Ideas From the Wide Moat Focus Index

Morningstar recently concluded the third-quarter rebalancing of the Wide Moat Focus Index, which contains the 20 cheapest wide-moat stocks based on price/fair value ratios, excluding master limited partnerships and most foreign companies. It is equal-weighted and rebalanced quarterly. It is also the basis for the exchange-traded fund with the ticker MOAT. Over the trailing 1- and 5-year periods as of Oct. 4, the Wide Moat Focus Index had delivered a total return of 25.4% and 17.1% per year, respectively. This easily outperformed the S&P 500's 18.3% and 11.5% annual total return, respectively, over the same periods.

Since Morningstar StockInvestor follows a similar strategy to the Wide Moat Focus Index--buying companies with very strong competitive advantages when they are trading for discounts to their intrinsic values--I find the regular index rebalancing to be a useful source of potential investment ideas. Below are the nine companies that were recently added to the index, along with my take on each.

 Sysco (SYY)
Price: $31.63
Fair value estimate: $38
Matt's take: Sysco has struggled to increase its intrinsic value over time. The reasons include the company's incomplete integration of numerous acquisitions; a multiyear restructuring that always seems to take longer, cost more, and produce fewer tangible benefits than management predicted; and restaurant sales that have been growing only 1%-2% per year, with Sysco seemingly unable to contain its expense growth to that level. I would need to see evidence that Sysco can return to an acceptable earnings growth trajectory--or a larger margin of safety--before getting interested.

 Coca-Cola (KO)
Price: $37.05
Fair value estimate: $45
Matt's take: A recent addition to StockInvestor's real-money Tortoise Portfolio. Coca-Cola is home to some of the world's most well-known and well-liked beverage brands. Besides its namesake, Coke also owns Fanta, Sprite, and Fresca; Dasani water, smartwater, and vitaminwater; Minute Maid, Simply Orange, and Odwalla juices; Fuze Tea and Honest Tea; Powerade and energy drink Nos; and endless variations on these themes: diet, "zero," caffeine-free, and flavored versions, different package sizes, and so on. The company also oversees an unparalleled global distribution system--you would struggle to find anywhere on the planet that you couldn't buy a Coke. Coca-Cola faces some headwinds, including a shift in consumer tastes away from carbonated soft drinks in North America and the threat of greater taxation on sugary beverages as governments attempt to tackle the obesity epidemic. However, I think the company's diversified portfolio and relatively low degree of penetration in many emerging markets still leave it plenty of room to grow. Management's strategic vision for 2020, including high-single-digit growth in earnings per share, seems attainable.

 CSX (CSX)
Price: $25.36
Fair value estimate: $30
Matt's take: CSX joined the Wide Moat Focus Index as a result of a recent upgrade to our moat rating. Railroads enjoy insurmountable barriers to entry. While returns on capital had historically been below the cost of capital, pricing increases and operational improvements in the last decade have positioned the rails to create shareholder value going forward. CSX's depressed valuation is the result of investor concern over the secular decline in demand for coal from Eastern basins. While this is a real risk, our analyst thinks the headwind has been more than incorporated in the stock price and that CSX can adjust its cost structure to enhance margins even in the face of lower coal volumes.

 Kinder Morgan Inc. (KMI)
Price: $35.02
Fair value estimate: $41
Matt's take: Kinder Morgan Inc. is the general partner to  Kinder Morgan Energy Partners (and related security  Kinder Morgan Management ) and is entitled to about half of the limited partnership's cash flows. Kinder Morgan Inc. is also the general partner of  El Paso Pipeline Partners and owns a variety of other midstream energy assets, most of which will be dropped down to the limited partnerships in the next few years. While KMI's yield is significantly lower than that of KMP/KMR, it makes up for this with faster growth thanks to both incentive distribution rights and its ability to collect more distributions when the limited partners issue new units. While the general partnership structure is a burden to KMP, it is a boon to KMI. Note that Kinder Morgan Inc. is a C corporation, which means it doesn't have the tax complications of a master limited partnership, and it pays qualified dividends, which are generally eligible for preferential tax rates in the U.S.

