7 Small-Cap Stocks With Wide Moats
Enduring competitive advantages are promising for any company but particularly so for smaller companies with long growth runways.
The cornerstone of Morningstar equity analysis involves identifying economic moats, or structural barriers that protect companies from competition. The same qualities that imbue a company with an economic moat are synonymous with quality: We look for companies whose returns on invested capital are likely to exceed its weighted average cost of capital in the future.
In addition, we also look for firms that appear to have at least one of the five sources of sustainable competitive advantage (intangible assets, cost advantage, switching costs, network effect, or efficient scale).
It's difficult to identify smaller-cap firms that exhibit moat-worthy characteristics. Strong and enduring competitive advantages are promising for any company, but they are particularly attractive for smaller companies with long growth runways, as they have the ability to compound shareholders' capital at high rates of return over long periods of time.
Earlier this year, we identified nine small-cap firms with wide economic moats, meaning that we think they have advantages that will allow them fend off competitors and remain profitable for at least 20 years. In the table below, we list seven more.
Not all of the stocks on the list are attractive buys right now. You may be familiar with the Warren Buffett quote, "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price." Indeed, though it's often difficult to find high-quality, wide-moat firms at fire-sale prices, valuation always matters in stock investing. Eaton Vance (EV), Jones Lang LaSalle (JLL), and Core Laboratories NV (CLB) are currently about fairly valued, with price/fair value ratios around 1. Included in the table is our "Consider Buying" price, the price below which the stock would fall into 5-star territory and would be trading at a large enough margin of safety to our fair value estimate that it would be a compelling opportunity.
If any stocks on the list pique your interest but aren't cheap enough to buy, save them in a watch list. Our Portfolio Manager tool makes it very easy to set one up. Select "New Watch List" under the "Create" tab, enter the tickers, name your watch list, save, and you're done. (The share number, purchase price, and commission fields can be left blank.) You can customize your watch list alerts to tell you about price swings or, if you're a Premium Member, you can be alerted when a new fair value estimate or Stock Analyst Report is published.
Meanwhile, four stocks on the list are trading at enough of a discount to fair value that it may be worth taking a closer look at them.
Plains GP Holdings LP (PAGP)
We recently upgraded Plains All American's moat rating to wide from narrow owing to the company's strong efficient scale. Energy sector strategist Stephen Ellis says the volatility and collapse in Plains' supply and logistics business over the past few years have distracted investors from what he believes is a wide-moat portfolio of oil pipelines and related assets. From an asset quality perspective, Ellis considers Plains' oil pipeline network (about 88% of EBITDA at midcycle) to be best in class. The network is extremely well-positioned in the most important U.S. shale basins and easily worthy of a wide moat given the size of the network and the resulting difficulty in replicating it from a capital, regulatory, and geographic perspective. The returns from the pipeline network, supported by a powerful position in the Permian Basin, which is also the lowest-cost U.S. shale basin, should continue to shine through, in Ellis' view.
Grupo Aeroportuario del Pacifico SAB de CV (PAC) and Grupo Aeroportuario del Sureste SAB de CV (ASR)
Senior equity analyst Chris Higgins assigns both Pacifico and Sureste a wide moat rating. Approximately 95% of all air traffic within Mexico uses 35 airports privatized by the government. Airport operations are split among three publicly traded companies--Grupo Aeroportuario del Sureste (23%), Grupo Aeroportuario del Pacifico (26%), and Grupo Aeroportuario del Centro Norte (15%)--and the Mexico City International Airport is operated by a separate private entity.
Out of three publicly traded Mexican airport operators, Pacifico holds the largest percentage of passenger market share at 26% (compared with 23% for Sureste, and 15% for Centro Norte), and growth remains strong as Mexican airlines are expanding fleets and opening routes. Unique routes served by Pacifico have grown at a roughly 6% average over the past five years, and Higgins expects this trend to continue.
Sureste, meanwhile, operates nine airports and handles approximately one fourth of domestic passengers traveling by air. In addition to the airports in Mexico, Sureste has acquired majority stakes in Puerto Rico’s primary airport and two airport operators in Colombia. Each additional airport held by Sureste outside of Mexico holds a concession arrangement, and in Higgins' view, benefits from a geographic monopoly established by their respective authorities.
Guidewire Software Inc (GWRE)
The property and casualty insurance industry relies on clunky, decades-old proprietary legacy software systems that lack sophistication and often lead to overpayment on claims and customer attrition, writes senior equity analyst Rodney Nelson. Nelson believes wide-moat Guidewire Software has emerged as the global leader in replacing these legacy systems with its full-feature core application suite, which manages claims, billings, and the entire policy life cycle.
Application software providers often carve out economic moats by developing robust products that become ingrained in a customer’s processes, creating a sticky relationship. Providers with the strongest competitive advantages are able to scale these products to reach a significant portion of the addressable market. In Nelson's view, Guidewire has achieved each of these milestones, roughly quadrupling the customer totals of its nearest competitor while becoming a stalwart vendor among the world’s largest P&C insurers, with solutions deployed in over 35 countries.
Karen Wallace does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.