If you're in the first half of your career and you're investing for retirement, you're investing for the long run – 20, 30 years or more.
That daunting time frame means it can be hard to pick individual stocks for a retirement portfolio. After all, which companies have the staying power to deliver returns for decades to come? The answers may lie in the strength of their competitive advantages – if they have erected barriers that will keep potential rivals from eating away their sales and profits.
Competitive strength is, of course, a matter of opinion. The investment research firm Morningstar, however, has placed the analysis of these competitive barriers at the core of its advice. Borrowing the term "moat" from billionaire investor Warren Buffett, Morningstar assigns the companies it covers an "economic moat rating," ranging from none to narrow to wide. And it says whether it thinks the competitive moat is getting bigger or smaller.
The competitive moats can be built on the economic concept of network effects, where the company's value to customers becomes greater as more customers use the product. (Facebook is a perfect example.) Others gain competitive advantages from intellectual property such as patents, their pricing power, or exceptional cost advantages or efficiencies.
Investors can couple Morningstar's moat evaluations with the firm's star ratings to find strong companies that are trading at a potential discount to their long-term worth. When a stock is trading at a steep discount to Morningstar's estimate of its fair value, it gets the top five-star rating. When the market price greatly exceeds the fair value, a stock can get tagged with just one or two stars.
Fair value, too, is subjective: Morningstar takes a long-term view, particularly in commodity prices. That's meant that a number of energy, mining and other resources companies currently have four- or five-star ratings.
Potash Corp. of Saskatchewan Inc. was the only Canadian wide-moat company with a five-star rating, at least until it announced its weak 2015 results and 2016 guidance and dividend cut on Thursday. Morningstar reduced its rating to four stars.
Why is the rating still high? Morningstar analyst Jeffrey Stafford notes Potash Corp. has some of the lowest production costs in the industry, and the "greenfield" costs of competitors opening new mines are "staggering." Morningstar's long-term price forecast for potash is $260 (U.S.) a tonne, which is not terribly higher than current levels and means no huge rebound is required for Potash shares to gain. But Mr. Stafford says he's keeping an eye on the weak Canadian dollar, which is making things more expensive for the company. Morningstar also assigns an "uncertainty" rating for companies and Potash Corp.'s is "very high."
Three of Canada's big banks – Royal Bank, Toronto-Dominion and Bank of Nova Scotia – get four-star, wide-moat ratings from Morningstar. All Canadian banks are entrenched thanks to foreign-ownership restrictions, but, Morningstar says, the three wide-moat banks have cost and scale advantages that narrow-moat rivals Canadian Imperial Bank of Commerce and Bank of Montreal do not. (Morningstar's continued concerns about Canadian housing prices prompt "high" uncertainty ratings for the three banks.)
B.C.-based Ritchie Bros. Auctioneers Inc., the world's largest seller of used farm and industrial equipment, also rates wide-moat status thanks to its network effects.
"As sellers and buyers increase in number at its live, unreserved auctions, the value to each participant increases," Morningstar analyst Kwame Webb said. It has a global chain of physical auction sites and it's successfully made the transition to the digital era, Mr. Webb says, as 50 per cent of its bids come in online. Morningstar gives Ritchie Bros. four stars.
Pipeline company Enbridge Inc. also garners wide-moat and four-star ratings. The moat rating, analyst Stephen Simko says, comes from the regulation of its assets, its ability to lock out competing pipelines, its significant growth opportunities and Morningstar's belief it will continue to develop projects that achieve high returns on capital.
Morningstar rates both Ritchie Bros. and Enbridge with just "medium" uncertainty, making them arguably the best combination of risk and current value of any of the Canadian wide-moat companies.
Two other Canadian companies get wide-moat ratings but are rated at three stars: Canadian Pacific Railway Ltd. and Canadian National Railway Co. Morningstar recently reduced its expectations for volume on the two carriers and updated its exchange-rate expectations, which lower its financial estimates for CP and CN.
What's on the other end of the spectrum – Canada's no-moat companies? Most gold miners, such as Barrick Gold Corp. and Teck Resources Ltd.; energy companies in the exploration and production space, such as Canadian Natural Resources Ltd. and TransAlta Corp.; the two big insurers, Manulife Financial Corp. and Sun Life Financial Inc.; and others such as BlackBerry Ltd., Gildan Activewear Inc. and auto-parts maker Magna International Inc.
Gildan, as an example, competes in a capital-intensive industry, and has the scale to have achieved more than 70 per cent of the U.S. "printwear" market. Offsetting that, though, is Morningstar's belief that the printwear industry is commoditized and multiple competitors give Gildan little pricing power.
Morningstar assigns "moat ratings" to assess companies' competitive strengths. It assigns star ratings based on the stock's current value. Here are the only 13 stocks that have both a "wide moat" and a five-star rating as of Jan. 28, 2016.