5 Great Stock Picks and the Exchange-Traded Fund that Owns Them

You probably know Morningstar as the gold standard in mutual fund data and research. I think its stock research is even better. Now there’s a new exchange-traded fund that invests in Morningstar’s top stock picks. Market Vectors Morningstar Wide Moat ETF (symbol MOAT), launched April 24, may be just the ticket for making money in a volatile stock market.

You may wonder how I can be so effusive about a fund that is less than one month old. First, consider some performance numbers. From the launch of the Morningstar Wide-Moat Focus index on September 30, 2002, through May 14, the index returned an annualized 14.4%. Over the same period, Standard & Poor’s 500-stock index returned an annualized 7.4%.

Why is the record so good? Partly, I think, it’s because Morningstar is an independent research firm. I trust independent research a whole lot more than I do the stuff churned out by brokerage-firm analysts. Morningstar has more than 100 stock analysts -- a big number for an independent firm -- and my sense is that Morningstar does a good job of hiring talented people.

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The index, like that of many benchmarks tracked by ETFs, is hardly an index in the conventional sense. Most indexes mirror a segment of the market, are weighted by market value (share price times number of shares outstanding) and do little trading.

The Morningstar index comes closer to looking like an actively managed product than a passive benchmark. It begins with Morningstar analysts dividing the universe of companies they cover into those with no moat, a narrow moat and a wide moat (the moat concept, as it pertains to stocks and companies, has been popularized by Warren Buffett).

Companies with wide moats are those that Morningstar believes possess sustainable competitive advantages over their rivals. An example of such a company is Wal-Mart Stores (WMT), which seems highly likely to sustain its cost advantage over other chains for many years to come. Most wide-moat stocks are blue chips.

Altogether, Morningstar classifies about 170 companies as having wide moats. To construct its index, Morningstar eliminates foreign-based companies as well as master limited partnerships, which can create tax headaches. That leaves 120 stocks.

Morningstar’s analysts assign a “fair value” price to every stock they cover. Every three months, Paul Larson, the firm’s chief equity strategist, identifies the 20 cheapest stocks based on the percentage by which the current share price trades below fair value. Each is assigned a 5% weighting.

That’s the index. Morningstar makes no effort to achieve diversification by sector. “Two years ago, we had 35% of the index in consumer discretionary stocks, and today we have zero,” Larson says. Similarly, the index currently holds both Martin Marietta Materials (MLM) and Vulcan Materials Company (VMC), the biggest producers of aggregates used in road construction.

The index changes a lot. On average, a stock stays in the index only about nine months. Stocks don’t get cheap enough to be in the index without some visible dents. Martin Marietta and Vulcan, for instance, are suffering because governments at all levels lack the money to build many new roads.

Some Caveats

The returns from 2002-07 are based on back-tested results. In other words, Morningstar sifted through its data to see how various stock-picking systems might perform. It’s easy to pick out good back-tested results. It’s totally different to run a real-world portfolio. Even Larson concedes that Morningstar’s back-tested results “should be taken with a grain of salt.”

But in late 2007, the Morningstar index began operating in the real world. That was when Elements Morningstar Wide Moat Focus ETN (WMW), an exchange-traded note (ETN), was launched to track the index. From the ETN’s inception through May 14, it returned an annualized 6.4%, compared with an annualized loss of 0.9% for the S&P 500. These are returns you can take to the bank.

There are lots of reasons not to invest in exchange-trade notes, which I’ll discuss another time. But now, with the launch of the Market Vectors ETF, sponsored by Van Eck Global, you have at your disposal a much more appealing vehicle for tracking the Morningstar index. The ETF charges 0.49% a year for expenses.

The index and the ETF do have one big problem: They’re about 20% more volatile than the S&P 500. Volatility -- how much a fund’s price bounces up and down -- has proven to be an excellent predictor of how much a fund loses during bear markets.

Consequently, I wouldn’t put too much money into this ETF. If you do buy the ETF, make sure you also invest in plenty of lower-risk investments.

All that said, the index performed relatively well during the 2007-09 bear market, falling 49.6%, compared with 55.3% for the S&P. That, plus the heavy emphasis on blue chips, is heartening.

Prefer to buy individual stocks? Vulcan, which is in the ETF, is one of Larson’s favorites. Here are four others that are in the ETF and that are among his top picks:

Cisco Systems (CSCO) is the dominant company in networking equipment, particularly routers and switches. Yet, at a price of $16.71, it trades at just 9 times the average of brokerage analysts’ estimated earnings for the coming 12 months.

Exelon Corp. (EXC) is the nation’s largest nuclear plant operator. That gives it a cost advantage over many other electric utilities. At $38.82, the stock yields 3.9%.

Oracle (ORCL) dominates computer databases and a host of other business applications. Morningstar expects it to successfully navigate the challenges of the move to cloud computing. It trades at just 10 times estimated earnings for the coming 12 months.

St. Joe (JOE) is the largest private landholder in Northwest Florida, with enormous tracts in the panhandle. The Florida real estate bust has put the company under a lot of pressure, but Morningstar sees that as a cyclical challenge the firm will surmount.

Steven T. Goldberg is an investment adviser in the Washington, D.C. area. He or at least one client owns shares of each of Larson’s five stock picks.

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