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Joshua Peach | Morningstar Australia
Investors are always on the hunt for quality stocks trading at a cheap price but distinguishing a company with a tangible edge over its peers can prove difficult.
To help, Morningstar assigns what’s called an Economic Moat Rating to companies that hold a sustainable competitive advantage expected to last over the long term.
A company with competitive advantages that are expected to last more than 20 years is designated a wide moat, while the advantages held by narrow-moat companies are expected to last for at least 10 years.
Morningstar has identified five company characteristics that could contribute to a moat:
But it appears cheap ASX stocks with narrow- or wide-moat ratings are becoming harder to find.
The price to fair value ratio (P/FV), which tracks whether a stock is trading above or below its Morningstar’s fair value estimate, for the average ASX moat stock in Morningstar’s coverage universe has drifted into overvalued territory since the start of the year.
This compares to non-moat stocks, which are still on average trading at a discount to their Morningstar’s fair value estimate.
To help identify what moat-holding companies are still trading at attractive prices, we’ve identified 10 stocks with a narrow- or wide-moat rating that are trading below their fair value estimate.
Vertically integrated heavy-haul rail freight company, Aurizon Holdings operates the largest coal rail track network in Australia.
Morningstar analyst Adrian Atkins says the narrow-moat company is trading at a significant discount to Morningstar’s fair value estimate of $4.70 and offers a generous fiscal 2024 dividend yield of more than 6%, mostly franked.
“The coal-exposed businesses are relatively stable, while growth should come from the smaller bulk division.”
Atkins says the company’s narrow moat designation is derived from its cost advantages and efficient scale.
“The core rail-haulage and tail network businesses hold significant cost advantages over road transport for bulk commodities, particularly coal.”
“Additionally, the limited market size and high capital costs from a new entrant act as formidable barriers to entry.”
Shares in financial services firm Perpetual were pulled down earlier this year by a global rout in the global finance sector.
Despite the firm’s fair value estimate falling from $35.50 to $33.00 earlier this year, analyst Shaun Ler says the outlook for the company remains strong.
“Ultimately, we think both the private wealth and corporate trust segments can better withstand the threat of competition, are subject to less fee pressure, and can generate more predictable earnings growth relative to its funds management operations.”
Australian property owner, manager, investor, and developer, Dexus Property Group controls around 25% of the Sydney premium office market.
Despite a pandemic-related hit to the group’s office portfolio, Morningstar analyst Alexander Prineas says the group’s recovery is underway.
“Dexus' office portfolio looks to be near the lows, with lockdowns in the rear-view mirror, and tighter financial conditions likely to curtail office supply from elevated levels in 2021 and 2022,” he says.
“We expect higher interest rates to depress office valuations somewhat, but our valuation is well above Dexus’ security price.”
Prineas says the group’s narrow-moat rating rests on high switching costs for Dexus’s wholesale funds management clients looking to exit contracts, as well as its strong position in a tight market.
A financial services company, Pinnacle was upgraded to a four-star, undervalued rating in early March, following a drop in the group’s share price.
Ler says narrow-moat Pinnacle is an attractive investment proposition.
“In our view, the market underestimates Pinnacle's growing asset class diversity, which provides optionality to investors and helps attract/retain assets through market cycles.”
Ler says the group’s narrow moat rating relies on the intangible asset of its brand and switching cost advantages.
“To investors, it is a ‘go-to’ destination for high-performing boutiques that has optimal capacity to deliver outperformance.”
Trading as “fairly valued” in early February, Charter Hall Group has jumped into five-star, undervalued territory in recent months, propelled by a 25% plunge in its share price.
Despite the fall, Prineas says the narrow-moat property fund manager has meaningful growth ahead of it.
“The group has a strong track record, in terms of fund performance, and the list of institutional investors it has been able to attract, from within and outside Australia.”
In terms of its narrow-moat rating, Prineas points to the group’s funds management business.
“Switching costs make it unlikely Charter Hall’s customer base would make widespread redemptions in a short period.”
The number-three mobile and number-two broadband player in the Australian telecommunications market, TPG Telecom is trading at a significant discount to its $7.40 fair value estimate.
Analyst Brian Han says, among Australian telecoms, TPG screens as the most attractive.
“We see clear catalysts for earnings recovery on several fronts,” he says.
“Recovery from COVID-19 effects, benefits from a more rational mobile market, and synergies from the recent Vodafone merger will be the key drivers, augmented by growth from fixed wireless and the corporate division.”
Integrated energy company AGL is one of the few dominant players—along with Origin and Energy Australia—in Australia’s electricity sectors.
A drop in the energy provider’s share price following its half year report in February has since been offset by a steep 25% jump in the last month.
”Operating conditions are improving for narrow-moat-rated AGL Energy and we think the shares should improve from here to reflect the underlying fundamental value we see,” Atkins says.
According to Atkins, AGL’s dominant place in the nation’s energy sector is underpinned by low-cost thermal generation capacity—which is also the source of its narrow-moat rating.
“It is extremely difficult to build a maintainable competitive advantage in the electricity and gas retailing sector.”
“Barriers to entry are low, and participants pay the same wholesale market price for the electricity they sell. However, low-cost electricity generators and gas producers can achieve an economic moat via low-cost production, which AGL has via its low-cost coal-fired generation plants.”
A report from short-seller Hindenburg Research wiped more than 20% of Block Inc’s share price in late March.
In the weeks since, the multinational technology conglomerate founded by Jack Dorsey has largely recovered to be up 2.5% on the year to date, but analyst Brett Horn says the company remains in undervalued territory.
“Narrow moat Block continued to show its ability to generate strong top-line growth in the fourth quarter, but historically the company has struggled to turn this growth into better profitability,” he says.
“We believe the scalability of the business model should allow for some margin improvement without overly constraining growth. On this front, management seems to recognize the need for more discipline,”
“While this shift has likely been at least in part due to market pressure, we see it as a potential positive going forward.”
Square’s narrow-moat rating is derived from its payment platform, which Horn says reaches and retains merchants effectively.
“Square has seen dramatic growth over the years and while it has not been consistently profitable, we think the company’s position in its niche is solidified and that it is nearing the point where it can generate attractive returns over time.“
SkyCity Entertainment operates casinos, restaurants and bars in New Zealand and Adelaide, and is trading at a 35% discount to its fair value estimate.
Shares in the company still have yet to fully recover following a 60% drop at the onset of the pandemic.
But despite the drop, analyst Angus Hewitt says the outlook for the operator is positive and bolstered by its long-dated and exclusive licenses—which underpin its narrow economic moat.
“We expect SkyCity to deliver strong earnings growth over the next decade.“
“In addition to licensed exclusivity, the substantial up-front capital investment requirements and relatively small size of the addressable market act as significant deterrents for any aspiring new entrants,” he adds.
Insurance software developer Fineos trades at close to half their fair value estimate and Ler says the market is underestimating the potential revenue upside and the increasing stickiness of Fineos' insurer customers.
“Revenue growth is currently soft and the market is punishing Fineos heavily. However, we think this is temporary, reflecting a move to cloud-based software, which brings the promise of a more valuable recurring revenue stream longer-term,” he says.
One of the few undervalued stocks with a wide-moat rating in Morningstar’s coverage universe, Fineos’ competitive advantages are its switching costs and sticky customers.
“Its comprehensive product suite performs mission critical functions for life, accident, and health carriers.”
“This customer cohort also demonstrates substantial risk aversion to changing software providers due to the importance of running a seamless, uninterrupted insurance business.”
Joshua Peach is a reporter for Morningstar Australia. Analysis as at 2 May 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.