 Medtronic (MDT)
Price: $52.72
Fair value estimate: $60
Matt's take: Medtronic has struggled to grow revenue and earnings in the past couple of years, but the company may be reaching a turning point in its product cycle. Medtronic's implantable cardioverter defibrillator and spine businesses have faced reimbursement and utilization headwinds, which show signs of stabilizing. More importantly, we see promise in the company's emerging technologies, such as MRI-compatible pacemakers, transcatheter heart valves, neuromodulation, treatments for atrial fibrillation, and renal denervation. Our fair value estimate recently received a boost from lowering our cost of equity assumption (to 8% from 10%) as we've reassessed the level of systematic risk across our health-care coverage universe.

 Spectra Energy
Price: $34.23
Fair value estimate: $39
Matt's take: Spectra has assets across the entire natural gas midstream value chain, from the wellhead to kitchen stoves: gathering pipelines, processing plants, transmission pipelines, storage facilities, and a distribution utility. The company is the general partner to  Spectra Energy Partners , but like Kinder Morgan Inc., Spectra Energy itself is a C corporation without the tax headaches of an MLP. Spectra is benefiting from booming domestic production of natural gas, which is creating plentiful opportunities for organic growth in the next five years.

 Covidien
Price: $60.55
Fair value estimate: $68
Matt's take: Another firm whose moat rating was recently upgraded to wide, in this case following the spin-off of the no-moat specialty pharmaceutical business as  Mallinckrodt . That transaction left Covidien with the far more attractive medical devices business. Following its own spin-off from  Tyco International a few years ago, Covidien has steadily transformed itself into a lean, R&D-driven leader in medical devices, with a particular focus on minimally invasive surgery. Covidien participates in a series of health-care niches, usually with only a small handful of competitors ( Johnson & Johnson (JNJ) is its main rival). While the company continues to sell some commodity medical supplies, most of its R&D and sales dollars are flowing into innovative product lines such as advanced surgical tools. Covidien appears to be less exposed to reimbursement pressure and has better growth prospects than most of its medical device peers.

 Allergan
Price: $90.14
Fair value estimate: $100
Matt's take: Allergan derives nearly 30% of its revenue from Botox, the infamous wrinkle-reducing neurotoxin. Botox is facing increasing competition from a variety of sources, most notably Johnson & Johnson's PurTox, which could reach the market around 2014. There are clouds over other products as well, including the threat of generic competition to dry-eye treatment Restasis (which represents about 15% of sales) and delays for clinical trials on a key pipeline drug. The good news is that barriers to success are relatively high in Allergan's niche markets--for example, injectable neurotoxins can have unique effects, which makes doctors and patients hesitant to try less-well-known brands. The company also continues to seek approval for Botox in new indications, which expands the drug's market potential, and to leverage its relationships with cosmetic physicians into adjacent product categories, such as facial fillers, breast implants, obesity intervention devices, and a drug called Latisse that is intended to extend eyelashes.

 ITC Holdings
Price: $93.70
Fair value estimate: $98
Matt's take: Another recent addition to the Tortoise. The margin of safety is slim, but ITC Holdings has very low uncertainty thanks to its formula-based rates with the Federal Energy Regulatory Commission. Regulatory approval of the  Entergy  (ETR) transmission merger remains an overhang, but the deal isn't essential to our investment thesis. ITC is well positioned to capitalize on the need for new transmission infrastructure to ensure reliability of the electricity grid, to facilitate competitive generation markets, and to enable development of renewable power resources (especially wind). The biggest risk is that regulators could lower the company's allowed returns on equity, but I don't think FERC has much incentive to do this considering how important transmission is to its policy goals and the fact that transmission accounts for a small percentage of utility bills.

The following stocks were removed from the Wide Moat Focus Index since last quarter, all because of valuation:  Facebook (FB),  Expeditors International of Washington (EXPD),  Qualcomm (QCOM),  National Oilwell Varco (NOV),   Schlumberger (SLB),  Vulcan Materials (VMC),  Maxim Integrated Products ,  Amgen (AMGN), and  Caterpillar (CAT).

Stock data as of Oct. 7.

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