One of my go-to stock screeners has just two criteria: wide moat stocks trading at five-star valuations.

The “wide moat” part of this screen finds companies our analysts think benefit from competitive advantages that will endure for at least 20 years. The “five-star” part finds stocks trade at a material discount to our analysts’ estimate of fair value. Combining them should find stocks aligned with Warren Buffett’s holy grail: high quality companies trading at attractive prices.

When I run this screen, I don’t just look at the stocks themselves. Instead, I look for themes and try to see which industries and sectors may be out of favour. When I looked at the results of my screen this time, two industries stood out.

Two out of favour industries

Of the twenty shares, seven came from two industries: pharmaceuticals and alcohol. When I widened my screen to include shares at a 4-star rating, the same trends appeared. Out of 93 wide moat shares at 4- or 5-star ratings, nine sell alcohol and nine are drug manufacturers.

If you are looking for high quality companies at knock down prices, big pharma and big booze could be happy hunting grounds. Seeing as Aussie markets have little exposure to many of these industries, I dug a little deeper. And for reasons I’ll go into shortly, I found current valuations in one specific area of the alcohol business especially interesting.

Wide moat alcohol shares at a discount

Here is a list of wide moat alcohol shares currently at 4- or 5-star prices:

The presence of the big western spirits groups Brown-Forman, Diageo and Pernod Ricard interested me most.

Some shares on the “wide moat, low price” screen have looked undervalued for years. Cigarette companies, for instance. When do they not look cheap? By contrast, I don’t think I’ve ever seen so many spirits companies look undervalued at the same time.

It turns out this hunch was correct. For the last decade, many spirits companies – even those assigned a narrow or no moat rating – have traded richly compared to the fair value estimated by our analysts.

big-spirit-stocks-value

For context, that isn’t far from where the ‘magnificent 7’ have traded on average.

mag-7-price-to-fair-value

It’s hard to pin down why spirit stocks were so expensive. Did people trade up to spirits instead of beer during lockdown? Maybe. Has ‘premiumisation’ entrenched the big players and their centuries old brands even further? Perhaps. Did these stocks benefit from ‘quality’ shares becoming bond proxies in the zero interest rate years? That’s also a possibility – because as we’ll see now, they have some of the most obvious moats going.

Big spirits, big moats

A moat is a structural advantage that allows a company to keep earning excess profits on capital invested in their business for a prolonged period. Moats can take many forms including cost advantages, network effects, efficient scale, switching costs and intangible assets. You can learn about different moat sources and how to spot them here.

Although scale-based cost advantages can help the big firms in certain product lines, our analysts think intangible assets are the most powerful moat source in the spirits business.

The power of intangible assets

According to our analysts, spirits have more potential for brand loyalty and pricing power than many consumer products. This is because there is more scope for real or perceived product differentiation. Our analysts feel that intangible assets are strongest in aged spirits like whisky, where different aging techniques can lead to big differences in taste and perceived product quality.

As Morningstar analyst Dan Su explains in her analysis of American whiskey powerhouse Brown-Forman, the time needed to age products also acts as a barrier to entry.

“Upfront costs to start a spirits brand are high, especially in aged categories such as American whiskey where on top of raw materials and manufacturing costs, a significant amount of capital is tied up in aging and warehousing inventories over the three-year maturation process.

In Brown-Forman’s case, the distiller carried $1.4 billion worth of aging inventories on its balance sheet as of January 2024. The hefty upfront cost and lengthy aging process, coupled with low visibility on end market demand and hence low distributor willingness to take on unproven brands, discourages newcomers from entering the scene, helping entrenched players preserve pricing.”

For non-aged and niche products, it can simply be a case of one brand dominating mindshare.

If I want to make an espresso martini at home, I don’t go to the shop looking for coffee liquor. I go looking for Kahlua. It’s the only brand I would recognise and be able to grab without thinking. If I want to buy my Mum a bottle of Baileys for Christmas, I‘m not going to choose a cheaper cream liquor while I’m at the bottle shop. I didn’t go there to buy cream liquor, I went in to buy Baileys. The next one isn’t a spirit, but how many people can name a stout that isn’t Guinness? How many would even know that Guinness is a stout? It’s just Guinness. This isn’t normal for beer-like products and it’s probably why Diageo owns it in the first place.

