3 Wide Moat Stocks

Finding stocks with a sustainable competitive advantage over peers, known as a wide moat, is key to successful investing. These stocks have a wide moat and pay income

Emma Wall 28 July, 2014 | 8:12AM
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Emma Wall: Hello, and welcome to Morningstar. I'm Emma Wall and here with me today to give his three stock picks is Nick Clay, manager of the Newton Global Higher Income Fund.

Hello, Nick.

Nick Clay: Hello.

Wall: So we're very big on moats here at Morningstar and I know you've got three wide moat names for us, who also provide an income. What's your first stock?

Clay: So, I mean, if we take a couple of examples. So, one which has already started to come through and succeed in its investment is Microsoft (MSFT), we bought that in the portfolio now over 12 months ago, it was being valued at the time, when we were buying it, on a double-digit free cash flow yield, which is, in effect the market telling you that the company has stopped growing, you should shut it down and just run it for cash and walk away with the cash, which we thought was a tad extreme, for Microsoft.

We thought it could grow again. Everybody thought at that time Apple (AAPL) was going to take over the world and Microsoft was one of the big victims of that, we obviously thought that was rubbish, and it is proving the case today as we look at the latest results that just came out. It's the fastest-growing cloud, the new way of computing these days in the commercial sector. It has two times the size of capacity for cloud for commerce than Amazon (AMZN) does, five times the size of Google (GOOG), who is by far the fastest-growing and will be the biggest operator.

That is a sign of a company, with straight, really good strong dominance in its marketplace. It generates margins, which are 40% in its enterprise part of its business and we think that's very protected, very well sustainable, and will repeat as it has repeated for ad infinitum since Microsoft was developed, and therefore the cash that comes off that can come back to shareholders and that's very much what the latest management are about, returning that cash to shareholders now. So, we find that very attractive.

Another example of that, is a company called Sysco (SYY) with an S in the U.S. which distributes food to everybody who eats food outdoors in the U.S. 45% of all the food in the U.S. is consumed outside, and Sysco is by far in a way the dominant distributor of food to all those operators, and now it is trying to acquire US Foods, which would take it to being the dominant number one player, five to six times larger than the second player in its marketplace.

So, again, this is a scale of business. The more food you can pump down the distribution channel, the better it is for your margins and our operating dynamics. So, the margins at Sysco are already industry-leading and they will become ever more industry leading. On top of that, it gives them the cash flow that they generate in the business to invest in their technology. So they're putting in an SAP system, which just further increases the moat around their company, and yet because it's deemed boring. It's not very exciting, it doesn't grow rapidly because eating outside is fairly stable business. It's not valued as such on a high multiple. So again, we're buying on a good free cash flow yield, paying out a good dividend yield, distributes its capital effectively and properly. Exactly the kind of company, we want at the moment in the portfolio.

Wall: Do you have a third stock example?

Clay: So, the third stock, which is one which is even sort of further down the production line. We think, a stock, sort of moving through the production line. Microsoft's sort of getting to the end where it's really firing. Sysco's in the middle. Then, we have another example, which is Orkla (ORK), which is, no one's probably even heard of Orkla. Orkla is a Norwegian/Scandinavian food branded consumer business, but it's a conglomerate as well.

So, it has some other stuff attached to it, which it's now trying to divest, stuff that is completely unrelated, an aluminum business. So, it's getting rid all of that stuff, which is very good in terms of focusing on returns, because of that too, it's able to now focus back on the core of its business, which is its core consumer brands, which it hasn't really done. It dominates its markets. It's quite a local flavors type, herring et cetera, so it has local dominance in its brands, but it hasn't really invested in them properly.

So, despite its strong market position, its margins are poor compared to a peer group, it makes about 15% margin on its core brands, a peer group with similar dominance in its marketplace like Marmite or Branston Pickle or something, they make 20% to 25% margins. So, there's plenty of scope to improve the profitability, because it's local and in a niche market, it doesn't attract lots of other people to compete with them.

So, it's about self-help. The management themselves can do something about improving their profitability, simplify the business, divest the stuff which they really shouldn't have been doing in the first place, aluminum which they are now doing, and again the latest set of results, which came are showing that those trends are now starting to come into place, taking out cost of the business et cetera, that's exactly what we want to see from the management and that's very much at the starting process of that investment story.

Wall: Nick, thank you very much.

Clay: Thank you very much.

Wall: This is Emma Wall for Morningstar. Thank you for watching.

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.

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Emma Wall  is former Senior International Editor for Morningstar