Three Values Hiding in Plain Sight

Pop quiz: If you had invested equal amounts in the following companies five years ago, how do you think your investments would have fared?

 Coca-Cola (KO)
 Microsoft (MSFT)
 Wal-Mart (WMT)

Pretty impressive group of companies, no? In your portfolio you would have had a company with one of the best brands in the world, a near-monopolistic software titan, and a behemoth of a retailer. All are bellwethers that have major advantages against their competitors, and all produce handsome cash flow and returns on capital. In other words, they all have wide--dare we say superwide--economic moats.

These are also exactly the types of companies I like to buy in the real-money Tortoise and Hare portfolios that I maintain in the Morningstar StockInvestor newsletter. An argument could be made that this group would make a respectable "dream team" for an investor.

Unfortunately, for those who bought this group five years ago, the dream team has been a set of big losers from an investment perspective. As a group, they are down approximately 4% on average. Instead of being an owner in these stalwarts of U.S. business, you would have been better off stuffing the cash in the mattress or (gasp!) in a savings account with a 0.5% interest rate.

So what's the problem? Did the economy turn south, or did these companies hit a rough patch? Have competitors been making inroads? Has profitability suffered?

Despite what might guess from looking at these stocks alone, it has been relatively smooth sailing for these companies; all three have enjoyed varying levels of success over the past five years. In fact, Wal-Mart and Microsoft have nearly doubled their sales during this time frame, while profits have also grown at both. This is quite an accomplishment for companies of their size. Coke has experienced slower top-line growth, but managed to expand its profits at a hearty clip. It's safe to say the underlying businesses have been successful the past couple of years.

There is only one explanation for why all three have been sorry investments: Those who bought these stocks five years ago overpaid for them.

Back in 2000, these companies may have even once looked relatively cheap compared with the scores of ridiculous dot-com stocks that were around at the time. But when you pay 50 times earnings for a company that is going to grow at a 10% rate--and a 10% growth rate is nothing to sneeze at--you are setting yourself up for disappointment. "Relatively cheap" is still no substitute for "absolutely undervalued."

Here at Morningstar, we don't engage in the "greater fool" strategy of investing--that is, knowingly buying something expensive in the hopes that someone will pay an even more expensive price down the road. Arguably, this is what people who bought these stocks in 2000 were doing. Rather, all we do is first try to figure out the intrinsic value of a business, then buy at a discount to that value. It really is that simple.

As the results from these three companies shows, just identifying quality companies and buying them at any price is a losing strategy. You have to identify quality companies and make sure to get them at a good price. Remember, the difference between a great company and a great investment is the price you pay. If you overpay for an investment, your returns will suffer, no matter how wonderful the underlying business.

Where To from Here?
There is a bright side to this story. While all three of these very well known companies were once far too expensive, all are now trading below our estimates of their intrinsic values to large enough of a degree that they now carry our 5-star rating. Instead of venturing off into stocks with dicey prospects, we think these values are hiding in plain sight.

These are not empty words: We recently bought Microsoft for our Hare portfolio and Wal-Mart for the Tortoise, while Coke is also a longtime portfolio holding. (Fair disclosure: the cook is eating the cooking here, and I personally own and have bought all three in recent months.)

Here are some of my thoughts on why each of these three should be on your radar screen today.

Coca-Cola (KO)
A superior set of brands, an impressive distribution system, and high profitability attract me to Coke, while returns on invested capital in the low 20s confirm the presence of a moat. Moreover, Coke has a negligible amount of debt, and the risk profile of the company is well below average.

The enormous free cash flow Coke is able to generate every year is highly enviable. It is currently generating approximately $5.5 billion per year in free cash flow, or about $2.25 per share, equating to near 5% of the current share price. A 5% free cash flow yield implies that the stock is not terribly expensive, especially considering the international growth opportunities Coke has as well as its overall low-risk profile. I also like the fact that Coke is putting its cash flow to shareholder-friendly uses, namely growing its dividend and buying back its stock. We think there is an adequate margin of safety to consider buying the shares today.
 
Microsoft (MSFT)
There is no doubt that Microsoft's Windows and Office franchises have exceptionally wide moats thanks to the network effect. And while the rest of Microsoft's businesses--Internet applications, enterprise software, video games--are not as deeply entrenched, these other businesses still provide decent profitability and growth opportunities.

Microsoft's financial health and cash-generating capacity is nothing short of exceptional. Returns on invested capital have averaged near 75% the past five years. Even after paying out $32 billion in special dividends last year, the company still has a $49 billion war chest of cash and investments against a mere $23 billion in liabilities. Plus, it spends $6-$7 billion per year on research and development--yet another competitive advantage--but still generates over a billion dollars each and every month in free cash flow. (The current run rate is about $1.3 billion per month.)

With the stock well below what we estimate to be to be its intrinsic value of $34 per share, we think it is worth considering today.

Wal-Mart (WMT)
Since 1999, Wal-Mart has more than doubled its sales, operating profit, earnings per share, and operating cash flow. However, the stock is trading exactly where it did back in 1999. It now trades at roughly 18 times trailing earnings--slightly less than the S&P 500--despite having below-average risk, superior competitive positioning, robust cash flow, negligible debt, and plenty of growth left. This is exactly the type of company we love to own in the Tortoise--healthy, boring, but left for dead by Wall Street.

Negative headlines about Wal-Mart abound. Whether it's about how the firm steamrolls smaller competitors, allegedly mistreats its workers, has the unions circling, or is importing too much merchandise from China--there seems to be more than enough to worry about. But behind this veil of worry is a retailing titan with hefty, structural competitive advantages and some serious profits that can be had on the cheap. 

Paul Larson is editor of Morningstar StockInvestor and manages the publication's two market-beating portfolios. He also wrote three recently published books: How to Get Started in Stocks, How to Select Winning Stocks, and How to Refine Your Stock Strategy.