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Here are 2 great stocks you need to sell

Nicholas Grove  |  01 Nov 2016Text size  Decrease  Increase  |  

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While the moat rating is a cornerstone of Morningstar's investment philosophy, paying too much for a terrific business--even one with an economic moat--is not a great formula for success.

 

As all subscribers to various Morningstar products would know, the moat rating is a cornerstone of the company's investment philosophy. It is a structural feature that allows a firm to sustain excess returns and fend off competitors over long periods of time.

Those companies that have been assigned a narrow moat are likely to achieve normalised excess returns beyond 10 years, while wide-moat companies are likely to sustain excess returns beyond 20 years.

There are five sources of an economic moat: intangible assets, switching costs, network effect, cost advantage and efficient scale.

But when it comes to investing, valuation is still of the upmost importance, and paying too much for a terrific business--even one with an economic moat--is not a great formula for success.

Bearing this in mind, below are two stocks which, despite having been assigned narrow economic moats by Morningstar, currently trade at substantial premiums to their fair value.

1) ARB Corporation

ARB Corporation (ASX: ARB) is a designer, manufacturer and distributor of four-wheel-drive accessories both in Australia and overseas.

The source of the company's narrow moat are its intangible assets, Morningstar equity analyst Ravi Reddy says.

"The company has established a strong competitive position in the niche four-wheel-drive accessories market despite low barriers to entry and easily copied products, which are mostly made from transformed steel," Reddy says.

"Product development is a key competitive advantage, with ARB consistently producing a pipeline of new product releases through its in-house research and development team.

"This has led to significant brand equity being established, coinciding with weak competition."

But despite its competitive advantage, Reddy points out that the stock is trading on a fiscal 2017 P/E of 26 times--a "ritzy multiple in anyone's language".

2) Technology One

Technology One (ASX: TNE) is an enterprise software developer focused on the market of midsize enterprises and government, as well as educational institutions.

The company boasts a strong suite of enterprise software products, which are critical to the proper functioning of businesses and government bodies, Morningstar senior equities analyst Gareth James says.

According to James, switching costs are what underpin this company's narrow economic moat.

"While the industry is intensely competitive and entry barriers are relatively low, Technology One has a strong track record spanning more than 20 years--longevity that testifies to the quality of its software," he says.

"Its evolution has been such that the company's enterprise solution products are now deeply embedded into customers' IT infrastructure.

"As a result, there are significant switching costs for existing clients to change suppliers."

However, with Technology One currently trading on a fiscal 2017 P/E ratio of 39, James believes the shares are overvalued.

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Nicholas Grove is a Morningstar journalist.

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