Market Update

4 High-Quality Stocks Top Managers Like

Susan Dziubinski

At long last, midterm elections are over. Now pundits will muse about what the outcome means for the stock market--as if knowing where the market is headed is that simple.

Instead of guessing where stocks are going next, we suggest investors focus on finding companies with competitive advantages--companies with moats--and buy them when they're trading at a discount to what they're worth. Then, hold on until they reach fair value.

In an effort to uncover opportunities, we often look to some of our favorite mutual fund managers for insight. Specifically, we peek into the latest portfolios of those managers whose funds earn Morningstar fund Analyst Ratings of Bronze or better. After all, the funds have earned those ratings because their managers have clearly articulated strategies that have met with success over a full market cycle. Why not pick their brains for stock ideas?

The team at Gold-rated Dodge & Cox Stock (DODGX) favors firms that are cheap on a range of valuation measures and uses bottom-up fundamental research to find companies with good management, competitive advantages, and solid growth. Last quarter, they took a new position in  CVS Health (CVS), which runs the largest pharmacy benefit manager and retail pharmacy chain in the United States. (Notably as we mentioned last month,  Oakmark (OAKMX) also picked up CVS last quarter.)

They explain in their latest commentary:

"Concerns about pricing pressures and potential competitive threats from Amazon  (AMZN) have lowered CVS Health's valuation to a 20-year low. However, we believe that CVS Health's valuation--approximately 11 times forward earnings--does not reflect the strength of its franchise. The company holds the number-one position in each of its five primary business lines: PBM; specialty pharmacy; retail/mail pharmacy; Medicare prescription drug plan; and, long-term care. In addition, over the past five years, CVS Health's shareholder-friendly management team has improved return on invested capital, generated robust free cash flow, and gained significant market share. The company acquired Caremark (a PBM) in 2006 and successfully transitioned Caremark's prescription script volume into CVS stores. CVS Health now plans to move into managed care with its pending acquisition of Aetna (the third-largest managed care company in the United States), which is expected to close by the end of 2018."

Morningstar awards CVS a narrow moat rating with a positive moat trend.

"The firm has positioned itself as a major player within the U.S. healthcare ecosystem by building itself into a top-tier pharmacy benefit manager and one of the largest U.S. pharmacy retailers," says senior analyst Vishnu Lekraj. Morningstar thinks the Aetna merger is a positive from an operational standpoint, and expects the unified CVS/Aetna to be a healthcare juggernaut: It'll be able to sell insurance and manage members through every aspect of their treatment regiments, Lekraj adds. Shares are trading in 4-star range, suggesting that they're undervalued by Morningstar’s metrics.

Manager Michael Keller, who leads Silver-rated BBH Core Select (BBTEX), pursues a disciplined approach targeting profitable cash generators with strong balance sheets that trade at least 25% below their estimated intrinsic value. He picked up shares of  Dollar General (DG) in July, noting in the fund's latest commentary that the discount retailer had been on the fund's "wish list" for a while, thanks to its attractive financial performance and high-quality management team.

"While the U.S. retail industry--including food and staples retail--is undergoing important structural shifts, we believe Dollar General can effectively leverage its size, scale and focus on the rural consumer not only to compete effectively, but also sustain its leadership position in a changing landscape," he explains. Shopping alternatives in the communities in which Dollar General operates tend to be sub-scale grocers or convenience stores that have higher like-for-like pricing, he adds, and consumers may have to travel significant distances to visit large retailers that offer similar value to Dollar General. Moreover, Keller likes Dollar General's economic resiliency.

"While we do not have a view on when the U.S. economy might enter another downturn, nor is our investment thesis predicated on such an occurrence, we believe Dollar General is well positioned to perform strongly in periods of economic stress," he concludes.

Morningstar assigns Dollar General a narrow moat rating and a negative moat trend. We maintain a favorable view of the retailer's prospects in a shifting competitive landscape.

"We believe Dollar General has capitalized on its efficiency, advantaged store locations (with roughly 70% of units in rural areas, which we believe can support only a limited number of retailers), and leverageable supply and distribution architecture to deliver low prices and convenience to consumers of modest means," says analyst Zain Akbari. He adds that the retailer has also wisely invested in new technology that should add to its standing with customers. That said, intensifying competition from convenience store, mass merchandisers, hard discounters, and grocery stores--among others--is diminishing its competitive edge. Shares are fairly valued today according to our metrics, trading at 3-star levels.

Last quarter, BBH's Keller also added to the portfolio's stake in  Allegion (ALLE), a global leader in security products and solutions.

"The company reported solid earnings results in August, highlighted by year-over-year organic growth exceeding 5% and steady operating margins driven by pricing, productivity, and other cost savings that offset input cost inflation headwinds," he says. "We maintain a high level of conviction that Allegion can continue to earn and compound high economic profits at attractive rates, and we continue to see the shares as being attractively valued relative to our intrinsic value estimate."

Morningstar assigns Allegion a wide moat rating and stable moat trend. Strong positioning in the Americas, which represents 73% of sales, has been the main driver of the firm’s consistent and industry-leading profitability, says analyst Brian Bernard.

"Despite competition from formidable competitors, Allegion has consistently capitalized on its brand equity, strong distribution network, and large installed base to drive excess returns," he explains. "Since the company's 2013 spin-off from Ingersoll-Rand, we estimate the firm has generated an average return on invested capital of about 22%, well above its weighted average cost of capital. We believe Allegion is well positioned to maintain its competitive advantages within the Americas business over the next 20 years. As such, we award Allegion a wide economic moat, supported by the firm's intangible assets and customer switching costs."

Shares currently trade in 3-star range, suggesting they're fairly valued.

Silver-rated American Century Equity Income's (TWEIX) lead manager Phil Davidson focuses largely on dividend payers with competitive advantages, modest debt, and solid returns on capital that trade at a relatively low valuation. Davidson and his crew added the largest food company in the world, Nestle (NSRGY), to the portfolio during the third quarter.

"Nestle has leading market shares, strong brands, a solid balance sheet, and a relatively attractive dividend yield," he explained in his latest commentary. "Nestle is in the process of focusing on its core businesses. It is divesting noncore assets and using the proceeds to reinvest back into its strongest segments and returning cash to shareholders."

Nestle earns a wide moat rating and a stable moat trend from Morningstar.

"Packaged food is increasingly becoming commoditized, and we see a risk that price competition may weigh on Nestle's growth," explains analyst Ioannis Pontikis. "The emergence of the hard discounters selling private-label products and the threat of the online channel lowering barriers to entry for smaller, nimbler manufacturers that have proven to be more adept at identifying the niche opportunities are all headwinds for large-scale consumer packaged goods firms."

Even so, Nestle can stand out. Cost-cutting efforts should allow it to reach margins in line with competition, she notes--and new management has put a lot of weight on reinvigorating growth active portfolio management and further investment in high-growth categories. Positive trends in emerging markets should help, too. Shares are fairly valued today according to our metrics.

Susan Dziubinski does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.

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