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7 Wide-Moat Stocks of Tomorrow

Many families have their go-to recipes for pound cake. Some call for almond extract or lemon juice–or rum–to provide extra flavor. Others say to top the cake with a glaze or powdered sugar. Still others (like our family’s recipe) keep it simple, with no topping and just a hint of vanilla.

No matter the extras, all pound cake recipes share four key ingredients: butter, eggs, flour, and sugar.

Similarly, companies poised to become industry leaders–in our parlance, those seeking wide-moat status–share some of the same ingredients. For instance, they have a competitive advantage (or two)–maybe that’s high switching costs, powerful brands, or a significant cost advantage. In other words, they’ve begun to carve out an economic moat. But they aren’t resting on those competitive advantages. Instead, these companies continue to dig a moat by exploiting trends in their industries. And they’re run by smart capital allocators who make shrewd investment decisions to keep the company competitive.

Today’s screen isolates companies with those qualities. We’re looking at narrow-moat companies with positive moat trends that also earn Exemplary marks for stewardship. While there’s no guarantee that these companies will eventually establish wide moats, they certainly have the right ingredients to do so.

Perhaps not surprisingly, most of these well-run companies are fairly or overvalued according to our measures. But they’re all topnotch watchlist candidates.

Air Products & Chemicals (APD)
Morningstar Rating (as of 11/14/19): 3 stars

One of the leading industrial gas suppliers globally, Air Products benefits from operating in an industry with a favorable cost structure, argues analyst Krzysztof Smalec. Uninterrupted product is key, and customers are often willing to pay a premium and sign long-term contracts to ensure that business runs smoothly. And those long-term contracts and high switching costs contribute to the company’s narrow moat.

Moreover, we think its moat is growing, says Smalec. Management’s increasing emphasis on on-site business leads to longer average customer contract terms, which enhances switching costs. Moreover, the firm has seen a remarkable improvement in margins since CEO Seifi Ghasemi took the helm in 2014.

Speaking of management, we rate Air Products’ team as exemplary. Ghasemi’s five-point plan to transform the company has led to margin expansion, divestiture of noncore segments, reduced debt, and improved earnings per share growth.

“We believe Ghasemi management has been proactive about pursuing growth opportunities and appropriately managing its portfolio,” concludes Smalec. 

AutoZone (AZO)
Morningstar Rating (as of 11/14/19): 2 stars

The aftermarket part retail industry in which AutoZone participates lends itself to the development of strong brands, suggests analyst Zain Akbari. When it comes to fixing their cars, consumers care less about price and more about part availability, convenience, and in-store services. As the leading DIY aftermarket parts retailer, AutoZone has built a narrow economic moat, thanks to the strength of its intangible brand asset and the cost advantages of its distribution infrastructure, he says.

Moreover, AutoZone’s moat trend is positive. The company has invested in rapid part ability, reports Akbari. And that investment should bolster the company’s brand strength relative to smaller regional players that can’t afford to make such investments. As a result, AutoZone faces a significant share growth opportunity, he argues: Availability and convenience will lure customers away from competitors.

Lastly, we rate AutoZone’s management as exemplary. The company has consistently generated industry-leading adjusted returns on capital, and practices a measured “test-and-assess” approach to expansion and investment.

“A prudent, deliberate approach to costly new inventory management initiatives, such as higher-frequency store replenishment and mega hub stores, has limited execution risk and ensured that the company continues to grow economically,” concludes Akbari.

Booking Holdings (BKNG)
Morningstar Rating (as of 11/14/19): 4 stars

The world’s largest online travel agency by revenue, Booking Holdings owes its narrow moat to a sustainable network effect, says senior equity analyst Dan Wasiolek. Booking has established a leading network of hotel properties and other services, which drives its increasing user base.

Moreover, we expect Booking Holdings’ global online travel agency leadership position to expand over the next decade, he adds, driven by a superior position in China, continued leadership in Europe, and an expanding presence in vacation rentals, restaurant bookings, and attractions, all of which are backed by leading marketing and technology scale. We’ve awarded the company a positive moat trend.

Booking is led by strong managers of capital. The firm accelerated stock repurchases when the stock was trading at steep discounts to our fair value estimate, and has invested in acquisitions like OpenTable and Kayak that strengthened its network advantage. Moreover, Wasiolek recounts that the company primarily consisted of just in the United States in the mid-2000s, and acquired for only $135 million in 2005.

“With our stand-alone valuation of near $100 billion, the acquisition is one of the most successful acquisitions of a foreign company by an American company in the past 50 years,” he asserts.

