Value investing is a term that is used extensively by investors but misconceptions about the strategy persist. In a pure sense it means finding shares that are priced below their intrinsic value. That could be a company growing quickly trading at a high relative valuation. It could be a company trading at a modest valuation. The pre-requisite is having an estimate of how much a share is worth.

In an investment world shaped by indexes that are agnostic to subjective estimates of the fair value of a share a different approach is taken. A relative valuation measure such as price to earnings (“P/E”) is used to divide the universe of shares between value and growth. Shares that fall into the value category are those trading at cheaper valuation levels on a relative sense to the overall universe of shares.

For instance, the S&P 500 style indexes (growth and value) ranks members of the S&P 500 by value characteristics (the price to book, price to sales and price to earnings) and growth characteristics (growth of earnings, growth of sales and the 12-month percent price change). The S&P 500 Value Index includes shares with the highest value characteristic scores. The S&P 500 Growth Index includes shares with the highest growth characteristic scores.

All shares in the S&P 500 must be included in each index and shares without a distinct style are included in both. The intention is to create indexes that provide exposure to the “broad style” an investor is seeking.

The underlying academic foundation of a value index driven by relative valuation measures is the Fama-French three factor model. The model studied historic returns and found that value as a factor led to outperformance. In non-finance speak this means that shares trading at lower price to book values, price to earnings and price to sales did better than shares trading at higher levels. The model was published in 1992. Recent results have been less positive. The S&P 500 Growth Index has delivered 13% annualised returns over the past decade. The S&P 500 Value Index has trailed significantly at 7.46% annualised returns over the same period.

Why is this happening? We don’t know for sure. There is speculation that a lack of focus by regulators on traditional anti-trust measures is creating winners-take-most competitive environments where better run companies keep gaining market share. There is speculation that the scalable asset light technology companies are more prevalent and investors are willing to buy them at increasing multiples. There is the impact of lower interest rates which makes growth more valuable as investors discount future expected cash flows back to the present at lower discount rates.

Maybe the real problem with value investing is that finding shares that are priced below their intrinsic value is not represented in the index construction methodology. Shares may be trading at cheap relative valuation measures because they have poor prospects and are not just temporarily cheap. Investors may achieve better outcomes by focusing on the intrinsic value than what index a share falls into.

3 undervalued US shares with sustainable competitive advantages

Are you a value investor? A growth investor? It really doesn’t matter. We all invest because we want to create a better future. That is what matters. Over the long-term that means finding great companies that are trading at a discount to their intrinsic value.

In that spirit the following three US shares from the S&P 500 Value Index are undervalued based on our analyst’s estimate of their fair value. They also all have a wide or narrow moat rating indicating our analyst’s belief they can sustain a competitive advantage for more than 20 or 10 years respectively. 

Read more about how to find a company with a moat or sustainable competitive advantage.

Pfizer (NYSE: PFE)

  • Fair value estimate: $42
  • Morningstar Moat Rating: Wide
  • Morningstar Uncertainty Rating: Medium

Pfizer is one of the world's largest pharmaceutical firms, with annual sales close to $50 billion (excluding COVID-19 product sales). While it historically sold many types of healthcare products and chemicals, now prescription drugs and vaccines account for the majority of sales.

Business strategy

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 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, leading salesforces in emerging countries position the company to benefit from the dramatically increasing wealth in nations such as Brazil, India, and China.

Pfizer's 2020 move to divest its off-patent division Upjohn to create a new company (Viatris) in combination with Mylan should drive accelerating growth at the remaining innovative business. With limited patent losses and fewer older drugs, Pfizer is poised for steady growth (excluding the more volatile COVID-19 product sales) before a round of major patent losses hit in 2028.

We believe Pfizer's operations can withstand eventual generic competition; its diverse portfolio of drugs helps insulate the company 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. Vaccines tend to be more resistant to generic competition because of their manufacturing complexity and relatively lower prices.

Moat Rating

Patents, economies of scale, and a powerful distribution network support Pfizer’s wide moat. Pfizer’s patent-protected drugs carry strong pricing power that enables the firm to generate returns on invested capital in excess of its cost of capital.

The patents give the company time to develop the next generation of drugs before generic competition arises. Additionally, while Pfizer holds a diversified product portfolio, there is some product concentration, with Prevnar representing just over 10% of total sales (excluding COVID-19 vaccine sales). However, we don't expect typical generic competition for the vaccine due to complex manufacturing and relatively low prices for the product. Eliquis and Ibrance each represent close to 10% of sales as well.