Imagine how hard it would be for a new entrant to dislodge the mindshare these brands have. And it isn’t just the customers they would need to convince. Distributors and bars much prefer to bet on sure-fire sellers. If a spirits company does own a clear category leader, trade customers pretty much need to have sales conversations with them. Otherwise they won’t have the products demanded by customers and they will lose sales. At the very least, their staff will get bored of telling people that they don’t have Baileys but do have Dubliner Irish Cream. 

If a business can offer several 'must have' products and other decent brands under the same umbrella, even better. It becomes even less likely that an upstart in any one product line will be able to dislodge them. Talking of strong product line ups, here are some of the brands owned by the biggest Western spirits groups:big-spirit-brands

The asset of time

You’ve no doubt heard of Johnnie Walker, the world’s best-selling Scotch brand with over 200 years of marketing behind it. You might not be so familiar with baiju, a type of Chinese liquor made from sorghum grain. The quality of a baijiu is mainly determined by the age of the cellar, and a cellar with longer history usually produces higher-quality liquor. For this reason, a small number of companies have an almost unshakeable grip on the super-premium tier of China’s baiju market.

Wuliangye’s fermenting cellars have been in existence for over 650 years. Laojiao has over 1600 different cellars that have been used for 100 years or more. Moutai, the market leader and world’s biggest spirits company by market value, has similarly ancient cellars. Oh, and was the only drink consumed at the ceremony marking the founding of The People's Republic of China in 1949. How could any marketing agency come up with a new ‘brand story’ to top that?

Although every company and market is different, it’s clear that the world’s biggest spirits firms have a lot of moaty characteristics: brands with pricing power, barriers to entry and hard to copy intangible assets to name just three.

You can see the impact of these things on the net profits and returns on invested capital achieved by big spirit firms over the last few years.

spirits-roic

Why are the shares cheaper now?

Investors have had a lot to digest. Profit warnings from Diageo and the drinks segment of luxury group LVMH (the MH stands for Moët Hennessy) have dulled short-term expectations. There have also been fears that China may place anti-dumping tariffs on French cognac like they did for Australian wine.

Concerns over the Chinese economy probably haven’t helped the baiju brands. And if the ‘bond proxy’ factor I mentioned earlier has any merit, the fact that actual bonds now yield over 4% won’t have helped valuations.

Wide moat spirits stocks at 4 or 5 star prices

Our star ratings are calculated automatically based on our analysts’ fair value estimate and the level of uncertainty attached to their forecasts. A five-star rating suggests that too much pessimism is baked in current prices, but these ratings are only a general guide. These shares may not be a good fit for you.

Our analysts can and often do prefer a four-star stock to a five-star stock. An example here are the Chinese baiju firms below, where our analyst Jennifer Song prefers the four-star super-premium firms Luzhou Laojiao and Wuliangye over the five-star Jiangsu Yanghe, which sells less prestigious brands.

Similarly, I decided to buy Diageo shares in November after they fell on that profit warning. They weren’t a five-star pick and they may not have been the cheapest big spirits company at the time. I didn’t check. I’m familiar with Diageo’s brands, have admired the business for a long time and it had reached a price that seemed reasonable. It’s an investment I can live with.

With that in mind, here is the list of wide moat spirits stocks currently trading at a 4- or 5- star prices. If your strategy is to buy high quality companies at fair prices, they may be worth a look.

big-spirits-five-and-four-star-picks

Terms used in this article

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn about finding different sources of moat, read this article by Mark LaMonica.

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Uncertainty Rating: Morningstar’s Uncertainty Rating is designed to capture the range of potential outcomes for a company. An investor can think of this as the underlying risk of the business. For higher risk businesses with wider ranges of potential outcomes an investor should consider a larger margin of safety or difference between the estimate of what a share is worth and how much an investor pays. This rating is used to assign the margin of safety required before investing, which in turn explicitly drives our stock star rating system. The Uncertainty Rating is aimed at identifying the confidence we should have in assigning a fair value estimate for a stock. Read more about business risk and margin of safety here.

Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.

Spirits stocks mentioned in this article: