Lauren Solberg is a data journalist for Morningstar. She covers market trends, inflation, and other macroeconomic news.
The stocks of high-quality companies have gained twice the returns of the broader U.S. stock market this year so far.
Lucky for long-term investors, Morningstar analysts still see room for growth in several of these profitable, well-governed names, such as Adobe ADBE, Microsoft MSFT, and BlackRock BLK. All of these stocks score highly on Morningstar’s measures of quality.
“Quality” is one of several investment factors commonly known to drive returns for stocks and funds. The stocks of high-quality companies tend to have high profitability and strong balance sheets. Historically, Morningstar researchers say, higher-quality stocks perform better over time than less-profitable and more highly indebted counterparts. They also tend to protect against downturns and be less risky than lower-quality stocks.
The Morningstar US Quality Factor Index—a collection of U.S. stocks with high profitability and low debt/capital ratios—has risen 8.8% for the year through March 2. That’s nearly twice the gain of the Morningstar US Market Index, which rose 4.7% for the same period.
And right now, there are several stocks in the quality factor index with 4-star Morningstar Analyst Ratings, meaning they’re trading below their fair value estimates. The 10 undervalued stocks in our list also carry Morningstar Economic Moat Ratings of wide, indicating they have competitive advantages set to last more than 20 years into the future.
10 Undervalued, High-Quality Stocks With Wide Economic Moats
Here are the undervalued, high-quality stocks that passed our wide moat screen:
Best-Performing Quality Stocks
Within the quality index, the stocks with the highest one-year returns come from a wide variety of sectors including technology, healthcare, and basic materials.
Mid-cap American steel producer Steel Dynamics rose about 80% over the past year. Other midsize stocks including specialty insurance provider Arch Capital and manufacturing software provider Aspen Technology each gained about 50% for the trailing 12-month period.
Pharmaceutical stocks Regeneron and Vertex were among the leading contributors to the Morningstar Quality Index’s overall gains over the past year. Regeneron, with a 1.6% index weighting, gained 24.7% and Vertex—weighing 1.1% in the index—rose 29.5%.
A Deeper Look at the 10 Quality Stocks to Buy Now
For now, several stocks in the index are trading well below their Morningstar fair value estimates. There were 10 undervalued wide-moat stocks in the Morningstar US Quality Factor Index as of March 2, 2023.
Google parent company Alphabet was the most undervalued, trading at a 39% discount to its Morningstar analyst-assessed fair value estimate. The least undervalued on the list was CME Group, trading at a 14% discount to fair value.
Alphabet
- Ticker: GOOGL
- Fair Value Estimate: $154
- Stock Price: $92.00
“Alphabet dominates the online search market with 80%-plus global share for Google, via which it generates strong revenue growth and cash flow. We expect continuing growth in the firm’s cash flow, as we remain confident that Google will maintain its leadership in search. We foresee YouTube contributing more to the firm’s top and bottom lines, and we view investments of some of that cash in moonshots as attractive. Whether they will generate positive returns remains to be seen, but they do present significant upside.”
“We believe Alphabet holds significant intangible assets related to overall technological expertise in search algorithms and machine learning, as well as access to and accumulation of data that is deemed valuable to advertisers. We also believe that Google’s brand is a significant asset; ‘Google it’ has become eponymous with searching, and regardless of actual technological competency, the firm’s search engine is perceived as being the most advanced in the industry.”
—Ali Mogharabi, senior equity analyst
Teradyne
- Ticker: TER
- Stock Price: $102.05
- Morningstar Fair Value Estimate: $167
“Teradyne is a heavyweight supplier of automated test equipment for semiconductors, boasting market-leading capabilities that run the gamut of chips. It is one of two companies worldwide that can produce testers for the most cutting-edge semiconductors, thanks to robust engineering talent across hardware and software and a structural lead in organic investment. The firm is a vital partner to chipmakers across the industry and has an impressively strong relationship with Apple and Taiwan Semiconductor. Teradyne’s market leadership exhibits itself in industry-leading margins, strong returns on invested capital, and a top market share.”
“We assign Teradyne a wide economic moat rating based on a combination of intangible assets in semiconductor automated test equipment and switching costs created at chipmaking customers. We think Teradyne’s proficiency, which has led to a leading market share in ATE, will enable the firm to earn impressive returns on invested capital that will continue for the next 20 years.”
—William Kerwin, equity analyst
Veeva Systems
- Ticker: VEEV
- Stock Price: $173.56
- Morningstar Fair Value Estimate: $265
“Veeva is the leading provider of cloud-based software solutions tailored to the life sciences industry. It provides an ecosystem of products to address the operating challenges and regulatory requirements that companies in the space face. Instead of focusing on a general, one-size-fits-all system, Veeva has created platforms that are purely designed to serve one industry.”
“We assign Veeva a wide moat rating because we believe the firm’s high retention rate and its customers’ unlikeliness to move to a different product (switching costs) should continue to support economic profits for at least the next 20 years.”
—Keonhee Kim, equity analyst
Meta
- Ticker: META
- Stock Price: $174.53
- Morningstar Fair Value Estimate: $260
“Meta’s Facebook is the largest social network in the world, with nearly 3 billion monthly active users. The growth in users and user engagement, along with the valuable data that they generate, makes Meta’s platforms attractive to advertisers. The combination of these valuable assets and our expectation that advertisers will continue shift their spending online bodes well for the firm’s top-line growth and cash flow.”
“We assign Meta a wide moat rating based on network effects around its massive user base and intangible assets consisting of a vast collection of data that users have shared on its various sites and apps. Given its ability to profitably monetize its network via advertising, we think Meta will more likely than not generate excess returns on capital over the next 20 years.”
