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Does It Pay to Invest in Wide-Moat Stocks?

It sure does--but don't disregard valuation.

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This analyst blog is part of our coverage of the 2017 Morningstar Investment Conference. 

It makes sense, in theory: Companies with sustainable advantages--or those that Morningstar says have economic moats--should perform better over time than those companies without such advantages.

But does that translate into superior stock performance?

Morningstar analysts addressed that question Wednesday at the 2017 Morningstar Investment Conference.

Taking a step back, senior equity analyst Andrew Lane, a member of Morningstar's Moat Committee, reminded the audience that a moat represents a sustainable competitive advantage that should help a company generate superior profits over time. Narrow-moat companies are expected to out-earn their weighted average costs of capital over 10 years; for wide-moat companies, the expectation stretches 20 years.

But investing in companies with moats isn't a guarantee of superior stock returns.

"Valuation is critical," said Lane.

For proof, Dan Lefkovitz, content strategist for Morningstar Indexes, pointed to the performance of the Morningstar Wide Moat Focus Index, which has outperformed the S&P 500 during the trailing 1-, 3-, 5- and 10-year periods.

"The Wide-Moat Focus Index marries valuation and moat," he said. The index includes the least-expensive wide-moat stocks in Morningstar's coverage universe. (Read more about how the index is built here.)

What this means is that even in an overvalued market such as the one we're experiencing today (Morningstar's Market Fair Value graph indicates that the market is about 4% overvalued based on our estimates), investors should still be able to generate superior long-term returns by cherry picking undervalued stocks with moats.

Some areas ripe for the picking can be found in the healthcare sector--specifically among wide-moat drugmakers.

"This space has definitely been in the news during the past year plus," noted Michael Waterhouse, a senior analyst with Morningstar's healthcare team. "The pricing discussions have maybe been overblown. The long-term investor who's willing to ride out the volatility has opportunity."

Waterhouse suggested sticking with the undervalued wide-moat names with robust portfolios and superior pipelines, including  Bristol-Myers Squibb (BMY),  Roche Holding (RHHBY),  Novartis (NVS),  Sanofi (SNY) and   Allergan (AGN).

Bridget Weishaar, a senior equity analyst who focuses on apparel for Morningstar, talked about wide-moat  L Brands (LB), whose portfolio includes Victoria's Secret and Bath and Body Works. She likes the company's pricing power, sees tremendous growth potential in China, and expects e-commerce penetration to grow.

"Long-term, we think this is a wonderful company to own," she said.

Weishaar acknowledges that it may take time for the China and ecommerce stories to play out--and the company's mall exposure is a concern, given the falloff in mall traffic overall. In other words, expect some bumps along the way.

Her favorite name today is actually a narrow-moat company,  Hanesbrands (HBI).

"The company is in category with fierce brand loyalty, and their pricing is appealing," she said. "We think they can be channel-agnostic in the next three years." 

That would allow it to continue to compete successfully, as weak mall traffic can be offset by rising ecommerce sales.

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