made up of stocks from one of the three moat categories. Whether equal-weighted or cap-weighted, the researchers found that the narrower the moat, the larger the return: no-moat stocks delivered average returns of 15.4% yearly, compared to 11.2% for wide-moat stocks. However, no-moat stocks had greater risk exposure, making wide-moat stocks better performers on a risk-adjusted basis.

The results were mirrored in an analysis of equally weighted stock portfolios constructed based on companies’ scores on Harris reputation polls. Companies in the lowest quartile of the poll returned an average of 12.6% yearly, while the most admired registered an average of 7.02%. But even on a risk-adjusted basis, stocks with lower reputation and brand scores did better than their higher-ranked counterparts.

The insights from the study can be applied to multiple fields of investing, including ESG. Speaking to the Journal, Idzorek said ESG investors who favour the best ESG companies out of hand could be overpaying or sacrificing returns for the privilege. Meanwhile, those willing to take on out-of-favour stocks like tobacco and fossil-fuel companies could enjoy higher returns, at least temporarily.

 

Follow WP on Facebook, LinkedIn and Twitter