It has been a strong first half of the year for most equity markets and Australia is no exception. A 4.34% rally in the All Ords has taken the index to a level that Morningstar thinks is fairly to modestly overvalued. But there is still plenty of value to be found at the stock level.

At Morningstar we preach the virtues of being selective in the stocks you buy. After all, these aren’t just tickers and prices moving on a screen. It is a real investment in a real company. So if you are going to buy a stock, you might as well buy a good one.

The question then becomes how to find good stocks for consideration. One easy way to do this is to use a stock screener to find the specific criteria you are looking for. At the highest possible level, I like to see three things in a potential investment.

Number one: business quality

I would like the business to be of above average quality. By that I mean the company has the potential to generate profits and positive returns on capital invested into the business. Not just for one or two years but for many years going forward.

In order to do this, companies need some form of protection from capitalism’s relentless competition. At Morningstar we call this a Moat. A Narrow moat rating means that our analysts thinks the company benefits from advantages that will sustain for at least 10 years. A Wide Moat rating means they think the advantages can last for 20 years or more.

To reflect this in my screen, I decided to filter for companies with either a Narrow or Wide Moat Rating from Morningstar’s analysts.

Number two: sound management

Management matters. I would like a management team that is creating value – or at the very least not destroying it.

This is hard to quantify in a screen but I decided to focus on what is arguably management’s most important task – the allocation of capital. At the most basic level, this includes choosing what to do with earnings that are generated by the company and how much debt to utilise in the business.

To reflect this in my screen, I decided to exclude companies that have been assigned a Poor Capital Allocation rating by our analysts.

Number three: an attractive purchase price

A stock’s price on any given day is an expression of how optimistic investors are about the company’s ability to generate profits in the future. When investors are optimistic, a company’s market valuation might get ahead of what the underlying business is worth. On the other hand, overly deflated expectations can cause a company’s stock price to fall below what it is likely worth.

Our analysts estimate a company’s Fair Value by forecasting its future cash flows and discounting them to reflect the fact that the future is uncertain and that a dollar today is worth more than a dollar in the future. If a stock trades at a large discount to this estimated value, we think the shares are more likely to outperform over a long time frame.

To reflect this in my screen, I filtered for shares that currently have 4 or 5 star Morningstar Rating. This suggests that the current share price is attractive relative to our analysts’ estimate of Fair Value and the level of Uncertainty they assign to their valuation. I also filtered out stocks with High or Very High levels of Uncertainty which indicates the level of business risk.

In summary then, my screen was as follows:

  • Region: Australia and New Zealand
  • Wide or Narrow Moat
  • Capital Allocation of standard and exemplary
  • 4 or 5 star Morningstar Rating
  • Uncertainty is Low or Medium

The screen returned several candidates, including the three ASX shares featured below. Remember that before considering an individual stock or fund, you should form a deliberate investment strategy. You can see a step-by-step guide to doing that here. Now, onto the stocks.

ResMed (ASX: RMD) ****

  • Moat Rating: Narrow
  • Capital Allocation Rating: Exemplary
  • Uncertainty Rating: Medium
  • Discount to Fair Value: 24%

ResMed is one of the largest respiratory care device companies globally, primarily developing and supplying flow generators, masks and accessories for the treatment of sleep apnea. Recent developments and acquisitions have focused on digital health as ResMed is aiming to differentiate itself by providing clinical data for use by the patient, medical professionals and other stakeholders.

The global OSA homecare device market, is a two-player duopoly with over 80% estimated market share split between ResMed and Philips, with ResMed the market leader in the majority of the 140 countries it competes in. Our ResMed analyst Shane Ponraj thinks ResMed has a Narrow economic moat due to switching costs (physicians are usually trained to use a specific brand) and intangible assets such as ResMed’s strong brand and large patent portfolio.

Turning to capital allocation, Ponraj believes the company’s decision to acquire health software companies is strategically sound. He also points the company generating returns on invested capital of above 20% for several years. The company’s balance sheet is also in healthy condition, with Ponraj forecasting a net cash position by the end of his five year forecast period.

The sleep apnea treatment market appears to offer a large global growth opportunity. 80% of sleep apnea cases in developed economies still go untreated. Meanwhile, emerging markets are essentially untapped. Ponraj thinks fears that obesity drugs will derail this growth opportunity are overblown. As a result of these concerns, the shares have been weak recently and now trade at a 24% discount to Ponraj’s Fair Value estimate of $40 per share.

You can see Shane Ponraj discuss the impact of obesity drugs on ResMed here.

