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Six ASX stocks poised to outperform over the long term

Morningstar's equity strategist Allen Good: To find stocks that are most likely to outperform, the key is to combine high quality with attractive price.

Sarah Dowling | Morningstar Australasia 

 

Just 17 companies on the ASX boast a coveted “wide moat” Morningstar rating – that is, a competitive advantage that should keep rivals at bay for the next two decades or so. Things like brand loyalty, the network effect, cost advantages, and economies of scale.

But moats alone won’t result in outperformance - these monopoly-like companies weren’t immune to the volatility of 2022. That’s where valuation comes in.

“To find stocks that are most likely to outperform, the key is to combine high quality with attractive price,” says Morningstar equity strategist Allen Good.

 

A winning combination

Even the greatest company can be a bad investment if you overpay, Good says.

“If you buy at the top, it’ll be almost impossible to earn return on your investment as a stock investor—no matter how high-quality the company.”

Still, companies with a wide moat have a better chance of outperforming over a long period of time.

“Economic moats add an element of quality to a company. Cash flow is expected to compound at a higher rate for a longer period of time, risk of bankruptcy is lower, and R&D investment is more productive,” he says.

“But it’s the combination of quality and valuation which ultimately impacts the long-term stock price.”

 

Undervalued opportunities on the ASX

Of the 17 companies with a wide economic moat, six are trading at a price considered to be a double-digit discount to their fair value.

 

1. Fineos (FCL)

The Technology sector index underperformed the broader Australia index in the past year but has outperformed in recent months.

Insurance software company Fineos is currently trading at a 50% discount to where Morningstar analysts see fair value.

Morningstar technology analyst Roy van Keulen says after a tough year, the key theme in the technology sector for 2023 will be a renewed focus on fiscal discipline.

“We believe Fineos (FCL) can reduce non-essential growth expenditure, increase the number of product holdings per customer and gain market share,” he says.

Fineos has a wide economic moat built on switching costs and few direct competitors. Its suite of products perform mission critical functions for insurance carriers. As a result, customers demonstrate substantial risk aversion to changing software providers.

 

2. InvoCare (IVC)

Death is one of few certainties in life, supporting steady demand for funeral provider InvoCare's services. 

In fact, the company ranks on the global equity best ideas list – available to Morningstar Investor subscribers.

Trading at a 26% discount to Morningstar’s fair value estimate, wide-moat InvoCare is an attractive buying opportunity according to equity analyst Angus Hewitt.

“With a wide economic moat underpinned by well-known, highly respected brands and cost advantages over the long tail of smaller competitors in a highly fragmented market, InvoCare will continue to dominate the Australia deathcare industry, in our view,” Hewitt says.

 

3. James Hardie (JHX)

Rapidly rising interest rates have dented demand for housing both here and in the US, which has hit James Hardie’s share price.

But Morningstar equity analyst Trevor Huynh says the negative sentiment is “overstated” and undervalues James Hardie’s “quality and long-term potential to generate an average estimated return on invested capital, or ROIC, of 17% per year over the next decade”.

“We allocate James Hardie a wide economic moat rating as a result of an intangible asset and scale-based manufacturing cost advantages in fiber cement building products,” Huynh says.

The company is trading at a 26% discount to where Morningstar sees fair value.

 

4. ANZ (ANZ)

In a fourth quarter update on Australian banks, Morningstar equity analyst Nathan Zaia named ANZ and Westpac as his top picks in the sector.

ANZ is trading at a 20% discount to its fair value estimate.

“We suspect shares do not factor in that rising cash rates will help the banks margins improve, and added headcount and investments to digitise processes, should make the wide-moat bank competitive again,” Zaia says.

ANZ has been assigned a wide moat based on maintainable cost advantages and switching costs.

 

5. Westpac (WBC)

Westpac is not only Zaia’s top pick in the sector, but also places on Morningstar’s global equity best ideas list.

“Wide-moat Westpac trades at a meaningful discount to our $29 fair value estimate,” Zaia says.

“Share price weakness followed disappointing guidance and operating expenses and lost market share in home loans, but we think both will improve over time,” he says.

Westpac continues to sit on surplus capital, is well provisioned, and pays generous fully franked dividends.”

 

6. Brambles (BXB)

Shares in wide-moat Brambles are trading at a 16% discount to Morningstar’s valuation.

But Huynh says investors underappreciate the “substantial medium- and long-term secular growth opportunities” available to the global pallet-pooling leader.

Brambles is experiencing a combination of lumber, labor, and transport inflation and pallet cycle time disruptions,” he says.

“We expect margins to recover longer term as contractual indexation supports the pass-through of higher costs to customers and pallet velocity increases in the network.”

Brambles’ wide moat status is underpinned by its operating scale.

 

REA joins ‘wide moat’ club

Last week, real estate giant REA Group (REA) was upgraded from narrow- to wide-moat status, which equity analyst Roy van Keulen says reflects its ability to defend its competitive lead over narrow-moat Domain (DHG).

But that doesn’t mean it’s a buy right now.

Currently, REA is trading at a 24% premium to Morningstar’s valuation.

“We expect Domain and REA Group to face significant challenges in the near term, as they navigate significant volatility in the Australian housing market,” van Keulen says.

“We estimate that residential transactions were around a third above trend levels during fiscal 2021 and 2022. With the normalisation of interest rates, we expect a return to trend, which implies around a 20% decline in listings by fiscal 2024.”

 

 

 

Sarah Dowling is editorial manager for Morningstar Australia. Analysis as at 23 January 2023. This information has been provided by Firstlinks, a publication of Morningstar Australasia (ABN: 95 090 665 544, AFSL 240892), for WealthHub Securities Ltd ABN 83 089 718 249 AFSL No. 230704 (WealthHub Securities, we), a Market Participant under the ASIC Market Integrity Rules and a wholly owned subsidiary of National Australia Bank Limited ABN 12 004 044 937 AFSL 230686 (NAB). Whilst all reasonable care has been taken by WealthHub Securities in reviewing this material, this content does not represent the view or opinions of WealthHub Securities. Any statements as to past performance do not represent future performance. Any advice contained in the Information has been prepared by WealthHub Securities without taking into account your objectives, financial situation or needs. Before acting on any such advice, we recommend that you consider whether it is appropriate for your circumstances. 


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