Wide Moats, Positive Moat Trends, Exemplary Stewardship

Three primary factors determine the quality of a business, in our view:

1. The strength of its competitive advantage, if any;
2. Whether the competitive position is improving or deteriorating; and
3. The quality of management. 

Morningstar captures these dynamics through our economic moat, moat trend, and stewardship ratings, respectively.  

Wide-moat firms have the strongest competitive advantages--structural business attributes that should protect the firms' economic profits against the onslaught of competition for at least 20 years. For example, consumers are fiercely loyal to  Altria's (MO) cigarette brands like Marlboro.  Cisco Systems (CSCO) benefits from switching costs, as customers don't want to risk disruption to their IT networks by using a competitors' equipment. And electricity transmission provider  ITC Holdings benefits from the fact that it would be inherently inefficient to build a second set of transmission lines along the same routes ITC already serves. Companies with less strong advantages have narrow economic moats, and those without a sustainable advantage have no moat.

Firms with positive moat trends are experiencing improving competitive positions--they are either creating economic moats for the first time or are expanding moats they already have. For example, no-moat children's apparel marketer  Carter's (CRI) is building its brand and gaining scale, which may one day result in a competitive advantage. Outsourced research provider  Icon (ICLR) is bolstering its narrow moat through long-term contracts with pharmaceutical firms, which increase customer stickiness.  Echo Global Logistics is adding both shippers and carriers to its logistics network, making the network more valuable to all parties involved. Firms with deteriorating competitive positions receive our negative moat trend rating, while the vast majority of companies have stable moat trends.

Lastly, only management teams that excel at both strategic execution and capital allocation receive our exemplary stewardship rating. For example, management at master limited partnership  Magellan Midstream Partners has created significant shareholder value through disciplined acquisitions and the early buyout of its general partner, simplifying the capital structure and lowering Magellan's cost of capital.  Potash Corporation of Saskatchewan's (POT) exemplary management team has also distinguished itself through smart capital allocation--expanding capacity in the competitively advantaged potash segment--and through pricing and production discipline. Executives at pharmacy benefit manager  Express Scripts   built a wide moat through savvy deal-making, which enhanced the company's bargaining power with suppliers. Lesser management teams receive our standard or poor stewardship ratings.

In light of the foregoing discussion, one can't help but wonder which companies exhibit all of these favorable characteristics: wide moats, positive moat trends, and exemplary stewardship. This is a very rare combination: There are only nine companies in our entire coverage that meet this test. Three of them, all of which look undervalued and are owned by StockInvestor's real-money Hare Portfolio, are highlighted below.

 EBay (EBAY)  
Price: $52.05 | Fair Value Estimate: $63 | Price/Fair Value Ratio: 0.83  
John Donahoe has led an impressive turnaround since becoming eBay's CEO, and he has a uniquely compelling strategic vision for the company: to make it a leading impartial facilitator of online commerce. The network effect is only strengthening as eBay attracts more users to its core marketplaces and PayPal products. The stock was down recently after management issued a weaker-than-expected second-quarter outlook, providing an attractive entry point to one of the highest-quality Internet companies. Some short-term headwinds--such as aggressive investment in mobile capabilities--could turn into long-term tailwinds.

 Novo Nordisk (NVO)     
Price: $166.06 | Fair Value Estimate: $212 | Price/Fair Value Ratio: 0.78    
Novo Nordisk is the world’s leading manufacturer of diabetes drugs, with more than 85 years of history and about a 50% share of global insulin volumes. Diabetes is an attractive niche for drugmakers. Aging populations, unhealthy diets, and sedentary lifestyles mean incidence rates of the disease are steadily climbing. It is far better and cheaper to manage diabetes with drugs than to treat all the complications that come with unmanaged diabetes, which can lead to favorable reimbursements. Insulin is relatively inexpensive but consumed in large volumes, so manufacturing scale is critical. And patients are closely involved in their own care, creating relatively high brand loyalty. 

 National Oilwell Varco (NOV)       
Price: $69.17 | Fair Value Estimate: $85 | Price/Fair Value Ratio: 0.81  
As the world looks farther afield for oil, National Oilwell Varco is a key partner, supplying best-in-class equipment and technological expertise. The majority of rigs in use today are more than 20 years old and use custom designs. NOV is positioned to be among the biggest winners from a replacement cycle, especially as oil and gas firms reassess rig safety following the Deepwater Horizon disaster in the Gulf of Mexico. Today’s market share gains in rig equipment could provide a multidecade stream of income from consumables and aftermarket parts and service.

Data as of June 11.

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