The new ETF will mimic the stock holdings of the Morningstar Singapore Yield Focus Index. With that in mind, it’s worth spending the time to understand how the stocks are selected. The 30-stock index applies three main criteria to Singapore-listed companies: business quality; financial health; and dividend yield.
Today, I would like to take a look at the first factor that is …
Phillip Capital Management’s website provided this snippet on how business quality is determined:
“The index screens for companies with sustainable competitive advantage, or Economic Moats in the parlance of Morningstar’s global equity analyst team. Moats protect income stream for erosion.”
The exact mechanism used by Morningstar to calculate a company’s business quality for this index hasn’t been shared. That said, it’s no secret that Morningstar is a strong advocate of economic moats — that is, a company’s ability to protect its future profits. From its website, Morningstar describes economic moats as:
“The idea of an economic moat refers to how likely a company is to keep competitors at bay for an extended period. One of the keys to finding superior long-term investments is buying companies that will be able to stay one step ahead of their competitors, and it’s this characteristic–think of it as the strength and sustainability of a firm’s competitive advantage–that Morningstar is trying to capture with the economic moat rating.”
The attributes of an economic moat include network effect, intangible assets, cost advantage, switching cost and efficient scale. Another sign of a company with an economic moat is described by Morningstar as follows:
“Companies that have generated returns on capital higher than their cost of capital for many years running usually have a moat, especially if their returns on capital have been rising or are fairly stable.”
A key measure here is the company’s return on invested capital (ROIC), which is compared with the firm’s cost of capital or weighted average cost of capital.
These calculations are important as it informs investors of the ability of the company to make money on its capital. The more profits a company can generate with a smaller amount of capital the greater its returns. Furthermore, if this ability can be sustained for long periods of time, it could indicate that the company has an economic moat.
For example, if Company X invests $100 and makes a net operating profit after tax of $5 this would result in an ROIC of 5%. However, if Company Y can make $15 on the same investment the returns are 15%. Naturally, if company Y can make better returns over the long term it makes sense for an investor to buy Company Y compare to Company X.
In sum, the ROIC can be a key measure to determine a company’s business quality.
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The Motley Fool Singapore contributor Esjay contributed to this article. Esjay does not own any of the shares mentioned.
The information provided is for general information purposes only and is not intended to be personalized investment or financial advice. Motley Fool Singapore writer Chin Hui Leong does not own any of the shares mentioned.