42% CAGR Returns Buying 5-star wide moat stocks?

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I use two main tools on a daily basis while doing my stock analysis and research: Value Line and Morningstar. Both provide a great long term history of company financial data all in one place, making it very easy to determine if a particular stock is worth investigating further. I use Value Line as more of a magazine to flip through stock tables on a daily basis looking for ideas. I use Morningstar as a way to quickly plug in ticker symbols I find that I want to get data on.

Both services have their own proprietary way of analyzing stocks and providing recommendations. I DON’T use these services at all as I’ve never really been able to find value in these types of services. I am not saying they are poor services. I’m simply saying I prefer to do my own research and rely on the numbers and hard data that these two services provide, rather than their recommendations.

Wide moat Stocks: 42% Annual Returns?

However, this weekend I caught a video at Morningstar that grabbed my attention regarding the historical backtested (aka hypothetical) results that one could have achieved by buying 5-star stocks with wide moats (Morningstar ranks the stocks they cover from 1-star to 5-star, 5 being the best). The results they provide in this video are attention-grabbing: They claim that by simply buying any 5-star, wide moat stock and holding it until it is no longer 5-star, you could have returned 42% per year vs the S&P’s 6% per year for the last 10 year period ending 10/31/12.

Huh?… was the initial reaction I had, and by reading the comments on the video, I could tell others had the same amount of skepticism. 42% per year? They go on to say that even by buying just the 5-star stocks (cheapest stocks) you could have attained 32% per year over the same period. 

But as opposed to all the (justified) skeptical viewers that expressed their disbelief, my comment would come from a different angle:

Why not investigate the methodology to determine if there is anything that we can take away from their strategy that might be helpful to us from a conceptual or strategic point of view?

Instead of complaining that the strategy is not investable because of the low number of stocks that qualify, or the concentration of the portfolio, or the various biases the backtest has, why not see if their system can reinforce or teach us any key concepts?

The first thing to understand is that Morningstar star ranking is basically based on valuation. They have 4 or 5 different inputs into their system, but the stars basically tell you how cheap they feel the stock is (5 is most undervalued, 1 is most overvalued). By digging a bit into the system you will also find the same thing others have: there are not many stocks that pass as being cheap (5-star) that also have a good competitive advantage (wide moat). This makes sense… most good companies don’t often sell at bargain prices. So the 42% results appear nice on paper, but you’d have to take enormous concentration to achieve them, potentially exposing the results to wide swings and/or large losses at some point.

Wide moat Stocks:Consider the Concept, not the Eye-Popping Results

All of those biases and shortfalls of the strategy are true, but what I found interesting is that by ignoring the “moat” aspect of their results, and by simply buying what is cheap, you could still have achieved 32% returns. Now many of the same biases occur with these results, but I believe they are closer to reality because there are many more 5-star stocks than 5-star wide moat stocks. In any event, even if the results overstate the actual reality by a long shot, they show that there is edge to looking at cheap stocks.

More importantly, it reinforces the idea that valuation (cheapness) is more important to focus on than quality. Although their results show that quality (wide moat, competitive advantages, etc…) seems to add value, the biggest reason for the outperformance in the test is not the quality, but the fact that the stocks in the screen are very cheap relative to their earnings, assets, and historical valuations.

Wide moat Stocks: Don’t trust Morningstar, but use their information to form your own methods

I don’t recommend trying to blindly follow a systematic strategy like the one above, but I do recommend digging deeper into the construction of the strategy to determine the logic and reasoning behind why the results appear to be so good. In doing so, you might reinforce key concepts or improve your own understanding of a specific aspect of investing. When you do that, you don’t need to rely on Morningstar to give you stock picks… you’ll develop your own method based on your own understanding of value investing.

All that this backtested system tells me is that buying cheap stocks works, and valuation is more important to focus on than quality, which is the opposite of what I think most investors believe. The title of the video should not be “When it Comes to Performance, Moats Matter”, but rather “When it Comes to Performance, Valuation Matters”.

One last note: I think Morningstar provides a great service, and despite me disagreeing with their logic on certain things, the data they provide along with some of their other analysis is outstanding.

Here is the video discussing Morningstar’s findings (UPDATE: Morningstar officially commented below regarding the content of this post and the results saying they did in fact make a mistake. See comment below)

Here is a link to a page explaining more details on Morningstar’s methodology.

If you don’t have time to read the document, I’ll summarize it in one sentence: The document basically says “We look for stocks that are cheap and good”.

A basic philosophy that resembles my own with one key difference: “I look for stocks that are cheap, then good”.

Both valuation and quality are important, as Buffett taught us… but as Graham taught us, valuation is the most important.

Via: basehitinvesting

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About the Author

John Huber
John Huber is the author of Base Hit Investing, a blog about value investing concepts and ideas. He also is the founder and portfolio manager at Saber Capital Management, LLC, a Registered Investment Advisor that manages equity portfolios for clients using the value investment principles of Ben Graham, Warren Buffett, Walter Schloss, and Joel Greenblatt.

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