Bapcor (ASX: BAP) *****

  • Moat Rating: Narrow
  • Capital Allocation Rating: Exemplary
  • Uncertainty Rating: Medium
  • Discount to Fair Value: 30%

Bapcor sells replacement vehicle parts to trade and retail customers. Through its Burson segment, Bapcor is Australia’s second biggest supplier of trade parts. Meanwhile, it has roughly 12% of Australia’s retail parts business thanks mostly to its Autobarn and Autopro stores.

Our Bapcor analyst Angus Hewitt has assigned Bapcor a Narrow Moat rating due to intangible assets and cost advantages over smaller peers.

Bapcor operates more than 180 trade stores in Australia and around 60 trade stores in New Zealand. This scale gives Bapcor additional buying power and lets it stock over 500,000 different items, many of which are slow moving, across its store network. Bapcor can usually provide more parts to customers in a timelier manner than smaller competitors, often within the hour. Although Bapcor’s retail arm has lower market share, it enjoys scale based advantages over smaller peers thanks to its 300 strong store network.

Bapcor shares have suffered from uncertainty about the company’s management succession plan and the potential for weaker discretionary spending to hit the retail business—about 20% of group earnings. Hewitt is positive on the business as a whole and notes that around 50% of the retail business’s sales can be considered essential purchases. The trade and specialist wholesale businesses are more resilient and the company noted continued sales growth in these divisions.

Turning to capital allocation, Hewitt gives Bapcor top marks. He points to the firm’s sound balance sheet that features a comfortable level of debt given Bapcor’s industry. Hewitt also notes that the firm has generated double-digit earnings growth for several years thanks to significant investments made in its business. He expects further investments in continued store rollouts in both retail and trade segments, bolt-on acquisitions, and the firm's nascent venture into Thailand. In his view, the expansion of Bapcor’s store network is key to protecting the firm's narrow economic moat.

Private equity group Bain attempted to take advantage of Bapcor’s depressed share price by making a takeover bid of $5.40 per share in June. The bid was rejected and Bapcor also ended speculation over the vacant CEO position by installing Angus Mackay as its new CEO and Chairman. Bapcor shares rallied in response to Bain’s bid but remain deeply undervalued according to Hewitt. The current price of around $5.11 per share is 30% below his $7.10 estimate of Fair Value.

You can read Hewitt’s view of Bain’s bid for Bapcor here.

Charter Hall (ASX: CHC) ****

  • Moat Rating: Narrow
  • Capital Allocation Rating: Exemplary
  • Uncertainty Rating: Medium
  • Discount to Fair Value estimate: 24%

Charter Hall Group manages retail and institutional listed and unlisted property investments. It typically co-invests, aligning itself with its funds management clients. This gives Charter Hall diversified property exposure, so rental income produced accounts for about a fifth of the group’s EBITDA. A smaller portion of EBITDA comes from development, including development fees for managing projects for clients, and development profits on its own stake in each project.

Morningstar’s Brian Han ascribes a narrow moat to Charter Hall Group due to the funds management business, which generates roughly two thirds of earnings. While performance fees are volatile, switching costs make it unlikely Charter Hall’s customer base would make widespread redemptions in a short period. The group’s base fees more than cover costs, meaning that when nonrecurring revenues such as transaction, performance, and development fees arise, they can be lucrative.

Soft values for commercial property will likely weigh on near-term earnings as Charter Hall navigates the present cyclical trough, but the cycle should eventually improve. Values for retail and industrial properties have shown some resilience but office values are taking some big hits, and offices make up about one third of Charter Hall’s funds under management. Falling or stagnant property values undermine base management fees, and funds will be less likely to hit performance fee thresholds as property values fall.

Han assigns Charter Hall a Morningstar Capital Allocation Rating of Exemplary, based on a sound balance sheet, exceptional investment strategy, and appropriate securityholder distributions. The group avoided raising equity in the Covid crisis at the head stock level and, overall, Charter Hall’s investments have been lucrative for securityholders. The group has been acquisitive, even in hot markets, however most properties are purchased and developed on behalf of Charter Hall funds. This generates development, leasing, and management revenue, without taking on too much risk or requiring much capital.

Han’s Fair Value estimate of $16.25 per share implies a 2024 P/E of 21 times and enterprise value/EBITDA of 16 times, though he thinks 2024 earnings are cyclically low. Performance fees and funds under management growth will likely slow in the face of higher interest rates. However, he thinks the market may be factoring in too much bad news. Charter Hall has structural growth opportunities as the property sector continues to move into the hands of fewer professional investors. Charter Hall's strong record and large management platform should see it benefit.

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.

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.

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