5 Wide-Moat Stocks Now Selling at a Discount

In the days leading up the historic referendum on whether the U.K. would remain in the European Union, most market observers were betting on a "stay" vote. So much so, in fact, that when all the ballots were counted on June 23, and it was revealed that Brexit had prevailed after all, global markets were gobsmacked.

European markets plunged. The FTSE 100 shed 3.2%, Germany's DAX fell 6.8%, and the Paris CAC lost 8% on June 24. Asian markets were also roiled, with the Nikkei 225 plunging 7.9%. We couldn't escape global markets' pain on this side of the pond, either, as the Dow Jones Industrial Average plummeted more than 600 points, losing 3.4%.

The upside to broad market sell-offs is that they can start to surface new buying opportunities for bargain-hunters. As Morningstar European director of equity research Alex Morozov discusses in this video, when markets sell off indiscriminately, investors tend to dump even high-quality names--those with sturdy financials and durable competitive advantages--along with everything else. Morozov cautions that investors shouldn't expect these names to bounce back immediately, however. In fact, they may fall further. Uncertainty abounds--patience, along with an iron stomach, is required when shopping the clearance rack.

We employed our

to find some high-quality stocks on our coverage list that were rated 4 or 5 stars, which indicates that we think they are undervalued relative to our estimate of their fair value.

We then we looked for companies with a fair value uncertainty rating of low or medium, which means we think we can more tightly bound the fair value because we can estimate the stock's future cash flows with a greater degree of confidence.

Finally, we looked for stocks with an economic moat rating of wide (meaning we think they have advantages that will fend off competitors for at least 20 years).

As of June 27, our screen returned 59 stocks. Here's a closer look at five stocks that made it through.

Wells Fargo

WFC

Fair value estimate: $61

Wells Fargo is the largest deposit-gatherer in major metropolitan markets across the country, explains Morningstar senior equity analyst Jim Sinegal. He estimates that more than one third of the bank's deposits come from markets in which Wells Fargo is the pre-eminent player, and more than two thirds are gathered in markets in which the company ranks among the top three. The firm's wide economic moat owes to its ability to generate exceptionally high levels of profitability: The bank builds on its funding advantage through efficient operations and solid underwriting, minimizing costs at the same time it maximizes revenue associated with every dollar held on its balance sheet. Wells Fargo does face risks, including greater regulatory scrutiny and macroeconomic uncertainty, Sinegal notes. However, Wells Fargo is highly profitable and its returns and capital are fairly safe. In addition, it's balance sheet strength is quite good. "Our base-case projections incorporate long-term returns on equity of 13%, well in excess of the bank's 9% cost of equity," Sinegal writes.

Nestle SA

NSRGY

Fair value estimate: $81

Morningstar sector strategist Phil Gorham concedes that this behemoth consumer-staples product company is poised for slower organic growth over the next decade than it achieved in the last, owing to "both cyclical and structural factors." He notes, however, that Nestle does have some secular growth drivers--particularly management's attempts to align the product portfolio with consumers' shifting preference to healthy products. Also, the company has pricing power in its infant formula and pet food product segments. The breadth of the firm's portfolio, spanning beverages, dairy products, nutrition and healthcare, ready-made meals, confectionery, and pet care, makes it "one of the most important suppliers to retailers globally and differentiates it from narrow-moat competitors with narrower product portfolios," says Gorham. Gorham notes that our wide-moat rating is supported by Nestle's ability to sustain excess returns on invested capital. "Even with the inclusion of goodwill, ROIC has hovered in the midteen percentage range during the past five years," Gorham says. "We expect that figure to remain fairly flat during the next five years."

Novartis AG

NVS

Fair value estimate: $89

Novartis derives its strength from a diversified operating platform that includes branded pharmaceuticals, generics, eye-care products, and consumer products, writes Morningstar healthcare sector director Damien Conover. Despite the recent patent losses of Diovan (for high blood pressure) and Gleevec (for a rare form of leukemia), the combination of a strong pipeline of new products and a diverse, well-positioned operating platform should translate into steady growth over the long term. Novartis differentiates itself because of its sheer number of blockbusters, explains Conover, including Gilenya for multiple sclerosis; Afinitor and Tasigna for cancer; heart failure drug Entresto; and immunology drug Cosentyx. All of these patent-protected drugs carry strong pricing power, which enables the firm to generate returns on invested capital in excess of its cost of capital. Corporate restructuring over the past few years has resulted in margin improvement, notes Conover--particularly the divestiture of both the animal health (to Eli Lilly) and vaccine unit (to Glaxo), both of which were carrying very low margins and not driving much of the cash flow for the company. "Following the restructuring, we project an average 2% annual sales growth rate during the next decade as new product launches unfold," Conover said.

Berkshire Hathaway

BRK.B

Fair value estimate: $170

Berkshire's wide economic moat is more than just a sum of its parts, says Morningstar senior equity analyst Gregg Warren. But he also offers that "the parts that make up the whole are fairly moaty in their own regard." While Warren explains there will be firms within Berkshire whose competitive advantages diminish over time, the large collection of moaty firms that reside within Berkshire's manufacturing, service, and retailing operations, as well as its finance and financial products division, is more likely to maintain a narrow economic moat in aggregate, even as a few firms along the way succumb to changing competitive dynamics within their industries. Insurance, which makes up 25% of pretax earnings and more than 30% of our fair value estimate, is not particularly conducive to the development of competitive advantages, Warren explains, because insurance products are largely commodities. But they also generate low-cost float--the temporary cash holdings that arise from premiums being collected in advance of future claims, which is a major source of funding for investments. That said, investors may need to temper their expectations for long-term returns. Although Warren expects Berkshire to continue to put money to work in value-creating projects in the near to medium term (such as Kraft Heinz and Precision Castparts), he thinks the huge sums of excess cash it generates on an ongoing basis will ultimately limit its ability to produce outsize returns.

MasterCard

MA

Fair value estimate: $120

The MasterCard network functions as a tollbooth on financial transactions, generating a small amount of revenue from every transaction that runs through its network and every dollar of payments made using the MasterCard brand. We expect that MasterCard will eventually process a much larger share of total payment transactions, resulting in healthy top-line growth for years to come, writes Jim Sinegal. As customers globally move away from cash and mobile-payment transactions pick up, this tailwind will be strengthened even further, Sinegal notes. MasterCard's network effect is powerful and symbiotic: A payment method widely accepted by merchants is attractive to cardholders, while a payment method used by many cardholders is attractive to merchants. This results in a wide economic moat. Though the company faces risk in the form of regulation and litigation, such a network is extremely difficult to replicate, with regulatory factors producing significant barriers to entry. In addition, MasterCard's trusted brand is an intangible asset that is important to customers.

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