How the Morningstar wide moat stocks did in 2019

Earlier this year we identified the “Morningstar Eleven” – the 11 stocks that boast a “wide moat” rating. That is, a competitive advantage that should stand them in good stead for the next two decades or so.

To gain entry to this exclusive club, companies had to show some key traits: a strong brand; a cost advantage; a product that is good enough to dissuade customers from changing brands and thereby incur the pain of “switching costs”; a “network effect”, whereby an increase in the users of a product or service results in a corresponding increase in mutual benefits for both old and new users; and efficient scale, which occurs when a market is effectively served by a small number of producers or sellers.

In the interests of transparency, and for no other reason than it’s the end of the year, we thought we’d check in with the year-to-date return of the Morningstar Eleven and see how they matched up against the Aussie benchmark, the S&P ASX 200, or XJO.

The results were both curious and expected. In short, the big four banks dragged the chain, while the stocks with monopoly-like characteristics (think, the ASX (ASX: ASX) and hearing implant maker Cochlear (ASX: COH)) beat the benchmark soundly.

The median return from the Morningstar Eleven beat the index by just over 6 per cent. On an average basis, however, the Eleven was pretty much even with the index.

Why? Well, for that you probably have to blame Westpac (ASX: WBC), which suffered most recently in the wake of a money-laundering and child exploitation scandal. Australia’s first and oldest bank got the wooden spoon, with a return of -2.6.

Topping the table was the ASX, which returned 35.6 per cent. It is the largest securities exchange in Australia with a monopoly in listing, trading, clearing, and settlement of Australian cash equities, debt securities, investment funds, and derivatives.

Morningstar wide moat stocks v ASX 200 benchmark XJO

Source: Morningstar; as at market close on 19 December

In second place was Cochlear, with 34.6 per cent, and in third was toll road operator Transurban, which returned 33.6 per cent.

While wide-moat Cochlear – a one-star stock – made no changes to fiscal 2020 earnings guidance of 9 to 13 per cent growth at its annual general meeting in late October, it has flagged slower long-term earnings growth.

Management says the company remains in the early phase of getting traction in the adult market for cochlear implants and is investing heavily to build this market, says Morningstar analyst Nicolette Quinn.

Time to sell overheated leaders?

Past performance is no guarantee of future success, of course, and as Morningstar director of equity research Adam Fleck notes, the top three names in the list – ASX, Cochlear, and Transurban – are currently overvalued.

The fundamentals are strong, but they haven’t grown at the same rate as the share price. Still, opportunities exist, Fleck says.

“After a strong year, the names at the top of this list look substantially overvalued, and now sit at 1 or 2 star ratings.

“This indicates that despite solid share price improvement, our analysts don’t think that the underlying business fundamentals have improved at the same rate, leading to current prices that we estimate offer a lower than required long-run return for the risk investors are taking.

“In many cases, the sharp rally in these names offers an opportunity for investors to sell at lofty prices and reinvest in other stocks that have underperformed and now offer a sizeable margin of safety.”

One name in the above category is consumer cyclical heavyweight Wesfarmers (ASX: WES), which returned 30 per cent. It is currently overvalued by 37 per cent.  

Of the 11 stocks in our list, three are four-star stocks: funeral home operator InvoCare; and three of the big four banks: NAB (ASX: NAB), Westpac, and ANZ (ASX: ASX). Commonwealth Bank (ASX: CBA), for the record, is a three-star stock.

The average YTD return for the big banks, incidentally, was 4 per cent.

Benchmark v the big four

Source: Morningstar. Data as at market close 19 December

“Overall it’s a very tough operating environment for the banks, given credit growth is slowing and there’s pressure on margins,” says Morningstar banking analyst Nathan Zaia.

“On top of that, you have increased scrutiny from the regulators and continued remediation costs. For example, in October NAB announced an additional $1.2 billion in remediation costs and Westpac’s AUSTRAC penalty is still to be settled.

