8 Wide-Moat Stocks of Tomorrow
These narrow-moat companies with positive moat trends are all trading in 4- and 5-star range.
In late April, the 2016 NFL draft will take place in Morningstar's home town of Chicago. Football enthusiasts who want to witness the draft in person can enter a lottery for tickets to the event. According to the Chicago Sun-Times, more than 79,000 fans from all 50 states applied to watch the draft in person last year. Devotees near and far want to see the next Peyton Manning or Jerry Rice.
Many investors would like to spot the "the next big thing," too. But just as team owners and scouts conduct extensive research on their top picks, investors need to do the legwork on their prospects, too. After all, you want to find stocks that can someday provide the endurance and competitive advantage of a Walter Payton, not a Johnny Manziel. In Morningstar parlance, that means uncovering the wide-moat stocks of tomorrow, today.
To generate a shortlist of potential wide-moat stocks of tomorrow, we screened Morningstar's database for narrow-moat companies with positive moat trends, or strengthening competitive advantages. We wanted to focus on those companies whose fair value estimates our analysts had the greatest confidence in, so we required our companies to carry low to medium uncertainty ratings. And finally, we narrowed our search further to stocks trading in 4- or 5-star territory. Eight companies made the cut.
Biotech, Biotech, and More Biotech
Five of the companies-- Alexion Pharmaceuticals (ALXN), BioMarin Pharmaceutical (BMRN), Celgene (CELG), Regeneron Pharmaceuticals (REGN), and Shire (SHPG)--are biotech concerns. Morningstar's biotechnology strategist Karen Andersen sees three key sources of moat, or sustainable competitive advantages, for biotechs: efficient scale, cost advantage, and intangible assets. (Learn more about the sources of moat here.) "[V]irtually all of the competitive advantages that biotech firms build are tied to intangible assets," notes Andersen. Intangible assets are things such as patents, government licenses, and brand identity that keep competitors at bay. "Overall, we think intangible assets are getting stronger [in biotech], creating many positive moat trends," adds Andersen.
Of the five biotechs included here with narrow moats and positive moat trends, Alexion and BioMarin are the best values; both earn 5-star ratings as of this writing.
Alexion's narrow moat owes in part to the long-term commercial potential of drug Soliris (which treats rare genetic blood disorders). "The drug costs $400,000-$500,000 per year and is typically used chronically over the course of a patient's life," says analyst Stefan Quenneville in his latest report. "In clinical trials, patients on Soliris had the same life expectancy and quality of life as similarly matched healthy patients. This clear benefit to patients helps justify its high price and facilitates its reimbursement by payers, both public and private." Patents for Soliris extend until 2020 in European markets and 2021 in the United States, and the company is developing next-generation versions of the drug that may be able to lengthen the life of the franchise further, notes Quenneville. Alexion's portfolio and pipeline include other lucrative and difficult to manufacture biologics, too. "Alexion's specialized salesforce and strong entrenchment with patients and doctors should allow it to maintain its quasi-monopoly hold on these disease niches for the foreseeable future," concludes Quenneville.
Like Alexion, BioMarin's drug therapies can carry six-figure price tags. Between the costs of the treatments and the high barriers to entry, the company earns a narrow moat. "We think BioMarin's lucrative monopolies in several rare disease niches have provided it with enough competitive advantages to warrant a narrow moat," writes Andersen in her latest report on the company. Two already-profitable products (Aldurazyme and Naglazyme) and one recently approved product (Vimizim) to treat rare diseases have patent protection through at least 2020. Biomarin's moat extends beyond patents, adds Andersen; efficient scale is another source of moat for the company: "Enzymes to treat rare genetic diseases--including Aldurazyme, Naglazyme, and Vimizim--are quite difficult to manufacture reliably … This, coupled with the fact that BioMarin's drugs hover well below blockbuster status, could make them less profitable targets for generics firms, once the costs of manufacturing, clinical trials, and global marketing are tallied."
Other Wide-Moat Stocks in Waiting
A trio of stocks from other industries round out our list.
Gap (GPS) earns 5 stars and is the sole retailer to make the cut. Senior equity analyst Bridget Weishaar expects the company to achieve low-single-digit top-line growth and midteen margin levels through product improvement and a responsive supply chain. The company's narrow-moat rating “reflect[s] the strength of the Gap and Old Navy brand intangible assets" as well as "the cost efficiencies from economies of scale that we expect will allow the company to achieve average adjusted returns on invested capital in the low- to mid-teens over the next five years, well north of its 9% cost of capital,” writes Weishaar in her latest report. Scale has provided the company with cost advantages, she adds, which allows Gap and Old Navy to be relatively price-competitive while preserving profitability. "Gap's strategic plan and investments in technology and supply chain management should increase moat-building cost advantages," says Weishaar, contributing to the company’s positive moat trend.
Invesco (IVZ), currently rated 4 stars, is the only asset manager on the list. "The publicly traded asset managers we cover tend to have economic moats, with switching costs and intangible assets their most durable sources of competitive advantage," says Morningstar senior equity analyst Greggory Warren. "Even though the switching costs might not be explicitly large, the benefits of switching from one asset manager to another are at times so uncertain that many investors take the path of least resistance and stay put." Invesco has a leg up on other asset managers, and is seeing an improvement in its investment performance and profitability. "Invesco is one of the few firms we cover with solid equity and fixed-income franchises, allowing it to benefit from changing investor behavior over the long run,” writes Warren in his latest report. “With a heavier presence in the retail channel, more equity exposure than fixed-income, and better investment performance than many of its peers, the firm should be able to generate annual organic growth of 2%-3% longer term, with market gains fueling the rest of the 6%-plus annual growth we're forecasting for its AUM longer term." Increasing size and scale of operations should lead to a 300-basis-point improvement in margins during 2016-20, says Warren.
LabCorp (LH), a leading independent laboratory, currently trades in 4-star range. "LabCorp's narrow moat is based on its vast national infrastructure, which translates into a considerable scale advantage over smaller regional labs in the independent diagnostic testing industry," writes senior equity analyst Debbie Wang in her latest report. "With 50 primary testing labs and 1,800 patient-service centers across the United States, LabCorp is able to run tests on 470,000 specimens each day at a substantially lower cost than most of the hospitals, doctors' offices, and smaller independent labs that populate the market. LabCorp's ability to accommodate higher throughput and its extensive use of automation affords the firm a much lower cost structure--significantly lower than that of hospitals and smaller independent labs." Wang thinks LabCorp is particularly well positioned to take advantage of longer-term opportunities emerging in the wake of healthcare reform and the focus on cost control, contributing to the company's positive moat trend.
The Morningstar Economic Moat Rating (video)
The Morningstar Fair Value Estimate (video)
The Morningstar Rating for Stocks (video)
What Makes a Moat? (article)
Why Moat Trends Matter (article)
Morningstar Equity Research Methodology (PDF)
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Susan Dziubinski does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.