Now on Sale: Stocks Worth Owning

Suppose that you needed to buy a car for one specific purpose--commuting to work so you could earn a living. Now, suppose I offered to sell you a stylish 30-year-old used sportscar for $15,000, or a dull, barely used Toyota for $12,000. You'd probably take the Toyota, right? It costs less, it's more reliable, and all you need to do is get to work each day. Drag-racing your neighbors isn't in the game plan.

Oddly, most investors are making the opposite choice right now by paying more for lower-quality companies than they are for higher-quality companies. The same thing is happening with regard to risk: Lower-risk companies are, in general, cheaper than higher-risk companies.

How do I know this? Morningstar analysts cover more than 1,400 stocks, and we publish fair value estimates on just about every one of them. By looking at the median ratio of market price to fair value within different portions of our coverage universe, you can get an interesting gauge of the market's mood. At the moment, it's bullish on sexy stocks and relatively bearish on their more staid counterparts. (You can check on much of this data yourself, anytime, by clicking on our Market Valuation Graph.)

The Wider the Moat, the Cheaper the Stock
In general, stocks with wide economic moats--that is, high-quality companies with durable competitive advantages--are trading for about 5% less than our estimates of intrinsic value right now. Wide-moat stocks have been mildly undervalued all year, and were undervalued by about 10% during the market sell-off in August. By contrast, the median no-moat stock is trading for about 17% more than we think it's worth. These companies aren't quite as expensive as they were in February 2004, when the median no-moat stock was 27% overvalued, but they're still not very attractive now.

The same relationship holds true for stocks with high and low business risk. By our estimates, low-risk stocks are about fairly valued, while high-risk stocks are about 15% overvalued. Low-risk stocks have been hovering right around fair value all year, while high-risk stocks have come down from being almost 30% overvalued at the beginning of 2004. (There's a fair amount of overlap between our risk and moat ratings, which is why the historical price/fair-value ratios of no-moat stocks and high-risk stocks are somewhat similar.)

These are curious results when you consider that, as I wrote recently, no-moat companies have destroyed substantial economic wealth over the past few years while wide-moat companies have delivered huge excess returns. Are investors expecting this relationship to suddenly reverse? Why would anyone even dream of paying more for a company that destroys wealth than for one that creates value?

Why Pay More for Companies That Make Less?
I think there are a couple of reasons for this. One is that many market participants (I hesitate to call them investors) are not interested in long-term value creation. They just want the stock to go up in the short run, because they don't intend to own it for very long, and their buy/sell decisions may often be completely unrelated to the underlying economics of the stocks they trade. But we're not just talking about day traders, here. With the average mutual fund turning over its portfolio once per year, and hedge funds playing an increasingly large role in the marketplace, there's a lot of money chasing short-term performance. Returns on capital are far less relevant to these folks than are things like catalysts, moving averages, and news flow.

Another reason for this odd valuation discrepancy is that, in my opinion, the market is generally complacent right now, and complacency leads investors to be overconfident and underestimate the likelihood of future bad news. Interest-rate spreads, which measure the excess yield demanded by bond investors to compensate them for the higher risk of owning a corporate bond relative to a risk-free Treasury bond, are on the low side--especially for risky junk bonds. Also, the VIX Index--which is essentially a measure of the volatility that options traders expect from equities in the near future--is at its lowest level since the mid-1990s.

In other words, investors aren't demanding a lot of return "bang" for their risk "buck." This seems to be the case in the bond market (spreads), the options market (the VIX), and in the stock market (wide-moat stocks cheaper than no-moat stocks.) It seems reasonable to assume that if investors' aversion to risk increases, the valuation gap between no-moat and wide-moat stocks will narrow considerably, as the value being created by stable wide-moat firms gets priced into their stocks, and the value being destroyed by no-moat firms gets priced out of their shares. At some point, quality will be back in vogue, and the junk will get quickly tossed in the market's garbage heap.

Their Loss, Your Gain
Regardless of the reasons why no-moat companies are currently expensive relative to quality companies, the relatively attractive valuations of many high-quality firms are a great thing for long-term investors. Companies that have wide economic moats are more likely to build value over time and generate the compound returns that put a smile on the face of patient investors. Moreover, wonderful companies don't trade at reasonable prices very often.

Even though the average wide-moat company is only 5% undervalued, we have some pretty high-quality companies-- Coca-Cola (KO),  Colgate-Palmolive (CL), and  Merck (MRK) come to mind, among others--that are trading for 25% to 30% less than our fair value estimates. Even if we're a bit off on our fair value estimates, these aren't the kind of companies that get into reasonable-price territory very often. Sure, all three have their respective issues at the moment, but at their lowest price/cash-flow ratios in a decade, it seems likely that those issues are already being discounted in the stocks' prices. (And if these three stocks aren’t to your liking, there are plenty of other 5-star wide-moat companies to look at.)

I'll close with a quote from Bob Goldfarb, one of the managers of the famed  Sequoia Fund (SEQUX), from the fund's shareholder meeting last May. "Time is the friend of the wonderful business, affording it the opportunity to reinvest incremental capital at favorable rates and increase the value of the enterprise. Over time, the price you paid for a terrific company looks cheaper and cheaper. For the inferior business at the cheap price, time may turn out to be the fell destroyer."

To extend Goldfarb's point, if you load up on inferior businesses at expensive prices, you're going to get hurt both ways--the price will come down, and the company will have a lower intrinsic value in the future. Sooner or later, economic value creation is rewarded by the market, and patient investors who buy great companies when they occasionally go on sale do very well indeed.

Etc.
The entire transcript of the Sequoia shareholder meeting is available through the firm's Web site. It's a heck of a good read.