High-Quality Firms Getting Left in the Dust

But there has also been a considerable spread between lower-quality firms and high-quality companies with competitive advantages. Our team of equity analysts assign an economic moat rating to every company they cover. Businesses that we think will be able to fend off the competition for years and consistently earn returns on invested capital above their cost of capital earn wide moats. Those that can't fend off competitors are rated no-moat. Narrow moat companies fall somewhere in the middle.

Since the S&P's bottom and the end of July, firms with wide moats have seen a 4.81% total return, narrow moat firms are up 16.6%, while no moat companies are up 26.1%. So has this outperformance been justified? We think not. No-moat companies were not trading at significantly lower discounts to our fair value estimates versus wide- or narrow-moat firms at the market bottom. We thought our entire stock coverage universe was about 40% undervalued before the rally.

Given the no-moats' relative outperformance since the bottom, it isn't surprising that our analysts now think that as a whole no-moat firms are about 15% overvalued. Wide moats in aggregate look much more attractively priced--about 15% undervalued.

So does this mean investors should short all no-moat stocks and buy all wide moats? Absolutely not. There are still plenty of firms with little competitive advantage that are attractively priced, and there are some wide moat firms that don't look cheap. You still need to evaluate each stock on a company-by-company basis. Still, this aggregate data does tell you that there are likely a lot of values in wide-moat stocks, and that might be a good jumping off point for your stock research.

We ran a screen for cheap, wide-moat stocks using the  Premium Stock Screener; here are three stocks that passed. You can run this screen yourself by  clicking here.

 Monsanto Company
| Fair Value Uncertainty: Medium
From the  Analyst Report: Monsanto is a fierce competitor that continues to dominate a market that it essentially created more than a decade ago. Through its ongoing commitment to research and development and assertive capital allocation, the company has positioned itself to increase shareholder value over the long haul.

Monsanto will continue to invest heavily in its R&D pipeline, leveraging its existing intellectual capital--and increasingly partnering with other research organizations--in order to expand its product portfolio. The firm is also committed to replicating its successes in North America in its key overseas markets, especially Brazil, Argentina, and India.

 Apollo Group
| Fair Value Uncertainty: Medium
From the  Analyst Report: Apollo Group is a leader in for-profit education. Adding to its associate degree class, while not without risk, should bode well for growth.

With the largest scale in the industry, efficient operations, price-inelastic customers, and corporate- and government-aided financing, Apollo has a wide economic moat, in our opinion. Focusing on working adults allows Apollo to eliminate dorms, food services, sports, and health care from its universities. This helps the firm run a more economically efficient school than its not-for-profit rivals. However, government-aided loan limits are typically set based on the tuition pricing of higher-cost traditional schools. These financial-aid limits allow the lower-cost-structured Apollo to provide educational services at prices similar to traditional schools. Along with financial aid, corporate tuition assistance helps keep students price-inelastic, as the up-front out-of-pocket costs are low. With price-insensitive customers, tuition rates typically grow above the rate of inflation.

 Applied Materials
| Fair Value Uncertainty: Medium
From the  Analyst Report: Applied Materials is the behemoth of the semiconductor equipment industry, with its unmatched scale and broad product portfolio. The firm has steadily been establishing its solar equipment business, which we think could turn into a key growth driver for Applied. However, a severe cyclical slowdown in the chip equipment market has been hampering the firm.

Applied is one of the more profitable semiconductor equipment firms. Although returns on invested capital fluctuated between negative 6% and 46% over the previous industry cycle, they averaged 15%, outstanding for a semiconductor equipment firm.

Note: A correction was made to this article since original publication. Please click here for details.