5 cheap wide-moat Canadian stocks

These stocks have fallen below our fair value estimates – and have a sustainable competitive advantage relative to their peers

Ruth Saldanha 16 March, 2020 | 8:00AM
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Clouds moat

Last week was another roller-coaster week for the markets – fueled by ongoing coronavirus concerns, the steep fall in oil prices and bearish market sentiment, the S&P TSX Composite Index plummeted, losing 10% over the week. U.S. markets did not fare much better, the Dow Jones Industrial Average officially slid into bear market territory on Wednesday, falling 20% below its early-year high. 

However, long-term investors don’t worry too much about volatility. As Morningstar.com’s director of content Susan Dziubinski says, “A market downturn can provide a chance to increase our positions in existing holdings or initiate new positions in stocks we’ve been eyeing.”

Won't make a difference in the long run
She also points out that Warren Buffett acknowledged that the coronavirus would have a near-term impact on companies that he owns, but he also noted that it likely won't make a difference when it comes to their 10- or 20-year outlooks. He added that if the market gives you an opportunity to buy something you like for far less than it was the day before, you're in luck.

This brings us to the fact that many Canadian companies in our coverage universe have now fallen into the four and five-star range this week--which means they're significantly undervalued by our measures.

However, this is not a call to buy these stocks, instead, it is a list of names with which to begin your research. When bargain hunting, be sure to consider company fundamentals and valuations--but don't overlook your risk tolerance and time horizon, too. Take for instance the ten cheapest names overall. 8 of the ten are either in extremely risky Cannabis stocks or in beaten-down energy. And if you think energy might be a good bet right now, remember that Dave Meats, Morningstar's director of research for energy and utilities, says that investors shouldn't rule out further weakening in these stocks.

"The resulting supply shock essentially coincides with a demand shock related to COVID-19, resulting in particularly steep price declines," he notes. "So the near-term outlook for energy companies is bleak, and it is likely that many of our fair value estimates will be revised lower as a result."

So then we looked at stocks that had an economic moat - We at Morningstar believe that when looking for stocks, you should look for a margin of safety, cheap valuation, and an economic moat. The Morningstar Economic Moat Rating represents a company's sustainable competitive advantage. A company with an economic moat can fend off competition and earn high returns on capital for many years to come.

So today, let’s look at five stocks that are cheap, but also have a ‘Wide’ economic moat. Here are the names: 

Name Morningstar Star Rating Economic Moat Moat Trend Fair Value
Enbridge Inc 5 Wide Stable 0.60
The Toronto-Dominion Bank 5 Wide Stable 0.63
Royal Bank of Canada 4 Wide Stable 0.71
Canadian National Railway Co 4 Wide Stable 0.82
Canadian Pacific Railway Ltd 4 Wide Stable 0.85

Morningstar Direct data as of March 12, 2020

We already discussed two of them – Enbridge and The Toronto-Dominion Bank earlier this week. Let’s look at the other three.

Royal Bank of Canada
With superior operating efficiency, leading share in the Canadian banking market, ‘moaty’ nonbank businesses, and the ability to primarily operate in the favourable Canadian banking environment, Morningstar analyst Eric Compton believes that Royal Bank of Canada is worthy of a wide moat rating.

“The bank has consistently operated with one of the best efficiency ratios in Canada, partially through superior operational execution, and partially due to the highest noninterest income proportion among the Canadian banks. The bank is also one of the two largest banks in Canada (along with Toronto Dominion) and has a dominant market share in many categories, including number-one or number-two share in all key retail banking products. It is also one of the dominant investment banks in Canada and a top-15 player worldwide. Combine all of these factors, along with explicit government subsidies on deposit insurance and mortgage insurance, as well as the implicit subsidy of being too big to fail domestically (all big six Canadian banks are labelled as domestic systemically important banks), and we believe an environment exists where excess returns for banks are almost certain to exist in Canada,” he says.

Canadian National Railway Co
Canadian National's wide economic moat is based on cost advantages and efficient scale. The Canadian National system is a unique three-coast, T-shaped network, spanning Canada from east to west and stretching from north to south in the Midwestern United States.

“CN's rights of way and installed track across the full width of Canada and top to bottom of the U.S. form a nearly impenetrable barrier to entry. We think there will be no new railroads built in North America, although line extensions by existing railroads (including restoring abandoned lines) may take place in select areas once the economy recovers,” says Morningstar equity analyst Matthew Young.

He points out that barriers to entry are powerful for railroads, but running a railroad requires massive reinvestment, which for CN amounts to annual capital expenditures of around 18%-20% of revenue. “While the rails don't outearn their cost of capital by much, our wide moat rating stems from our confidence that rails will leverage cost advantage and efficient scale competitive advantages to generate positive economic profits for shareholders' benefit with near certainty 10 years from now and more likely than not 20 years from now; by our methodology, this defines a wide economic moat,” he says.

Canadian Pacific Railway Ltd
Young believes that the heavy lifting is done in transforming Canadian Pacific from worst in class to tied for best (with Canadian National Railway). In early 2017, operations expert Keith Creel took the helm at CP, following his longtime mentor, legendary railroad leader Hunter Harrison. “While the cadence of change was breathtaking under Harrison as CEO and Creel as COO, we expect Creel to continue to guide CP on its margin improvement trajectory for several more years and to thoroughly infuse CP's culture with precision railroading excellence, such that it does not rely on having a key man running operations or the entire organization. We think Canadian National has been at that stage for years. CP is closing in on the best in class mid-50s operating ratio mark, and we have no qualms about Creel, who worked alongside Harrison for 20 years and led operations at both top Class I railroads, CN and CP,” he says.

 

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About Author

Ruth Saldanha

Ruth Saldanha  is Senior Editor at Morningstar.ca. Follow her on Twitter @KarishmaRuth.

 
 
 

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