Will these Warren Buffett-style ‘moat’ ETFs protect against inflation?

With inflation at nearly 10% in the UK, these two ETFs that track companies with sustainable competitive advantages are options to consider.

What’s the perfect company to invest in? According to Warren Buffett, it is one with a so-called moat. This refers to a business with a long-term sustainable competitive advantage, which protects its market share and profits from rivals. 

As Buffett himself has described it: “What we’re trying to do is we’re trying to find a business with a wide and long-lasting moat around it, protecting a terrific economic castle with an honest lord in charge of the castle.”

The idea is that the main threat to any company is its rivals. Over time, competitor firms will try to steal market share and erode the revenues of a company. The perfect company, therefore, has some sort of competitive advantage that stops rivals eating into their market share. This advantage is its moat and the wider the moat, the safer the company.

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On top of that, companies with competitive advantage can often charge higher prices without the risk of losing market share.

Moat outperformance?

So does a moat translate into better share price performance? Using the Morningstar Wide Moat Focus Index, data from FE Analytics shows that historically they have. Over the past five years, the Morningstar Wide Moat Focus Index has returned 117% compared with  62% for the MSCI World Index, in sterling terms to 11 September 2022.

The Morningstar Wide Moat Focus Index uses the Morningstar Economic Moat Rating methodology, which assigns an economic moat rating to companies from the five sources of competitive advantage mentioned above. However, it also screens for companies it deems to be trading at attractive valuations.

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Inflationary pressures

With inflation at 9.9% in the UK, and 8.3% in America, the era of low inflation is well and truly over.

Forecasts are for inflation to remain high, with the Bank of England expecting year-over-year price changes of 13% at their peak next year.  This should force investors to think hard about the type of assets they hold in their portfolio and what inflation will mean for them. When it comes to their equity allocation, investors should ask what type of companies will perform better in a more inflationary world. And this is where companies with economic moats come in.

A key part of having an economic moat is pricing power. Companies with strong intangible assets, network effects, high switching costs and cost advantages all have the power to charge higher prices without risking losing market share to rivals. This is potentially a great benefit in a world of higher inflation.

Higher inflation means higher input costs for companies, be it raw materials or the wages of workers. For many companies, these higher costs will force them to choose between raising prices at the risk of losing market share, or keeping prices down but seeing smaller profit margins. Either way, inflation hurts.

Companies with strong competitive advantages do not face this dilemma. In theory, firms with strong economic moats can pass these costs on to consumers, keeping margins high without threatening market share.

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ETFs to access moat companies

So how should investors convinced of the case for economic moat companies put this into practice?

First, there is the VanEck Morningstar Global Wide Moat Ucits ETF. This tracks the previously mentioned Morningstar Global Wide Moat Focus Index, for an ongoing charge of 0.52%.

Currently, this exchange-traded fund (ETF) has 71 holdings, but this can change depending on Morningstar’s regular reviews of the index. The minimum number it can hold is 50.

As for the current holdings, as of September 2022,  the ETF’s largest holding was Kellogg, at 2.4% of the fund, followed by Gilead Sciences and Ambev, with similar allocations.  Well-known American tech firms also feature, including Microsoft, Adobe and Alphabet.  

However, the fund is not full of overvalued tech holdings, with Morningstar including valuation in its index construction. It currently sits on a 12-month trailing price-to-earnings ratio of 18x, which is just slightly higher than the MSCI World index. Since launch in July 2020 the global moat ETF has returned 24.5% versus 28% for the MSCI World index. This year it is up 1% versus a 4% drop for its global index.

The other option is the VanEck Morningstar US Sustainable Wide Moat ETF.  This index is composed of US companies with strong moats and attractive valuations. It is slightly cheaper than the global version, charging 0.49%.

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This ETF’s portfolio is composed of 61 stocks and It looks very different to the wider US market. Its biggest holding is Polaris, a manufacturer of motorbikes and snowmobiles, and Kellogg, the consumer staples company.

In part, this is a result of Morningstar’s index review in 2020, which resulted in a notable reduction of big tech firms and other growth-oriented stocks, in a move to shift towards value stocks.

So, for example, while the roughly half a dozen big tech companies account for around a fifth of the S&P 500, only Alphabet and Microsoft sit in the US moat index, each accounting for around 2%.

Since launch in October 2015, VanEck Morningstar US Sustainable Wide Moat ETF has returned 198% compared with 173% for the S&P 500 index. Year-to-date it is down 4% versus a 2.5% drop for the S&P 500 index.

Where do moats come from?

According to Morningstar, there are five main ways a company can gain a moat. Network effect: this happens when the value of a company’s service increases as more people start to use it. The obvious example here is a social media platform. This makes it hard for rivals to gain a foothold in the market.

Intangible assets: patented drugs, unique software or production processes, branding and other intangible assets can prevent competitors from copying a company’s products. This can also mean the company can charge higher prices.

Cost advantage: companies that have a structural cost advantage can offer lower prices than competitors, defending their market share. Or, such companies can charge the same as rivals and earn relatively higher margins.

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Switching costs: if changing product is too costly or troublesome for the consumer, the company has less risk from competitors and can potentially charge higher prices.

Efficient scale: in some sectors, the cost of servicing the market is so high it deters new entrants. Costs are so high that new entrants would cause returns for all players to fall to too low a level to be worth it. The classic example here is oil and gas pipelines.

Most companies deemed to have an economic moat will have some combination of these, to varying degrees.