Moat Index: Industry Views Under Review

For the Month Ending June 30, 2019

The Morningstar^® Wide Moat Focus Index^TM (“U.S. Moat Index”) underwent its quarterly index review in late June. Half of the index, or one subportfolio, was assessed, reconstituted and rebalanced to represent 40 attractively priced wide moat-rated U.S. stocks. This quarterly process allows the index to potentially lock-in gains realized in some positions while allocating to or remaining invested in companies that appear undervalued according to Morningstar’s fair value estimate.

Historically, valuation assessments have driven the overwhelming majority of index turnover. Over the past five years, approximately 89% of all removals from the index were driven by those companies’ price-to-fair value ratio no longer remaining attractive enough relative to other wide moat companies at the time of review. One percent of index deletions resulted from unique scenarios such as sector capping or company acquisition, leaving 10% of index removals being the result of economic moat rating downgrades.

When a company is downgraded, it tends to be removed from both index subportfolios in two subsequent quarters, if applicable, due to the staggered index review process. Therefore, that 10% may actually reflect several companies that were scaled out of the index over two review cycles. Recent trends in industry moat ratings have resulted in a slight uptick in the number of times a company is forced out of the U.S. Moat Index due to a moat rating downgrade.

Moat Ratings Amid Evolving Industry Trends

Changes to Morningstar’s view on entire industries have driven much of the aforementioned 10% of index turnover events. As industries evolve, so, too, will Morningstar’s industry-level assumptions and, therefore, its conviction about the sustainability of a company’s competitive advantages. This may impact multiple companies in the U.S. Moat Index for the same reason, as opposed to individual companies facing idiosyncratic issues. In other words, a company may be downgraded not due to structural concerns about the company but rather changing industry dynamics that impact Morningstar’s forward-looking conviction.

Real Estate Services

A fresh look by Morningstar at the real estate services industry resulted in a downgrade of the economic moat rating for Jones Lang LaSalle (JLL) from wide to narrow. JLL was removed from the U.S. Moat Index subportfolio under review in June. JLL still has a robust competitive advantage because of its reputation-based intangible assets and switching costs, but Morningstar is no longer confident that excess returns will persist for 20 years. JLL operates in a cyclical industry that is rapidly consolidating, raising the prospect that the company will compete more directly once consolidation eventually stabilizes. There is also reason to be cautious about the potential effect technology may ultimately have on broker/client relationships.

Pharmaceutical Distribution

According to Morningstar, AmerisourceBergen (ABC), Cardinal Health (CAH) and McKesson (MCK) still maintain moat ratings due to scale and cost advantages, but an uncertain drug pricing environment and growing customer leverage limit them to narrow moat ratings. Pharmaceutical revenue has declined because of slower inflation and a shift in revenue mix (increasing generic versus branded drugs). Meanwhile, margins have declined, likely due in part to the increasing negotiating leverage of customers driven by healthcare provider consolidation. These factors have weighed on the companies’ return on invested capital, and these trends are likely to persist over the long term. Because of these views and revised economic moat ratings, all three companies were removed from the U.S. Moat Index subportfolio under review in June.

Asset Management

In September 2018 Morningstar issued a note stating that it sees a confluence of a few different issues ­­that have made it increasingly difficult for asset managers with predominantly active portfolios to generate organic growth: poor relative active investment performance, the growth and acceptance of low-cost index-based products, and the expanding power of the retail-advised channel. This leaves them more dependent on market gains to drive managed asset levels higher. Morningstar noted that they continued to believe that there will be room for active management, and they expected the advantage will go to asset managers with greater scale, established brands, solid long-term performance and reasonable fees. This change in view resulted in an economic moat rating downgrade for Franklin Resources (BEN), which was then scaled out of the U.S. Moat Index in September 2018 and removed entirely in the subsequent December.