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
How many wide-moat bargains are there? The short answer: not many. With the market runup in 2009, the number of high-rated wide-moat stocks has come way down. Last fall, the price/fair value ratio of our wide-moat universe bottomed at 0.54, meaning that the median wide-moat stock traded at just 54% of our fair value estimate. The ratio is now back up to 0.89. Even so, there are a handful of bargains in our opinion. For our screen, we look for those wide-moat names that earn a current Morningstar Rating for stocks of 5 stars or better. 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. Currently, 26 wide-moat companies are trading in 5-star territory.
And Overall Stewardship Grade <= C
And Financial Health Grade > C
To narrow our list further, we require companies to meet two additional quality screens. First, their Stewardship Grade, as determined by Morningstar's equity analysts, is at least a C. In assigning these grades, our analysts consider a company's compensation policies (are executive incentives structured in a way to reward shareholders?), its record of capital allocation (does management focus on earning a high return on capital?), and other measures of shareholder-friendliness.
Second, we require a Financial Health Grade of B or better. The Financial Health Grade is a quantitative measure that ranks companies by likelihood of financial distress. In a nutshell, we estimate the market value of a company's assets and compare that value with the company's liabilities. The greater the chances that its future asset value falls short of liabilities, the lower the grade. This yields a list of nine stocks, five of which we highlight below.
In an era of concerns about global warming and rising fossil-fuel prices, Exelon maintains an enviable position as the largest nuclear plant operator in the United States. Its ability to produce low-cost, carbon-free electricity should produce substantial, sustainable, and growing shareholder value for many years, regardless of what path power prices take. This is why we consider it the only utility in our coverage universe with a wide economic moat.
Genzyme has its roots in treating rare diseases, and the firm has overcome significant cost and manufacturing challenges to create enzyme-replacement therapies for patients with genetic disorders. These products provide enormous benefits to a small number of patients, so insurance coverage is usually strong despite sky-high prices; For example, while Gaucher disease drug Cerezyme is prescribed to roughly 5,600 patients worldwide, sales of the drug surpassed $1.2 billion in 2008.
Monsanto is a fierce competitor that continues to dominate a market that it essentially created more than a decade ago. Through its ongoing commitment to research and development and assertive capital allocation, the company has positioned itself to grow value for its shareholders over the long haul. Monsanto is, at its heart, a powerful R&D engine. The firm continues to plug an average of 10% of sales into its research efforts, but this figure belies the full scope of the firm's colossal R&D machine.
Paychex was formed through the consolidation of 17 payroll processing companies in 1979 and has been one of the most successful human resources outsourcing firms in the United States. The minimal amount of capital required for operations and the firm's significant competitive advantages have allowed it to produce returns on invested capital that have averaged 70% over the last 10 years. High customer switching costs, inherent scalability, and a respected brand image are the main drivers of the firm's wide economic moat, which we believe form a potent combination that will last for some time to come.
Zimmer shines in several orthopedic niches that typically possess high barriers to entry and sticky surgeon relationships. The company claims a leading market position in reconstructive devices, where it excels in knee and hip implants. Market share in this niche is typically quite sticky because orthopedic surgeons display high levels of supplier loyalty. With patient outcomes dependent on skills developed with a particular manufacturer's devices, surgeons have little incentive to switch once they're comfortable with a supplier's product set for a particular procedure.
Haywood Kelly, CFA, is vice president of equity research at Morningstar.