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4 high-quality bargains in an uncertain market

Susan Dziubinski  |  14 Sep 2020Text size  Decrease  Increase  |  
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Stock investors have experienced quite the roller-coaster ride in the past week or so. Technology stocks took it on the chin. Tesla (TSLA) plummeted. And the Nasdaq sank 10 per cent in just three trading days, putting it in correction territory.

Buckle up, investors: Market uncertainty will likely persist in coming weeks, because of the pandemic, economic downturn, and upcoming election.

Given the uncertainty in the market, we went looking for stocks that we felt relatively certain about--they're high-quality and we expect them to remain so, we have high confidence in our fair value estimates of these names, and they're undervalued.

Specifically we screened for the following:

Wide moats: Firms with wide Morningstar Economic Moat Ratings have unmatched advantages that should allow them to fend off their competitors and outearn their costs of capital for the next 20 years. By their very natures, wide-moat companies are reliable in terms of their businesses--think of them as "steady Eddies."

Stable or positive moat trends: To qualify, a company needs to be maintaining or growing its competitive advantages, not facing impossible-to-overcome headwinds that may ultimately threaten its moat.

Low uncertainty: Such companies enjoy sales predictability, modest operating and financial leverage, and limited exposure to contingent events. As a result of these factors, we can more confidently estimate the future cash flows of these companies and therefore have high confidence in our fair value estimates.

Lastly, we focused only on those names trading in 4- and 5-star range, ensuring that there's a significant margin of safety. 

 

Coca-Cola (KO)

Morningstar rating: 4 stars | Economic Moat: Wide | Moat Trend: Stable

"Coca-Cola's ubiquity and brand resonance in the non-alcoholic beverage category have been going strong for over 130 years, and we see structural dynamics to ensure this persists. We think that, despite competing in a mature industry, the firm is adequately exposed, either directly or indirectly, to growth vectors such as water and energy drinks. Moreover, we believe Coke will be able to continue extracting incremental value growth from the carbonated soft drink market even as volume declines.

"The runway for growth is supported by ample room for share gains as well as geographic tailwinds. We estimate that Coke derives more than 40 per cent of sales from developing or emerging economies with burgeoning middle classes and low per-capita soft drink consumption. We expect commercial drinks will become a larger portion of beverage consumption globally, and we see the company executing against each of its market-idiosyncratic strategies.

"In developed markets, where Coke's brands are firmly established, its strategies are geared toward profit growth driven by innovation. In developing markets, where its trademarks are highly visible but competition is rife, Coke is focused on differentiating its brands so they can eventually be parlayed into higher-margin offerings. In emerging markets where it is less established, Coke is focused on driving volume growth even at the expense of modest margin dilution. We view these approaches as prudent and see no significant impediments to execution.

"Coke's future trajectory is not without risk, as it faces covid-19 disruption, secular headwinds in terms of consumer sentiment, and well-capitalized rivals. Still, with a more aligned distribution system following its bottler refranchising, digitization initiatives to drive engagement and operational efficiency, and vast financial resources, the firm is equipped to defend its turf, in our view. Coke's overarching goal is to put drinks in more hands in more places more quickly than any competitor. We believe this is the crux of the firm's competitive positioning, underpinned by its cost advantage and intangible assets."

Nicholas Johnson, analyst

 

Novartis AG (NVS)

Morningstar Rating: 3 stars | Economic Moat: Wide | Moat Trend: Stable

Novartis was trading in 4-star territory last week but has since firmed. "With strong positions in multiple key healthcare businesses, Novartis is well positioned for steady long-term growth. Strong intellectual property supporting multi-billion-dollar products, combined with an abundance of late-pipeline products, creates a wide economic moat. While upcoming patent losses on anemia drug Exjade and cancer drug Afinitor will weigh on near-term growth, a strong portfolio of drugs along with a robust pipeline should ensure steady long-term growth.

"Novartis' drug segment is poised for long-term growth driven by new pipeline products and existing drugs. Novartis' strategy to focus largely in areas of unmet medical need should strengthen the firm's pricing power. Additionally, Novartis differentiates itself by its sheer number of blockbusters, including Gilenya for multiple sclerosis, Cosentyx for immunology diseases, and Tasigna for cancer. Also, it has generated a strong late-stage pipeline with recent launches of migraine drug Aimovig and cancer drug Kisqali. Despite the upcoming patent losses on Exjade and Afinitor (and potentially multiple sclerosis drug Gilenya), the combination of a strong pipeline of new products and a diverse, well-positioned operating platform should translate into steady growth.