However, we expect new products will mitigate the eventual generic competition of key drugs over the long term. Pfizer’s operating structure allows for cost-cutting following patent losses to reduce the margin pressure from lost high-margin drug sales. Overall, Pfizer’s established product line creates the enormous cash flows needed to fund the average $800 million in development costs per new drug. A powerful distribution network sets up the company as a strong partner for smaller drug firms that lack Pfizer’s resources.

We think the company does face environmental, social, and governance risks, particularly related to potential U.S. drug price-related policy reform to increase access by lowering drug prices. Ongoing product governance issues (including litigation related to side effects and patents) also weigh on the company. While we have factored these threats into our analysis, they are not material to our moat rating.

Want to learn more about find the right shares? Listen to our 3 part Investing Compass podcast series on investing in shares. 

Kinder Morgan (NYSE: KMI)

  • Fair value estimate: $20
  • Morningstar Moat Rating: Narrow
  • Morningstar Uncertainty Rating: Medium

Kinder Morgan is one of the largest midstream energy firms in North America, with an interest in or an operator on about 83,000 miles in pipelines and 140 storage terminals. The company is active in the transportation, storage, and processing of natural gas, crude oil, refined products, natural gas liquids, and carbon dioxide. The majority of Kinder Morgan's cash flows stem from fee-based contracts for handling, moving, and storing fossil fuel products.

Business strategy

Kinder Morgan's assets span natural gas, natural gas liquids, oil, and liquefied natural gas. The company's U.S. gas pipeline business is particularly impressive. Management claims its daily gas transportation capacity is equivalent to 40% of average U.S. gas consumption and it handles 50% of the LNG market. LNG remains a key growth driver, particularly for gas storage assets. Kinder serves most major U.S. gas supply and demand regions.

Kinder Morgan's size is both an opportunity and a challenge. Its expansive asset footprint provides numerous investment opportunities if supply or demand bottlenecks develop. Kinder has the financial and commercial heft to execute any project, no matter the size. However, large-scale projects have been more challenging to find, though the Permian gas and related LNG projects are helping offset the loss of major efforts elsewhere due to stakeholder pushback. The shift forced Kinder out of Canada, in what we think was a wise decision, particularly as Trans Mountain pipeline costs have soared since Kinder’s exit.

With limited growth prospects, management has slashed investment, strengthened the balance sheet, and focused on returning cash to shareholders through the dividend and stock buybacks. For example, it has bought back meaningful amounts of stock in 2022 and 2023, creating a modest amount of shareholder value.

With ample excess free cash flows, Kinder is pursuing more clean energy investments. It already considers more than 80% of its backlog to be low-carbon investments, and it has formed an energy transitions group to pursue investments in renewable natural gas, biofuels, and carbon capture projects. The Kinetrex deal added several renewable natural gas projects at a highly attractive multiple in 2021, and it built on this success with more deals in 2022.

Given Kinder’s extensive experience with CO2 pipelines and processing facilities, we think it is better positioned than most U.S. peers to evaluate and invest in carbon capture and storage opportunities across its footprint, as well. Methane reduction is another opportunity, and Kinder has been working on this area since 2014 via its ONE Future efforts.

Moat Rating

Kinder Morgan has assembled a set of energy infrastructure assets that we believe would be very difficult to replicate. Its pipelines and storage facilities are moaty assets, as the challenges of constructing a competing pipeline confer near-monopoly status on pipeline operators.

On the whole, we think its asset portfolio has earned a narrow moat from an efficient scale moat source, as returns excluding goodwill are above its cost of capital. We exclude goodwill because the goodwill was largely incurred during a deal-making spree in 2011-13 where Kinder spent more than $40 billion on largely high-quality natural gas assets, adding $20 billion in goodwill at the time. Since then, with the exception of the one-time corporate consolidation in 2015, which did not materially increase goodwill or intangibles balances, Kinder has refrained from M&A on a similar scale, and we don’t expect it to engage in large-scale M&A going forward.

In total, Kinder Morgan’s assets move about 40% of U.S. natural gas consumption and exports, making its infrastructure mission-critical to U.S. stakeholders. Virtually all the business is focused on natural gas or related activities. In that regard, Kinder Morgan looks very similar to narrow-moat peer Williams, which handles 30% of the nation’s natural gas.