—Ali Mogharabi, senior equity analyst
Lam Research
- Ticker: LRCX
- Stock Price: $489.98
- Morningstar Fair Value Estimate: $620
“Lam Research is a major vendor of semiconductor fabrication tools. The firm is the leader in dry etch, a critical step in the chipmaking process where material is selectively removed. We believe Lam has a wide economic moat as a result of cost advantages and intangible assets related to equipment design. Lam’s leadership position creates scale advantages that fuel research and development spending at levels only Applied Materials and Tokyo Electron can match. At the end of 2021, Lam had an installed base of 75,000 units, up from 40,000 in 2015. This large installed base creates stickiness and offers Lam an intimate look into problems faced by chipmakers, providing valuable information it can use to implement solutions and additional capabilities in future tools.”
“We believe Lam Research has a wide economic moat, thanks to cost advantages and intangible assets. We view the scale and resources required to compete for the business of leading-edge manufacturers as major barriers to entry, with firms such as Lam boasting R&D cost advantages over smaller peers. We also believe that incumbent tool providers have intangible assets related to equipment design derived from service contracts and customer collaboration during process development and subsequent high-volume manufacturing. Taken together, these two sources of competitive advantage allow leading equipment firms to earn excess returns on invested capital over extended periods of time.”
—Abhinav Davuluri, equity strategist
Adobe
- Ticker: ADBE
- Stock Price: $333.50
- Morningstar Fair Value Estimate: $425
“Adobe has come to dominate in content creation software with its iconic Photoshop and Illustrator solutions, both now part of the broader 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. The December 2021 launch of Adobe Express helps further broaden the company’s funnel, as it incorporates popular features of the full Creative Cloud, but comes in lower-cost and free versions. We think the company is properly focusing on bringing new users under Adobe’s umbrella and believe that converting these users will become more important over time.”
“For Adobe overall we assign a wide moat, arising from switching costs and network effects. Based on the company’s segments, we believe digital media has a wide moat from switching costs and network effects, digital experience has a narrow moat arising from switching costs, and publishing has a narrow moat from switching costs.”
—Dan Romanoff, senior equity analyst
Microsoft
- Ticker: MSFT
- Stock Price: $251.11
- Morningstar Fair Value Estimate: $310
“Since taking over as CEO in 2014, Satya Nadella has reinvented Microsoft into a cloud leader such that it has become one of two public cloud providers that can deliver a wide variety of PaaS/IaaS solutions at scale. Additionally, Microsoft embraced the open-source movement and has largely transitioned from a traditional perpetual license model to a subscription model. The company has also enjoyed great success in upselling users on higher priced Office 365 versions, notably to include advanced telephony features. These factors have combined to drive a more focused company that offers impressive revenue growth with high and expanding margins.”
“For Microsoft overall we assign a wide moat rating arising from switching costs, network effects, and cost advantages. We believe that Microsoft’s different segments and products benefit from different moat sources.”
—Dan Romanoff, senior equity analyst
Pfizer
- Ticker: PFE
- Stock Price: $40.62
- Morningstar Fair Value Estimate: $48
“Pfizer’s size establishes one of the largest economies of scale in the pharmaceutical industry. In a business where drug development needs a lot of shots on goal to be successful, Pfizer has the financial resources and the established research power to support the development of more new drugs. Also, after many years of struggling to bring out important new drugs, Pfizer is now launching several potential blockbusters in cancer, heart disease, and immunology.”
“Patents, economies of scale, and a powerful distribution network support Pfizer’s wide moat. Pfizer’s patent-protected drugs carry strong pricing power that enables the firm to generate returns on invested capital in excess of its cost of capital. Pfizer’s operating structure allows for cost-cutting following patent losses to reduce the margin pressure from lost high-margin drug sales. Overall, Pfizer’s established product line creates the enormous cash flows needed to fund the average $800 million in development costs per new drug. The company’s powerful distribution network sets up the company as a strong partner for smaller drug companies that lack Pfizer’s resources.”
—Damien Conover, equity sector director
BlackRock
- Ticker: BLK
- Stock Price: $685.91
- Morningstar Fair Value Estimate: $810
“Unlike most of its peers, BlackRock, which is at its core a passive investment shop, has been able to offset many of the secular headwinds facing the traditional asset managers with a few tailwinds of its own. In an environment where retail-advised and institutional clients are expected to seek out providers of passive products, as well as active asset managers that have greater scale, established brands, solid long-term performance, and reasonable fees, we believe that BlackRock is well-positioned.”
“We believe that the asset-management business is conducive to the creation of economic moats, with switching costs and intangible assets being the most durable sources of competitive advantage for firms operating in the industry. Driven by ongoing investments in retail distribution, enhanced product/vehicles and technology, the company should continue to have a better-than-average switching cost profile compared with its traditional asset-management peers.”
—Greggory Warren, equity sector strategist
CME Group
- Ticker: CME
- Stock Price: $186.50
- Morningstar Fair Value Estimate: $215
“CME’s equity index futures business has produced impressive performance as a result, with multiple years of double-digit revenue growth. We do, however, expect revenue from CME’s equity derivatives to partially normalize over time as equity market volatility returns to normal levels and retail interest in equity markets fades. That said, the rise of $0 commissions, changes in investor behavior, and the availability of futures on retail brokerage platforms will provide a permanent tailwind to CME’s equity business.”
“CME Group has achieved a wide Morningstar Economic Moat Rating as a result of its position as a leading venue for trading U.S. futures contracts. More than 95% of U.S. interest-rate futures trade on CME’s exchange, the company has exclusive licenses to issue futures contracts on the S&P 500, Russell 2000, and Nasdaq indexes, and the company is the dominant venue for trading WTI oil futures. We see the company’s strong competitive advantages allowing the firm to earn excess returns on capital for the foreseeable future.”
—Michael Miller, equity analyst
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