Investing in blue-chip stocks: trust the titans of the market

Over the last few years more and more market commentators have noticed a concentration effect whereby a small number of very successful businesses are becoming more powerful in terms of market share, which in turns leads to higher share prices. Backing these businesses has been a profitable trade for active fund managers.

For investors with a more passive inclination the choice in this context has historically been more limited, but that is now changing. In recent years a few new exchange-traded funds (ETFs) have tried screening national or global markets for a more focused collection of large, highly profitable businesses where the competitive advantage is defensible.

Borrowing from Buffett

An enduring competitive advantage is known as a “moat”. A company with a wide moat can keep competitors at bay for an extended period of time. It’s an idea borrowed from Warren Buffett but is also widely used by many active fund managers. It’s also the core strategic objective of a new ETF from US-based issuer called VanEck. It’s called the VanEck Vectors Morningstar Global Wide Moat UCITS ETF (LSE: GOAT), and has just launched on the London Stock Exchange. According to VanEck, the Morningstar Global Wide Moat Focus IndexSM, which the fund tracks “has outperformed the MSCI World Index by 3.97% since its launch on 23 April 2018”, and contains stocks from Europe, Japan, China and Australia. The underlying index tracks “the overall performance of attractively priced global companies with sustainable competitive advantages”. The new ETF has a total expense ratio of 0.52% per year.

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So how are the stocks chosen? Morningstar’s analysts crunch lots of numbers starting with the “return on invested capital (ROIC) relative to the company’s cost of capital to determine profitability”. The next step is called “show me the money”: has the ROIC exceeded their expectations?

Then the analysts see whether that abnormal return can persist, by looking for advantages such as high switching costs (is it a pricey hassle for a client to move to a rival?), a distinct cost advantage, lots of intangible assets or maybe a technology-driven network effect: everyone needs to be on a platform to take advantage of a product. These are the hallmarks of firms with wide moats. To Morningstar, a key criterion is also an ability “to generate ROIC in excess of its cost of capital for at least 20 years”.

What kind of businesses pass these tests? A US version of the GOAT fund gives us the answer. Top holdings include Tencent, Alibaba, Microsoft, Constellation Brands, Salesforce and Julius Baer. The average market cap is $178bn, with an average price/earnings ratio of 22.2 – US stocks account for 64% of the index, China 7%, and the UK 6.6%. In terms of sectors, healthcare stocks are the biggest weighting at over 20%.

An alternative approach

Building a fund around moat companies isn’t the only strategy for targeting large-cap, high-margin, successful businesses. There is also the S&P Dow Jones Global Titans Index, which is tracked by the Lyxor DJ Global Titans 50 UCITS ETF (LSE: MGTU); it has gained an impressive 94% in three years. This index looks at market cap, revenue and net income and then for each company ranks their weighting in the index by market cap, at 60%, the revenue rank at 20%, and the net profit rank at 20%. The 50 companies with the highest final rank are selected.

Top holdings include Fast Retailing (whose brands include Uniqlo, at 8.81%) and Itochu, an industrial firm (8.78%), alongside better known names such as Softbank (6.85%), Amazon, Toyota and Fujitsu.