Beware 5-Star Stocks Bearing No Moats

In researching stocks it's easy to get excited when finding a name with a Morningstar Rating of 5 stars attached to it. After all, that 5-star rating means the stock is selling well below our equity team's estimate of its fair market value, and buying underpriced stocks and holding them until they appreciate is a time-tested investment strategy.

But don't let the twinkle of all those stars blind you from other important factors to consider before buying. Among the most important of these is the stock's moat rating, or ability to sustain its competitive advantage for years to come. Moats can be built in a number of different ways, and Morningstar analysts assign narrow- or wide-moat ratings to companies with these characteristics depending on the extent of the advantage. Then there are companies that carry a no-moat rating, meaning they have no competitive advantage. This could be because the company operates in a highly competitive industry in which building such an advantage is difficult, or simply because the company has not found a way to develop one.

One caveat that comes with 5-star, no-moat stocks is the fact that no-moat stocks' fair value estimates tend to have higher fair value uncertainty ratings than do stocks with moat ratings. That's because stocks with sustainable competitive advantages tend to be more predictable in terms of fundamental performance, which makes it easier to estimate their fair value with greater precision. The greater the fair value uncertainty rating, the greater the margin of safety required for a stock to reach a range at which it is considered highly undervalued. (Read more about uncertainty ratings here.)  For example, a stock with a high uncertainty rating must trade at a discount of at least 40% to its fair value estimate to be rated at 5 stars whereas one with a low uncertainty rating needs to trade at merely a 20% discount.

Aside from fair value uncertainty, investors should keep in mind that no-moat companies operate on a more competitive playing field than do stocks with moats. For example, a wide-moat stock like  Google (GOOG), which dominates the Internet-search space, clearly has competitive advantages in its industry whereas
 Gap (GPS), which operates in the highly competitive retail clothing industry, has no moat. The uncertainty created by greater competition means a no-moat stock may offer a bumpier ride than a wide- or narrow-moat stock and therefore require closer monitoring. 

Are You Getting a Fair Price? 
That isn't to say a 5-star, no-moat stock can't be a good buy--or that a 1-star, wide-moat stock is a bad one, for that matter. Rather, the point is that an attractively priced stock without any competitive advantages might not be the bargain it appears to be.

With the market--and no-moat stocks in particular--more or less fully valued these days, only a handful of no-moat stocks currently carry 5 stars. Premium Members can see the list of these stocks--which we found via the  Premium Stock Screener--by clicking  here. Among the names on the list are the following:

 General Motors (GM)
The automotive giant has made a nice comeback since its federal bailout in 2009. It's become a more efficient company making higher-quality vehicles and just recorded its best March sales totals since 2008. That said, the company faces increasing competition in the U.S. market from the likes of Hyundai and
 Volkswagen (VLKPY), while its money-losing European operations continue to weigh down performance. Although the company's stock appears attractively priced, Morningstar equity analyst David Whiston notes that our fair value estimate "could change dramatically" based on factors such as North American light-vehicle production and the weighted average cost of capital, which is why the stock carries a high fair value uncertainty rating.  

 Exelixis (EXEL)
Although biotech companies as a group are overvalued, according to Morningstar estimates, this maker of cancer treatments bucks the trend. The company has more than 10 compounds in development and partnerships with larger firms such as
 GlaxoSmithKline (GSK) and  Bristol-Myers Squibb (BMY). However, only one of the firm's drugs has cleared regulatory approval, and there are questions about the full potential of the firm's oncology program. As a result, the no-moat firm's fair value estimate carries a high uncertainty rating.

 Schnitzer Steel Industries (SCHN)
Working in a highly cyclical industry, this Oregon-based scrap metal recycler's access to deep-water ports puts it in good position to meet growing demand in emerging markets. But price volatility and uncertain global steel production, especially in China, make for an uncertain outlook and thus a high uncertainty rating for the stock's fair value estimate. Equity analyst Bridget Freas writes, "We still expect returns to remain below our estimate of Schnitzer's cost of capital, supporting our view that the company does not have an economic moat."