When buying a stock, investors own a piece of the underlying business. It’s important to understand the quality of the business. The best companies tend to exceed expectations and find investment opportunities that increase the intrinsic value of their business. Over time, these companies tend to be worth much more than they are today.
Morningstar analysts think having a stake in a high-quality company will put investors in a far better position than chasing market movements or the brief boom of a low-quality business. With that in mind, here is a group of rock-solid companies that are truly positioned to stand the test of time.
What Makes a ‘Best Company’?
One of the keys to finding the best long-term investments is buying good companies that can stay one step ahead of the competition. Legendary investor Warren Buffett originally coined the term “economic moat” to refer to a company’s ability to keep competitors at bay over time. Morningstar builds on this idea to rate companies based on their “moat,” or the strength and durability of their competitive edge.
We have compiled a list of the best companies to invest in under our analysts’ coverage that are available to Canadian investors. These companies have successfully carved out wide moats between them and their industry competitors, and we’re confident that they will produce returns that outweigh their costs for the next 20 years or more. In other words, these are good companies that will reliably be able to produce returns for investors over a long period, even as they invest in their growth.
The companies that make our list also have predictable cash flows (or predictable amounts of money going into and out of a company), so our analysts can more accurately estimate how much the businesses are worth. These companies also make smart decisions about how they manage and invest their money.
We aren’t advocating that you buy shares of each company on this list today. Even the greatest company can be a bad investment if investors overpay. The share prices of many companies on this list overestimate their real value, so it may not be the right time to buy. Still, we believe these companies are essential for any stock investor’s watchlist.
We’ve grouped the companies on this list according to the sectors of the economy in which they compete.
Financial-Services Companies
The financial-services sector includes banks, asset managers, financial research and data companies, credit services, investment brokerage firms, stock exchanges, and insurance companies. Just as the services they supply differ, the companies below fend off competition in distinct ways. The most common characteristic among them is that their customers face relatively high hurdles when they want to switch service providers.
Many companies in financial services are economically sensitive to interest rates, the level of the stock market, and the financial health of consumers and businesses.
Industrials Companies
Planes, trains, and heavy machinery: Companies in the industrials sector support and transport all things industry. The sector includes companies that produce machinery, handheld tools, and industrial products. It also includes aerospace and defense firms, as well as transportation services.
Many of the good companies in the industrials sector benefit from their incumbent position in their respective industries. It allows these businesses to develop brands and patents that give them their edge. Many further benefit from a cost advantage, operating in industries where infrastructure or regulation limitations make it expensive for new competitors to enter the market.
Best Companies to Own: Methodology
The companies on this list are covered by Morningstar Research Services’ equity analysts and have shares available to Canadian investors. This means that Morningstar equity analysts have calculated fair value estimates for the shares of the companies.
Within that coverage list, the best companies meet the following criteria:
- Wide Economic Moat. The Morningstar Economic Moat Rating summarizes the length of a company’s competitive advantages. An economic moat is a structural feature allowing a firm to generate excess profits over a long period. If Morningstar Research Services believes that excess returns will persist for 20 years or more, that company earns a wide moat rating.
- Standard or Exemplary Capital Allocation. The stock’s Morningstar Capital Allocation Rating is an assessment of the quality of management’s capital allocation, with particular emphasis on the firm’s balance sheet, investments, and shareholder distributions. Capital allocation is judged from an equity shareholder’s perspective, considering companies’ investment strategy and valuation, balance-sheet management, and dividend and share buyback policies on a forward-looking basis. A company can receive an Exemplary, Standard, or Poor Capital Allocation Rating.
- Low or Medium Fair Value Uncertainty. The fair value Morningstar Uncertainty Rating represents the predictability of a company’s future cash flows and, therefore, the level of certainty in the fair value estimate of that company. The Uncertainty Rating for a company can be Low, Medium, High, Very High, or Extreme. It captures a range of likely potential intrinsic values for a company based on the characteristics of the business underlying the stock, including such things as operating and financial leverage, sales sensitivity to the economy, product concentration, and other factors. The more predictable cash flows, the smaller the range of potential intrinsic values, the lower the uncertainty.
What Gives a Company an Economic Moat?
Companies with moats have one or more of the following characteristics:
- Network Effect. Lots of people are using the service, which then makes the service more valuable to the people who use it.
- Intangible Assets. Patents, brands, regulatory licenses, and other intangible assets can prevent competitors from duplicating a company’s products or allow the company to charge a significant price premium.
- Cost Advantage. Firms with a structural cost advantage can either undercut competitors on price while earning similar margins or charge market-level prices while earning relatively high margins.
- Switching Costs. When it would be too expensive or troublesome to stop using a company’s products, the company often has pricing power.
- Efficient Scale. When a niche market is effectively served by one or a small handful of companies, there is no room or incentive for potential competitors to enter the market.
