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Why the MOAT ETF Dumped Facebook, 8 Others

Don't worry, those companies still have moats that are plenty wide

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The turnover comes down to Morningstar’s index methodology. Having an unassailable moat isn’t the only criteria; the stocks must also be attractively priced. And on this count, Morningstar uses a discounted cash flow model with a twist. Based on their assessment of the strength of the company’s moat, the Morningstar analysts forecast its return on invested capital relative to its cost of capital (the wider the moat, the bigger the spread between the return on capital and the cost of capital).

If that last sentence made your eyes glaze over, don’t feel bad. Academic finance has its own language, and Morningstar is being a little wonkish here. In plain English: Morningstar makes a list of the 20 cheapest stocks that it classifies as having a “wide moat.”

Facebook and the eight others weren’t booted off the list because their moats shrank. They were simply replaced with stocks that, in Morningstar’s view, were more undervalued.

What are we to take away from all this?

The MOAT ETF doesn’t have a long trading history (not even two years), but over its short life it has outperformed the S&P 500 by about 10%. Of course, this is before taxes, and with a turnover ratio of 45%, MOAT will generate its fair share of capital gains taxes in non-IRA portfolios.

With only 20 holdings, MOAT’s portfolio is also pretty undiversified by ETF standards. It’s heavily weighted towards healthcare and technology (at least until its next reconstitution) and has very little exposure to consumer-focused sectors.

And if you’re buying MOAT for its “Buffett-like” investing style, the high turnover and short holding periods are a little inconsistent. Yes, Warren Buffett actively trades, and not all of his holding periods are “forever.” But Buffett would never hold to a fixed reconstitution schedule, and it would be rare for him to unload nearly half of his portfolio every year. Interestingly enough, Buffett’s Berkshire Hathway (BRK.B) is one of MOAT’s holdings.

My advice? Use MOAT’s holdings as a stock screener for quality stocks trading at a reasonable price. Morningstar’s analysts have done excellent research here, and you can essentially piggyback on it for free by following the ETF’s trading moves.

You don’t have to buy every stock in its list — and you certainly don’t have to sell a good stock simply because MOAT sold it. But I consider MOAT one of several good screeners to get you started in your research. Some others I like as well are the Shareholder Yield ETF (SYLD) and Greenblatt’s Magic Formula.

Charles Lewis Sizemore, CFA, is the chief investment officer of the investment firm Sizemore Capital Management. As of this writing, he was long KMI and SYLD.  Click here to receive his FREE 8-part investing series that will not only show you which sectors will soar but also which stocks will deliver the highest returns. The series starts November 5 and includes a FREE copy of his 2014 Macro Trend Profit Report.

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