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Stock Strategist

Keep an Eye on These Two Bellwethers

Thoughts on two firms added to StockInvestor's Bellwether 50 watch list.

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In Morningstar StockInvestor, a publication for which I am editor, I maintain a watch list called the Bellwether 50 that is full of companies with wide economic moats. These companies represent the best of the best, and I use the list to keep track of stocks I might be interested in adding to StockInvestor's Tortoise and Hare real-money model portfolios.

I recently updated the Bellwether 50 and added seven companies to the watch list. Below are some thoughts on two of those that were added.

 ExxonMobil (XOM)
I think ExxonMobil was the most obvious candidate for addition to the Bellwether 50. The vast majority of the energy companies we cover at Morningstar attain only a "narrow" moat rating, yet Exxon stands alone as the only wide-moat oil company. I know this firm intimately, having covered it for more than three years at Morningstar before taking the helm at StockInvestor.

In an industry where bigger is better, Exxon is the largest, and it can use its massive size to squeeze the most economies of scale from its operations. Exxon can also afford to go after the "elephant" projects that smaller energy companies might not have the capital or technological know-how to tackle. Its century of experience operating in far-flung and volatile corners of the globe also give it valuable existing relationships and expertise.

Moreover, Exxon is a stickler for capital discipline, which is something we love to see. It will not grow just for growth's sake. Rather, it seeks to maximize its returns on invested capital. Combine this with its size and its operational excellence, and it should not be surprising to hear Exxon easily clears its cost of capital even at cyclical low points while also possessing the highest long-term returns among its peers.

Some of the other statistics about Exxon are exceptionally impressive. Exxon is the most direct descendent of the original Rockefeller-controlled Standard Oil--a company with such a wide moat at the time that it single-handedly spawned antitrust regulation early in the 20th century--and the firm has had a AAA credit rating for more than 80 years. It has more than $200 billion in assets, zero net debt, and earned aftertax net income of $36 billion for 2005, a new world record. (Exxon also paid just less than $100 billion in income, excise, and other energy taxes for 2005 alone. And you thought your tax bill was bad!)

Though Exxon has run up with the rest of the energy sector over the past couple of years and is not exactly inexpensive today, it's worth keeping on the radar for when the energy tide turns and commodity prices come back down to a normalized level. If I could get it cheap enough, I'd snap up Exxon in a heartbeat.

 J.P. Morgan Chase (JPM)
When looking at the entire list of wide-moat companies, one of the noticeable things is the sizable number of large banks. I asked associate director of equities research Craig Woker, who heads up our 16-analyst financials team, to name the two firms he thought had the widest moats among the big banks. J.P. Morgan and Citigroup (C) were his top two answers. I agree, so J.P. Morgan now joins Citibank on the list.

All banks benefit from customer switching costs, meaning customers would rather pay small fees or receive slightly lower rates on their deposits than go through the hassle of switching their direct deposit, automatic bill pay, and so on. The banks also have intangible assets in their reputations and established commercial relationships. And last but perhaps most important, nearly all financial-services businesses benefit from economies of scale, and J.P. and Citi are among the biggest.

They also each have very broad and diverse business lines that strengthen one another. Here's how Craig described his view to me:

"While potentially only a couple of other businesses at other financial firms have a deeper set of competitive advantages and larger level of return on invested capital, J.P. and Citi have hundreds of competitive advantages. In the aggregate, I believe this ensures a better persistency of returns than any individual business line--no matter how good the individual business line.

"Thus, in my view, large, diversified conglomerates capable of generating returns above their cost of capital are more impressive--and more-stable investments--than any single business, no matter the depth of its moat. A single disruptive technology, political development, new competitive dynamic, etc., can disrupt even the deepest of moats. However, it is far less likely that a confluence of hundreds of events would come together to ever impair all of the business lines of Citi, J.P., GE (GE), Procter & Gamble (PG), etc., thereby driving the returns down to unattractive levels."

To see the rest of the companies on the newly updated Bellwether 50 watch list, check out Morningstar StockInvestor.

Paul Larson has a position in the following securities mentioned above: JPM, XOM. Find out about Morningstar’s editorial policies.