Stocks of companies with the strongest competitive advantages and solid fundamentals took a hit earlier this year, but they’ve been gaining back lost ground in recent weeks.
Since the bear-market low point on June 16, stocks with economic moats are doing better than those without a moat, on balance. But when it comes to the year 2022 to date, it’s still a mixed picture.
Companies with Morningstar Economic Moat Ratings of narrow (those with competitive advantages our analysts expect will help them fend off rivals and earn excess returns on capital for up to 10 years) rose 14.9% since the bear market’s low in mid-June, as measured by the Morningstar Narrow Moat Index.
This group is outperforming wide-moat companies, up 13.6%, while stocks without a moat of any kind have gained 13.1%. Morningstar analysts assign a wide moat rating to companies with competitive advantages expected to last for 20 years or more.
Overall, Morningstar analyst valuations show that wide-moat stocks are deeply undervalued, while prices for narrow-moat stocks have been blown out of proportion.
The differences in short-term performance and valuation have more to do with market-cap weights than moat status, says Morningstar’s director of equity research for index strategies Andrew Lane.
"The performance of the market-cap-weighted wide-moat index is going to be largely determined by the performance of Big Tech stocks, as those stocks account for a large combined weight," Lane says.
Wide-moat companies have stronger pricing power, Lane says, meaning they are better able to pass on rising inflation-related costs directly to consumers. And the performance of wide-moat stocks over the past several years reveals that wide- and narrow-moat stocks have outperformed the broader equity market.
On balance, the US equity market is fairly valued, and the Morningstar US Market Index hovers at 98% of its fair value by market-cap-weighted average. Most of the largest holdings in the Morningstar Narrow Moat Index are now expensive and have risen to prices well above their analyst-assessed fair value estimates.
Narrow-moat Apple (AAPL) is the heaviest-weighted company in the Morningstar Narrow Moat Index at a 16% weighting and is 33% overvalued as of Aug. 15. Narrow-moat companies Tesla (TSLA) and UnitedHealth Group (UNH) are also overvalued by 22% and 35%, respectively, above their fair market value prices.
Heavyweights from the wide-moat group, by contrast, trade at discount prices as of August 15. Wide-moat Microsoft (MSFT) is at 83% of its fair value price, while fellow wide-moat firms Amazon.com (AMZN) and Alphabet (GOOGL) hover around 70% of their fair value.
At the start of the year, the Morningstar Narrow Moat Index was 23% overvalued on a market-cap-weighted average basis, and the Morningstar No Moat Index was 13% overvalued. The Morningstar Wide Moat Index was only 6% overvalued.
"The narrow-moat index has outperformed since mid-June primarily because Apple has soundly outperformed the market," Lane says. "The company has a massive 16% weighting in the no-moat index."
Since the bear-market low, narrow-moat stocks including Apple (up 28.1%) and Tesla (up 32.8%) have seen outsize returns. At the industry level, consumer electronics, a collection of companies that make and sell audio and video equipment, contributed 4.3 percentage points to the Morningstar Narrow Moat Index’s total return of 14.9%. Tesla single-handedly represented the auto manufacturing industry and added an additional 1.41 percentage points to narrow-moat gains.
Among wide-moat companies, leading industries have been internet retail, which has rallied by 34.1% since the bear-market trough, and software infrastructure, up 16.4%. Internet retail includes cyclical companies engaged in the online sale of merchandise, such as Amazon. The software infrastructure industry is composed of companies that develop and provide products and related services for a wide range of business applications and includes Microsoft and Adobe (ADBE).
Historically, companies with economic moats have outperformed the broader market over the long term. For the past five years, the Morningstar Wide Moat Index has surged 95.5%, while the broader market rose 86.8%. At the same time, the wide-moat index outperformed the no-moat group by 24 percentage points.
"If inflation remains elevated, wide-moat stocks are well-positioned to weather the storm versus stocks lacking durable competitive advantage," Lane says. "Companies with wide economic moats typically command pricing power, so they can pass on inflation costs more effectively than no-moat peers. This dynamic helps support margins and cash flows."
