Terrific Companies at Terrible Prices
We'd love to own these stocks--if only they were cheaper.
"The market, like the Lord, helps those who help themselves. But, unlike the Lord, the market does not forgive those who know not what they do. For the investor, a too high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments." --Warren Buffett, from his 1982 chairman's letter
Though delivered with his signature folksy humor, Buffett's point is a critically important: Valuation matters. Even a fantastic company can be a bad investment if you buy it when the price is too high.
We recently screened our coverage for companies we'd love to own, if only their prices were right. First we looked for companies with a fair value uncertainty rating of low or medium, which means we think we can more tightly bound their fair values because we can estimate the stock's future cash flows with a greater degree of confidence. Then we looked for stocks with an economic moat rating of wide--we think they have advantages that will fend off competitors for at least 20 years.
Our screen turned up 39 stocks as of July 19, 2016. (Premium users can click here to view the screen or tweak it to suit their specifications.) All of the stocks in our screen are rated 1 or 2 stars, meaning that they are overvalued relative to our estimate of their fair value.
So what can you do with this list of high-quality but overpriced stocks? If a few of the stocks pique your interest, save them in a watch list. Our Portfolio Manager tool makes it very easy to set one up: Just click here, select "New Watch List" under the "Create" tab, enter the tickers, name your watch list, save, and you're done. (The share number, purchase price, and commission fields can be left blank.) You can customize your watch list alerts to tell you about price swings or, if you're a Premium Member, you can be alerted whenever a new fair value estimate or Stock Analyst Report is published.
Here's a closer look at five stocks that made the cut.
3M Co (MMM)
Price/Fair Value: 1.10
3M has a long history of returning capital to shareholders, having paid dividends without interruption for 99 years, according to the firm itself. Unlike many capital-intensive industrial firms in our coverage list, however, 3M's high percentage of consumables (products intended to be used quickly), which make up about 50% of its product portfolio, give the company healthy profitability and insulate it from the volatile industrial capital spending cycle. We believe that 3M's products spring from four main technological competencies: abrasives, adhesives, filters, and coatings, Morningstar equity analyst Barbara Noverini says. And the company's wide economic moat owes to its intangible assets (such as patents and a strong brand), cost advantage, and switching costs. Because of these, the company is able to generate attractive returns on invested capital despite the fact that its offerings are largely disposable, finite-use products that might otherwise be described as commoditylike. That said, Noverini believes 3M's research and development prowess crafts products that are far superior, supporting performance claims that create the powerful brands for which 3M is known.
Price/Fair Value: 1.18
Costco offers investors the highest near-term cash flow visibility in the retail defensive sector because of its membership fee model and high-quality customer base, writes Morningstar equity analyst Ken Perkins. Costco derives roughly 75% of its operating profits from membership fees, and importantly, member renewal and retention rates have not suffered much after membership-fee increases. This suggests that Costco also wields a different form of pricing power over its customers, Perkins says. By using staples such as fresh food and gas as loss leaders--which means that the company sells these products at a loss to attract customers--Costco can preserve the market share it has already captured and fend off other discounters and online players like Amazon, in Perkins' opinion. Massive sales volume and rapid inventory turnover lead to exceptional unit productivity levels, which help to offset inherently thin margins. Overall, Perkins believes Costco possesses a cost advantage that supports a brand intangible asset, and the combination of these mutually reinforcing competitive advantages is worthy of a wide economic moat.
Intel Corp (INTC)
Price/Fair Value: 1.13
Intel is the largest semiconductor company in the world, and it holds roughly four-fifths share in the microprocessor market. According to Morningstar equity analyst Abhinav Davuluri, the firm has sustained its position at the forefront of technology by investing heavily in research and development--its R&D budget averaged $11.4 billion annually from 2013 to 2015. Davuluri believes this trend should continue. The firm's wide moat emanates from its superior cost advantages realized in the design and manufacturing of its cutting-edge microprocessors. Semiconductor manufacturing is inherently capital-intensive, and thus requires methodical planning and execution to keep the cost per chip at a reasonable level. Intel accomplishes this through investments in the latest process equipment technologies. However, in order for the economics of the business to be pragmatic, there needs to be strong demand via differentiated products that can be sold at high margins, which, Davuluri says, Intel achieves through its investment in R&D.
Johnson & Johnson (JNJ)
Price/Fair Value: 1.15
Morningstar sector director Damien Conover believes Johnson & Johnson stands alone as a leader across the major healthcare industries--medical devices contribute about a third of sales; pharmaceuticals make up over 40% of revenue; and over-the-counter products, including brands with strong pricing power, make up the balance. The company maintains a diverse revenue base, a developing research pipeline, and exceptional cash flow generation that together create a wide economic moat. J&J's healthy free cash flow (operating cash flow less capital expenditures) is close to 20% of sales; strong cash generation has enabled the firm to increase its dividend for over the past 50 years, and Conover expects this to continue. Moreover, Conover notes that the diverse operating segments coupled with expected new products insulate the company more from patent losses relative to other Big Pharma firms. Further, in contrast to most of its peers, J&J faces the majority of its near-term patent losses on hard-to-make complex drugs, which Conover believes should slow generic penetration.
McCormick & Co (MKC)
Price/Fair Value: 1.17
McCormick is more than 4 times larger than its next largest competitor in the global market for spices and seasonings, with more than 20% share of the $10 billion global market. This makes it a valuable partner for retailers, according to senior equity analyst Erin Lash. McCormick also operates as the leading private-label producer in the spices and seasonings category, Lash notes. Other consumer product manufacturers have struggled to play in both the branded and private-label space; however, McCormick has effectively used this positioning to enhance its retailer relationships, solidifying its wide economic moat. McCormick also has the resources to invest to bring new products to market: It spends 7% of sales or $300 million each year in combination on marketing and research and development; Lash believes this spending enhances the stickiness of its retail relationships. "McCormick has consistently posted returns on invested capital (including goodwill) in the low double digits, well above our 7% cost of capital estimate--supporting our take that the firm maintains a wide economic moat," she said.
Price/fair value data as of July 19, 2016.
Karen Wallace does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.