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Morningstar's eleven: How to spot a wide-moat stock

Lex Hall  |  20 Aug 2019Text size  Decrease  Increase  |  
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What do an Aussie funeral parlour and a Kiwi airport have in common? That may sound like the set-up to some crass joke but it’s actually a serious question. And the punchline, or rather, the answer is: a wide moat.  

The companies in question are InvoCare and Auckland International Airport and they both belong to a select group of eleven stocks in Morningstar’s coverage list: the wide moat club. 

The term “wide moat” is Warren Buffett-speak for competitive advantage. According to Buffett’s medieval metaphor, a wide moat is a company’s ability to withstand rivals—the same function a moat serves in protecting a castle. “The key to investing,” Buffett wrote in a celebrated 1999 article in Fortune magazine, “is determining the competitive advantage of any given company, and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.”

And if the moat can widen each year, then that’s even better. 

Morningstar has used the moat concept as the foundational pillar of its stock analysis method—a method that can be applied across a broad global list of companies. In their book Why Moats Matter: The Morningstar Approach to Stock Investing, Heather Brilliant and Elizabeth Collins define a wide moat company as one that is certain to generate excess returns for the next 20 years. A company is deemed to have a “narrow” moat if it can only generate excess returns for the next ten years.  

Morningstar looks for five characteristics when deciding whether a company has a wide moat: 

Intangible assets: these include brands, patents, or government licences that keep competitors at bay. 

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Cost advantage: A company that can beat its rivals by undercutting them on the price of its goods or services is deemed to have a cost advantage. On the other hand, they may sell their products or services at the same prices as their competitors but make bigger profit margins.

Switching costs: Changing from one provider to another can be a pain, which can cause a loss in productivity. “Customers facing high switching costs often won’t change providers unless they are offered a large improvement in either price or performance,” note Brilliant and Collins, “and even then, the risk associated with making a change may still prevent switching in some industries.” 

Network effect: A network effect is said to occur when an increase in the users of a product or service results in a corresponding increase in mutual benefits for both old and new users. Social media giant Facebook is held to be a prime example of the network effect in action.

Efficient scale: This occurs when a market is effectively served by a small number of producers or sellers. This dynamic dissuades newcomers because their entry would result in insufficient returns for all players. 

In this two-part article, we examine which of these characteristics apply to the eleven stocks in the wide-moat club. Some companies obviously possess more than one of these characteristics. Australia’s big four banks, for instance, build high barriers to entry because of their edge in pricing and efficient scale. Conglomerate Wesfarmers, similarly, has an edge in pricing power and the number of brands it controls. Its hardware chain Bunnings is a household name. 

But it’s crucial to note that a company’s wide moat will not always remain wide. Take Nokia, for example. Founded in 1865, the Finnish phone company once boasted the majority share of the mobile phone market. Then along came Apple in 2007 with its iPhone, a development that revolutionised the mobile phone market and shoved Nokia into irrelevance. A similar shift is occurring in the world of video games, note Brilliant and Collins. Whereas Nintendo was once the console king, these days it faces stiff competition from the sophisticated giants of today’s gaming landscape: Microsoft with its Xbox, and Sony with its PlayStation. As Brilliant and Collins argue, “profits attract competitors, and competition makes it difficult for firms to generate strong growth and margins over the long term.”

More in this series:
Morningstar's Eleven: How to spot a wide-moat stock—Part 2

Wide moat no guarantee of value

Before we look at Australian wide moat companies, a word on valuation. Investing in wide moat companies is a sound strategy—provided they are trading at a good price. And that means heeding the advice of Brilliant and Collins when they say buy good businesses and good prices. “There is a fair market value of any business, and opportunities to purchase great businesses at less than that fair market value give investors an advantage in generating future returns.” With that in mind, it’s crucial to note that several of our wide moat club members are currently overvalued, in the eyes of Morningstar analysts. Still, we hope this guide gives you a better idea on how to value and spot companies worth investing in.

Australian wide moats

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InvoCare's ubiquitous brand name

The ubiquitous funeral parlour alluded to in our introduction is InvoCare (ASX: IVC)—and it’s a good example of a company that has built a competitive advantage based on the intangible asset of its brand. InvoCare’s network of funeral homes, cemeteries and crematoria spans Australia, New Zealand and Singapore. This network comprises more than 290 funeral locations and 16 cemeteries and crematoria, and in Australia, it is the market leader, boasting a share of about a third.

