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Three Wide Moat Stocks on a Deep Discount

The stock market downturn has uncovered some investment opportunities with lasting competitive advantages.

Vikram Barhat 28 September, 2022 | 4:48AM
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3m factory

Skyrocketing stubbornly, inflation continues to remain well above the 2% target despite the U.S. Fed and BoC trying to tame it with large and frequent interest rate hikes. Add to the mix a worsening macro backdrop - market uncertainty, Ukraine-Russia war, and fears of inevitable recession - and we have investors scrambling for companies with fundamentals strong enough to ride out the rodeo.

Fortunately, the Morningstar coverage universe offers some wide-moat names that boast rock-solid fundamentals and represent all-weather protection for investors seeking solace. Undeniably, companies with a sustainable competitive advantage, or wide moat, have over the years tended to substantially outpace both the broader market and companies with limited or no competitive advantage.

For the past five years, the Morningstar Wide Moat Index has risen 73.18%, far outstripping the 51.20% returns for the Morningstar Narrow Moat Index and the 40.98% gain for the Morningstar No Moat Index, as of Sept 22.

The following names represent particularly attractive opportunities with the rare combination of a wide moat and a market price significantly below their fair value, offering the best of both worlds.

A multinational conglomerate, 3M (MMM) is known for its research and development laboratory. The firm operates four business segments: safety and industrial, transportation and electronics, healthcare, and consumer. Nearly half of its revenue comes from outside the Americas, with the safety and industrial segment constituting the bulk of sales.

At its core, 3M is a materials science company that leverages its science and technology across multiple product categories.

3M is a GDP-plus business, which means its revenue growth remains above the U.S. GDP growth rate. “We attribute 3M’s ability to remain ahead of GDP based on its suite of innovative products that are a byproduct of its research and development efforts,” says a Morningstar equity report, stressing that 3M’s “legion of engineers improves everyday products down to their basic chemistry.”

The company keeps its proprietary secrets closely guarded and rarely grants licenses, and its technology is difficult to replicate. “As a result, 3M typically charges a 10%-30% price premium relative to the market,” notes Morningstar equity analyst Joshua Aguilar.

Wide moat 3M’s ability to adapt its technology into multiple use cases also gives it economies of scope, which helps lower overall unit costs, leading to solid gross margins.

Further, 3M recently acquired workflow solutions provider MModal and medical device company Acelity to boost its presence in the stable and ever-growing healthcare market.

“The firm can increase its top line safely between 3% and 4% over the medium term thanks to broad-based strength, even as respirator sales now become a near-term headwind,” asserts Aguilar, who puts the stock’s fair value at US$183.

Adobe (ADBE) provides content creation, document management, and digital marketing and advertising software and services. Digital media accounts for nearly 75% of revenue. This segment comprises Creative Cloud (nearly 50% of revenue), and Document Cloud (about 10% of revenue).

Creative Cloud is composed of such iconic products as Photoshop, Premier, Illustrator, InDesign, After Effects, and Dreamweaver, among others. Document Cloud consists of the Acrobat family of products, including Scan and Sign.

Adobe is a dominant force in content creation software with its market-leading products Photoshop and Illustrator solutions, both now part of the broader subscription-based Creative Cloud.

“The company has added new products and features to the suite through organic development and bolt-on acquisitions to drive the most comprehensive portfolio of tools used in print, digital, and video content creation,” says a Morningstar equity report.

The undeniable benefits of software as a service (SaaS) offer significantly improved revenue visibility and the elimination of piracy for the company, and a much lower cost hurdle to overcome.

“Adobe benefits from the natural cross-selling opportunity from Creative Cloud to the business and operational aspects of marketing and advertising,” says Morningstar equity analyst Dan Romanoff, who pegs the stock’s fair value at US$450, implying an adjusted P/E multiple of 33 times, and a 4% free cash flow yield.

The firm’s Document Cloud, driven by legacy products Acrobat and PDF file format, is now a US$2.0 billion business, says Romanoff, noting that Adobe is attacking an addressable market greater than US$205 billion.

Blackbaud (BLKB) provides CRM, financial management, digital marketing, payment, and analytics solutions for nonprofit organizations, corporate charitable organizations, and institutions in the faith-based, healthcare, and educational areas. The company enables more than US$100 billion in donations annually across a customer base of over 40,000 customers in at least 50 countries.

Blackbaud is deeply entrenched in the social-good community and is expected to continue to grow its revenue as it transitions to a subscription model. “Such transitions tend to pressure near-term results, but we think the worst is behind the company and that results should naturally improve over the next couple of years,” says a Morningstar equity report.

The company experienced an oversized impact of the pandemic within the software space. However, as the world returns to normal, Blackbaud is well positioned to benefit.

Existing clients drive the bulk of revenue, which means the company’s business model transition will remain key over the next couple of years. That said, as a result of its thought leadership and strong portfolio, the company enjoys strong customer retention in the low to mid-90% area. “With much of the product work complete, the company is focusing on adding sales reps and driving revenue,” says Romanoff, who appraises the stock’s fair value to be US$70.

The company’s wide moat is underpinned by high customer switching costs and, to a lesser extent, intangible assets.

About 25% of charitable donations in 2020 were made on Blackbaud’s platform. Future growth could come from “both further penetration with additional products in larger clients, as well as the accumulation of new logos,” says Romanoff. 

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
3M Co124.64 USD-3.41Rating
Adobe Inc328.97 USD-1.59Rating
Blackbaud Inc58.15 USD-0.82Rating

About Author

Vikram Barhat

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

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