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Wide Moats, Good Stewardship Potent in Bear Market

Companies with wide moats and A Stewardship Grades have held up relatively well so far; use this screen to find some.

Haywood Kelly, 03/31/2009

During the brutal bear market of the past year, Morningstar analysts have noticed two interesting patterns among stocks they cover. First, the shares of wide-moat stocks (as tracked by Morningstar Indexes) have held up relatively well. Over the trailing one-year period, wide-moat stocks have shed 28.2% of their value, compared with a 49.4% drop for no-moat stocks.

                       Wide     Narrow     None
2008 Rtrn%   -28.2     -40.6       -49.4

As a reminder, wide-moat firms are those Morningstar's equity analysts think have the strongest competitive advantages. They're firms like Coca-Cola KO, eBAy EBAY, and Microsoft MSFT, which have the ability to earn outsized returns on capital for decades. Given their staying power, it's perhaps no surprise these companies have been held up better than most. The second pattern to emerge during the bear market is relatively good showing of companies with a demonstrated record of serving shareholders well. We see this clearly when breaking out performance by Morningstar's Stewardship Grades for Stocks. Firms with A Stewardship Grades--those with the most shareholder-friendly corporate practices--have posted the best returns. Perhaps companies that treat shareholders well were a little less likely to get caught up in the go-go lending policies of the past few years, or a little less likely to load up their companies with debt.

                           A            B          C           D           F
2008 Rtrn%   -28.25   -33.01   -39.14   -47.07   -35.57

It's important to emphasize that these two concepts--moats and stewardship--are entirely distinct. A moat or lack thereof characterizes a business, regardless of the quality of the managers and directors who run it. Morningstar covers many wide-moat companies that earn D's or F's for Stewardship, including AllianceBernstein AB, Amgen AMGN, Blackrock BLK, Federated Investors FII, and Hershey HSY. Likewise, many horrible businesses are run by capable, upstanding managers. But great management can't turn a poor business into a great one.

For this screen, we'll focus on companies that enjoy both a wide moat rating as well as an A Stewardship Grade. Even if economic conditions deteriorate, Morningstar still has confidence that these companies will live to fight another day. This screen works in Morningstar Advisor Workstation, but not Principia.

Economic Moat = Wide
Stewardship Grade = A
PAGEBREAK

About 30 stocks--out of more than 2,000 Morningstar analysts cover--pass this test. It's a pretty select group. To whittle the list down further, the screen will select only stocks that earn a Morningstar Rating for stocks of 5 stars. The star rating depends on our analysts' estimates of fair value for each stock. A rating of 5 stars means we think the stock trades at a significant discount to fair value.

Morningstar Rating for Stocks = 5

This yields a list of 12 stocks, including some well-known names like Berkshire Hathaway BRK.B, Microsoft MSFT, and General Dynamics GD. But let's focus on the four with the smallest market caps--companies you and your clients might not be as familiar with but which are great companies trading at great prices.

Landstar System LSTR
Sector: Business Services
Industry: Land Transport

Business: Landstar has established a broad asset-light freight shipping network across North America. The firm serves as a matchmaker for shippers and truckload carriers. The cost and time required to replicate Landstar's extensive system of 1,397 agents, 25,000 truck broker carriers, and 9,000 Landstar-dedicated drivers functions as a barrier to entry.

Management: Morningstar has few complaints about Landstar's management and corporate governance. Management is executing the core strategy successfully. Morningstar appreciates the majority independent board and the separation of the roles of chairman and CEO, though the board is chaired by a former CEO. However, Morningstar prefers directors to be elected annually rather than in three-year staggered terms. Henry Gerkens has been CEO since July 2004 and has worked as a Landstar employee for almost 20 years. The 2006 CEO compensation of $5.3 million was quite generous for a $2.5 billion firm, but it's hard to argue with Gerkens' success: During his tenure, Landstar has generated record margins and returns on invested capital. In 2007, when Landstar failed to achieve its internal targets for operating income and earnings, the firm paid senior executives no cash bonuses.

Waters WAT
Sector: Health care
Industry: Medical Equipment
Business: Waters' relentless emphasis on innovation continues to pay off, adding to its leading position in the liquid chromatography market and rapidly expanding its presence in the mass spectrometry business. Such technological prowess enables Waters to generate returns on capital well above those of peers, and this performance serves as a foundation of its wide economic moat.PAGEBREAK

Management: Morningstar gives Waters its highest Stewardship Grade. The company and its long-tenured CEO, Douglas Berthiaume, have an exceptional record of doing right by shareholders. Under Berthiaume, Waters has grown into an industry leader. Morningstar favors companies that align executive-compensation packages with business performance, and Waters is one of these companies. All executive officers, including Berthiaume, received lower bonuses in 2005, following a below-expectations performance by the company. Waters' pay structure is heavily weighted toward long-term incentives such as stock options, in lieu of cash; Morningstar sees this as fostering long-term thinking. Morningstar's only recommendation for Waters would be to split the chairman and CEO duties.

Expeditors International of WA EXPD
Sector: Business Services
Industry: Transportation-Misc
Business: Expeditors International of Washington is the performance leader among non-asset-based freight-forwarding and third-party logistics providers. Investors seeking exposure to the growing international shipping market will be hard-pressed to find a more profitable firm. Expeditors' record of steady growth, high margins, and high returns on invested capital supports a wide economic moat.

Management: Expeditors' proven management team has delivered steady growth and profitability for years. Several of the company's founders are still in the top ranks. Management wields compensation as a powerful tool, paying a relatively moderate base but offering a clear plan for substantial incentive pay. Management supplies clear financial reports, including publishing written responses to investor questions on a periodic basis. Directors own significant shares, so their interests should be well aligned with minority shareholders'. The firm offers no egregious perks--even the CEO pays for his own parking at headquarters.

Zimmer Holdings ZMH
Sector: Health care
Industry: Medical Equipment
Business: Zimmer is a market leader in reconstructive devices, including top global spots in knee and hip replacements. This leadership is usually quite stable because orthopedic surgeons typically display high levels of brand loyalty. With patient outcomes dependent on the skills developed using a particular manufacturer's devices, surgeons have little incentive to switch once they're comfortable with a supplier's product set.

Management: Morningstar gives Zimmer an A Stewardship Grade. Zimmer separated the chairman and CEO positions after Ray Elliott retired from both spots. CEOs should have to report to a higher authority (namely shareholders) through the board, and it can be difficult for a board to remain objective when the CEO is also the leader of the board. Zimmer named insider David Dvorak as his CEO replacement and John McGoldrick as chairman. We also like that Zimmer removed the supermajority voting provision that has blocked the board's declassification in recent years. Those changes were another step in the right direction, and Morningstar hopes its strategic focus and financial transparency remain positive.

Haywood Kelly, CFA, is vice president of equity research at Morningstar.

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