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10 Cheap Wide-Moat Stocks

We review the changes to the Morningstar Wide Moat Focus Index during the latest reconstitution and reveal the least-expensive names.

The Morningstar Wide Moat Focus Index tracks companies that earn Morningstar Economic Moat Ratings of wide and that are trading at the lowest current market price to fair value. How has this cluster of high-quality names performed over time? Pretty well: The index has beaten the S&P 500 during the trailing one-, three- and five-year periods. As a result, the index's constituents are a fertile hunting ground for investors looking for high-quality stocks trading at reasonable prices.

In an effort to keep the index focused on the least-expensive high-quality stocks, we reconstitute the index regularly. The index consists of two subportfolios containing 40 stocks each, many of which are overlapping positions. The subportfolios are reconstituted semiannually in alternating quarters, on a "staggered" schedule. We re-evaluate the index's holdings and add and remove stocks based on a preset methodology. Because stocks are equally weighted within each subportfolio, the reconstitution process also involves right-sizing positions.

After the most recent reconstitution on June 21, half of the portfolio added nine positions and eliminated nine. The index now holds 52 positions.

The Additions Two of the new additions to the index hail from the healthcare sector: UnitedHealth Group UNH and Amgen AMGN. Healthcare stocks were undervalued by as much as 8% according to our metrics in April, but valuations have compressed since then: Today the average healthcare stock in our coverage universe is trading just 2% below fair value.

Two aerospace and defense firms have entered the index: General Dynamics GD and Raytheon RTN. The latter recently announced plans to merge with United Technologies UTX to become the second-largest aerospace and defense firm.

“Because the merger is a merger of equals without a takeover premium assigned and both firms trade at similar discounts to our fair value estimates, we don’t believe that the combination comes at the cost of either company’s shareholders,” says analyst Josh Aguilar. “We think the combined company will benefit from increased scale, complementary technology that plugs the gaps of each separate company’s portfolios, and a portfolio that can offset a slowdown in either end market’s spending growth. We also don’t expect any significant hurdles on the regulatory front, given that both firms have minimal overlap in terms of their underlying businesses.”

Of the remaining additions, perhaps Alphabet GOOG is the most noteworthy. Although its traditional price/earnings and price/sales metrics exceed those of the market, the stock is undervalued according to our fair value estimate. As a reminder, we base our fair value estimates on how much cash we think a company will be able to generate in the future.

“We expect continuing growth in the firm’s cash flow, as we remain confident that Google will maintain its leadership in the search market,” explains senior analyst Ali Mogharabi. “We foresee YouTube gradually contributing more to the firm’s top and bottom lines, and we view investments of some of that cash in moonshots as attractive. Whether they will generate positive returns remains to be seen, but they do present significant upside.”

The Drops Three pharmaceutical distributors-- Cardinal Health CAH, McKesson MCK, and AmerisourceBergen ABC--were let go because their moat ratings were downgraded.

Analyst Soo Romanoff says, “We are reassessing the pharmaceutical distribution segment in light of the evolving competitive and regulatory environment. Based on continued decline of pharmaceutical spend growth and external shock threats, we are lowering our moat ratings for AmerisourceBergen, Cardinal Health, and McKesson from wide to narrow with a negative moat trend. We are also reducing our fair value estimates.

“Despite the stable foothold in the oligopoly market, where the three companies handle 90% of the market, the role of pharmaceutical distributor continues to evolve in an increasingly competitive and highly regulated environment. Scale and regulatory requirements have provided insulation to maintain share and generate market returns, but competitive pressures continue to build with declining reimbursement, healthcare consolidation, and decline in overall pharmaceutical spending growth.”

Jones Lang LaSalle’s JLL moat was also downgraded and has therefore been removed from the index. Allergan AGN got the boot as well, as we no longer have an analyst covering the company.

The remaining four stocks-- Equifax EFX, Starbucks SBUX, Mondelez International MDLZ, and Walt Disney DIS--were pushed out by stocks trading at more attractive price/fair values.

High-Quality Stocks in the Bargain Bin Exhibit 3 lists the 10 cheapest stocks in the Morningstar Wide Moat Focus Index as of June 21.

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