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These wide-moat companies are rare value deals in bull market

As valuations rise, these stocks are among the few that offer both a margin of safety and a sustainable competitive advantage.

Vikram Barhat 15 February, 2017 | 6:00PM
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North American stock markets appear to have shaken off economic uncertainty in the immediate wake of the November 2016 U.S. presidential elections. Their relentless upward march to new record highs is an indication that the markets have given a big thumbs-up to Donald Trump who has now sits in the Oval Office as the 45th U.S. President.

Buoyed by his pro-growth policies, the Dow has jumped more than 10% since the election results; the S&P 500 index is up about 8%; and the Nasdaq Composite Index has advanced roughly 9.3% during the same period, as of January 25.

The unstinted climb of the markets, however, is making investors worried about stretched valuations, making it harder to find stocks that have healthy future growth potential yet are trading at a sizeable discount to their fair value, thus providing a margin of safety.

We scoured the vast universe of Morningstar's stock coverage for companies that have a wide economic moat rating -- whose competitive advantage will ward off competition for at least 20 years -- and whose stocks are among those trading at the steepest discount to their fair value estimates.

Bristol-Myers Squibb Company
Ticker BMY
Current yield 2.94%
Forward P/E 17.4
Price US$52.03
Fair value US$64
Data as of Feb. 13, 2017

 Bristol-Myers Squibb (BMY) discovers, develops and markets drugs for cardiovascular and infectious diseases, cancer and immune disorders. The firm's primary focus is immuno-oncology, where it is a leader in drug development. With strategic partnerships and acquisitions, Bristol-Myers has built a strong portfolio of drugs and a robust pipeline.

While it faces significant patent losses, the company's next generation of drugs provides a safety net that could plug the patent holes over the next decade. "More than half of Bristol's late-stage pipeline focuses on immunology and cancer--indications where the FDA aggressively approves drugs," says a Morningstar report. "In addition, these drugs tend to carry strong pricing power."

The drugmaker's sustainable competitive advantage, or wide moat, flows from a broad line-up of patent-protected drugs, an entrenched sales force and economies of scale. As well, its pipeline contains drugs that have the potential to develop into major blockbusters. "Bristol's PD-1 cancer drug Opdivo holds the potential to revolutionize cancer treatment and should develop into a multi-billion-dollar opportunity," asserts Morningstar sector director Damien Conover.

Moreover, Bristol has been aggressively repositioning itself to focus on its core pharmaceutical business. "The company has shed its diabetes business, medical imaging group, wound-care division and nutritional business in an effort to focus on the high-margin specialty drug group," says Conover, who estimates the stock to be worth US$64, and forecasts annual sales to grow at an average of 2% over the next 10 years.

Salesforce.com Inc.
Ticker CRM
Current yield -
Forward P/E 53.1
Price US$80.91
Fair value US$99
Data as of Feb. 13, 2017

 Salesforce.com (CRM) is a cloud computing company that provides software on demand. The firm operates in three clouds -- sales, service and applications -- each of which generates more than US$1 billion in annual revenue, the bulk of its sales (75%) coming from the Americas.

The company has solidified its dominant position in the pure-play software-as-a-service (SaaS) market with "several cloud products that address large enterprise markets, creating substantial switching costs for its customers," says a Morningstar report.

The software powerhouse benefits from customer stickiness as more than 75% of its clients deploy all three of its cloud services. "Enterprises will increasingly turn to cloud computing to eliminate costly IT infrastructure and maintenance costs," creating strong opportunities for growth in each of Salesforce's product segments, says Morningstar equity analyst Rodney Nelson.

The company's strong competitive advantage is rooted in a combination of "mission-critical applications, the ubiquity of its products in the enterprise, and increasingly valuable data generated by these applications, [which] yield substantial customer switching costs," says Nelson, who puts the stock's fair value at US$99, about 25% above its current price.

Salesforce, he adds, is also carving out an advantageous position in digital marketing and campaign management. The company's compound annual revenue growth rate is projected by Morningstar to be 14% over the next 10 years, led by service cloud and app cloud, and supported by continued penetration of the sales and service portions of the customer relationship management (CRM) market.

TransDigm Group Inc.
Ticker TDG
Current yield -
Forward P/E 18.1
Price US$252.21
Fair value US$305
Data as of Feb. 13, 2017

 TransDigm (TDG) manufactures aircraft components including electronic, fluid, power and mechanical motion control. It also supplies products used for cabin structures, lighting, laminates and pallets, among other applications. The company generates roughly 70% of sales from commercial customers such as airlines and aircraft manufacturers, and about 30% from defence customers.

"We expect the share of defence revenue to increase slightly over the coming years since recent acquisitions have been more defence-heavy," says a Morningstar report.

TransDigm's robust competitive edge is built on switching costs. "Its aerospace products meet Federal Aviation Administration certification requirements and must also pass a separate aircraft manufacturer qualification process," the report says. "Aftermarket sales, which account for over 75% of profitability, are particularly sticky."

The firm owns intangible assets in the form of intellectual property on its products, particularly in the aftermarket where this effectively blocks competitors. "High proprietary content makes it difficult for competitors to copy TransDigm's products or even service them, as they do not have access to the technical data," says Morningstar equity analyst, Chris Higgins. "The company's strategy explicitly seeks to reinforce its moat by maintaining a significant exposure to the aerospace and defence aftermarket, a large portfolio of proprietary products, and a sole-source position [where TransDigm is the only company available to perform the work] on most products."

TransDigm enjoys the highest margins of any company in Morningstar's aerospace coverage, translating into impressive returns on invested capital, says Higgins, who appraises the stock's worth to be US$305, and forecasts revenue to increase at an annual rate of 9.6% from fiscal 2017 to 2021, and an annual EBITDA growth rate of 9.5% over the same period.

Zimmer Biomet Holdings Inc.
Ticker ZBH
Current yield 0.82%
Forward P/E 12.5
Price US$117.75
Fair value US$130
Data as of Feb. 13, 2017

 Zimmer Biomet (ZBH) designs, manufactures and markets medical equipment including orthopedic and dental reconstructive implants, and surgical equipment for orthopedic surgery. The firm holds the leading share of the reconstructive market in the U.S., Europe and Japan.

Zimmer enjoys strong competitive advantage inherent in its status as "the undisputed king of hip and knee implants, by far," says a Morningstar report. "High switching costs and high-touch service keep the surgeons closely tied to their primary vendor, and the surgeons bring in enough profitable procedures to keep hospital administrators at bay."

Zimmer is well positioned to benefit as more boomers reach the age when knee replacement is common. "We expect favourable demographics, which include aging baby boomers and rising obesity, to fuel solid demand for large joint replacement that should offset price declines," says Morningstar equity analyst Debbie Wang.

The firm also benefits from the close relationship with orthopaedic surgeons and vendor loyalty, both of which help retain market share in orthopaedic implants. "As long as Zimmer can launch comparable technology within a few years of its rivals, it can remain in a strong competitive position," says Wang, who recently raised the stock's fair value from US$116 to US$130, prompted by favourable volume projections for large joint replacement.

Wang is optimistic about Zimmer's ongoing businesses, as she projects 5% and 3.5% average annual volume growth for knees and hips, respectively; annual revenue growth of 8% through 2020; and 10% growth in operating income during the same period.

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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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