Investing tip of the month from Morningstar Investment Research Center by Christine Benz, director of personal finance and editor of Morningstar PracticalFinance.
Investors who are in or nearing retirement face a conundrum. On the one hand, increased longevity means that holding stocks is a must for most retirees. Without the growth potential that equities afford, the risk of outliving your assets is simply too great. On the other hand, the recent market debacle amply demonstrated the havoc that stocks can wreak on retiree portfolios. If your portfolio incurs big losses before or during retirement, the net result might not be just sleepless nights but also a meaningful change in your standard of living.
Because your asset allocation is such a big determinant of how your portfolio behaves, finding the right stock/bond/cash mix is the most significant investment decision you'll make, no matter what your life stage. Not only should the size of your portfolio play a role in the asset-allocation decision-making process, but also whether you have income from other sources, your ability to withstand losses (would portfolio losses of a certain magnitude require you to reduce your spending?), and your desire to leave a legacy for your loved ones.
Assuming you've decided to carve out a portion of your portfolio for stocks, however, the type of stocks you choose will also have an appreciable impact on your portfolio's return potential, as well as its potential for losses. True, 2008 might have seemed like the kind of market environment when stock investors simply couldn't win: Stock types that retirees may have assumed to be less risky, including dividend payers, large- and mega-caps, and value-oriented names, all tumbled at once.
When viewed through another lens, however, 2008 was very much a tale of two stock markets. And while it wasn't possible to avoid losses entirely, it would've been possible to dramatically reduce them by adding another tool to your stock- and fund-picking arsenal. Companies with what Morningstar's stock analysts call moats--in short, defensible franchises and sustainable competitive advantages--clearly held up better than no-moat companies last year. By extension, mutual funds that held wide-moat companies also posted much smaller losses than funds with no-moat or narrow-moat firms. No-moat companies lost close to 50% in 2008, whereas wide-moat firms lost 20 percentage points less.
That trend has reversed itself thus far in 2009. As investors embraced risky assets again, narrow- and no-moat firms have trounced wider-moat companies.
That zig-zag 2008/2009 performance pattern argues for maintaining some exposure to both types of companies if you want to be truly diversified. Nonetheless, you're still far better off avoiding losses in the first place than trying to make them up after a downturn. And needless to say, loss avoidance is particularly important for those who are already in retirement and may not have years and years to wait around for their portfolios to recover. For example, the investor who lost 49% by holding no-moat stocks in 2008 would have to see his portfolio double in value during a recovery just to get back to break-even. The wide-moat investor who had lost 28% in 2008 would have his work cut out for him, too--losing a fourth of your portfolio is nothing to sneeze at--but he'd have to gain a much smaller percentage in a recovery to get back to break-even.
It's also worth noting that wide-moat stocks currently appear to be undervalued relative to no-moat companies. Thanks to the latter's recent outperformance, Morningstar's stock analysts believe low-quality stocks are roughly 15% overvalued, based on their estimates of companies' price/fair value ratios. Wide-moat companies, in contrast, are roughly 15% undervalued, according to our analysts' estimate. (These data are as of early September.) So if you have cash you've been waiting to deploy into equities but are concerned about buying after six months' worth of rally, wide-moat stocks and funds could prove to be a very good way to go about it.
Moats and Why They Work
For these reasons, I strongly believe that retirees can help their own cause by skewing the equity components of their portfolios toward wide-moat firms. True, all bear markets are different, and it's a mistake to assume the patterns we saw during 2008 will hold true in future downturns. For example, smaller-cap and value names strongly outperformed large-cap growth stocks during the 2000-02 bear market, but that wasn't the case in 2008. (Our stock analysts weren't assigning moats to every company they covered during the bear market earlier this decade, so it's not possible to examine the performance of wide-moat versus no-moat stocks during that downturn.)
But just as it's easy to understand why investors gravitate to Treasury bonds when they're worried about the future, it's also easy to see why wide-moat companies hold up better than narrow- or no-moat companies in times of economic turmoil. Simply put, the strong get stronger during tough economic environments, and wide-moat firms have generally shown a consistent ability to earn a return on invested capital that's higher than their cost of capital. Wide-moat firms hail from a variety of market sectors.. But, typically, companies with what our stock analysts call wide moats have one of the following characteristics, and many wide-moat firms have more than one of these qualities.
Huge Market Share: When a firm enjoys economies of scale in areas like manufacturing, sales, and marketing, that can be a strong competitive advantage. Wal-Mart WMT is a good example of a company that enjoys an economic moat due to its size. As the world's largest retailer, the company can negotiate favorable terms on everything from the products on its shelves to store leases and distribution agreements.
Low-Cost Production Capabilities: The ability to produce and sell products or services at a lower cost than competitors is an advantage that's especially potent in commodity industries. Wal-Mart is another good example here. Because its prices are lower than most retailers of everyday goods, it can readily steal market share from higher-cost competitors. That ability was on display in 2008, when strapped consumers traded down from higher-priced retailers.
Patents, Copyrights, or Governmental Approvals and Licenses: Some companies generate enormous profits when their products or markets are protected by the government. Pharmaceutical maker Abbott Laboratories ABT exemplifies a firm with a wide economic moat as a result of its many patent-protected drugs.
