Jason Stipp: I’m Jason Stipp for Morningstar and welcome to The Friday Five.
Through Dec. 22, wide-moat stocks have done better than the S&P 500, and a few of them have done really well.
Here to talk about five of those outperformers is Morningstar markets editor Jeremy Glaser.
Jeremy, thanks for being here.
Jeremy Glaser: You’re welcome, Jason.
Stipp: Wide-moat stocks have outpaced the S&P so far this year. Why do you think that is?
Glaser: It hasn’t been a dramatic outperformance, but I think it can be partially explained by a flight to quality. Investors who have looked at some troubling headlines or are worried about overall market valuations or what’s happening in the global economy, might see these wide-moat stocks that have more stable cash flows, that are more predictable, as a safer place to put their money than more-speculative names.
Stipp: Health care had a lot of outperformers; there was a lot of M&A in health care. Wide-moat Allergan and Actavis were among some of those top performers.
Glaser: They were actually the two top performers of wide moats this year, and really it was M&A that was driving that. Allergan will be acquired by Actavis after a bit of a bidding war. That brought Allergan stock up, but it also brought Actavis up quite a bit.
We think this runup in Actavis actually is well substantiated. We have raised our moat rating from narrow to wide on the company. We think that as a combined entity, it has much stronger competitive advantages. We also raised our fair value estimate substantially. So even after that big runup in Actavis, we still think that shares are in 5-star territory and could be compelling.
This was just one of many health-care M&A deals this year. This was a big story throughout 2014, as companies potentially were looking to do tax inversion deals. They realized there could be some substantial tax savings through M&As. Or they were looking for scale. Sometimes it’s a bit cyclical in health care, but right now scale is seen as something that’s a real positive, so firms are trying to build that, and I think that it’s a trend that we may not have seen the end of yet.
Stipp: Over in the tech sector, Facebook had a really good year, up 45% so far.
Glaser: It was a big year for Facebook, and it was really driven by mobile.
One of the question marks on Facebook at the IPO was, will they be able to translate the success they’ve had on desktop over to mobile? And they’ve really answered that they can. They have a lot of mobile users now who are using native apps; they are able to serve ads to them and are getting good rates on those ads, and that’s something that investors have cheered.
This has been a story among a lot of tech and media companies. Are they able to make this transition from a desktop world into one that is more driven by apps, more driven by mobile, more driven by the cloud? Will they be able to manage this transition, or are they going to be left behind? The answer to that question has been driving a lot of the returns of these firms over the last year.
Rick Summer, our Facebook analyst, does think that shares look a little bit pricey right now, but he does say that given how much Facebook is investing in its future and in long-term growth, there is a chance that you could have a few quarters that don’t look so great–maybe the stock could sell off. There might be an opportunity for a better entry point for investors sometime in the near future.
Stipp: You call wide-moat Berkshire Hathaway a bit of a “quiet giant” in 2014, and perhaps maybe even doing a little better than Buffett expected?
Glaser: Berkshire stock had a good year. It doubled the return of the S&P 500, and that was driven by a couple of factors. You wouldn’t really expect a company as big and as diversified as Berkshire Hathaway to beat the market by that much, but I think investors did see that Buffett is able to do some deals. You look at Duracell Batteries. You look at his move into the auto dealership space. None of these are going to be game-changers for what Berkshire looks like, but it’s a sign that they still are able to get M&A done.
I think Buffett also continued to lay the groundwork for what the company is going to look like when he’s gone. You saw continued emphasis of the Berkshire brand over the Buffett brand. The auto dealerships are going to be rebranded. You look at the energy business that was rebranded. You see these moves as a way that they are trying to make people see that Berkshire is still going to have a lot of these advantages after he’s gone.
He sold some of his legacy equity holdings, allowed his investment lieutenants to take over more of that portfolio, and they are doing very well. I think that really made people feel good about the future of the firm over the long haul.
Stipp: Home improvement retailer Lowe’s started the year off slow but has really picked up here.
Glaser: It was a tough beginning of the year for Lowe’s, driven by two big factors–one being that the weather was just dreadful. It’s easy to forget that it was just a year ago that we had the polar vortex, and a lot of people just were not shopping for anything, particularly home improvement items. And also the housing market was pretty stagnant, and no one really felt the need or the desire to invest in their home, or that they were moving and needed to do so.
But that changed in the second half of the year. As the weather got better and people felt a little bit more confident, they were out there spending, and Lowe’s really saw their results get much better and also their stock performance improved quite markedly.
I think this is part of the big story about what happened to housing in 2014–it remained a middling category. It did not take off in ways that many people had hoped it would. But there is still some hope that housing will start to see a real turnaround in 2015. Bob Johnson, our director of economic analysis, points to the fact that credit standards are getting a little bit easier, that rates remain very low, that affordability remains pretty good in most markets, that we could see housing data start to get better. And potentially the fact that people are feeling more confident, as we are seeing at Lowe’s, is a sign that housing could be a driver for next year.
Stipp: 3M’s wide moat was really working well for it this year but investors have noticed.
Glaser: 3M had a solid year, solid quarters of results, and like you said, it was really their economic moat that was driving it. They were able to grow the business faster than some of their underlying industries, faster than industrial production in their industrial space, which is a sign that their brands and their products and their competitive advantages are allowing them to potentially take some market share here, to continue to grow.
But this is not something that has been a secret or that was hidden from the market, and the shares were bid up to the point where they have become quite overvalued right now, in 1-star territory.
I think this is a good example of how companies can be great businesses and can be doing well, but aren’t great investments if they are too expensive. Particularly now, given where we are with valuations, the median stock in all of our coverage universe is about 3% overvalued, and for wide moats, it’s 4% overvalued. You have to be very careful that not only are you buying a high-quality business that you are going to be able to hold for years, that’s going to compound for years, and is going to be able to compound earnings for years, but you are also buying it at a reasonable price, at a discount to fair value estimate or [at least] at the fair value estimate, and that’s really the key to long-term success.
Stipp: Great insights on wide-moat outperformers, Jeremy. Next week we’ll check in with you on some wide-moat laggards. Thanks for joining me today.
Glaser: Thanks, Jason.
Stipp: For Morningstar I am Jason Stipp. Thanks for watching.