The dream outcome from any stock purchase is for the initial investment to grow many times over.

This kind of return doesn’t usually happen quickly, and trying to achieve that kind of return quickly is usually a dangerous endeavor. Epic investment results usually occur over a far longer period of time, thanks to the power of compounding. Compounding is earning a return on a return. Over time the same percentage gains in an individual holding or your overall portfolio represent larger and larger dollar increases in your wealth.

This compounding in share price doesn’t happen by accident. In most cases, it will be a result of the company’s underlying earnings also compounding. Which, in turn, is usually a result of a company reinvesting a portion of its earnings to sow future profits. Unfortunately for most businesses, results like this are highly improbable.

This is not because of a lack of desire, intelligence or effort from those involved. But because capitalism is defined by relentless competition. If a business is generating the profits and returns on investment needed to compound small amounts into large fortunes, you can bet others will try to do it too.

For most businesses, this competition eventually sees profits and the returns on investment fall towards the cost of capital (the cost of raising funds through a loan or by selling shares). A far smaller portion of businesses have structural advantages that protect the returns they achieve. At Morningstar, we call this a moat. And if you can find a company with a moat, you may have found yourself a potential compounder.

I’ve identified three companies that our Morningstar analysts have assigned a Wide Moat rating. This means our analysts think these companies have durable competitive positions that can protect their returns on capital for at least twenty years. That is a very high bar. What’s more, these companies all command a 5 star Morningstar rating, which means our analysts think the shares currently trade at a notable discount to Fair Value.

In each case we’ll look at the source of the company’s moat and what our analysts think the shares are worth. For a deeper explanation of Morningstar’s Moat and Fair Value ratings, please read the explainer note at the foot of this article.

Bristol-Myers Squibb ★★★★★

Bristol-Myers Squibb (NYS: BMY) is a major global pharmaceutical company. It sells a wide portfolio of internally and externally developed drugs, especially in the cancer treatment field. Morningstar’s Damien Conover thinks Bristol has a Wide Moat based on its broad portfolio of patent-protected drugs, entrenched salesforce, and economies of scale.

Patents fall under our ‘intangible assets’ category of moat and are usually the most important moat source for pharmaceutical firms. This is because a patent blocks other companies from selling treatments using the same molecular formula for a set period of time. This allows the patent holder to charge highly profitable prices with no direct competition, as long as their formula continues to be among the best treatments for the condition in question.

For drugs made purely from chemical molecules, it is easy for other companies to study the patented treatment and sell an unbranded version once the patent expires. As these ‘generic’ drugs are chemically identical to the branded medicine, sales for the previously patented product will usually plummet. The difficulty and cost of copying a biologic treatment, which are based on living organisms such as bacteria or a virus, is much higher. This can give the patented firm more protection from generic competitors.

If a company faces a big hit from patents expiring, you might hear this referred to as a ‘patent cliff’. To avoid sales from evaporating due to patent expiries, most drugmakers will dedicate a sizable portion of their profits to researching (or acquiring) new drugs with the potential to benefit from patent protection. As a result, the two key variables that investors focus on for drugmakers are their patent portfolios and drug development pipelines.

Bristol's two top drugs – cancer drug Opdivo and cardiovascular drug Eliquis – see their patents expire in 2027-28. Our Bristol analyst Conover thinks the firm is developing a strong pipeline to mitigate this. The pipeline focus on immunology, oncology, and rare diseases should increase the probability of development success given the higher level of unmet medical need in these areas. Several of Bristol's currently marketed drugs, including Opdivo, are biologics. This could offer some protection from generic competition.

Bristol's sheer size means it generates the strong and stable cash flows required to fund the approximately $800 million needed, on average, to bring each new drug to the market. This puts it in a strong position to buy promising candidates from smaller biotechnology firms. It can also offer smaller drug companies access to its large salesforce which has valuable and highly entrenched relationships with buyers.

Conover assigns Bristol Myers Squibb a fair value of $63 per share. He expects Opdivo and Eliquis to grow healthily before the patent losses begin and thinks that Bristol remains well positioned in treatments for melanoma and renal cancer.