High Customer-Switching Costs: If you can make it tough for your customers to use a competitor's product, it's usually easy to keep ratcheting prices up just a bit year after year, which can lead to big profits. Microsoft's MSFT wide moat owes in part to high customer-switching costs. Many computers come preloaded with Microsoft software, meaning that consumers have to go out of their way to use another operating system.
The Network Effect: This is a relatively rare, but potentially quite potent, source of competitive advantage, and often accrues to the first mover in an emerging technology. Because a network's value increases as more people use it, the company that creates the network can create a massive economic moat. Our stock analysts point to credit-rating agency Equifax EFX as an example of a wide-moat firm that benefits from the network effect. Not only do businesses rely on its reports, but they also provide it with data, leading to a virtuous circle.
Identifying Wide-Moat Stocks
So how do you find wide-moat companies? Identifying wide-moat stocks using Morningstar Investment Research Center is easy. Go to the Stock Screener and choose Morningstar Economic Moat from the dropdown menu and set the condition to equal. You can also layer on additional criteria such as companies with low price/fair value ratios, meaning that our analysts think they're trading cheaply. I also like to look at low fair-value uncertainty ratings, which generally mean that our stock analysts have a high degree of confidence in the predictability of a company's future free cash flows. Our preliminary analysis shows that companies with low fair value uncertainty ratings, like those with wide moats, dramatically outperformed in 2008.
Here are some individual stocks that look good on all three metrics: wide moats, low fair-value uncertainty ratings, and price/fair value ratios of less than 1.0, indicating that our stock analysts think they're trading at a discount to what they're truly worth.
Abbott Laboratories ABT
As I noted before, Abbott's portfolio of patent-protected drugs provides it with a wide moat. Because patent expirations are inevitable for drug firms, however, the firm also has strong lineups in the areas of health-care diagnostics and nutritional products. The stock is currently trading at just 70% of what our analyst thinks it is worth, and investors get paid to wait: The company had an above-market dividend yield of 3.4% in late September.
ExxonMobil Corporation XOM
Like all energy firms, Exxon is vulnerable to swings in volatile energy prices, but our analysts think the firm's successful pursuit of operational efficiencies will set it apart from other firms within the same sector. Management also has a good track record of allocating capital to the highest-payoff projects. ExxonMobil is currently trading at an 80% discount to our analyst's estimate of its fair value.
Procter & Gamble PG
This consumer-product stalwart has built a wide moat with its product development and marketing prowess, and it has also done a good job of acquiring and integrating competitors with complementary product profiles, as was the case with its Gillette purchase in 2005. Our analyst is also impressed that the firm, which is the largest consumer-products company in the world, has been able to avoid bloat despite its girth, controlling costs and delivering strong per-employee productivity levels. Like Abbott, P&G has a dividend yield that's comfortably above that of the broad market.
Stryker SYK
Unlike the above-mentioned firms, medical-equipment maker Stryker didn't hold up especially well in 2008, as reduced hospital spending cut into the firm's sales. However, the analyst particularly likes the firm's orthopedic-implant business, including artificial knees and hips, because the business tends to be sticky: Once a surgeon learns to use a certain type of artificial implant, he or she is loath to make a change. Stryker appears particularly undervalued right now, with a price/fair value ratio of just 0.63.
Identifying Wide-Moat Funds
Even if you're not a stock investor, you can ensure that your portfolio also has wide-moat stocks. Here are some of my favorites that are widely available to fund investors. You'll note that many of these funds haven't performed particularly well thus far in 2009, but they may also have greater upside potential from here than do funds with more narrow- or no-moat companies.
Jensen JENSX
It's no surprise that Jensen consistently shows up on Morningstar's list of the funds with the highest share of wide-moat companies: Management seeks firms that have delivered returns on equity of 15% or better in each of the past 10 years, a feat that would be impossible to pull off without having a sustainable competitive advantage. Whereas this portfolio has historically tilted heavily toward consumer-staple stocks and drugmakers, and still does, management has recently been finding more technology and industrial companies that meet its criteria. Jensen's portfolio also earns a remarkably low fair-value uncertainty rating, meaning that our analyst team has high confidence in the cash-flow-generating abilities of its underlying companies.
Dreyfus Appreciation DGAGX
Yes, its year-to-date performance has been underwhelming, and yes, I wish its costs were lower. But apropos for retiree portfolios, this fund's basket of wide-moat stocks has helped it excel on the downside, making it easy for shareholders to hang on during periods of broad-market turbulence. The fund's investor returns, a measure of what the average shareholder has actually earned here, are higher over the past decade than its published total returns. I'd argue that owes to the fund's low volatility, which has helped keep shareholders from buying high and selling low.
Sequoia SEQUX
Although Sequoia's average moat rating isn't quite as high as the aforementioned funds, it still towers above most mutual funds. The fund's fair-value uncertainty rating is also very low relative to other large-company funds, indicating our analysts have a high degree of confidence in the cash-flow-generating abilities of its underlying companies. The merits of such a portfolio were on full display in 2008, when it lost fully 10 percentage points less than the S&P 500.
Vanguard Dividend Appreciation VDAIX
Vanguard Primecap VPMCX also has a big share of wide-moat companies, but it's closed to new investors. This fund is a close second on the moat front at Vanguard, however, as its focus on companies with a record of growing their dividends has helped keep the overall portfolio's quality high. Note that its strategy doesn't give it a high dividend yield in absolute terms, but we're still bullish on this fund's prospects and think its very low costs are another big plus.
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