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2 Wide-Moat Stocks for Your Watchlist

We recently upgraded Morningstar Economic Moat Ratings on these companies.

Doing our part to flatten the coronavirus curve, many of us are hunkered down at home, looking for moments of normalcy. Noticing buds on the trees, for example. Doing the laundry that still piles up. Or watching the annual Grammy tribute concert, this year honoring Prince. (Misty Copeland's performance was particularly stunning, if you ask me.)

Here at Morningstar, something that's "normal" for us is to provide investors with an update of stocks that have recently experienced a change in their Morningstar Economic Moat Ratings.

As a refresher, we think companies with moat ratings of narrow or wide have unmatched advantages that should allow them to fend off their competitors and outearn their costs of capital and generate positive economic profits. Companies that we expect to compete effectively for the next decade earn narrow moat ratings, and ones that can outearn their costs of capital for 20 years or more earn wide moat ratings.

Today we’re focusing on two companies that joined the wide-moat club in April. Neither is trading in buying range as of this writing, but both are worth keeping an eye on.

( Premium Members have access to a complete list of all wide-moat stocks.)

Ansys ANSS Morningstar Rating (as of April 23, 2020): 2 Stars An industry leader, Ansys engineering software is used for testing products ranging from aircraft to medical devices during the design phase. We raised the firm's moat rating to Wide in mid-April; here's what analyst Julie Bhusal Sharma had to say in her note about the upgrade:

"We are raising our fair value estimate for Ansys to $196 from $158 as we’ve updated our assumptions for the company’s cost of capital and believe it can outearn its cost of capital over an even longer period of time. Similarly, we’ve changed our moat rating for Ansys to wide from narrow, as we have great confidence in Ansys’ ability to retain the strength of its moat sources over the next 20 years given its incomparable standing in simulation over the last 50 years as well as the relatively nonthreatening trends ahead for the company given its robust moat sources and their future stability.

"Given our confidence in Ansys’ ability to maintain its hold on the simulation industry via its wide moat--and the margins that come with it--we’ve reduced our estimates for Ansys’ cost of capital to 7.4% as opposed to our former estimate of 8.8%. The reduction has led to our significant fair value increase to $196 per share, even after accounting for top-line growth deceleration in 2020 due to COVID-19. Our revenue estimates for 2021 and beyond are greater than our prior assumptions as we’ve reassessed Ansys’ growing addressable market and expect a rebound after 2020.

"Customers use Ansys software for testing products, from aircraft to medical devices, in the design phase as opposed to costly physical testing. A first-mover advantage from being in the simulation space for 50 years has aided Ansys’ best-of-breed status, in our view. Plus, we think Ansys’ industry leadership is well-protected for the future thanks to significant switching costs in retraining engineers on complex simulation software with critical consequences in the case of improper use. Furthermore, Ansys is well-steeped in the curricula of thousands of engineering programs. We think these academic origins help perpetuate Ansys’ dominance in corporate engineering teams, which we think will ensure Ansys retains its estimated dominant 25% share in the computer assisted engineering market."

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Lam Research LRCX Morningstar Rating (as of April 23, 2020): 3 Stars A major vendor of semiconductor fabrication tools, Lam Research posted below-expected earnings for the most recent quarter, proving that it isn't immune to coronavirus-related obstacles to the supply chain. Still, Lam remains our top pick in the capital equipment space, notes strategist Abhinav Davuluri. Here's what he had to say when we boosted the firm's moat rating to Wide in mid-April:

"We now believe Lam Research has a wide economic moat and stable moat trend. We view the scale and resources required to compete for the business of leading-edge manufacturers as major barriers to entry, with firms such as Lam boasting research and development cost advantages over smaller peers. We also believe that incumbent tool providers have intangible assets related to equipment design derived from service contracts and customer collaboration during process development and subsequent high-volume manufacturing. As the market leader in dry etch, Lam benefited from key industry trends such as the shift from planar to 3D NAND and multiple patterning applications in logic, foundry, and DRAM processes. While we are lowering our near-term estimates for Lam due to COVID-19, our moat upgrade and increased optimism for the firm’s longer-term prospects collectively lead to us raising the firm’s fair value estimate to $310 per share from $275. Based on valuation, Lam is currently our top pick in the equipment space.

"Previously, Lam’s heavy exposure to the memory market and concentration in the competitive etch and deposition markets was a concern for our assessment of the firm’s moat. Lam’s served addressable market has significantly expanded as a result of the rise in multiple patterning associated with the transition to 10- and 7-nanometer processes at logic and foundry customers. In calendar 2019, Lam enjoyed growth in its aggregate logic and foundry revenue of 76%. This helped soften the blow of a weaker memory environment (Lam’s total DRAM and NAND sales fell 35%), leading to a roughly even split between memory and logic/foundry sales for Lam for the year. Going forward, we have greater confidence in Lam’s ability to drive a healthier mix of logic, foundry, and memory sales. Additionally, with the consolidation of both equipment suppliers and chipmakers, we think the equipment market is now more supportive of sustained and resilient excess returns."

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