As well as brand power and reputation it has pricing power. As Morningstar analyst Mark Taylor notes, it has reached the point where it can effectively segment the market with a number of service-level offerings at various price points. Consider its flagship brand, White Lady Funerals, for instance. It is a unique, all-female service with an emphasis on emotional support. This premium service costs on average around 25 per cent more than a traditional InvoCare funeral. But in times of grief, price can be a secondary concern.

“Customers (typically the family of the deceased), are relatively price-insensitive, given the highly emotional context surrounding the service,” says Taylor. “The intangible assets are the primary reason approximately 70 per cent of InvoCare's business comes from repeat business, or referrals from prior customers. Customers typically have an emotional connection with funeral directors from prior experiences, which makes it difficult for new entrants or competitors to gain market share.”

InvoCare is a three-star stock with a PE ratio of 29.3. It has a 3.1 per cent fully franked dividend yield. 

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Wesfarmers' hardware edge

Like InvoCare, conglomerate Wesfarmers (ASX: WES) is shielded by cost advantage and the intangible brand power of its hardware store chain Bunnings. And it’s not just your weekend tinkerer visiting the vast network of stores. Across Australia and New Zealand, Bunnings supplies project builders, commercial tradespeople and the housing industry. It employs 43,000 people, with revenue of $12.5 billion, and a network of 375 trading locations, comprising 265 warehouses, 75 smaller format stores and 32 trade centres.

It’s this scale that allows it to generate significant bargaining power with suppliers when sourcing products, negotiating rents with landlords, and other areas, says Morningstar analyst Johannes Faul. “The chain passes along a large portion of these savings and operating efficiencies to its customers. Bunnings' strategy has been to grow volumes over profit margins, broadening its range, investing in service and continuously cutting prices to grab market share and build a loyal customer base.” 

What’s more, the nature of hardware stores helps Bunnings fend off e-commerce rivals. The high weight/value ratio of many products makes shipping hardware is expensive. And the specialised knowledge of Bunnings staff is hard to replicate, Faul says. 

Wesfarmers is a two-star stock with a PE ratio of 17.4. It has a forecast fully franked dividend yield of 4.2 per cent.

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Brambles' pallet pool

Brambles (ASX: BXB) has two ways to describe itself. On one hand, it’s “a supply-chain logistics company operating in more than 60 countries, primarily through the CHEP brand.” Translated: it’s widely known for making pallets and crates. On the other hand, its platforms form the “invisible backbone of global supply chains, primarily serving the fast-moving consumer goods, fresh produce, beverage, retail and general manufacturing industries. The world’s largest brands trust Brambles to help them transport life’s essentials more efficiently, safely and sustainably.”

blue wooden pallets

Therein lies the core of its moaty nature. Brambles has a pallet-pooling network, which delivers a cost advantage as more customers join. “The majority of products moved on CHEP pallets are non-discretionary items,” notes Morningstar analyst Grant Slade. “Therefore, Brambles' volumes aren't materially affected during periods of subdued economic conditions.”

Brambles was the first mover in the North American market, with CHEP USA and its pallet pooling network entering the US in 1990. It now has about 40 per cent market share. While in Europe, Brambles estimates its share of the European pallet market at 28 per cent.

Brambles is a two-star stock with a PE ratio of 21.5. It has a forecast partially franked dividend yield of 2.9 per cent.

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The ASX: monopoly network in full effect

The Australian Securities Exchange (ASX: ASX) is ranked among the world’s top five exchanges. And crucially, as far as moat characteristics are concerned, it is the only organisation licensed to operate securities clearing and settlement services in Australia for exchange-traded securities and derivatives, which make up 46 per cent of group revenue. The key word here is obviously “only”—which suggests a monopolistic grip on what it does.

“The ASX also has a monopoly in the Australian primary listed equity market and generates initial and annual listing fees from companies on its exchange, constituting 20 per cent of group revenue,” notes Morningstar analyst Gareth James. The ASX only faces competition in secondary-market cash equities trading, which contributes 5 per cent of group revenue.

Its rival here, Chi-X, which launched in October 2011, poses little threat, says James, as it is generating little meaningful profits or market share. “A competitor could create similar products and attempt to create a market overseas, but we consider this, along with the prospect of a rival derivatives exchange in Australia, to be unlikely.”

ASX is a one-star stock with a PE ratio of 32.7 It has a forecast fully franked dividend yield of 2.8 per cent.

is senior editor for Morningstar Australia

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