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Beware 5-Star Stocks Bearing No Moats

Lack of competitive advantages may mean these companies aren't the bargains they seem to be.

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In researching stocks it's easy to get excited when finding a name with a Morningstar Rating of 5 stars attached to it. After all, that 5-star rating means the stock is selling well below our equity team's estimate of its fair market value, and buying underpriced stocks and holding them until they appreciate is a time-tested investment strategy.

But don't let the twinkle of all those stars blind you from other important factors to consider before buying. Among the most important of these is the stock's moat rating, or ability to sustain its competitive advantage for years to come. Moats can be built in a number of different ways, and Morningstar analysts assign narrow- or wide-moat ratings to companies with these characteristics depending on the extent of the advantage. Then there are companies that carry a no-moat rating, meaning they have no competitive advantage. This could be because the company operates in a highly competitive industry in which building such an advantage is difficult, or simply because the company has not found a way to develop one.

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