Midstream moats are primarily earned via an efficient scale moat source. Efficient scale refers to situations where companies are effectively serving a very limited market size, and potential competitors have little incentive to enter the market because by doing so, they would lower the industry’s returns to below the cost of capital.

While the midstream industry is massive, individual companies connect a limited number of markets to one another. Therefore, the underlying routes they serve can each be considered individual, localized markets to which efficient scale applies. Even though low-cost shale oil and gas production in North America has grown rapidly, we've seen little evidence of speculative capacity additions with the majority of a pipeline’s takeaway capacity being contracted before starting construction, ensuring that new capacity is added in an efficient manner.

Midstream markets exhibit several of the characteristics we look for in efficient scale markets. Demand for oil and gas products is growing slowly and should peak within the next decade or two, discouraging potential new entrants. Incremental demand can be met by incumbent companies at a very low cost, typically via compression, twinning a pipeline, or other means, making it difficult for new entrants to see a profitable investment opportunity. Demand is also fairly inelastic for oil and gas, meaning potential new entrants can’t simply undercut existing operators on price to gain market entry.

There are also significant barriers to entry in terms of multi-billion-dollar investments to build new pipelines and related investments as well as satisfying regulatory and other stakeholder concerns, which have only increased in recent years. Finally, exiting the market is extremely difficult, as assets can operate for decades safely with minimal maintenance investment, and repurposing older pipelines that may have low utilization for a higher and better use is a key skill set of good midstream management teams.

New pipelines are typically constructed to allow shippers or producers to take advantage of large price differentials (basis differentials) between two market hubs because supply and demand is out of balance in both markets. Pipeline operators will enter into long-term contracts with shippers to recover the project’s construction and development costs as well as a return on capital, in exchange for a reasonable tariff that allows a shipper to capture a profitable differential, and capacity will be added until it is no longer profitable to do so.

Pipelines are approved by regulators only when there is an economic need, and pipeline development takes years. Regulatory oversight is provided by the Federal Energy Regulatory Commission and at the state and local levels, and new pipelines under consideration have to contend with onerous environmental and other permitting issues.

A network of pipelines serving multiple end markets and supplied by multiple regions is typically more valuable than a scattered collection of assets. A pipeline network allows the midstream firm to optimize the flow of hydrocarbons across the system and capture geographic differentials, use storage facilities to capture price differentials over time, and direct more hydrocarbons through its system via storage and gathering and processing assets, ensuring security of flows and higher fees.

Kinder's portfolio includes 72,000 miles of natural gas pipelines, which provide transportation between most of the country's largest gas supply and demand regions. In addition, Kinder Morgan operates one of the largest products pipeline and terminals networks in the country. Kinder Morgan's extensive natural gas and refined products pipelines and continued investment in major projects look set to extend the company's asset footprint and cash flows.

Historically, Kinder has assembled its assets by aggressively purchasing third-party assets of all sizes, including large transactions (El Paso, Copano, and Hiland, for example) to small bolt-on acquisitions and including pipelines, storage and terminal facilities and Jones Act vessels. The purchase prices for midstream assets had been bid up as competition from many midstream players has been fierce. However, virtually all of these investments took place nearly a decade ago, and M&A activity has been far more restrained and thoughtful over the past decade, as asset sales and pruning have come to the forefront.

Importantly, more than 90% of its contracts are take-or-pay or fee-based. Among its most important business, which are natural gas and terminals, contracts are almost entirely take-or-pay, providing substantial security that Kinder will be paid throughout any oil and gas environment. More than 50% of the business operates under regulators’ pricing, providing additional security for the durability of returns. More than 70% of its customers are end users such as utilities, integrated energy firms, refineries, and other industrial users providing a steady source of demand. This dynamic is in contrast to supply oriented contacts that would be exposed to concerns over a basin’s economics and drilling activity.

While contract lengths across the business are shorter, on average, between a few years and up to 10 years, we think this reflects the maturity of Kinder’s assets versus a lack of pricing power. For newbuild assets such as Whistler which cost billions of dollars, long-term contracts over 10-20 years are expected to recover the investment outlay. However, on average, with Kinder’s network highly developed, the incremental investments tend to be smaller individually and thus require shorter contracts to recover the lower amounts of investment needed. In fact, we wouldn’t be surprised if some of Kinder’s smaller assets operate without contacts entirely, given their dominance over their local market for a lengthy period of time and the lack of competing assets.

