What are we looking for?
U.S. consumer defensive companies showing competitive barriers to entry.
The screen
I use Morningstar CPMS to hone in on companies in the consumer defensive sector that are likely to keep competitors at bay for an extended period. To find them, I look to Morningstar’s Economic Moat rating. The rating (no moat, narrow moat or wide moat) is based on a company’s ability to earn a return on capital greater than its weighted average cost of capital. Morningstar’s analysts see five distinct sources of Economic Moat: network effect (when the value of a company’s service increases for new and existing users as more people use the service); intangible assets (such as patents, brands, regulatory licences); cost advantage (for example, being able to undercut competitors on price while earning similar margins); switching costs (when it would be too troublesome for a customer to stop using a company’s products); and efficient scale (when a niche market is effectively served by one or a small handful of companies).
In addition to looking for narrow or wide moats, I ranked the consumer defensive sector within the CPMS U.S. database (which today consists of 111 companies) by the following factors:
- Five-year average return on equity;
- Five-year growth rates in sales and earnings per share (on average, how much the top and bottom lines have grown over the past five years);
- Net profit margin;
- Three-month EPS estimate revision (today’s consensus estimates compared with the same figure three months ago).
To qualify, companies must have at least three active analysts who cover the stock and must have a narrow or wide moat rating from Morningstar.
More about Morningstar
Morningstar Research Inc. provides independent investment research in North America, Europe, Australia and Asia. Its research tool, Morningstar CPMS, provides quantitative North American equity research and portfolio analysis to institutional clients and financial advisers. CPMS data cover more than 95 per cent of the investable North American stock market. With more than 120 equity and credit analysts, Morningstar has one of the largest independent institutional equity research teams in the world.
What we found
I used Morningstar CPMS to back test this strategy from April, 2004, to November, 2018. During this process, a maximum of 15 stocks were purchased and equally weighted. Once a month, stocks were sold if their rank fell below the top 50 per cent of the ranked universe, or if consensus estimates dropped by more than 10 per cent. When sold, the positions were replaced with the highest-ranked stock not already owned in the portfolio. Over this period, the strategy produced an annualized total return of 12.2 per cent while the Morningstar U.S. Consumer Defensive Total Return Index returned 9.2 per cent. Today, only five stocks meet my requirements and they are listed in the accompanying table.
It is always recommended to speak to a financial adviser or investment professional before investing.
Ian Tam, CFA, is a relationship manager for CPMS at Morningstar Research Inc.
Ian Tam, CFA