Quant Concepts: Wide Moat Winners

Phil Dabo builds a strategy that looks for companies with a sustainable competitive advantage and strong financial health

Phil Dabo 8 January, 2021 | 4:28AM
Facebook Twitter LinkedIn



See more episodes of Quant Concepts here

Phil Dabo: Welcome to Quantum Concepts working from home edition. 2020 has been a year full of surprises and we're moving into 2021 with a lot of uncertainty. There's a lot of optimism surrounding the Coronavirus vaccine. So it's going to be interesting to see how the economy recovers moving forward. We've already seen the S&P 500, up around 16%. So it's not surprising to see that the best performing wide moat stocks are up around 100% year-to-date. Today let's take a look at a strategy that focuses on wide moat stocks, and see if we can identify some of those companies that performed well throughout different market cycles.

We're going to start by selecting our universe of stocks, which is the Russell 1000, because we want a good mix of both mid and large cap stocks. Then we're going to rank our stocks from 1 to 1000 according to four key factors. The first two factors are the Morningstar Financial Health and Morningstar Economic Moat. The financial health variable reflects the probability that a firm will face financial distress in the near future and uses a predictive model designed to anticipate when a company may default on its financial obligations. The wide moat variable is based on the likelihood that companies can keep competitors at bay for an extended period. One of the keys to finding superior long-term investments is buying companies that will be able to stay one step ahead of their competitors. Next, we want companies with really strong earnings momentum, and really strong cash flow momentum.

Now that we have our stocks ranked from 1 to 1000, let's start going through our buy and sell rules. We're only going to buy stocks that are in the top fifth percentile of our list. Both the financial health variable and the economic moat variable go from 1 to 5, with 5 being the strongest, we only want companies that are at least a 5 for economic moat or 3 for financial health. We're only going to buy companies that have a market cap of at least $3.7 billion. And we only want companies that rank in the top third based on the price change to 12-month highs, because in theory stocks that are trading near their high in the previous 12 months tend to continue doing well. We want very low turnover for this strategy. So we've kept the sell rules very simple. We're only going to sell stocks that drop below the 40th percentile of our list.

Now let's take a look at our back tested performance. The beginning of our period is January 2005. And we can see that the strategy has performed well with a 17% annualized return, which is 7.3% more than the S&P 500 with only 19% annualized turnover. The strategy has beaten the benchmark over every single significant time period. As well has generated superior risk adjusted returns as measured by the Sharpe ratio. The beta of the strategy is 1 and this standard deviation is slightly higher. However, when looking at this chart, we can see really strong outperformance. And then when looking at the up and downside capture ratios we can see again that this strategy performs well throughout different market cycles.

This is a great strategy to consider if you're looking for companies with a sustainable competitive advantage and strong financial health. The top five companies on the buy list have generated 40% year-to-date and should provide stability in both up and down markets as we navigate through volatile times. You can find the buy list with a transcript of this video.

From Morningstar, I'm Phil Dabo.

List of stock picks


For a higher resolution image of the buy list, click here

Get the Latest Personal Finance Insights in Your Inbox

Sign up for the Latest Here

Facebook Twitter LinkedIn

About Author

Phil Dabo  Phil Dabo is Director, CPMS Sales

© Copyright 2024 Morningstar, Inc. All rights reserved.

Terms of Use        Privacy Policy       Disclosures        Accessibility