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Stock Strategist

Crossing These Moats Will Cost You

An economic moat is great for these businesses, but it won't protect investors if they overpay for the stock.

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At Morningstar, we've long espoused the notion that stock investors should think like business owners. After all, to buy a share of stock is to take a stake in a business.

Imagine if the owners of the jewelry store down the street knocked on your door and invited you to buy in to their fast-growing operations. As a potential business partner, you'd naturally want a few questions answered before you dig out the checkbook: What sets you apart from the jewelry store across the street? Are your profits stronger? Can you charge more for your wedding rings, or is your merchandise constantly on sale? What keeps your customers coming back?

At Morningstar, we look at stocks the same way, and attempt to sum up the strength and durability of the underlying business's competitive advantages with our economic moat rating. Measured as "wide," "narrow," or "none," this rating measures how likely a company is to keep its competitors at bay for an extended period. And certainly some of our best stock ideas, especially for long-term investors, are wide-moat names.

But one other question any potential business owner should ask is, "how much?" A moat can protect a business from its rivals and a tough market, but it won't protect stockholders from losing money if they pay too much for their shares. When lofty expectations are baked into a stock price, even a whiff of disappointment can bring the shares back down to earth in a hurry.

So our Ideas Week screen of the day asserts that a good business doesn't always make a good stock. To underscore this, we searched for wide- or narrow-moat firms with a 1-star rating (indicating that the stock is overvalued at today's market price compared with our analyst-driven fair value estimate). These firms may look promising on paper, but they look pricey on the market.

As of Dec. 9, about a dozen companies popped up, all narrow moat. There are currently no wide-moat, 1-star stocks, which makes sense given the recent performance trends we've seen in the market this year--namely investors' continued preference for bidding up lower-quality equities.

Three of the stocks that passed our screen are highlighted below. Premium Members can  click here to run the screen themselves and see the most recent results.

 Tiffany & Co. (TIF)
Narrow Moat | Current Price: $62.57 | Morningstar Fair Value Estimate: $43 |
Fair Value Uncertainty: Medium | 1 Star

According to Morningstar's stock  Analyst Report, Tiffany's namesake brand is a key competitive advantage as it enables this jeweler to charge premium prices for commodity-based products such as diamond engagement rings. Additionally, Tiffany's unique jewelry collections by famous designers, such as the Frank Gehry line, help differentiate its nonengagement offering, giving it a leg up over rivals. And while the competitive landscape is heating up with DeBeers' entry into the United States retail market, we think Tiffany can keep competitors at bay by maintaining its brand cachet and offering distinct products.

But despite its fundamental advantages, the price tag on the stock is lofty. Morningstar stock analyst Paul Swinand's late November Analyst Note explains:

Given that Tiffany's shares have appreciated over 50% since July, we view the third-quarter results as solid but wonder if investors aren't setting up for disappointment if growth should slow even modestly, or if 2011 guidance is conservative. We point out that Asia sales, while up 24% on a reported basis in the third quarter, were up 21% in the second quarter and 50% in the first quarter. Management now is guiding to earnings per share of $2.72-$2.77 for 2010 (excluding $0.06 in charges), which we view as very reasonable, but we feel when it comes time to forecast next year, management will want to be conservative when staring at tougher comparisons. If 2011 earnings estimates rise to the $3.10-$3.25 range (implying midteens growth), multiples would appear a touch high at around 18-20 times earnings, possibly setting up for disappointment if high expectations are not met.

 OpenTable (OPEN) 
Narrow Moat | Current Price: $71.86 | Morningstar Fair Value Estimate: $25 |
Fair Value Uncertainty: Very High | 1 Star

Morningstar director of consumer research R.J. Hottovy outlines OpenTable's compelling fundamental case in his  Analyst Report:

With restaurants increasingly embracing technology to drive traffic and cut costs, we find OpenTable's automated reservation platform compelling. We believe OpenTable has developed a narrow economic moat, given the high switching costs for restaurants, unique product features, and the lack of meaningful competition. More importantly, we see early signs a network effect could be at play. As more consumers become aware of and use OpenTable.com, the more valuable it becomes for restaurants to be on the network. A well-established network can often lead to a wider economic moat.

But despite an intriguing fundamental story, the stock has gotten ahead of itself, according to Hottovy's estimates. In a November note, he wrote:

Despite our optimism about the firm's business model and growth opportunities ... we remain perplexed as to why the market continues to reward the stock with such a lofty valuation. At this writing, the stock is trading [at $68, which is] around 70 times our 2011 earnings per share estimate and an enterprise value/EBITDA of more than 30 times. To arrive at the current valuation, our model would require more than 30% annual revenue growth over the next five years and operating margins of greater than 50%. In our view, these assumptions are unrealistic, as the top-line growth rates would imply an installed restaurant base of 35,000-40,000 locations (depending on the success of new revenue streams), or almost 60% of restaurants currently taking reservations, according to National Restaurant Association estimates. Additionally, operating margin assumptions of 50% are well ahead of any transaction-based Internet firm in Morningstar's coverage universe, including Google (GOOG) and eBay (EBAY). We continue to view OpenTable's shares as grossly overvalued.

 Estee Lauder (EL)
Narrow Moat | Current Price: $78.23 | Morningstar Fair Value Estimate: $46 |
Fair Value Uncertainty: Medium | 1 Star

Efforts to trim costs and improve returns on marketing and innovation should ensure that Estee Lauder remains a formidable player in the beauty-care segment over the long run, notes Morningstar's Erin Swanson in the firm's  Analyst Report. The company is supported by the strong brand equity inherent in its product portfolio and global distribution network, which spans more than 150 countries. Further, we believe its scale advantages should provide Estee Lauder with more bargaining power over its suppliers and enable it to invest more in research and development and marketing than competitors.

But following the firm's first quarter results in late October, Swanson reiterated concerns about the stock price:

We think the market is significantly overestimating the sustainability of Estee Lauder's improvements. Our fair value estimate implies forward fiscal 2011 price/earnings of 16 times versus the multiple the market is assigning, which is a whopping 25 times our fiscal 2011 earnings estimate. We've been more bearish on the stock for some time, as we've believed that its depressed levels of marketing investments were unsustainable, given the intensely competitive environment in the global beauty-care market. Further, we've been concerned that Estee Lauder has been slow to adapt to shifts in the beauty industry, as it maintains sizable exposure to the slower-growing traditional department store channel.

Jason Stipp does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.