Kinder's carbon dioxide business is directly exposed to commodity price fluctuations. Although we generally do not assign a moat to oil production, we think the CO2 business on its own deserves recognition. By controlling the source and transportation of CO2 and oil production from two fields using CO2 floods, Kinder has created a minimonopoly in the Permian that would be difficult for a competitor to replicate.

Looking for ASX listed shares? Read our article on the 11 ASX stocks offering great value right now.

Johnson & Johnson (NYSE: JNJ)

  • Fair value estimate: $164
  • Morningstar Moat Rating: Wide
  • Morningstar Uncertainty Rating: Low

Johnson & Johnson is the world's largest and most diverse healthcare firm. Three divisions make up the firm: pharmaceutical, medical devices and diagnostics. Geographically, just over half of total revenue is generated in the United States.

Business strategy

Johnson & Johnson stands alone as a leader across the major healthcare industries. The company maintains a diverse revenue base, a developing research pipeline, and exceptional cash flow generation that together create a wide economic moat.

J&J holds a leadership role in diverse healthcare segments, including medical devices, consumer healthcare products, and several pharmaceutical markets. Contributing close to 50% of total revenue, the pharmaceutical division boasts several industry-leading drugs, including immunology drugs Stelara and Tremfya as well as cancer drugs Darzalex and Imbruvica. The medical device group brings in almost one third of sales, with the company holding controlling positions in many areas, including orthopedics and Ethicon Endo-Surgery's surgical devices.

The consumer division largely rounds out the remaining business lines, but the firm divested its consumer healthcare group called Kenvue. A partial divestment of close to 10% of Kenvue occured in May 2023 with the remaining divestment in 2023 left JNJ with ~10% ownership inerest, which leaves the remaining company more focused on drugs and devices.

Research and development efforts are resulting in next-generation products. The pharmaceutical segment has recently launched several new blockbusters. However, relative to the company's size, J&J needs to increase the number of meaningful drugs in late-stage development to support long-term growth. The company has also created new medical devices, including innovative contact lenses, minimally invasive surgical tools and robotic instruments.

These multiple businesses generate substantial cash flow. J&J's healthy free cash flow (operating cash flow less capital expenditures) is over 20% of sales. Strong cash generation has enabled the firm to increase its dividend for over the past half century, and we expect this to continue. It also allows J&J to take advantage of acquisition opportunities that will augment growth. Diverse operating segments coupled with expected new products insulate the company more from patent losses relative to other Big Pharma firms.

Moat Rating

We believe Johnson & Johnson carries one of the widest moats in the healthcare sector, supported by intellectual property in the drug group, switching costs in the device segment, and strong brand power from the consumer group. The company's diverse revenue base, strong pipeline, and robust cash flow generation create a very wide economic moat. An extensive salesforce makes J&J a powerful candidate for a smaller biotechnology company looking to partner on a new drug, which strengthens Johnson & Johnson's ability to bring new products to market.

Johnson & Johnson's diverse operations are a major pillar supporting the wide moat. The company holds a leadership role in a number of segments, including medical devices, OTC medicines, and several drug markets. Further, the company is not overly dependent on one particular operating segment; the pharmaceutical business, medical device group, and consumer products represent close to 50%, 30%, and 20% of total sales, respectively.

Additionally, within each segment no one product dominates sales. Despite carrying some lower-margin divisions, J&J maintains strong pricing power and has posted gross margins above 70% during the past four years, validating its strong competitive position.

Johnson & Johnson's R&D efforts support its robust revenue base. In pharmaceuticals, the firm recently launched several new blockbusters, which should allow Johnson & Johnson to escape largely unscathed from upcoming patent expirations. Its efforts in medical devices, including robotics and digital data, should help maintain leadership in several medical device areas as well as support strong pricing power. Further, switching costs remain high with several of the device products. (For example, physicians switching vendors for hip and knee devices could take weeks if not months to learn the new products, which keeps physicians tied to the company's products.) On the consumer side, new product advancements combined with a solid brand power (reinforced by marketing campaigns) should maintain solid pricing power.

We think the firm does face environmental, social, and governance risks, particularly related to potential U.S. drug price-related policy reform (close to 30% of total sales are generated by prescription drugs sales in the U.S.) to increase access by lowering drug prices. Ongoing product governance issues, including litigation related to side effects and patents, also weigh on the company. While we have factored these threats into our analysis, we don't see them as material to the company's moat rating.