By continuing to use this site, you agree to use of cookies. You can change this and find out more by following this link Accept cookies

When a Wide Moat Is Not Enough

These stocks have sustainable competitive advantages but are looking very pricey

Adam Zoll 8 March, 2013 | 6:00AM

Knowing that a stock you own has a wide economic moat can provide great peace of mind. A wide moat, after all, means the company has sustainable competitive advantages that can give it a leg up over its competitors. Wide-moat stocks also tend to be less volatile than their narrow- and no-moat peers, according to Warren Miller, Morningstar's director of quantitative research.

Investors who buy stocks based on moat alone run the risk of over-paying for quality companies

Yet investors who buy stocks based on moat alone run the risk of over-paying for quality companies. A wide-moat company with a Morningstar Rating of 1 star is no bargain, since that 1-star rating implies the company is expensive and is trading well above Morningstar's fair value estimate.

In conducting research to understand more about economic moats and market performance, Miller found that wide-moat stocks that carried 5-star ratings--meaning the stocks traded well below their fair value estimates--returned 19% annually for the 10-year period ended Dec. 31, 2012. Meanwhile, wide-moat stocks with 1-star ratings, on the other hand, lost 4% per year.

(The research looked at 10-year annualized total returns for portfolios of stocks grouped by moat and star rating. The methodology equal weights stocks in each portfolio and rebalances daily to account for changes in star ratings, for example.)

Despite the stock market's recent impressive performance, which has the FTSE 100 hitting fresh five-year highs, Morningstar's overall Market Fair Value estimate shows stocks in our global coverage universe are pretty much fairly valued, with wide-moat stocks also at that level. Even so, there are a handful of wide-moat stocks that currently carry just 1 star because they are trading well above their fair value estimates. Below are two of these names:

SABMiller (SAB)    
Fair Value Estimate: 2,350.0p | March 5 Close: 3,383.5p     

The world's second largest brewer controls about 14% of the global beer market, behind only Anheuser-Busch InBev (ABI) (18%). The company has considerable exposure to emerging markets, which Morningstar analyst Thomas Mullarkey says represent "a huge long-term opportunity for SABMiller in these regions as wage growth in the coming decade should serve as a catalyst to increase per capita consumption of beer." However, it's important to note that Morningstar's forecast anticipates softness in beer sales in some of the company's developed markets. Foreign-currency fluctuations are also a risk here, which could result in big revenue and earnings swings. Also, government regulation and taxation in some markets could eat away at profits.

LinkedIn (LNKD)       
Fair Value Estimate: $83 USD | March 5 Close: $175.99     

Shares of this professional social-networking website have been on fire since debuting at the IPO price of $45 in May 2011. Morningstar equity analyst Rick Summer says no other social-networking site monetises its user base better. The site enjoys a wide economic moat as a result of its user base of 200 million (according to the company's website) and the obvious network effect this creates, not to mention switching costs. (People who have set up a profile and built a network in LinkedIn may not be inclined to switch to another professional networking service.) But Summer says that even though the company has posted strong financial performance so far, its stock is overpriced relative to Morningstar's forecast. "Despite our optimism for the company, we don't believe investors would be adequately compensated for their risk if they were to overpay," he writes. As a point of comparison, Facebook (FB), another wide-moat social-networking giant, currently trades in the 3-star range, slightly below its fair market value.

The original version of this article was published on Morningstar.com, a sister site to Morningstar.co.uk.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Securities Mentioned in Article
Security NamePriceChange (%)Morningstar
Rating
Anheuser-Busch Inbev SA93.78 EUR0.22
Facebook Inc Class A79.88 USD1.89
LinkedIn Corp234.61 USD1.19
SABMiller PLC3,378.00 GBX0.09
About Author

Adam Zoll  is an assistant site editor with Morningstar.com, the sister site of Morningstar.co.uk.