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Stock Strategist

How Four Wide-Moat Firms Stay Ahead

Recognizing business models that stand the test of time.

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We think smart investors look for good companies that have solid management teams and can build a strong economic moat around their profits. At Morningstar, we are constantly searching for these economic moat builders--companies that focus on long-term strategic plans, create distinct operating models, and harvest competitive positions, all of which allows these firms to create long-term value for shareholders.

What Makes a Moat?
All management teams say that they are working to increase shareholder value over the long term. In reality, though, setting goals is different from actually achieving them. At Morningstar, we think the proof is in the pudding, and you can look at how a company has positioned itself to gauge whether or not the managers have achieved their goal.

The quick and dirty moat test is really an evaluation of a company's position or products relative to its peers, suppliers, customers, and any potential substitute products that may arrive.

When investors are looking for solid, long-term holdings, they should first consider the following: 

  • Is something preventing a company's customers from easily switching to a competitor?
  • Has the company positioned itself as a low-cost producer in its field?
  • Has the company developed products, techniques, or services that are difficult for others to replicate? To that end, does the company have a strong brand, patent, regulatory approval, or geographic advantage that competitors cannot duplicate?
  • Does the company consistently generate returns above its cost of capital?

These are just some of the questions investors need to ask before committing to partner up with a company as a long-term investor. Smart investors should also look for a management team that has a history of worrying about the same things investors do and, even better, has the proper incentive scheme in place to encourage them to do so.

More on Moat Ratings
At Morningstar, we assign companies to three economic moat categories: wide, narrow, and none. Before awarding a company a wide-moat rating, we have to be very confident that the firm's competitive advantages will persist for quite some time. Also, there has to be considerable evidence that this company and its management team have been generating solid and sustainable returns on capital. Only about 10% of the stocks we cover (out of nearly 2,000) receive wide-moat ratings.

In addition to the moat rating, investors should also be keenly aware of valuation. (After all, even a wide-moat company is a poor investment at the wrong price.) We award a stock a 5-star rating when we believe it is trading at a large discount--i.e., a margin of safety commensurate with its risks--to our fair value estimate. Thus, when a wide-moat stock hits 5 stars, we consider it an especially compelling value.

Though none of the following wide-moat stocks is trading in 5-star territory, we think their strong competitive positions have earned them a place on investors' watch lists, should a buying opportunity arise. (Morningstar ratings are as of April 12, 2007.)

 Walgreen (WAG)
Morningstar Rating: 4 stars
Economic Moat: Wide
Business Risk: Average

Even as competitive pressures intensify, Walgreen should be able to maintain steady growth as it benefits from the rapid increases in prescription drug spending and continues to aggressively build new stores. Morningstar analyst Mitchell Corwin thinks that Walgreen is years ahead of its peers in scouting locations for stores, and it aggressively pursues the sites it wants, paying premium dollars for prime locations. We estimate that a Walgreen store is 30% more productive than its nearest competitor's. More-productive stores equate to better earnings per store, robust free cash flow, and the highest returns on invested capital of any drugstore chain.

 Kinder Morgan (KMP)(KMR)
Morningstar Rating: 3 stars
Economic Moat: Wide
Business Risk: Below Average

It is not just the high, tax-advantaged yield (6.2% annually at our fair value estimate) that attracts us to Kinder Morgan (KMI) and subsidiary Kinder Morgan Energy Partners (KMP). KMP owns stable assets that generate substantial free cash flow largely insulated from swings in commodity prices. KMP's high-quality asset base has a history of producing returns that exceed the company's cost of capital. Kinder Morgan's partnership distributions are large and growing. KMP also seems to remain one step ahead of the competition, anticipating the need for new infrastructure and completing more profitable projects than any other company in the midstream sector. For these reasons, among others, Morningstar analyst Michael Cumming thinks Kinder Morgan enjoys a wide economic moat.

 Harley-Davidson (HOG)
Morningstar Rating: 3 stars
Economic Moat: Wide
Business Risk: Average

Morningstar analyst Marisa Thompson believes that Harley-Davidson's brand strength and scale allow the company to earn returns on invested capital in excess of 30% per year. Harley-Davidson holds a large and steady share of the domestic and international markets for heavyweight motorcycles. The firm maintains exclusivity with over 80% of its domestic dealers and has had early success in replicating high levels of exclusivity with overseas dealers as well. Additionally, free cash flow margins average 14%-16%, facilitating the return of more than $2.7 billion to shareholders in the form of dividends and stock repurchases during the last three years. Thompson thinks that Harley-Davidson's business model is solid and management is executing well.

 McCormick (MKC)
Morningstar Rating: 3 stars
Economic Moat: Wide
Business Risk: Below Average

Unlike most consumer packaged goods companies, which battle private labels and pricing threats that keep them from earning their cost of capital, McCormick proved that they can be profitable businesses. McCormick controls half of the market for spices and seasonings in North America and is more than twice the size of its next-largest branded competitor. Over time the company has introduced new products on top of its trademark brands while maintaining its value-added focus on flavor. McCormick is also the largest producer of private-label spices and seasonings in North America. This allows it to limit the threat posed by private labels, ensuring that no other company gains enough scale in this segment to significantly affect the pricing of McCormick's branded offerings. For these reasons, among others, Morningstar analyst Ann Gilpin thinks McCormick profits from a wide economic moat. And while McCormick's sales may take a hit in the short run and restructuring charges will crimp operating margins, Gilpin believes that the company's restructuring plan and solid execution of its profitable growth strategy will benefit the bottom line longer term.

You can learn more--straight from company representatives--about how some of our favorite firms built and maintain their economic moats at Morningstar's first annual company management conference, The Management Behind the Moat, on April 26. Senior management representatives from a dozen companies--Walgreen, Kinder Morgan, Harley-Davidson, McCormick,  Illinois Tool Works (ITW),  CDW (CDWC),  Wipro (WIT),  Bemis (BMS),  Fuel Tech (FTEK),  Realty Income (O),  Republic Services (RSG), and  Actuant (ATU)--will give presentations to and take questions from conference attendees. Click here to learn more.

The Management Behind the Moat conference is being held in conjunction with our Annual Morningstar Stocks Forum, which will take place on April 27. At the forum, our three equity strategists--who head up our StockInvestor, DividendInvestor, and GrowthInvestor newsletters--and stock analysts will share their best stock picks, offer insights into how we value stocks, and provide in-depth answers to questions from the audience.

Ramesh Poola has a position in the following securities mentioned above: FTEK. Find out about Morningstar’s editorial policies.