“CBA stood out. Its result reflects the strength of its franchise - it has a funding and operating cost advantage because of its sheer size. It has more customers, more products, it’s also further ahead in its digital offerings.

“Another key reason for CBA’s outperformance is that it’s already gone through the pain of remediation whereas the uncertainty is still lingering for the other banks.”

Falling rates help bond proxy infrastructure stocks

Falling interest rates have benefited bond-like infrastructure companies under Morningstar coverage, says Fleck.

Auckland International Airport returned 27.2 per cent and is a 2 star stock.

“As Auckland is highly geared, its debt costs are falling. It has had lower earnings growth, but the price of the stock has done well because of lower interest rates,” says Fleck, referring to the cash rate, which this year fell to a historic low of 0.75 per cent.

There are other headwinds, too. Passenger growth is slowing the and the benefits of the airport’s retail expansion are now behind the company.

Auckland must also deal with a regulator that is insisting the airport lower its prices. However, this is unlikely to affect its moat status, Fleck says.

“Airports like Auckland and Sydney Airport (ASX: SYD, narrow moat) are high cash flow, steady businesses generally so falling interest rates lead to a share price rally. They’ve gone from a four-star stock to a two-star stock.

“You’re locking in a lower rate of return by buying these returns now. If rates stay lower for longer that’s a rational decision but for now we’d argue they look a little overheated.”

ASX now a one-star stock

The ASX is also overheated, and currently trading at a 30 per cent premium to its fair value estimate of $57.

“We continue to believe the strong performance of the ASX share price in recent years is largely a result of falling bond yields, rather than an improving growth outlook, which has driven yield compression,” says Morningstar analyst Gareth James.

Benchmark v Auckland Airport, ASX, Cochlear

Source: Morningstar. Data as at market close 19 December

“Share price growth has exceeded EPS growth in recent years resulting in expansion of the P/E ratio to 31 from 18 five years ago, a trend which is an unsustainable source of investment returns in the long term.

“We expect ASX to deliver a mid-single-digit EPS compound annual growth rate over the next decade, with the wide economic moat protecting strong margins and enabling returns on invested capital to exceed the weighted average cost of capital.”

InvoCare offers ‘compelling value’

InvoCare (ASX: IVC) has performed well this year, and at the start of the year regained a spot on the Morningstar Global Equity Best Ideas list.

And at $13.39 per share, InvoCare is trading at 16 per cent below the Morningstar fair value estimate of $16. “This is compelling value for a high-quality company,” says Morningstar equity analyst Angus Hewitt.

Benchmark v Brambles, InvoCare, Transurban, Wesfarmers 

Source: Morningstar. Data as at market close 19 December

InvoCare is the largest funeral, cemetery, and crematorium operator in Australia, New Zealand, and Singapore. It owns a portfolio of 60 brands, including three national Australian brands: White Lady, Simplicity Funerals, and Value Cremations.

“The firm's portfolio of respected brands and its scale delivering cost advantages underpin its wide economic moat,” says Hewitt.

“We expect the firm will continue to grow its market share, driven by advancement in its ‘Protect and Grow’ refurbishment strategy, and supplemented by small bolt-on acquisitions.

“Protect and Grow is firstly about cutting costs. They’ve amassed a stack of market share, but not really leveraged their scale. So they should start integrating the businesses better, probably getting better prices for coffins, etc.

“And secondly, upgrades and refurbishments to existing businesses. They’re bringing forward a lot of capex here to improve their already strong offering relative to competitors.

“P&G is causing a lot of near-term disruption, and InvoCare had a poorer 2018 as a result. But we expect the bulk of remaining investment to be spent in fiscal 2020, and disruption should be well-over before peak death rates in about 15 years (i.e. boomers).”

Rounding out the list is 3-star pallet-maker Brambles (ASX: BXB), which returned 20.4 per cent and is fairly valued.