SMID-Cap Moats leading the market rally

Morningstar US Small-Mid Cap Mot Focus Index (“SMID Moat Index”) managed to outperform all three market cap segments of the US stock market in January. The SMID Moat Index provides mostly mid cap exposure as well as some small cap exposure among US companies that benefit from sustainable competitive advantages.

Mid caps followed by small caps for the month. Large caps generally participated least in the January market rally. Despite the SMID Moat Index’s relatively low exposure to small caps, it outperformed them in January by 2.25%. In fact, for those “moot heads,” the SMID Moat Index even outperformed its big sister. morningstar wide mot focus index, who had an equally impressive month,

Banner January for SMID Moat Investing

1 month total return till 1/31/2023

Source: Morningstar. by 1/31/2023, Past performance is no guarantee of future results. The performance of the Index is not indicative of the performance of the Fund. Fund performance as of the most recent month end is available by visiting vaneck.com or by calling 800.826.2333. Indices are unmanaged and are not securities in which to invest.

Stock selection a major contributor to January performance

The SMID Moat Index benefited most from its exposure to consumer discretionary, industrials and information technology companies, while not a single sector posted negative returns within the index as a whole. With nearly 75% of its exposure in mid-cap stocks, the SMID Moat index was heavily influenced by stock selection Within that market cap segment. Stock selection in small cap stocks, though less risky, contributed almost majorly to January’s strong performance.

Notably, only five SMID Moat Index companies posted negative returns for the month: Baxter International, Kellogg Companies, Hasbro Inc., Sirius XM Holdings and Zimmer Biomet Holdings.

Some leaders are lesser known, and most are in the car business, so let’s get to know them a bit economic gap and evaluation.

Top SMID Ditch Companies in January

Adient (ADNT)

Adient plc is an automotive seating business that was spun off from Johnson Controls in 2016 and has about 33% of the global seating market according to Morningstar. While auto parts may not be the most interesting segment of the market, competitive advantage matters here. Morningstar sees seating as one of the busiest areas of the supply chain as automakers require consistent quality that can be delivered with precision around the world. Stated differently, automakers will typically pay for the right supplier rather than seek the lowest cost provider. In fact, Morningstar notes that it is common for existing seating suppliers to achieve next-generation vehicle schedules almost 100% of the time.

Adient has been given a narrow gap rating conducted by Morningstar Intangible assets, Profitable And switching costs, While its advantages are strong, it has been assigned a narrow moat rather than a wide one due to the growing global potential of automaker customers and Adient’s lack of immunity to the cyclical nature of the auto industry. Morningstar believes that Adient can generate economic profit for 10 years, but for reasons stated, they cannot say that Adient can generate economic profit for 20 years.

Adient’s fair value estimate was raised from $64 per share to $68 in November 2022 to reflect continued operating improvement over time. Adient was a victim of global chip shortages and higher steel and chemical input costs, which offset negative sentiment in the recent period, according to Morningstar. The company ended the month at a 30% discount to Morningstar’s fair value estimate.

Lithia Motors (LAD)

Lithia Motors is a publicly traded auto dealer that has carved out a distinct business as the only public dealer serving rural markets. In fact, many Lithia brand stores have no competitors within 100 miles, according to Morningstar. Dealers, like some other publicly traded dealers, benefit from cost advantages and intangible assets. It also enjoys the lack of competition for many vehicle brands, given its focus on rural areas. Morningstar believes that public dealers enjoy several advantages over private dealers, such as centralized back-office operations and the much higher volumes that scale brings. They are also not dependent on any single vehicle brand as many have a diverse portfolio of dealerships.

Morningstar also sees the parts and service operations in Lithia as a strong advantage. Customers are prone to return to the dealer for service due to warranty or proximity to home and expertise to service a particular vehicle. Getting multiple quotes on a single vehicle repair can be time consuming. According to Morningstar, all of this leads to inelasticity of demand and strong pricing power for dealers.

For the better part of the decade, Lithia has traded near Morningstar fair value. Outside of the market selloff in March 2022, Lithia shares haven’t traded at such a steep discount to fair value in the last 10 years. Shares ended January at a nearly 40% discount.

Sensta Technologies (ST)

Staying on the automobile subject, Sensta Technologies is primarily a supplier of sensors and electrical protection for the automotive market. According to Morningstar, it has positioned itself well to participate in secular trends towards electrification, efficiency and connectivity.

Sensta’s narrow gap rating is primarily attributed to switching costs. Its sensors and controls are often part of mission critical processes related to electric vehicle battery management systems, avionics systems and power grids. As Morningstar explains it, once a supplier’s component is designed into an end application, it is likely to last throughout the product’s lifecycle – up to five to seven years in cars and more than 10 years in aerospace applications. . Morningstar believes Sensta also has strong design and engineering capabilities, demonstrating intangible assets that complement its moat.

After closing January below $53 per share, Sensata was at a more than 25% discount relative to its Morningstar fair value estimate.

Asbury Automotive Group (ABG)

ABG, like Lithia Motors, is a publicly traded auto dealer and benefits from similar cost advantages and intangible assets. ABG operates around 150 dealerships and generates the overwhelming majority of its revenue from the luxury automobile segment. This makes it a bit more recession proof, as customers of luxury brands have higher-than-average incomes and can often afford new cars and maintenance through economic cycles.

Morningstar raised its fair value estimate substantially from $233 per share to $377 in April 2022 based on the company’s growth trajectory. Morningstar maintains its fair value outlook, following a strength run in the fourth quarter of 2022.

ICU Medical (ICUI)

ICU Medical is a comprehensive infusion and IV provider offering infusion consumables, infusion pumps and IV solution manufacturing. Morningstar believes that its unmatched scale in consumables allows ICU to offer extremely low prices that will be difficult for competitors to beat and that the firm’s ability to generate excess returns over the coming decade assures me. ICU Medical also benefits to some extent from switching costs in its infusion systems segment.

Like medical technology firms, which benefit from intellectual property and regulatory factors limiting competition, only a handful of competitors have meaningful scale in the ICU markets. As Morningstar points out, infusion consumables are relatively commodity-like parts that are used in IV administration. These include mostly plastic parts such as IV sets, IV connectors, closed system transfer devices, disinfectant caps, and more. ICU Medical has the leading US market share in this segment. Morningstar doesn’t see this changing anytime soon, as ICU Medical has been able to price its consumables at significant discounts to the market, attracting hospitals and other health providers.

After trading at a steep discount to fair value for most of 2022, ICU Medical is now trading near fair value.

Top contributors and detractors of the SMID Moat Index

January 2023

Source: Morningstar. by 1/31/2023, Past performance is no guarantee of future results. Nothing described herein is intended as a recommendation to buy or sell any securities.

VanEck Morningstar SMID Moat ETF (SMOT) Morningstar seeks to track the price and yield performance of the US Small-Mid Cap MoAT Focus Index as closely as possible before fees and expenses are factored in.

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