20 Cheap Stocks, 20 Great Businesses

Times are tough. Unemployment is at a 16-year high. Unrest in the Middle East continues to drain U.S. resources and wedge uncertainty into the collective global psyche. Consumer confidence is low. Business spending is falling. Once-dominant global franchises have been reduced to shells, and many are going bankrupt. CEOs--generally an optimistic bunch--are qualifying sales expectations with cautionary disclaimers, if commenting at all. Although recent deflation has offered some relief in the form of lower gas and grocery prices, it's merely a symptom of the crushing drop in home and stock market prices that has battered investors. Fear is the sentiment, with 0% yields on short-term Treasuries providing damning evidence.

Although near-term prospects look grim, we believe recent events have created an enormous opportunity to buy many firms with long-term competitive advantages--or wide moats--at meaningful discounts to their intrinsic values. Morningstar has created an index, called the Morningstar Wide Moat Focus, that tracks our 20 cheapest wide-moat stocks. The methodology is straightforward. We narrow our coverage universe of 2,000-plus companies down to only those that we deem to have a durable competitive advantage, then we select the 20 cheapest each quarter for equal-weight inclusion in the index.

Each candidate for the index has some structural advantage--whether it be scale, customer lock-in, network effects, or a valuable brand--giving us confidence that the firm will generate excess returns for many years to come. As an example,  Autodesk (ADSK) is a current member of the index. Autodesk has a near lock on the CAD software market, and its product has become an industry standard for engineers and architects. According to software analyst Rafael Garcia, "The firm benefits from its customers' high switching costs: It takes time to learn a new design software application, and operational disruption and downtime costs discourage companies from changing CAD providers."  These switching costs give us greater confidence that Autodesk can weather the current economic storm and emerge even more competitive. Less than 10% of the companies that we follow have built a competitive advantage that is durable enough to qualify for our wide-moat rating, limiting our wide-moat universe to 177 candidates. 

We rank each of these 177 wide-moat stocks from cheapest to most expensive, based on the current market price versus our estimate of the value of the firm's future cash flows. Overpaying for businesses, even great businesses, is not a recipe for investment success, and each quarter we place only the 20 cheapest wide-moat stocks into the index.  Starbucks (SBUX), for example, sports a stock price that is less than half our fair value estimate, and it is currently a component of the index. Fairly valued  McDonald's (MCD) is not. Both are great businesses within the restaurant industry that have established wide moats. Both will survive the current recession. However, the market seems to believe that consumers will forever ditch high-priced lattes, lounging, and laptops for combo meals, convenience, and cost savings. We believe this view is myopic, and the Wide Moat Focus Index seeks to benefit from such short-sightedness. In the words of senior stock analyst John Owens, "In our view, there's plenty of room for both Starbucks and McDonald's to succeed in this large and still-growing business. We believe McDonald's competes on price, while Starbucks caters to customers aspiring to a higher-end experience, with baristas handcrafting and customizing the drinks." 

At Morningstar, we believe that buying high-quality businesses at discounted prices leads to long-term investment success. Recent performance of the Wide Moat Focus Index supports our belief. As of Jan. 15, the S&P 500 Index dropped 37.4% over a trailing 12-month period, while the Wide Moat Focus Index fell only 17.9% over the same period. Losing 18% of invested capital is never pleasant, but this relative outperformance suggests that when times are tough, the market takes a more favorable view of firms that have built a durable competitive advantage. Moreover, given the attractive valuations, we believe that shares of firms in the Wide Moat Focus Index stand a better-than-average chance of sharply appreciating when markets recover.

For a summary view of the Morningstar Wide Moat Focus Index, including current holdings, click here.