Some of the strongest companies out there, with the largest economic moats, tend to have well-deserved price premiums on the stock. There are different types of value investors out there - those that seek to buy decent or troubled companies that appear to be very undervalued, and those that seek to buy excellent and sturdy companies at a reasonable price.
Most of us mix a bit of both in our portfolios - we have some outstanding choices that trade for a bit of a premium, and some less-than-stellar companies with fair fundamentals that we feel are trading below their real value. The former is what we would be wise to base our core holdings on, assuming we can acquire them at a price we consider reasonable.
Quantitative models for determining a fair stock price are valuable, but adding a reasonable premium onto a fair share price is more of an art than a science. Investors are willing to pay up for a company that has such a strong economic position over its rivals. After all, if there is a generic company out there with all of the same numbers and metrics as Coca Cola (KO), but isn't Coca Cola and doesn't have their long-term advantages, then of course we'd rather buy Coca Cola.
Realizing that risk-adjusted returns are more important than simply potential for returns, we are willing to pay a premium for a company that has an extremely powerful economic advantage over their competitors. As value investors, we want that premium to be as small as possible to maximize risk-adjusted returns.
Great companies stand the test of time, require less portfolio trading and maintenance, are able to survive dramatic economic recessions, and typically provide decades of growing passive income and overall substantial shareholder return. So presented below are six companies, some larger than others, that I believe have a very strong economic advantage, but that trade at valuations that are not particularly ideal. In other words, these are companies to add to a watch list and consider buying after deeper analysis on moments of stock weakness.
The Procter & Gamble Company (PG)
Procter and Gamble is a $180 billion consumer products company, with 43 brands that each have more than $500 million in annual sales (with 23 of which having more than $1 billion in sales). The company has a moderately strong balance sheet, with a strong debt/equity ratio and a high interest coverage ratio, but substantial goodwill. This giant has set goals for high single digit or low double digit EPS growth over the long term, along with the 3+% dividend yield it currently offers. PG has grown its dividend for 55 consecutive years.
Price to Earnings: 17.0
Five-Year EPS Growth: 6.5%
Dividend Yield: 3.24%
LT Debt/Equity: 0.32
Interest Coverage Ratio: 18
Economic Moat: PG has scale, a large distribution network, brand recognition, international exposure, and is among the top players in its markets.
Colgate-Palmolive Company (CL)
Colgate Palmolive is a nimbler version of Procter and Gamble, with a greater percentage of international exposure. The company, which has paid uninterrupted dividends since 1895, has a considerable market share of tooth paste, manual tooth brushes, and other oral care, and also competes among the top players for consumer soap products. The company is more focused on key product areas than competitors like Procter and Gamble.
A noteworthy aspect of CL is that approximately 3/4ths of their sales come from countries outside of the US, which is higher than even most other international US blue-chips. A downside is that they have more debt than I consider ideal, but on the other hand, their debt carries a low interest rate and has resulted in a very high interest coverage ratio.
Price to Earnings: 17.8
Five-Year EPS Growth: 12%
Dividend Yield: 2.72%
LT Debt/Equity: 1.30
Interest Coverage Ratio: 53
Economic Moat: CL has scale, brand recognition, noteworthy international exposure, and is more focused than some larger competitors.
Compass Minerals International (CMP)
Compass Minerals is lesser known than the other names on the list, but the moat is larger than one would expect. The company produces salt products and fertilizer, with the largest business being the salt deicing market. The company owns some of the largest salt mines in the world, including the world's largest underground salt mine in Goderich, Canada. In addition, their largest mine is located right on the Great Lakes, which gives them easy access to water transportation.
For a cheap commodity product like salt, transportation costs are a huge factor in determining price, and the lowest price results in a deal with governments and other end-users. The combination of the scale of their mining operations and the geographic proximity to water and rail access gives the company an economic moat that competitors cannot reproduce. Apart from a substitute for rock salt when it comes to deicing, there isn't much that any competitor could do to slow down this company.
