Top Returns From 'Wide-Moat' Stocks

NEW YORK ( TheStreet ) -- Warren Buffett has long talked about the virtues of businesses with "moats."

Such companies rely on strong brands or other advantages to defend their markets from encroachments of rivals. Buffett's favorites include Coca-Cola ( KO) and American Express ( AXP).

Can wide-moat stocks outperform the markets? Maybe so. Several wide-moat ETFs have delivered solid returns. Among the most promising choices are two products that track a Morningstar index, ELEMENTS Morningstar Wide Moat Focus ETN ( WMW) and Market Vectors Wide Moat ETF ( MOAT). During the past five years, the Elements ETN returned 10% annually, compared to 4.6% for the S&P 500, according to Morningstar.

Buffett popularized moat companies in a remarkable article that he wrote for Fortune magazine in 1999. At the time, stocks were soaring as investors embraced technology stars. Many investors believed that markets would continue delivering double-digit returns as the Internet introduced a new era of productivity growth.

But Buffett sounded a cautious note. The markets would likely produce annual returns of around 6% in the next 17 years, he predicted. The problem was that prices had become rich.

Conceding that new technology would bring important changes, Buffett pointed to earlier breakthroughs, such as cars and airplanes. Those had altered society, but the stocks of the new products proved to be poor long-term investments.

Buffett said that instead of seeking businesses that can change society, investors should buy stocks with durable competitive advantages. "The products that have wide, sustainable moats around them are the ones that deliver rewards to investors," he wrote.

Within a year, Buffett's forecast appeared prescient. Technology stars crashed, while mundane companies that dominated their markets proved more resilient.

Buffett's thinking had a big impact on researchers at Morningstar who set out to locate companies with wide moats. The researchers began compiling a list of businesses that could dominate their niches for decades.

These days, the Morningstar ranking of wide-moat companies includes such solid performers as Caterpillar ( CAT) and Buffett's Berkshire Hathaway ( BRK.B).

To develop the index, the Morningstar analysts studied how companies with advantages had performed in the past. What became clear was that many companies achieved strong profits for a year or two and then slipped back to producing mediocre results. In a common pattern, a fashion company would develop a new style that produced a profit surge. But competitors soon developed copies that took away sales.

The researchers concluded that long-lasting moats tend to fall in several categories. Some companies simply thrive by keeping costs low. Businesses gain cost advantages by developing superior management systems or attaining a size that competitors cannot duplicate.

A prime example of a low-cost champion is Wal-Mart ( WMT). Other businesses maintain advantages because they hold well-known brands or patents. Pharmaceutical companies such as Pfizer ( PFE) have long delivered rich profits by developing patented drugs that competitors cannot sell.

To pinpoint winning companies, the analysts evaluate 1,500 stocks and assign a moat rating to each. At the top of the list are companies with wide moats. These have histories of generating solid returns on capital. Because of their moats, the businesses seem poised to continue performing at high levels for the next two decades.

A step down the scale come companies with narrow moats. While these have some competitive advantages, they may not maintain an edge for the next two decades. Finally there are companies with no moats.

About 120 companies qualify for wide-moat ratings. From this group, the analysts assemble the 20 stocks that sell at the biggest discounts to their fair values. The low-cost group makes up the Morningstar Wide Moat Focus Index.

Current holdings in the index include Weight Watchers ( WTW), Microsoft ( MSFT) , and Western Union ( WU), the leading provider of money transfer services. The index makes no attempt to be diversified, and sector weightings often shift. The assets in consumer discretionary stocks dropped from 30% of the portfolio at the beginning of 2010 down to zero two years later.

Morningstar argues that the index approach works because short-term Wall Street investors fail to appreciate the value of wide-moat stocks. Champion companies may temporarily slip out of favor, but they rebound eventually because of their persistent advantages.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.
Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.