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Safety Picks for the Many Moods of Mr. Market

Use this screen to find low-risk picks with nice potential.

David Krempa, 02/02/2012

European troubles have dominated the financial media for months now, with no end in sight. With all this uncertainty constantly making the front page and sending the market on a spree of volatility, it’s no surprise that many investors have been concerned about putting money to work in the stock market. With interest rates remaining near record lows, however, cash and fixed-income assets do not look particularly attractive, either. With this issue’s stock screen, we will try to find low-risk investments that still offer potential attractive returns, through both income and appreciation.

Domestic = Yes

Our first criterion will help us eliminate Europe-based firms, because they are experiencing significantly more uncertainty and volatility than businesses in the United States. In today’s globally connected economy, it is hard to avoid all European exposure because the majority of large corporations are going to derive some portion of their sales from Europe. However, on average, U.S. firms rely on Europe for a smaller portion of revenue than European firms do. More significantly, U.S. firms will likely see less of a direct impact from new regulations or austerity measures that may be imposed on European companies. This domestic-only restriction isn’t perfect, but when combined with other criteria, it should help isolate some solid investment opportunities.

And Fair Value Uncertainty = Low

Next, we search for companies with a low fair value uncertainty rating. Morningstar’s equity analysts assign each firm we cover an uncertainty rating, which assesses how much uncertainty there is in estimating the intrinsic value of the business. Lowuncertainty firms should have lower sales and earnings volatility and should be less susceptible to external factors that could significantly impact the firm’s value, such as regulation, pending litigation, or a rapidly changing competitive environment. We would prefer to find firms with reliable revenue and earnings streams and that compete in industries that are slow to change.

And Economic Moat = Wide

Stocks with economic moats possess significant competitive advantages over competitors. Firms with wide moats should have the most-durable moats. Barriers to entry, patents, scale advantages, or high switching costs may help insulate these firms from competition.

And Dividend > 3%

Investors looking for safety used to be able to turn to savings accounts or Treasuries to provide them with a decent amount of income. However, with the 10-year Treasury hovering around 200 basis points, it has become increasingly difficult for investors to earn even modest amounts of income from their savings without taking on significant amounts of risk. The low-risk companies we are looking for in this screen have likely been around for years and are beyond their initial growth stages, which means they are able to pass on earnings to investors in the form of dividends, rather than being forced to reinvest all of the earnings back into the business. We set the bar at a dividend yield of 3% for this screen.

And Star Rating > 3

It’s important for investors looking for safe assets to scout out low-uncertainty businesses that possess strong competitive advantages, but investors must also make sure they are paying an attractive price for the business. Companies with 4 or 5 stars are the firms that Morningstar analysts think are the most attractively priced in our coverage universe. They trade at a substantial discount to their intrinsic value, as calculated on a discounted cash flow basis, so they offer investors a large margin of safety.

We ran this screen in December. Here are some of the stocks we found.

Abbott Labs ABT
On the foundation of a wide lineup of patent-protected drugs, a leading diagnostics business, a strong nutritional division, and a top-tier vascular group, Abbott Laboratories has dug a wide economic moat. We expect these operating lines will continue to generate strong returns and drive growth. Further, the company’s decision to split itself into two is likely to result in two well-positioned companies (a drug company and a diversified health-care company) with strong competitive advantages.

PepsiCo PEP
We assign a wide economic moat to PepsiCo because of its economies of scale, dominance in the snack category, and effective distribution network. The direct store delivery system allows the firm to leverage its impressive portfolio of brands and should ensure that PepsiCo maintains its strong returns on invested capital over the long run. Although longtime rival Coca-Cola KO may have won the battle for the leadership of the cola industry, PepsiCo is winning the war against its competitors in the broader snack and beverage market with a group of brands that hold leading or second-place positions across several categories. Collectively, these products give Pepsi control of around 39% of the U.S. macro snack market and a leading 23% share of the market in Western Europe. The North American snack business is Pepsi’s most profitable segment, generating 26% of the firm’s total revenue in 2010 but 42% of its profits.

Sysco Corp SYY
Sysco is the leading food-service distributor in the United States and Canada, with around 17% share of this estimated $220 billion market. Although food distributing is generally a low-margin, capital-intensive business, economies of scale have allowed Sysco to consistently post returns on invested capital in excess of our estimate of the firm’s cost of capital. Through more than 150 acquisitions since its founding about 40 years ago, Sysco has developed a wide-reaching distribution network over which to spread high fixed costs that no other competitor has been able to replicate.

Paychex PAYX
Paychex was formed through the consolidation of 17 payroll-processing companies in 1979. It 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 past 10 years. High customer switching costs, inherent scalability, and a respected brand image are the main drivers of the firm’s wide economic moat, and we believe they form a potent combination that will last for some time to come. Switching from one payroll-processing vendor to another is a very difficult task, and customers’ unwillingness to do so has allowed Paychex to build a relatively sticky client base. This inelasticity has enabled the firm to raise prices annually and expand profits. Strong scalability has also allowed the firm to be price competitive without feeling significant margin pressure. Paychex is the secondlargest player in the payroll-outsourcing market (based on revenue), and it can leverage its 550,000 clients to spread costs associated with its servicing infrastructure. The firm’s strong brand also plays a significant role, because clients are hesitant to entrust their critical HR functions and payroll cash to an unproven competitor. The combination of these factors has produced margins that have been well above 30% during the past 10 years.

David Krempa is an associate analyst with Morningstar.

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