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Four wide-moat stocks on sale

These companies have sustainable competitive advantage and are currently priced well below their fair value.

Vikram Barhat 28 March, 2018 | 5:00PM
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Investors are wading through a world of growing uncertainties. From President Donald Trump's trade policies to conflict in the Middle East, frequent flare ups between the U.S. and North Korea and rising interest rates, there is a veritable suite of macroeconomic shocks that are taking turns to roil equity markets around the world.

While market gyrations create new investing opportunities, they also tend to push skittish investors to the sidelines. It is in times like these that stock selection becomes a crucial art. However, finding the right stocks after a tsunami of sell-off takes more than just buying the dips, because not all stocks that appear cheap are great picks.

No doubt, valuation is a key part of stock selection, but those looking for sustained long-term growth through ups and downs of capital markets must find companies that have differentiated product offerings, a nimble business model and the ability to compete in a crowded market.

In an era of disruptive technologies and rapid product innovation, businesses that possess a wide economic moat, or sustainable competitive advantage that will help them ward off competition for at least 20 years, are the ones that will bring stability to your investment portfolio during periods of volatility, and predictable growth during good times.

Here are four formidable wide-moat names from the vast universe of Morningstar's equity coverage.

 

L Brands Inc.
Ticker: LB
Current yield: 6.40%
Forward P/E: 11.6
Price: US$37.86
Fair value: US$69
Value: 45.1% discount
Data as of March 26, 2018

 L Brands (LB) is a women's intimate apparel, personal care and beauty products retailer that owns popular brands including Victoria's Secret, Pink, Bath & Body Works and La Senza. The company generates the majority of its business in North America, with only about 3% of sales coming from international markets.

Victoria's Secret and Bath & Body Works, which account for over 90% of total sales, are both competitively differentiated and the source of the company's robust competitive advantage. "Victoria's Secret is the number-one millennial fashion brand worldwide on Facebook, Twitter and Instagram," says a Morningstar report, underscoring high consumer brand loyalty that picks quality and fit over price.

That it owns four of the top 20 fragrances in the U.S. is a reflection of its brand strength and high consumer loyalty. "The strong Victoria's Secret and Bath & Body Works brands can command a relatively sustainable, consistent pricing power," says Morningstar equity analyst Bridget Weishaar. "New entrants would be at a pricing disadvantage, given Victoria's Secret's scale advantages, the lower cost of marketing owing to word of mouth, and social media strength."

Near term, there are multiple catalysts for sales and margin performance, which include discontinued categories and new products. "Further, the company has a healthy long-run growth opportunity in China," says Weishaar, projecting 3% to 4% revenue growth in the next two years.

L Brands' 41% gross margin last year -- a metric reflecting brand strength -- points to significant cost advantages versus its competitors, notes Weishaar, who puts the stock's fair value at US$69 and asserts the current market price is "an attractive entry point."

 

Allergan PLC
Ticker: AGN
Current yield: 1.77%
Forward P/E: 10.2
Price: US$160.18
Fair value: US$263
Value: 39.1% discount
Data as of March 26, 2018

Best known for Botox,  Allergan (AGN) makes specialty pharmaceutical products in aesthetics, ophthalmology, women's health, gastrointestinal and central nervous system segments.

Allergan's diverse, industry-leading portfolio of defensible products, broad pipeline and future acquisitions underpin its healthy earnings growth. "Allergan has used acquisitions to transform into a major pharmaceutical contender," says a Morningstar report, which adds that the sale of its generics and distribution segments "deleveraged the balance sheet with ample cash [over US$20 billion] to initiate a dividend and pursue pipeline acquisitions."

Allergan's sustainable competitive advantage is built on branded assets like Botox and Restasis, projected by Morningstar to contribute nearly 20% and 9% of revenue, respectively. "With over US$2 billion in annual sales, Botox has historically been a critical ingredient of Allergan's wide moat," says Morningstar sector strategist Michael Waterhouse. In addition to Botox, which holds a 70% share of the global neurotoxin market, Allergan's facial fillers and breast implant franchises are regulated as devices, thereby facing limited competitive risks due to regulatory and marketing hurdles.

