Finding quality stocks trading at a cheap price can be a challenging and time-consuming task. You not only need to identify whether a company has a tangible edge over its peers. You also need to assess whether a stock is over- or under-valued.

The Global Best Ideas list (available for Morningstar Investor subscribers) is compiled by Morningstar’s equity analysts every month. To earn a spot on the list, these stocks have high analyst conviction in their future prospects and are trading at a price significantly below what our analysts calculate them to be worth.

Buying stocks when they are undervalued gives investor’s a higher margin of safety, therefore reducing the risk of an uncertain future.

Additionally, analysts consider the stock’s moat rating. This rating is an indication of the analyst’s expectations for the company to maintain a sustainable competitive advantage. A wide moat rating is awarded to companies that are expected to maintain and grow their earnings for at least the next 20 years, a narrow moat for the next 10 years.

Brian Han, Director of Equity Research, says of the list “These Best Ideas are sourced from all main sectors of the market, to provide a diversity of names across the spectrum. The last thing investors want is a Best Ideas list chock-full of cheap mining stocks when commodity prices tank, or a litany of oversold retail stocks when consumer sentiment slumps.”

In April we added narrow-moat AUB Group (ASX:AUB) to our Best Ideas List. AUB Group is a highly cash-generative business that provides a network of insurance brokers direct access to insurers, with exclusive policy wording and pricing, support on claims handling, and software needed to run the business.

AUB owns equity stakes in the brokers in its network, which combined are responsible for around 10% of premiums written by intermediaries in Australia. The switching costs between the customer and the broker, and the broker and AUB, provide a durable competitive advantage that we expect to underpin low-double-digit returns on equity over the long term.

Brokers earn commission on insurance premiums written, and we expect they will benefit from price increases as insurers seek to improve margins and returns amid escalating claims costs. Inflation, more frequent and intense large natural hazard events, and the rising cost of reinsurance all contribute.

We also see room for brokers to take market share from the direct channel as customers faced with rising prices seek out insurance brokers to find a better deal. AUB's increasing ownership interests in brokers that are part of the network is a low-risk M&A strategy that further supports earnings growth. Revenue and cost synergy targets associated with the 2022 acquisition of London-based wholesale broker Tysers appear to be on track.

Moat rating

We assign AUB Group a narrow moat based on switching costs. As AUB’s revenue is dependent on brokers remaining in the network and the annual premiums each broker in the network writes, retention of the end customer is crucial. There are two aspects to AUB’s switching cost advantage. First, the switching cost between the customer and broker, and secondly the broker remaining within the AUB network.

First, the tangible benefits for clients to switch to an alternative broker are uncertain; and there are tangible risks and/or costs in moving from a broker who understands the specific business need (and can align those to a broad range of insurance offering), versus one who does not. AUB’s client retention rate is high, exceeding 90%, impressively strong given normal SME attrition.

Insurance brokerage is a relationship-based business, with a network of offices around the country supporting relationships at a local level with SMEs. Relationships are valuable given SME and corporate insurance needs are often varied and specialized.

Brokers can search the insurance market more efficiently than individual buyers. Leveraging: (i) technological capabilities in analyzing and processing; and (ii) well-diversified product lines and insurer base to more effectively match insurance market products with client insurance risks. The complexity of these services creates switching costs, as the value of changing providers is not clear to insurance consumers and there is perceived value in continuing to work with a broker experienced in managing their risks.

For insurers, the underwriting intermediaries provide specific expertise in specialty lines, and in turn through AUB, access to a pool of customer demand. There is limited incentive for an insurer to switch underwriting agencies, provided risk is appropriately priced for the insurer.

Secondly, there is an incentive for the brokers and underwriting agencies themselves to remain within the AUB network. To begin with, AUB holds equity stakes in associated investments which creates a barrier to a broker leaving the group. For a broker to leave the AUB network, they would need to negotiate to buy out AUB or be bought out by AUB. We see little evidence this has occurred in the past, and believe AUB has delivered on its value proposition to provide access to market leading product and price, and technology required to do so efficiently. We believe underwriters similarly join to have access to AUB’s relationships with insurers and a large pool of end clients to distribute product to.

Brokers benefit from being part of a larger group as a broader range of policies, either more competitive or with better terms, can be offered. In addition, AUB provides the software required to obtain insurance quotes, manage client information, and business performance. These benefits reflect AUB’s scale and strong position in the Australian intermediated general insurance market. Despite its network’s gross written premiums under its influence much smaller than Steadfast’s, we believe AUB is still large enough to have similar negotiating power with insurers. AUB still accounts for over 20% of SME and Commercial insurance written. These benefits should allow brokers to push through higher volumes than small operators and (1) earn higher commissions, and/or (2) sell insurance at a more competitive rate.

AUB acquired a 40% stake in BizCover in 2020. BizCover is a commercial insurance platform that allows micro-SME clients to purchase some insurance products online without broker intervention. In addition to being an investment to take share in the micro-SME market, where it has not been profitable for a broker to allocate resources, we believe this investment is a good example of AUB using its scale to bring in technology which will benefit the entire network. All AUB brokers use a common broking platform, which will incorporate technology from BizCover to help speed up processing of low-value premiums. As some of these micro-SMEs on BizCover are successful and become larger businesses with more complex insurance needs, AUB can present that lead to a broker within its network.

The switching costs also extend to AUB’s underwriting agencies. Insurers who (i) want to write specialty lines of business, but (ii) lack the underwriting expertise or distribution reach turn to AUB’s network of underwriting agencies who deal in many specialized coverage lines. These lines include strata, business interruption, hospitality, bus and coach, or building and construction insurance where specialized expertise is often needed. There is no reason for an insurer to cease working with an underwriting agency--given their familiarity with risks inherent in specialty policies--so long as they continue to write profitable policies.

The risk of disruption by online aggregators or a foreign player is relatively low in our view. Online aggregators have increased product awareness and competition in the more commoditized consumer insurance space, but more complex and specific requirements in the SME insurance market mean online aggregators are unlikely to gain traction. Online aggregators in Australia such as iSelect, Choosi, and Compare the Market, all white label the BizCover platform which AUB owns a stake. The direct to customer channel offers limited policy options for very small SMEs, competing more with the direct offering of insurers themselves. Foreign players make up a small share of industry GWP, unlike Steadfast and AUB Group who collectively account for close to half of the Australian intermediated general insurance market. It is difficult to motivate broker switching away from these networks, and with client retention high, it is challenging and likely slow for smaller competitors in the ANZ market to make meaningful market share inroads.

A foreign player could adopt an acquisition-led growth strategy, such as the acquisition of Wesfarmers’ broking assets by AJ Gallagher in 2014. Nonetheless, the scale of these acquisitions has historically been very small. To this end, we believe the likelihood of a foreign player acquiring a large portion of the Steadfast or AUB broker network--such as to materially threaten their competitive position--is low.