"Novartis is getting more focused with its recent spin off its eyecare division, Alcon. While the drug division markets eyecare drugs, we have viewed the overlap with Alcon's surgical and vision-care products as relatively minor. As a result, we don't expect many dissynergies by spinning off the Alcon business. The spin-off is in line with Novartis' strategy to focus on human prescription drugs, which has been playing out over the past several years with the divestitures of the vaccine, animal health, and consumer healthcare businesses.

"Additionally, the company's move to sell its small-molecule US generic business should move the firm to be more focused on innovative branded drugs. Given the weak pricing power of generic drugs, we believe the move to divest this division will strengthen the company's overall competitive positioning."

Damien Conover, director

 

Pfizer (PFE)

Morningstar Rating: 4 stars |  Economic Moat: Wide | Moat Trend: Stable

"Pfizer's foundation remains solid, based on strong cash flows generated from a basket of diverse drugs. The company's large size confers significant competitive advantages in developing new drugs. This unmatched heft, combined with a broad portfolio of patent-protected drugs, has helped Pfizer build a wide economic moat around its business.

"Pfizer's size establishes one of the largest economies of scale in the pharmaceutical industry. In a business where drug development needs a lot of shots on goal to be successful, Pfizer has the financial resources and the established research power to support the development of more new drugs. Also, after many years of struggling to bring out important new drugs, Pfizer is now launching several potential blockbusters in cancer, heart disease, and immunology.

"Pfizer's vast financial resources support a leading salesforce. Pfizer's commitment to postapproval studies provides its salespeople with an armamentarium of data for their marketing campaigns. Further, Pfizer's leading salesforces in emerging countries position the company to benefit from the dramatically increasing wealth in nations such as Brazil, Russia, India, China, and Turkey.

"While entrenched as an industry leader, Pfizer faces challenges in the near term. The loss of patent protection on several drugs will weigh on future growth. In particular, the recent 2019 US patent loss on neuroscience drug Lyrica is weighing on near-term growth. However, Pfizer's recent decision to divest its off-patent division to create a new company in combination with Mylan (MYL) should drive accelerating growth at the remaining innovative business at Pfizer.

"Further, we believe Pfizer's operations can withstand the additional generic competition, and the firm's diverse portfolio of drugs helps insulate it from any one particular patent loss. Following the merger with Wyeth several years ago, Pfizer has a much stronger position in the vaccine industry with pneumococcal vaccine Prevnar 13. Vaccines tend to be more resistant to generic competition because of the manufacturing complexity and relatively lower prices."

Damien Conover, director

 

Roche Holding AG (RHHBY)

Morningstar Rating: 5 stars | Economic Moat: Wide | Moat Trend: Stable

"We think Roche's drug portfolio and industry-leading diagnostics conspire to create sustainable competitive advantages. As the market leader in both biotech and diagnostics, this Swiss healthcare giant is in a unique position to guide global healthcare into a safer, more personalized, and more cost-effective endeavor. Strong information sharing continues between Genentech and Roche researchers, boosting research and development productivity and personalized medicine offerings that take advantage of Roche's diagnostic arm.

"Roche's biologics focus and innovative pipeline are key to the firm's ability to maintain its wide moat and continue to achieve growth as current blockbusters face competition. More than 80 per cent of Roche's pharmaceutical sales are from biologics, which provides a buffer against traditional generic competition. Blockbuster cancer biologics Avastin, Rituxan, and Herceptin accounted for 36 per cent of Roche's revenue in 2018, but all three are under threat from biosimilars in the United States and Europe (although growth in China remains strong). However, with the launch of Perjeta in 2012 and Kadcyla in 2013, Roche is in a strong position to continue expanding its breast cancer franchise beyond Herceptin, regardless of biosimilars. Gazyva, now approved in chronic lymphocytic leukemia and non-Hodgkin lymphoma and in testing in lupus, will also extend the longevity of the Rituxan franchise. Avastin's lung cancer sales are vulnerable to biosimilars and competition from new therapies Opdivo and Keytruda, but Roche's own immuno-oncology drug Tecentriq launched in 2016. Roche is also expanding outside of oncology with multiple sclerosis drug Ocrevus (US$9 billion peak sales) and hemophilia drug Hemlibra (US$6 billion peak sales) launching strongly.

"Roche's diagnostics business is also strong. With a 20 per cent share of the global in vitro diagnostics market, Roche holds the number-one rank in this industry over competitors Siemens, Abbott (ABT), and Ortho. Pricing pressure has been intense in the diabetes-care market, but new instruments and immunoassays have buoyed the core professional diagnostics segment."

Karen Andersen, strategist

Morningstar's Global Best Ideas list is out now. Morningstar Premium subscribers can view the list here.

 See also Morningstar Guide to International Investing

is director of content for Morningstar.com.

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