ASX Ltd ★★★★★

ASX (ASX: ASX) is Australia’s leading provider of equity listings, settlement, clearing and trading. It has an effective monopoly on equity listings in Australia with over 95% market share. ASX’s catchment zone also extends to New Zealand, with New Zealand based companies cross listing on the ASX equating to around a third of total companies listed on the New Zealand Stock Exchange.

Our ASX analyst Roy Van Keulen has given ASX a Wide Moat rating due to network effects in its settlement, trading and clearing businesses. A network effect is where a company’s products and services are improved by every additional user. This generally eventually leads to a winner-takes-most competitive environment.

In ASX’s case, higher trading volume leads to better liquidity, lower costs and tighter bid-ask spreads for traders. We also think that ASX benefits from these network effects in its technology and data business, which can offer products and services based on proprietary data generated by ASX markets. You can read more about network effects here.

As ASX provides much of Australia’s financial infrastructure, the firm’s activities are heavily regulated. Our analysts believe this limits the company’s upside and downside potential. ASX has long been protected from competition through exclusive licenses to clearing and settlement.

However, ASX’s decision to shelve long-promised upgrades to its settlement system has led to concerns that regulators will seek greater competition. Our analysts think the chances of this are reduced by the fact that equity settlements and clearing are hardly hot-button issues for most of the Australian electorate. Van Keulen thinks it is more likely that the Australian financial system continues to consolidate around ASX due to its monopoly-like market share and the network effects mentioned earlier.

ASX shares have been weak recently after management guided to higher-than-expected investments into the business. While Van Keulen admits this will see ASX’s profit margins take longer to recover, he held his Fair Value estimate for the firm at $75 per share. This is based on revenue growth assumptions of 6% per year for the next decade and higher profit margins as investments in the clearing upgrade wind down.

Van Keulen thinks ASX could benefit from increased trading and hedging volumes if market volatility continues because of changing interest rates and geopolitical tensions. This is especially relevant to materials and energy companies, which comprise most of the companies listed on ASX. While more volatility could impact the number of new listings, he thinks the important role of metals and natural gas in the net zero transition could outweigh this and lead to listings growth.

Reckitt Benckiser ★★★★★

Reckitt Benckiser (LON: RKT) is a consumer products group with brands spanning household products, consumer health and infant nutrition. Morningstar’s Reckitt analyst Diana Radu assigns the firm a wide economic moat based on intangible assets, reflecting both the strength of its brands and its entrenchment in retailers’ supply chains.

Reckitt’s competitive strength comes from its focus on somewhat niche categories such as auto dishwashing, surface and disinfection, sexual health and sore throat. Reckitt enjoys around 30% global market share in each of these categories thanks to its ownership of brands such as Calgon, Finish, Lysol, Dettol, Durex and Strepsils. Over 50% of the company’s operating profit comes from consumer health and infant nutrition, categories in which market leaders such as Reckitt have clear-cut pricing power given the reluctance of consumers to experiment with unfamiliar or unbranded products.

Overall, the company owns the number-one or number-two brands in around 15 narrowly defined categories at a global level, which we believe makes it a key supplier for retailers in those categories. Radu believes the finite nature of shelf space in grocery stores gives rise to natural barriers to entry, coupled with retailers’ preference to build solid relationships with a limited number of reliable and efficient suppliers. The most coveted position by manufacturers is that of category captain—a title usually awarded to the largest or second-largest player in a category, that retailers perceive as a true business partner and with whom they nurture a mutually beneficial relationship.

Radu assigns Reckitt a fair value of GBX 6700 per share compared to a current share price of around GBX 4400. Radu expects organic revenue growth of around 4% per year over the next five years. She thinks most of this growth will come from the health and hygiene segments, as the infant nutrition business could see headwinds from falling birth rates in developed countries and increased competition in the US. Radu also expects Reckitt to improve its operating margins and keep more of these sales as profits. This is partly because the health and hygiene segments have juicier margins and should grow as a percentage of overall sales.

Terms used in this article

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.

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.

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.