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Take Care to Not Blindly Invest in Wide Moats

Wide-moat stocks are a good bet in today's market, but not all are attractively priced.

This week was a good reminder that volatility remains the name of the game in the investing world. The instability in the markets continues to be driven by the same fundamental worries over Europe and the U.S. economy. And there was plenty to add to those worries this week. More conflicting news from Europe dampened hopes that that leaders were close to a breakthrough in shoring up the banking system. In the United States, the Federal Reserve seemed deeply conflicted about what its next course of action should be. Fed officials left the door open for another round of monetary stimulus, but there doesn't appear to be any imminent action.

As we've discussed before, none of these issues is going to evaporate overnight. Creating a fiscal union in Europe is way easier said than done. It is a project whose progress will be measured in years, not days. The U.S. economy is also in for a long adjustment as we work off the debt hangover and the housing recovery remains fairly anemic. A gridlocked political system and the threat of the so-called fiscal cliff in 2013 aren't helping matters much either. Add in worries about China's and other emerging markets' growth, and you have a recipe for uncertainty.

So what should investors do? We've advocated that one of the best places to ride out the storm is in high-quality businesses. These wide-moat stocks have great competitive advantages which can help them grind along even if the economy were to materially weaken from here. Crucially, they also tend to have excellent balance sheets and aren't dependent on the debt or equity markets being open to sustain their operations. If there were another crisis, most wide-moat firms won't be dependent on their creditors.

Despite the advantages, diving into these stocks at any price isn't a winning strategy. Pay too much for a great business, and you could still end up with pretty poor returns even if the firm posts decent fundamental results over time. Buying at a price below your estimate of a stock's intrinsic value is even more important in uncertain times. Having that built-in margin of safety means that if something doesn't go according to plan, you still have some cushion.

Returns have shown that valuation matters when picking wide-moat stocks. During the last five years, wide-moat firms as a whole have returned 1.4%. The Morningstar Wide Moat Focus Index, (which tracks the 20 cheapest wide-moat stocks), on the other hand is up more than 6%. Even year to date, the cheaper stocks are outperforming the broader universe 9.5% to 7.7%. It pays to avoid the priciest wide-moat stocks, no matter how good the business is.

To find these pricey wide-moat stocks to avoid, we used the  Premium stock screener to find wide-moat shares with Morningstar Ratings for stocks of 1 or 2 stars. You can run the screen for yourself  here. Below are three stocks that passed.

 Advisory Board 
| Fair Value Uncertainty Rating: Medium
From the  Premium Analyst Report:
Advisory Board, a leading provider of best-practices research and analysis, has established a niche for itself in the health-care industry. The company has an attractive business with high revenue visibility, a highly leverageable operating model, and substantial barriers to entry. These factors have helped the company to create a wide economic moat around its operations, in our view. However, its focus on health care limits its long-term growth potential.

 Intuitive Surgical (ISRG)
| Fair Value Uncertainty Rating: Medium
From the  Premium Analyst Report:
Intuitive Surgical looks set to continue expanding in its niche of robotics-assisted minimally invasive surgery by targeting new procedures within several surgical specialties. Through its large installed base and first-mover advantages, we think Intuitive has developed a wide economic moat that should keep returns on invested capital high even if direct competitors arise in the future.

 Diageo (DEO)
| Fair Value Uncertainty Rating: Medium
From the  Premium Analyst Report:
As a result of its immense distribution system that spans 180 countries coupled with its cornucopia of top-shelf brands, Diageo has established a wide economic moat. Although we like the firm's focus on premium brands and investments in international growth, we worry that cyclical weakness in some key European markets could induce a temporary headwind to earnings and might entice management to overpay for an acquisition.

Data as of July 12. 

Bearemy Glaser does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.