3 High-Quality Tech Stocks With More Room to Run

Technology stocks are on a tear. As of this writing, the Morningstar U.S. Technology Index is up nearly 20% year to date, handily outpacing all other U.S. sector-based indexes for the year.

We've isolated three tech stocks that have left the index's return in the dust (each is up at least 35% this year). Even better, these stocks all boast wide economic moats and stable or positive moat trends; these aren't flashes in the pan, but rather powerful competitors positioned to endure. And best of all, each of these stocks is trading below our estimate of its fair value, despite their significant stock-price runups this year.

Microsoft

MSFT

Morningstar Rating:

4 stars

Uncertainty:

Medium

Moat Trend:

Stable

YTD Return (through 9/24/18):

35.53%

Earlier this month, Morningstar increased its fair value estimate on Microsoft to $130 per share and upgraded the firm's Stewardship Rating to Exemplary. CEO Satya Nadella has radically transformed the firm's culture in only a few years, argues analyst William Fitzsimmons.

"After Nadella took the helm, the firm has revitalized itself," he says in his latest report. "In our opinion, Microsoft is increasingly a cloud leader, the business is more user-friendly, the firm is willing to take risks in investing in nascent technologies, and employees have implemented a growth mindset. We see Microsoft's future as oriented around Office 365, Azure, and LinkedIn, while seeing broad-based contributions from smaller segments such as Xbox, Surface, and Dynamics."

While no longer considered the "monopoly" it was in the 1990s tech boom, Microsoft is still a tech leader with significant competitive advantages. It earns a wide moat and a stable moat trend.

"We firmly believe Microsoft's offerings maintain monopolistic qualities," adds Fitzsimmons. Far less reliant on Windows and Office, today's Microsoft capitalizes on its investments in cloud computing and artificial intelligence, in addition to its purchases of LinkedIn and GitHub. Azure, the firm's public cloud offering, has been a success as workloads move to the public cloud and serves as a hedge against declines in legacy businesses.

"These various factors give us confidence in a wide economic moat rating for the aggregate business," concludes Fitzsimmons.

Despite its healthy return of more than 35% this year, shares are still about 12% undervalued, in our opinion.

Salesforce.com

CRM

Morningstar Rating:

4 stars

Uncertainty:

Medium

Moat Trend:

Positive

YTD Return (through 9/24/18):

67.24%

Morningstar recently boosted the fair value estimate of this software heavyweight to $175 from $158 per share. A shift to cloud applications and enterprises undergoing a digital transformation, coupled with robust aggregate customer relationship management (CRM) spending growth, should propel Salesforce's top line, says Fitzsimmons. He describes Salesforce as an "end-to-end CRM juggernaut."

Essentially the first CRM vendor to make software as a service a success, Salesforce built a large customer base and applications to service multiple verticals. It has carved a wide economic moat from strong switching costs and a network effect. We believe Salesforce benefits from a network effect in terms of its platform offerings, both from a developer and application ecosystem standpoint. And because its applications are tied directly to the revenue generating functions of its client base--coupled with the training and implementation costs that exist with its software as a service offerings--high switching costs are inherent in Salesforce's tools.

"The firm's acquisition of MuleSoft (acquired at an expensive multiple of 22 times revenue) and incremental investments in its AI tools (Einstein) embolden our confidence in Salesforce's increasing switching costs," says Fitzsimmons. In fact, the firm's moat trend is positive, suggesting that its competitive advantages are strengthening.

The stock has soared more than 67% this year but still trades in 4-star range.

"With shares trading at a discount to our fair value estimate, even after an impressive year-to-date run, we still anticipate additional upside for Salesforce and still see this as an attractive point of entry," concludes Fitzsimmons.

ServiceNow

NOW

Morningstar Rating:

4 stars

Uncertainty:

Medium

Moat Trend:

Positive

YTD Return (through 9/24/18):

48.11%

In late July, we upgraded the cloud software provider's economic moat rating to wide and raised its fair value estimate to $221 from $195.

"ServiceNow has followed the successful software paradigm of introducing a single, mission-critical product in a market vertical and expanding from that beachhead into other niches, providing ample upsell and cross-sell opportunities," explains Fitzsimmons. That first product was a cloud ticketing tool designed to track internal IT issues. Since then, it has been offering scalable and customizable products relating to workforce productivity, expanding into a variety of software verticals, including IT operations management, IT business management, human resources and security, among others.

The firm's wide moat stems from its switching costs; it has developed a sticky customer base, says Fitzsimmons. Moreover, its competitive positioning is only improving, as its positive moat trend suggests.

"Our overall thesis for our wide moat rating is anchored in both ServiceNow's industry leading customer retention metrics and lifetime value to customer acquisition ratio, or LTV/CAC," he expands.

The stock is up a healthy 48% so far this year, yet shares continue to trade below our fair value estimate.

"Our current fair value estimate of $221 per share places ServiceNow shares in 4-star territory, and we believe this represents an attractive entry point for a firm set to capitalize on enterprise clients undergoing a digital transformation as they upgrade their IT infrastructure," says Fitzsimmons.