A downside, apart from the rich valuation, is that the company has a fair bit of debt. The risks of this company are associated mainly with the weather rather than with the economy. The EPS growth is shown for six years rather than five, because five years ago the company had a particularly low EPS result and it would unrealistically boost the calculation. The six or four year calculations showcase truer pictures of what occurred.
Price to Earnings: 19.3
Six-Year EPS Growth: 19%
Dividend Yield: 2.11%
LT Debt/Equity: 1.19
Interest Coverage Ratio: 9.5
Economic Moat: CMP has the largest salt mines, in attractive geographic locations for transport, that gives them fundamental price advantages in a commodity product over competitors. In addition, their large deicing salt business offers a product that is absolutely necessary to be purchased in the geographic regions where they operate, assuming typical weather conditions over a long period.
McDonald's Corporation (MCD)
McDonald's has been selling hamburgers and other meals for decades, consistently increasing dividends and expanding worldwide. The company brings in substantially more revenue than their rivals, giving them advantages of scale. The strong economic advantage of McDonald's can partially be seen over its competitors by comparing net profit margins: 20% for McDonald's, 10% for Yum Brands (YUM), and 0% for Wendy's/Arby's.
The company is decentralized, as it is significantly franchisee-operated, which means the business is highly scalable and gives McDonald's the ability to expand nearly without limit worldwide. The company is also shareholder friendly, with strong dividend increases and share repurchases.
Price to Earnings: 17.1
Five-Year EPS Growth: 17%
Dividend Yield: 3.02%
LT Debt/Equity: 0.73
Interest Coverage Ratio: 17
Economic Moat: MCD has brand recognition, high industry margins, ability to quickly change and customize food options, and is the top player in the industry.
Costco Wholesale Corporation (COST)
Costco sells a variety of products in a warehouse format at very low prices, large quantities, and limited offerings, and utilizes membership fees. They have been able to grow in the face of larger rivals by accepting low margins to compete on price terms and by streamlining their product offerings to the basics. The company is known for its ethical treatment of employees compared to competitors like Wal-Mart (WMT), and has shown strong success in its international expansion, which is still in its early stages.
While Wal-Mart is potentially the value play, Costco is potentially the longer-term investment that is better respected in almost every way. The company is streamlined, favoring organic growth over acquisitions. This policy, combined with prudent and conservative management, has resulted in a pristine balance sheet, with very low debt, no substantial goodwill, and a very high interest coverage ratio. The valuation, however, is currently prohibitive in my opinion, but the company deserves a mild premium and investors might do well to keep the company on their watch lists.
Price to Earnings: 24.5
Five-Year EPS Growth: 5.8%
Dividend Yield: 1.22%
LT Debt/Equity: 0.10
Interest Coverage Ratio: 21
Economic Moat: COST has scale, a strong membership community from which they derive most of their income, the strongest balance sheet on this list, and growing and successful international expansion.
The Coca-Cola Company (KO)
Coca Cola is the epitome of a large moat company that always trades for a premium. The company has been in business for 125 years and offers 3,500 products in 200 countries or territories. 1.7 billion servings of Coca Cola products (soda, juices, waters, teas, and other drinks) are consumed every day. By sticking specifically with beverages, the company has kept the net margins quite high, and management has also shown discipline in keeping the balance sheet strong.
Consumers in high-population countries like China, India, Pakistan, Nigeria, and Indonesia consume considerably fewer product servings per capita from Coca Cola than do their more heavily saturated developed markets, which shows the company has considerable room for continued expansion. For EPS growth shown below, the 2004-2009 period is used for calculation rather than the 2005-2010 period because the company had a one time EPS boost in 2010 due to acquisition related events, and this period shown is more conservative and realistic.
Price to Earnings: approximately 20 (due to one-time events, it is 12.5)
Five-Year EPS Growth: 8%
Dividend Yield: 2.90%
LT Debt/Equity: 0.40
Interest Coverage Ratio: 11
Economic Moat: KO has scale, brand recognition, noteworthy international exposure, high margins, an enormous multi-corporation distribution system, a strong balance sheet, and is the top worldwide beverage company.