Chinese wide-moat stocks at a discount

Chinese stocks have extended their 2021 downturn well into this year. Investors are nursing several worries: a renewed covid outbreak, a slowdown in the property sector, the ongoing regulatory crackdown, warnings from the US that some Chinese stocks could be delisted, and the war in Ukraine. So far, the Morningstar China Index has registered a year-to-date loss of 28%.

Amid the pain, Morningstar analysts see several wide-moat names trading at attractive valuations. Many, such as internet giants Baidu and Alibaba, have been caught up in the selloff over the past 18 months. However, analysis shows wide-moat companies hold their edge over the longer term. 

In the short-term, moat stocks are struggling…

Hong Kong and China stocks under coverage have registered year-to-date loss averages of 15%, versus a plunge of 20% in 2021. Wide moat stocks Baidu (09888), Alibaba (09988), Tencent (00700) have all had disappointing performances. In particular, Alibaba’s shares are in freefall – down 50% in 2021 and another 34% so far this year – bringing the country’s largest e-commerce player further below its IPO price.

Companies without an economic moat appear to have suffered less pain, falling 9% year to date and 5% in 2021, on average.

Economic moats are awarded to company's with sustainable competitive advantages expected to persist for a minimum of ten years.

…Long-term, the picture changes

To put this into historical context, we dug into Morningstar Direct data over the past market cycle. The findings show that these short-term losses do not justify counting out shares in companies with the greatest competitive advantages and strong fundamentals.

As we look at it from a longer-term perspective of 10-year performance, a strong case emerges that moat-y stocks were outperformers against the wider universe. Between 2012 and 2021, stocks with wide economic moat outpaced the no-moat names in seven calendar years out of 10. The most prominent difference was spotted in 2020. As the coronavirus pandemic wreaked havoc on the world, companies with greater competitive advantages and quality endured the challenges better. Wide moat names delivered a hefty return of 70% on average. This also means wide-moat names outperformed the market by 40%.

Their no-moat peers outperformed the market only three times out of 10, and to a much smaller extent. Their less frequent outperformance was found in the year 2012, 2019, and 2021, on a scale ranging between 0.4% and 5.5%.

Another observation coming from the same chart is that, unlike no-moat names, moat-y companies have experienced corrections after a strong year of market returns. This finding leads us to look at a rolling window of different durations. Do outperformances in some years smoothen the bad years?

Over longer periods, wide-moat stocks have tended to be the best performers in the market, outpacing the broad market, narrow- and no-moat names by a large margin. The outperformance was even more visible in a five-year window. This has also reflected the resiliency and longevity of companies with better Morningstar moat ratings.

Wide-moat stocks are also “quality” stocks. Morningstar equity analysts make use of the moat rating to highlight companies with durable competitive advantages: things like brand loyalty, the network effect, cost advantages, and economies of scale. For the longevity part, our analysts believe that a company with a wide economic moat is positioned to fend off competitors for more than 20 years, while a company with a narrow moat rating holds advantages expected to support the company’s strong fundamentals over the next 10-20 years.

Why moats matter

Into 2022, China and Hong Kong stocks had already been trading around a 20% discount to their fair value estimates. Now, valuations on wide-moat stocks have come down even further, and present an opportunity.

Economic moats and moat trends are good measures, among other fundamental gauges like valuations, to find stocks with longer-term investment value. Companies with competitive advantages generally outperform when inflation and interest rates are rising thanks to their ability to pass on price increases to customers. They are also often able to finance growth in their businesses without heavy borrowing.

In the Hong Kong and Chinese stock markets, there are multiple quality names, which our analysts believe are severely undervalued:

4-and-5 Star Wide-Moat Stocks