Why This Wide-Moat Firm Is Underappreciated

Andrew Lane: At Morningstar, we recently published a two-part report series called the Moats and Multiple Series that really aims to provide some useful information to investors. The main idea is that moat ratings can’t be solely relied upon to inform investors as to which stocks are likely to outperform or even likely to underperform. And also, the main conclusion is that the width of the moat ratings that we assign, none, narrow or wide, also have a very clear positive correlation with the terminal valuation multiples that are observed across the companies that we cover.

For example, when you consider the midcycle price/earnings multiples that we assign to the companies under our coverage, the median wide-moat company that we cover has a midcycle price/earnings ratio of about 19 and a half times, just below 17 times for the median narrow-moat company, and then just about 14 times for the median no-moat companies. So that shows that positive correlation between the width of a company's moat and, on average, the multiple at which it should be expected to trade in the midcycle environment.

This report series is really valuable in a couple of different ways. First of all, because Morningstar covers such a wide variety of stocks and has such expansive equity coverage, we have a chance to provide guidance ranges for terminal multiples, and this can help investors determine ranges as far as what type of multiple might make sense as a sanity check when trying to value companies on their own. Additionally, the information from these reports aid in the identification of companies that probably aren't getting due credit for the economic moats that they have. In other words, we might call this "moat arbitrage."

I'll provide one example of how we use this information in an effort to uncover an undervalued company that has a moat that we don't think is getting the respect it deserves. That company is Compass Minerals. Compass Minerals mines rock salts and produces sulfate of potash. So it is a commodity producer, but nonetheless, unlike almost all commodity producers, we actually think the company has a very wide economic moat through a very powerful cost advantage in the extraction of the resources that it produces. Thanks for that cost advantage and that wide moat rating, we feel the company should really have a higher multiple than the market is currently reflecting. When we published this report series, the company was trading at an EV/EBITDA multiple close to about 9 times, and that actually puts it below the median multiple for the broader basic-materials sector.

Even though this is a wide-moat company, it was trading as though it were a narrow-moat company and perhaps even a low-grade narrow-moat company at that. And when you think about how strong the company's moat is, we have a lot of conviction in the wide moat rating for this company, and it's clear to us that this is a company that's not getting the credit it deserves from a moat perspective as reflected by its multiple.

That's just one example how this report series can help identify high value companies that probably aren't getting the respect they deserve and should be subject to multiple expansion in the coming years.