Morningstar ETN Bets On Wide-Moat Firms

Companies with moats have "sustainable competitive advantages" such as a monopoly or oligopoly, the ability to produce goods or services at a very low cost, a patent, a copyright, economies of scale or a loyal customer base through high switching costs. Think American Express (NYSE: - ), Bank of America (NYSE: - ) and Coca-Cola (NYSE: - ).

These companies also have recurring revenue streams, a strong brand that insulates them from competition and the ability to raise prices. They have predictable earnings, returns on capital higher than the cost of capital, and long-term staying power, says Morningstar (NasdaqGS: - ), which advocates wide-moat investing. The investment advisory and research firm says there are high odds that such companies' intrinsic value will rise over time and lead to higher shareholder returns.

Morningstar has teamed up with Deutsche Bank (NYSE: - ) to launch a new exchange traded note that offers returns of the Morningstar Wide Moat Focus Total Return Index.

Heavy Concentration

The Wide Moat Focus Elements ETN tracks 20 companies selected from a universe of 2,000 "wide-moat companies" that Morningstar follows.

"We don't think that diversification is a substitute for good research," said Pat Dorsey, director of stock research for Morningstar. "And while we recognize that a more concentrated portfolio is going to have lumpier returns, the long-term investor would prefer a lumpy 12% return to a smooth 8% return."

Discounted Cash Flow

The equally weighted index is rebalanced every quarter to include the top 20 stocks that are trading at the cheapest valuation, as measured by the Morningstar price-to-fair value ratio.

And how do you define cheap? Simply, they're the stocks trading the furthest below intrinsic value based on the discounted cash flow method. That's projecting the cash flow a business will generate in the future and estimating what it would be worth in today's dollars.

Hence nearly half of the index is weighted in out-of-favor financials: Bank of America, Capital One Financial (NYSE: - ), Citigroup (NYSE: - ), Federated Investors (NYSE: - ), JPMorgan Chase (NYSE: - ), Legg Mason (NYSE: - ), Marsh & McLennan (NYSE: - ) and Progressive Corp. (NYSE: - )

All of these are trading 13% to 26% below their 52-week highs, except for Federated.

This ETN, says Dorsey, is for long-term investors looking to buy good businesses at 80 cents on the dollar. The index is currently heavy with financials and large caps because they're cheap. But the weightings will change over time to include companies of all sizes and sectors, he says.