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New Wide Moats in Banks and Software

Matthew Coffina, CFA
Jeremy Glaser

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.

I'm joined today by Matt Coffina, editor of our StockInvestor newsletter. We are going to look at some recent ratings changes and moat upgrades from our equity research team.

Matt, thanks for joining me.

Matt Coffina: Thanks for having me, Jeremy.

Glaser: Let's start with banks. We recently upgraded the moat to "wide" on several global banks. Can you talk about what precipitated this move and how we think about competitive advantage when it comes to these institutions?

Coffina: Our thinking here has really evolved over the years. Before the financial crisis we had way too many wide-moat banks, and of course we all know what happened to the banking sector during the financial crisis. Around that time, we downgraded the vast majority of those wide-moat banks to narrow moat, and I think the pendulum may have swung a little too far.

There are still are a handful of banks with very strong competitive advantages, usually resulting from cost advantages--for example, lower credit losses, lower operating costs, especially lower costs of funds if they have a lot of low-cost deposits. At the same time, a lot of these banks have high customer-switching costs or at least customers usually take the path of least resistance. If you already have your direct deposit set up, you have your automatic bill-pay set up, you have some credit cards linked to your bank account, and so on, customers would just as soon stay with their existing bank. Given that, banks can get away with charging some fees here and there, and the bank has to do something really bad for customers to go out and look for a different bank.

The combination of cost advantages and customer-switching costs, we think, does allow for wide moats with a very small minority of banks.

Glaser: Which banks did we recently upgrade?

Coffina: We really went through our coverage universe country-by-country, and we found that some countries are more conducive to wide-moat banks than others. We looked at, for example, macroeconomic and regulatory factors, the competitive environment, and so on.

We found that, for example, the U.S market is actually one of the least attractive banking markets in the world; it's still very, very competitive. Whereas a lot of international banking markets have consolidated around just a few large banks, the U.S. still has thousands of banks competing aggressively for deposits and loans. The U.S. also has multiple regulators. Regulators in general are more stringent these days in terms of capital requirements and other factors like that.

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That said, other markets, ones that really stand out to us, include Australia, Canada, Chile, and Sweden. We saw a few more wide-moat banks in those markets. That's not to say we didn't upgrade any U.S. bank. We think Wells Fargo and U.S. Bancorp are really the best of the best in terms of domestic banks--again with very low costs relative to peers and high customer-switching costs, effective cross-selling, and things like that.

In those international markets, we upgraded six banks altogether, plus we already had a few wide-moat Australian banks. The banks that we upgraded included Toronto-Dominion, Royal Bank of Canada, Banco Santander-Chile, and a few others.

Again, I think banking in general is still a very challenging business, with high degree of regulation, very competitive. But in the right market conditions, and if the bank has strong enough competitive advantages, we think it is deserving of a wide moat.

Glaser: Do any of those look like good values right now?

Coffina: A few of them are trading at moderate discounts to fair value. We don't have any 5-stars, but U.S. Bancorp, Westpac Banking in Australia, and Toronto-Dominion are a few of the names that stand out as trading somewhat below fair value. There are not any screaming buys, but I think given their wide moats, they are at least worth a look for investors right now.

Glaser: We had a few other moat upgrades, the first being Blackbaud. What was the story there?

Coffina: We have a bit more positive take on enterprise application software. This is a business that we've always liked, but now we are coming around, especially on the cloud software side, and seeing some of these companies establish wide moats.

As you said, we upgraded Salesforce.com as well as Blackbaud. They join a group that already included, for example, Autodesk, Adobe Systems, and Cerner, which are some other wide-moat application software vendors, and the competitive advantage in this case really results from very high customer-switching costs.

Salesforce is known for its customer relationship management software. Blackbaud sells software that helps nonprofits with their fundraising and internal organizational efforts. In both of these cases, the software gets very deeply ingrained with the customers' daily operations, such that they would risk too much disruption if they tried to switch out their software vendor for a competing platform. It's really that risk of disruption that ties these customers into a given platform, and then those customers can stick around for years or even decades.

Glaser: We've become a bit more bullish on health-care REITs, and REITs are generally an area we haven't seen a ton of value recently. Why do we think that these health-care REITs are a rare pocket of value in this space?

Coffina: REIT valuations in general have been swinging around wildly based on moves in interest rates. So, for example, in early 2013 a lot of REITs were significantly overvalued. Interest rates came up, a lot of the REIT stocks crashed, and we had some bargains. Interest rates during 2014 trended down again, REITs again did very well, and now we're sort of on that downslide again, where rates have been moving up, and REIT stocks are getting hurt.

I'd say, in general, REIT stocks have been moving a lot more than the fundamentals would dictate. We are seeing some pretty wild swings, which can create opportunities on both sides. Specifically with respect to health-care REITs, we think there are certain advantages to this property segment. For example, it's not particularly economically sensitive. With retailers, for instance, you are going to get a lot of vacancies in a recession. But generally people won't leave a senior housing facility or a nursing home. A doctor won't stop using their medical office building during a recession. So, it's economically defensive.

There are also demographic tailwinds. Obviously, the aging population in the U.S. is going to create more demand for senior housing and nursing homes, and that sort of thing over time.

Then you also have a relatively small share of overall health-care real estate that is in the hands of REITs, which creates some opportunities for public/private arbitrage, which is to say the publicly traded REITs generally have a lower cost of capital than private owners, and so they can create value by acquiring properties and bringing them into a public REIT structure. Right now, only about 15% of health-care real estate in the U.S. is estimated to be in the hands of REITs, and we expect that percentage to steadily increase over time.

We also lowered our cost-of-equity estimates in some cases--usually pretty modest adjustments. But under our new cost of equity methodology, we are using 7.5% for most health-care REITs versus 8% previously, and this resulted in fair value increases for the big three health-care REITs--Ventas, HCP, and Health Care REIT--and of these our analysts' favorite is Ventas. It has a below-average payout ratio, above-average growth prospects at least over the medium term, and a successful acquisition track record. We also like HCP, which is a holding in StockInvestor's Tortoise Portfolio. Both of those, we think, look somewhat more attractively valued than Health Care REIT, which looks a little more fully valued. But still, we think the health-care property sector is the most attractive within the REIT universe.

Glaser: Matt, thanks for the ratings update today.

Coffina: Thanks for having me, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.