"Allergan's considerable scale in niche markets of ophthalmology and aesthetics offers a long runway for growth thanks to defensible products (especially Botox) and an attractive pipeline," says Waterhouse, whose US$263 fair value for the stock underscores a significant upside potential.

Despite the recent weakness in the stock, attributed to the threat of an affordable biosimilar version of Botox, and the FDA's decision to extend the review period for Allergan's uterine fibroid drug, Esmya, Waterhouse argues these items don't have a material bearing on his forecasts or wide moat rating, maintaining the stock is "considerably undervalued."

 

Baidu Inc. ADR
Ticker: BIDU
Current yield: -
Forward P/E: 25.0
Price: US$236.00
Fair value: US$322
Value: 26.7% discount
Data as of March 26, 2018

China's largest online search service,  Baidu (BIDU) holds nearly three-quarters of mobile traffic share in the search market. The technology-driven company, which generates 86% of its revenue from online marketing services, has been investing in artificial intelligence technology, including self-driving cars.

Baidu has been pivoting from a mobile-first to an artificial-intelligence-first company, taking on regional rivals  Alibaba (BABA) and  Tencent (TCEHY). As the tech giant's search revenue faces headwinds, its Netflix-like streaming service, iQiyi, has emerged as a key growth driver in recent years, says a Morningstar report.

Following the regional trend, "iQiyi's monetization model has been shifting from advertising to a mix of advertising and subscription," says the report. With 20 million paid subscribers, as of June 2016, iQiyi is an important advertising platform that reeled in CNY 17 billion in revenue in 2017, posting a 55% increase.

Baidu recently launched a US$2.4 billion initial public offering for iQiyi in a bid to bulk up its financial muscle and content offering.

Baidu's robust competitive advantage comes from its leadership position in the Chinese search market, which Google left in 2010, and of which it held 73.8% as of September 2017.

"The largest database of user behavior data in China, which Baidu's search engine has accumulated over two decades, is critical in generating the most relevant results for users, which leads to increased usage and more data, and in turn higher advertising efficiency," says Morningstar equity analyst Chelsey Tam, who pegs the stock's fair value at US$322 per ADR. "Baidu's advertisers are willing to pay higher prices for search ad purchase as [they] can reach the largest potential audience."

 

Microchip Technology Inc.
Ticker: MCHP
Current yield: 1.54%
Forward P/E: 16.1
Price: US$98.01
Fair value: US$112
Value: 12.5% discount
Data as of March 26, 2018

 Microchip (MCHP) makes microcontrollers (MCUs), which are semiconductors that act as the brains within a range of electronic devices.

"Microchip's historical strength has been the 8-bit MCU segment [making chips that] tend to be used in a wide range of simpler electronic products," preventing the chipmaker from being overly exposed to a single technology segment or customer, says a Morningstar report. The firm's position in more advanced 16- and 32-bit MCUs, though relatively weaker, has been gaining ground lately, while its analog chip business has been growing both organically and through bolt-on acquisitions.

Neither type of chip is capital intensive, and chips are picked for performance rather than price. "Chips have long product lives because switching to a competing MCU could involve redesigning the entire end product," says Morningstar sector director Brian Colello. "Thus, MCU and analog firms are able to maintain high margins and returns on invested capital."

Additionally, the firm's approximately US$10.15-billion acquisition of Microsemi will provide greater exposure to the communications, data centre and aerospace and defense end markets. The move prompted Colello to raise the stock's fair value to US$112 from US$97, calling the deal "highly accretive to the firm."

Stringent quality requirements placed on chipmakers by some markets, such as the automotive space, create a barrier to entry, as it would be difficult for a new entrant to achieve both a high level of quality and volume production.

Proprietary chip designs, manufacturing expertise and switching costs are some of the other factors that form Microchip's sustainable competitive advantage, says Colello, who believes the firm's 7% to 9% long-term organic revenue growth target is attainable.

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About Author

Vikram Barhat

Vikram Barhat  Vikram Barhat is a Toronto-based financial writer specializing in investing, stock markets, personal finance and other areas of the financial services industry. He also writes for CNBC, BBC, The Globe and Mail, and Toronto Star.

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