Idexx Laboratories (IDXX)
Morningstar Rating (as of 11/14/19): 1 star

Senior analyst Debbie Wang calls Idexx (which manufactures and distributes diagnostic products and services for pets and livestock) the “top dog” in animal diagnostics. The firm has successfully increased its scale and reach, thereby carving out a narrow moat. That moat is driven by several sources, including its ability to consistently innovate in diagnostic tests and switching costs across many of its products, she says.

Moreover, we think Idexx’s moat is improving. Trends are on its side. Pet ownership continues to grow, confirms Wang, and pet owners have shown a greater willingness to spend more on their animals: Spending on pet products and services has tripled since 1994. Plus, the market is split between smaller pure-play companies and pharmaceutical giants. Wang suggests that the large pharma competitors with bigger opportunities elsewhere are unlikely to push harder into this market–and the smaller pure plays could be appealing acquisition targets for Idexx.

Moreover, we think management has made wise capital-allocation decisions thus far. It has a fine record on acquisitions, notes Wang, and has been willing to pass on deals where there isn’t an opportunity to enhance value.

“We remain confident that new CEO Jay Mazelsky and current CFO Brian McKeon can handily execute on the long-standing strategies that have served Idexx well,” concludes Wang.

Illumina (ILMN)
Morningstar Rating (as of 11/14/19): 3 stars

This diagnostics and research firm provides tools and services to analyze genetic material with life science and clinical lab applications. Intangible assets and switching costs underpin Illumina’s narrow economic moat rating, explains senior analyst Julie Utterback. In particular, patents prevent competitors from copying its technology for a long while.

Moreover, we think Illumina’s moat is strengthening. The firm continues to innovate, which strengthens its intangible assets as related to patent protection. In addition, the company continues to make select acquisitions that expand its differentiated technology, says Utterback.

We think the company is managed by wily capital allocators and therefore award the company an exemplary stewardship rating.

“In our view, Illumina’s innovation has been supported by high research and development spending combined with prescient and well-timed acquisitions, and those activities have upheld impressive growth and returns on invested capital,” concludes Utterback.

Nvidia (NVDA)
Morningstar Rating (as of 11/14/19): 2 stars

Nvidia has established its narrow moat via cost advantages and intangible assets related to the design of graphics processing units, explains sector strategist Abhinav Davuluri. The firm is the leader in discrete graphics, having taken market share away from longtime rival Advanced Micro Devices. We think the market has significant barriers to entry in the form of advanced intellectual property, he stresses, and the firm’s significant R&D budget should allow it to continue to innovate and stoke demand for its high-margin chips.

We assign Nvidia a positive moat trend, as the company expands opportunities for its GPU technology beyond PCs. That’s making Nvidia’s intellectual property around GPU design increasingly valuable, says Davuluri, strengthening the company’s cost advantage. Moreover, Nvidia stands to benefit from its first mover advantage in adjacent markets, including AI and automotive, which are currently in the early stages.

The company is run by shrewd managers. Though the firm has periodically made acquisitions in the past, deals have been smaller than the ones made by rivals such as Intel. Moreover, management has been willing to adapt when a particular venture isn’t performing as planned, emphasizes Davuluri.

“Nvidia’s management team has shown a willingness to invest in new opportunities in the past several years outside the firm’s core PC graphics processor business,” he says. “As a result, Nvidia has become a key player in the artificial intelligence accelerator market with its Tesla GPUs. The firm has also sought to drive the push toward autonomous driving with its Drive PX platform.”

O’Reilly Automotive (ORLY)
Morningstar Rating (as of 11/14/19): 2 stars

Like its competitor AutoZone, O’Reilly Automotive has carved out a narrow economic moat based on the cost advantages of its distribution infrastructure and the strength of its brand intangible assets, observes Akbari. Smaller peers can’t match O’Reilly’s inventory flexibility: O’Reilly can adeptly shift inventory to meet customer demand.

O’Reilly’s moat trend is positive, as it’s ideally suited to capitalize on industry conditions favoring scaled retailers, he notes. Its cost advantage should strengthen as the industry consolidates behind efficient, larger players that can easily provide rapid parts delivery. And as the company’s fixed costs are spread across an increasing sales base, the firm should be able to invest margin profits in brand building and efficiency improvements, Akbari adds.

Finally, O’Reilly’s management has been adept at allocating capital, thereby transforming the company from a regional player into a top national chain.

“Management has done well to leverage the company’s size to drive returns and capitalize on the firm’s ability to provide more consistent and rapid part availability relative to smaller and independent peers,” says Akbari. “The benefits of the firm’s broad store and distribution network, as well as management’s operational prowess, have pushed returns on invested capital higher over the last five years.”

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