Morningstar's Best Stock Ideas

As the name suggests, purchasing a stock of a company makes you a partial owner of the business. That means that you own a portion of everything that the company has or does. This may take the form of tangible assets such as factories, equipment, real estate, cash and securities. Or intangible assets such as patents, trademarks, copyrights and brand names. As well as assets, buying a stock also means that you “own” a portion of any liabilities a company may have. This may take the form of debt and other obligations a company has, including payments to suppliers, wages and taxes.

At Morningstar, we take an owner-oriented approach to stock investing. What does that mean? When investors buy stocks, we don't think they're just trading tickers, short-term stock news events or stock market stories. Rather, they're buying partial ownership in companies. As such, we think it's important to understand a company's fundamentals before purchasing its stocks.

Owning a stock of a company that is traded on the share market is no different to setting up your own business. Small business owners don’t cavalierly sell their otherwise successful business because of one poor month of sales. They certainly wouldn’t sell their business if it grew significantly but slightly below the expectations. An owner’s mentality means taking a long-term view. Unfortunately, however, many things can conspire against even the most well informed investor.

Our approach to stock investing boils down to three basics: having an intimate knowledge of the company's sustainable competitive advantages, determining what its stocks are worth, and then only buying the stock when there's a significant margin of safety in doing so. Sign up for a FREE 4-week trial^ of Morningstar Investor to unlock qualitative research on more than 1600 companies plus data on over 46,000 global securities, including analyst ratings, fair value price and more. No credit card required.

If you want to be a successful long-term investor it doesn’t get much easier than simply buying stocks in great businesses and holding them for a long time. So, what should you watch out for in a stock? At Morningstar we believe a great business is one that has a long-term competitive advantage, which allows it to fend off competitors while investing capital at a high rate of return. The long-term competitive advantage of a business is called an economic moat. Just as moats were dug around medieval castles to keep enemies at bay, economic moats protect the high returns on capital enjoyed by the world’s best companies. A company with an economic moat is quite rare because any time a profitable product or service is developed other firms respond by trying to produce a similar version, or even improving on the original version. Some companies are able to withstand the relentless competition of the marketplace and these are the wealth-compounding machines that an investor wants to find and own.

We believe there are five major sources of competitive advantage, or economic moat:

1. Intangible assets: These can include brands, patents, or government licenses that explicitly keep competitors at bay. This can be seen in pharmaceutical companies with patent protection or with consumer brands that have long-standing and well-regarded brands.
2. Cost advantage: Firms that can provide goods and services at lower costs have significant advantages over rivals as they can either undercut their rivals on price or sell at the same price and earn a higher profit margin. Generally, moats based on cost advantage are due to economies of scale. Economies of scale is defined as the cost advantages that companies obtain due to the scale of their operations with the cost to produce a product or service going down as output increases.
3. Switching costs: Switching costs refer the inconveniences or expenses associated with a customer switching from one product to another. Banks can be good examples as it is time-consuming to switch bank accounts once you have set up direct deposits and payments.
4. Network effect: The network effect occurs when the value of a particular good or service increases as more people use the good or service. Social media sites are perhaps the best example as a low number of members provides less of a benefit to a user than a high number of members.
5. Efficient scale: Efficient scale applies to companies that serve limited markets where there are a small number of competitors. Potential competitors are discouraged from entering the market based on the small opportunity. An example can be a pharmaceutical company that produces drugs for diseases that only affect small patient populations.

Morningstar analysts assign a moat rating to select companies in our coverage universe. You can find the moat rating and a full description of the rationale for over 1,600 inside Morningstar Investor. Click here to get free access with a 4-week trial^.

There are countless ways to value a stock. At Morningstar we believe in fundamental equity analysis. A fundamental research approach means gaining a deep understanding of each investment. At its core, a fundamental investing approach means focusing on the future earnings of an investment and not its prospective price change. Our focus on fundamental research means we don’t fall victim to convincing stories to support the merits of an investment or get caught up chasing after popular stocks performing well recently.

We believe that there is both an art and a science to valuing stocks. An art in deeply understanding the company, the product, the customers and the competitive landscape, and a science in being able to marry those understandings with the financial statements. The output from this analysis is a fair value estimate of the stock. We don’t care what the stock market says the stock is worth. We care what the underlying company is worth because we think in the long term that will be reflected in the stock price. Ultimately, Morningstar analysts believe a company's intrinsic worth is linked to the future cash flows it can generate.

Our fair value estimates are our take on what we think a company's stocks are worth. We look beyond fleeting metrics, such as a company's recent earnings or any stock price momentum. Rather, we calculate fair value estimates based on how much cash we think a company will generate in the future. Our fair value uncertainty rating--depicted as low, medium, high, very high, or extreme--depicts the level of uncertainty around our fair values estimate, based on things like a company's sales predictability, operating and financial leverage, and exposure to contingent events.

Lastly, the Morningstar Rating for stocks indicates whether a stock is undervalued (4 or 5 stars), fairly valued (3 stars), or overvalued (1 and 2 stars) based on where a stock's market price is relative to our fair value estimate, adjusted for uncertainty. To unlock more or Morningstar's ratings on over 1,600 companies, click here to get free access to Morningstar Investor's stock reports with a 4-week trial^. No credit card required.