Use this screen to find strong stewards of shareholder capital.
This article originally appeared in the December/January 2013 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000.
For this search, we will look for business trading at attractive valuations that also have exceptional management teams.
Stewardship = Exemplary
Morningstar recently launched new stewardship ratings to assess the quality of management teams. Morningstar’s analysts now rate the management of each firm they cover as Exemplary, Standard, or Poor. The rating seeks to analyze each management team’s stewardship of shareholder capital, with particular emphasis on capital allocation decisions. Analysts consider companies’ investment strategy, history of investment timing and valuation, dividend and share buyback policies, execution, among other factors. Firms that earn an Exemplary rating have a history of allocating capital to high-return investments with strong execution. Firms that earn a poor rating likely have a track record of overpaying for acquisitions or pursuing value-destructive investments. By limiting our search to only Exemplary firms, we eliminate more than 90% of Morningstar’s coverage universe.
And Morningstar Rating > 4 stars
Screening for 4- and 5-star-rated firms gives us companies that Morningstar’s equity analysts believe are trading below the business’ intrinsic value. Morningstar analysts use explicit forecast of firm’s fundamentals to arrive at a discounted cash flow valuation. Even the most well-run business could be a bad investment if the valuation is too high, so this criterion will make sure we are paying an attractive price for these well run businesses.
And 3 Year Revenue Growth > 5%
Next, we screen for stocks that have reported an average annual revenue growth rate of more than 5% over the past three years. Although recent results don’t provide a guarantee of what future results will look like, this screen should help us find businesses that have strong growth prospects. If nothing else, it will eliminate declining businesses. Declining businesses can be a strong investment at the right price, but with this screen, we are focusing on strong management teams that can create significant value for shareholders over a long time period, so growing businesses are much more likely to fit our bill.
And Price to Cash Flow < 15
Lastly, we screen for stocks that trade at a price/cash-flow ratio of less than 15. This metric is a simple ratio to double-check our valuation work and confirm that we aren’t overpaying for the business.
We used Morningstar Principia to run this screen in October. Here are some of the results.
Over its long history, 3M has invented some of the world’s greatest products. We think the firm’s innovative culture, bottom-line focus, and low-cost manufacturing have carved a wide moat around its business that will enable the company to reap outsized rewards over the long run. That said, the company tends to feel the pinch of economic slowdowns relatively early, and near-term headwinds could crimp the firm’s results for several quarters.
Although 3M sells thousands of products to disparate markets, the firm cites only a few dozen technological pillars that support its wide array of offerings. The company’s ability to create new pillars and leverage the technology across multiple industries forms the backbone of its historical success. As a result, the firm has enjoyed returns on invested capital well above its estimated cost of capital during the last 10 years, while annual free cash flow averaged an impressive 15% of sales.
Costco offers investors the highest near-term cash flow visibility in our defensive coverage sector. The company books nearly all of its profits 12 months in advance. Membership revenue, although deferred over the life of the annual membership, is paid at the beginning and accounts for nearly all of Costco’s operating profits. Furthermore, even after fee increases and in recessions, member renewal rates have remained steady around the 86% level. Costco cardholders renewed their memberships at an 86% rate during and after the Great Recession. Therefore, we have a very high level of certainty in our near-term financial forecast.
Moreover, cash, a debit card, or an American Express charge card are the only forms of payment accepted at Costco. In our view, this indicates a customer base that has a high credit quality, which we believe can better withstand economic downturns. For these reasons, as well as being free-cash-flow positive and in a net cash position, Costco trades at premium valuation to nearly all of the other companies in our defensive space.
Express Scripts ESRX
After its merger with Medco, Express Scripts is the only wide-moat company among health plans and drug-supply-chain middlemen. We expect Express Scripts, supported by a superb management team, to use its newfound scale to pressure suppliers and drive down administrative costs—creating value for both clients and shareholders.
Pharmacy benefit managers administer drug benefits on behalf of clients such as employers and managed-care organizations, with the principal goal of controlling costs. Express Scripts has two primary strategies for achieving this. First, it leverages its purchasing power to extract better prices from suppliers. Second, it encourages its members to make cost-effective pharmaceutical consumption choices, such as switching to generic drugs and preferred brands, improving therapy adherence, or using lower-cost retail pharmacies or the company’s own mail-order pharmacy.
Teva Pharmaceuticals TEVA
A decline in generic drug launch opportunities by 2014 and impending generic competition on its highly profitable drugs Copaxone and Provigil creates near-term hurdles, but we continue to appreciate Teva’s long-term prospects. Teva’s global low-cost operations, expansion into emerging markets, complex generic manufacturing capabilities, and drug pipeline should preserve the company’s growth, profitability, and market dominance. With more than double the next competitor’s revenue, Teva’s broad market exposure, massive manufacturing infrastructure, and vertically integrated operations position the firm as a leader in the generics industry. The generics market is highly fragmented, especially in low-cost labor markets such as India and China, but a select few firms control the lion’s share of worldwide generics production. Thanks to a history of aggressive acquisitions, Teva has amassed nearly a quarter of industry market share, massive economies of scale, and vertically integrated operations. By our estimates, Teva, Sandoz (a subsidiary of Novartis NVS), Mylan MYL, and Watson WPI account for about half of all generics sales.
UnitedHealth Group UNH
UnitedHealth’s scale endows the firm with significant competitive advantages. With underwriting and regulatory concerns fading to the background, we think United- Health will continue churning out free cash flow and creating value for investors for the foreseeable future.
UnitedHealth’s scale results in a narrow economic moat for several reasons. The company’s 35 million medical members allow it to spread out fixed administrative costs and negotiate large discounts with health-care providers. The company’s extensive database of claims improves underwriting and can be used to identify the most cost-effective health-care providers. Finally, UnitedHealth’s industry-leading position across geographies and product lines reduces its risk, differentiates its products, and allows management to be opportunistic about its allocation of effort and capital.