Focusing on stocks with the most visible cash flows has been a winning strategy, and this screen can find them.
When we examine the performance of the Morningstar Rating for stocks, one pattern jumps out: Buying the stocks of wide-moat companies-when those stocks trade at a discount to our fair value estimates-is a darn good strategy.
This makes sense. Other things equal, our ability to forecast the cash flows of a firm will increase with the width of the company's moat. And the more dependable the cash-flow forecasts, the more accurate the resulting fair value is. After all, a fair value is simply the present value of a stream of future free cash flows. Why would wide-moat firms be easier to forecast? These are firms with competitive advantages-some edge over potential competitors such as economies of scale (bigger is better), structurally lower costs (such as access to a scarce resource), or high customer-switching costs (once a customer, always a customer). In general, the more insulated a company is from competitors, the more sustainable and predictable its future cash flows. Those cash flows are unlikely to be competed away by new entrants or existing players.
Let's turn to the numbers. The chart shows the performance of the Morningstar Rating for stocks for just our wide-moat universe. Over the trailing five years, wide-moat firms with Morningstar Ratings of 5 stars have outperformed wide-moat firms with Morningstar Ratings of 1 star by 22% annualized. This means that within the universe of wide-moat stocks, there's been a huge margin between those rated "buys" by our analysts and those rated "sells."
We also track the performance of our cheapest wide-moat stocks through the Wide Moat Focus index. We construct the index by taking the 20 cheapest wide-moat stocks every quarter and allocating 5% of the index to each. Over the past five years, the index has outperformed the S&P 500 by 7.91% on an annualized basis.
For this issue's stock screen, we'll focus on companies that enjoy a wide moat rating and have a stock that we think is undervalued. Currently, we rate 174 companies as having wide moats. We cover 1,800 stocks, so the wide-moat group is a select one. This screen works in Morningstar Office, and every criterion but Stewardship Grade is available to Principia users.
Economic Moat = Wide
And Morningstar Rating for Stocks = 5 stars