The Best Ideas list is a compilation of stock ideas sourced from Morningstar’s global equity research team. With more than 100 analysts covering nearly 1,500 companies, we’re able to provide a wide variety of what we believe are attractively priced securities looking across sectors, industries, and geographies. Best Ideas are nominated by analysts and approved by managers in addition to the normal due diligence processes that precede our published research and ratings. Below are the four stocks on the list that are listed in the UK.
We believe that a company’s intrinsic worth results from the future cash flows it can generate. The Morningstar Rating for stocks identifies stocks trading at a discount or premium to their intrinsic worth—or fair value estimate, in Morningstar terminology. Five-star stocks sell for the biggest risk-adjusted discount to their fair values, whereas 1-star stocks trade at premiums to their intrinsic worth.
Four key components drive the Morningstar rating: our assessment of the firm’s economic moat, our estimate of the stock’s fair value, our uncertainty around that fair value estimate and the current market price. This process ultimately culminates in our single-point star rating. Underlying this rating is a fundamentally focused methodology and a robust, standardized set of procedures and core valuation tools used by Morningstar’s equity analysts.
Diageo (DGE)
Sentiment is low on Diageo following three years of underperformance, several strategic and execution errors, acquisitions that have failed to create value, and most recently, an SEC inquiry about their shipment practices. We think Diageo has a wide moat due to the breadth and strength of its brand portfolio, and the scale of its production that allows it to produce at a lower average cost than smaller competitors. These competitive advantages should drive sustained excess returns on capital. The catalyst for the stock, however, remains a turnaround in volumes. In an environment of low real wage growth, we like Diageo’s self-help options for delivering that turnaround. First, management should streamline channel inventory as a matter or priority, in order for medium-term growth to match depletions.
Second, Diageo should plug holes in its portfolio, particularly in brown spirits, without stretching its brands too thinly in noncore consumer segments. Third, it could unlock the value in its beer portfolio in Africa by either divesting it or integrating the route to market of its beer and spirits portfolios. In addition to these self-help measures, Diageo’s volumes are likely to benefit from any macroeconomic upswing, as premiumisation is sensitive to the economic cycle in developed markets.
Kingfisher (KGF)
We think DIY retailers possess structural advantages against the encroachment of online competition in some categories, due to the high-ticket nature of room remodeling, the inefficiency of shipping heavy items, and the emergency nature of some DIY purchases. We think this gives Kingfisher a narrow economic moat.
For most of this year, the business has underperformed our expectations for its normalised growth algorithm, but catalysts in its two core markets in the form of lower stamp duty in the U.K. and capital gain tax relief in France should boost housing transactions and prices next year, two of the critical drivers of home improvement industry sales.
Procter & Gamble (PG)
Wide-moat Procter & Gamble strikes us as a particularly attractive investment idea, as the market’s confidence in the firm’s competitive edge and ability to drive accelerating sales growth to a mid-single-digit level over the next several years continues to wane. We stand by our contention that P&G's strategic endeavour to right-size its brand mix is a wise course that shows the firm aims to become a more nimble and responsive operator, without sacrificing its scale and negotiating leverage with retailers.
Further, we think this should enable P&G to increase its focus, from both a financial and personnel perspective, on the highest-return opportunities, which is critical in the intensely competitive environment in which it plays. However, we've long thought these initiatives would play out over the next few years rather than a couple of months, and as such, we look for it to drive profitable growth longer term, despite muted progress to date.
Royal Bank of Scotland (RBS)
Royal Bank of Scotland has been undervalued by investors because of the depth and complexity of its problems, but we think it will be increasingly in a position to demonstrate its underlying strength. We think investors should focus on three issues that we believe are not particularly well understood. First, we think RBS' legal liabilities will be large but manageable. Second, the attractive profitability of RBS' retail business has been obscured by large non-operating costs.
Third, the excess capital that RBS' transformation is likely to generate by 2018, which we estimate at £20 billion, is enough to repurchase three fourths of the government’s 72% stake at current prices.
