Editor's note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.
While certainly anxiety-inducing, market shocks such as the one we’re experiencing can be beneficial. After all, the patient among us can pick up the stocks of great companies at great prices.
Of course, investors define “great” in different ways. From our perspective, great companies are those that’ve carved out solid (and in some cases growing) competitive advantages that will allow them to thrive for years to come--in Morningstar parlance, they’ve built economic moats. These companies are also led by adept managers who have a record of allocating capital in ways that add value.
To find such exceptional firms, we looked for the following qualities.
First, they need to boast wide Morningstar Economic Moat Ratings--and their Morningstar Moat Trend Ratings need to be stable or positive. In other words, these companies have unmatched competitive positions that are steady or even improving.
Second, they must earn our top Morningstar Stewardship Rating--Exemplary. In other words, these companies are led by exceptional corporate managers who have a proven record of making investments and acquisitions supporting the competitive advantages and core businesses of their companies--and they won't pay an arm and a leg to do so. They'll divest underperforming or noncore businesses. They'll find the right balance of investing in the business and returning cash to shareholders via dividends and share repurchases. And they'll assemble a portfolio of attractive operating assets and skilled human capital, and then execute well.
Third, we need to have a high degree of certainty in our fair value estimates for the stocks of these companies, limiting our search to stocks with fair value uncertainties of low or medium. This rating represents the predictability of a company's future cash flows. As such, we have a pretty high degree of confidence in our fair value estimates of companies with low and medium uncertainty ratings. (Long version: The uncertainty rating captures a range of likely potential intrinsic values for a company based on the characteristics of the business underlying the stock, including such things as operating and financial leverage, sales sensitivity to the economy, product concentration, and other factors. If the range of potential intrinsic values is narrow, the company earns a low uncertainty rating. If the range is great, the company earns a high uncertainty rating.)
And lastly, the stocks of these companies must be trading at a decent discount to our fair value estimates--selling at Morningstar Ratings of 4 or 5 stars as of this writing.
More than two dozen stocks made the cut.
Here’s what our analysts have to say about three of the businesses on the list.
3M MMM "Market sentiment has turned against 3M stock for three reasons: 1) slowing organic growth as the company matures; 2) recent weakness in the auto, semiconductor, and Chinese markets; and 3) litigation risks related to PFAS. As a result, bears now maintain 3M's model is irretrievably broken. We disagree.
"In our view, 3M is a GDP-plus business. We attribute 3M's ability to remain ahead of GDP based on its suite of innovative products that are a byproduct of its R&D efforts. At its core, 3M is a materials science company. The firm's legion of engineers improves everyday products down to their basic chemistry. For instance, 3M's microreplication technology, which has been around since the 1960s, was originally used in overhead projectors. That technology has now been adapted into multiple use cases, including making signs brighter, reducing friction in aerospace applications, and more recently, is being developed for vaccine delivery as an alternative to hypodermic needles.
"The firm's proprietary secrets are closely held as 3M rarely grants licenses, yet its technology is difficult to imitate. As a result, 3M typically charges a 10% to 30% price premium relative to the market. 3M's ability to adapt its technology into multiple use cases gives it additional economies of scope,which reduce overall unit costs, as evident in its superior gross margins.
"While we expect near-term headwinds will continue in 2020, we believe the company can grow its top line nearly 3% organically over the next five years, with another point from acquisitions. With the recent acquisitions of workflow solutions provider MModal and negative wound care solutions provider Acelity, we believe the firm can capitalize on the stable and ever-growing healthcare market. Healthcare benefits from multiple positive secular trends, including an aging population, greater access to care, as well as rising incidence of chronic disease and surgical procedures. We believe the rest of the portfolio will also benefit from rising industrialization and urbanization trends. Finally, we've surveyed prior environmental and product liability cases and believe the stock price bakes in overly pessimistic litigation risks.”
Josh Aguilar, analyst
Deere DE "John Deere pioneered the use of the steel plow when he fashioned one out of a saw blade in 1837. Farmers quickly saw the benefits of this invention and rapidly adopted the technology, ushering in the era of mechanized farming in the early 1900s. Fast-forwarding to the 21st century, wide-moat John Deere has become the world's pre-eminent manufacturer of agricultural equipment.
"In a global agricultural equipment marketplace, John Deere stands out as one of the world’s most valuable brands. Unlike its agricultural equipment competitors, Deere focuses its marketing efforts on a single brand. Most of Deere’s growth has been organic. However, in 2017, it made a key acquisition of road-building equipment vendor Wirtgen, which improves Deere’s position in global infrastructure and urbanization trends.
"As a modern industrial powerhouse, Deere provides a complete suite of agriculture equipment including tractors, planting equipment, sprayers, harvesters, and a host of other implements. It also manufactures construction equipment, which accounts for 30% of company revenue. Its most complex pieces of equipment such as combines are effectively factories on wheels that can cost more than $500,000. These machines must be created with durability in mind. Hence, the quality associated with the John Deere brand is critical to the company’s success.
"In the developed world, margins from farming are quite low, which allows Deere to sell farmers on efficiency gains through continuous product innovation in what has become an agricultural arms race. The growth of precision farming has led to a dramatic increase in onboard software, processing, and sensor technology, which are being developed by Deere’s Intelligent Solutions Group.
"One of Deere’s great strengths is the robustness of its dealer network, which includes approximately 1,500 dealers in the United States and 3,700 globally. Deere’s strong dealer network provides a one-stop shop for farmers offering parts, service, equipment, and financing. Approximately 60% of Deere’s revenue originates from sales to customers in the U.S. and Canada, with the remainder distributed across every continent except Antarctica.”
Scott Pope, analyst
Masco MAS "We think Masco's financial performance over the past five years has been as much of a self-help story as a story of improving end markets. Masco almost entirely refreshed its senior executive management team in 2014. Since then, it has taken significant measures to build a stronger and more consistent business model. The firm divested its most cyclical and least profitable businesses (it spun off its installation business, now named TopBuild, to shareholders in 2015 and sold its windows and cabinetry businesses in 2019 and 2020, respectively. Management also executed significant cost-reduction initiatives and shored up Masco's balance sheet.
"In our view, Masco's sale of its windows and cabinetry businesses is a positive development for the firm because we had long viewed its plumbing and decorative architectural businesses as the firm's crown jewels and key drivers of the company's valuation, while Masco's cabinetry and windows businesses have often been laggards that have been a drag on margins and returns on invested capital.
"The health of the housing market, and to a much greater extent, repair and remodel, or R&R, spending in the United States are major drivers of Masco’s financial performance. After divesting its installation, windows, and cabinetry businesses, we estimate the firm's overall exposure to the R&R market is 89% of sales.
"U.S. housing construction slowed in 2018, and that weakness persisted through the first half of 2019, but demand strengthened in the waning months of 2019. Overall, we remain bullish on new-home construction longer term. We project housing starts will reach over 1.4 million units by 2025. With an improving housing market, we also expect solid R&R spending, so we see a nice growth runway for Masco over at least the next five years as the company capitalizes on improving end markets and internal growth initiatives across its remaining plumbing and decorative architectural platforms.”
Brian Bernard, director