It was a rough year for some of Australia’s biggest companies as covid a toll and low rates inflated asset prices. For the year 2020 only two of Morningstar's 11 wide moat stocks posted positive returns. At the end of the year Australia’s top stocks were in general back to square one, with the benchmark S&P ASX 200 posting a return of -0.36 per cent. The top performer among the 11 wide moat stocks was Wesfarmers (ASX: WES), which posted a return of 27 per cent. It was streets ahead of the other stocks on the list. Second place went to Commonwealth Bank (ASX: CBA), which posted a return of almost 9 per cent while the ASX exchange itself (ASX: ASX) recorded about -1 per cent. Westpac (ASX: WBC) posted the lowest return of -16 per cent. Funeral home operator InvoCare (ASX: IVC) and Auckland International Airport (ASX: AIA) posted similar returns of about -12 per cent as restrictions on gatherings and of course travel bit. For 2020, the median return for the Morningstar 11 was -6.71 per cent. On an average basis, the 11 trailed the index by 3 per cent.

Morningstar wide moat stocks v ASX 200 benchmark XJO

Source: Morningstar Direct

Snapshot of a tough year

The wide moat stocks didn’t escape when the pandemic slammed into markets in late February, causing a historic sell-off. That said, however, it’s crucial to keep in mind that a wide moat stock implies a 20-year advantage, and this is a mere snapshot in what has been a historically bad year for many sectors and companies. And near-zero interest rates have drawn investors to the equity market, which has in turn inflated asset prices. Morningstar banking analyst Nathan Zaia said the underperformance of some banking stocks was to be expected. “It’s not too surprising that bank share prices underperformed the market, an economic recession hits bank profits harder than most sectors, with the potential for loan losses to overwhelm provisions, erode profits, and force equity raisings,” Zaia said. “Fiscal and monetary stimulus, and action by banking regulators and the banks, has prevented the worst-case scenario from playing out though, which is seeing the market begin to reprice the banks. “Banking is a cyclical game; we don’t think the share price underperformance owes to the competitive position weakening, more just the near-term earnings headwinds.” The competitive advantages of the major banks were not materially affected by the pandemic, said Zaia, adding that investors can expect good returns. “COVID meant lower profits and dividends in the short-term, and even in the medium-term as cash rates will now be lower (and for longer) than the pre-COVID outlook. But longer-term, the banks sticky retail deposits and operating scale are advantages which will see them generate good returns on shareholder equity again over time.”

Wesfarmers shines

Covid-19 was a boon for Wesfarmers, which owns Kmart, hardware chain Bunnings and Officeworks. Quarantine measures and travel restrictions caused people to spend more on at-home office supplies and on home improvement. In the September quarter, sales growth in hardware was close to four times the 10-year average rate, according to the Australian Bureau of statistics. Bunnings’ total sales rose by 25 per cent in the four months to October 2020, five times higher than full-year sales growth of 5 per cent in pre-COVID-19 impacted fiscal 2019. But while covid boosted consumer spending habits, Morningstar director of equity research Johannes Faul argues these changes are mostly transitory and there will be a return to the long-term sustainable sales trend. Wesfarmers is overvalued by 40 per cent, according to Faul’s valuation. “Our thesis implies a challenging trading period lies ahead for Wesfarmers’ retailing businesses near-term—which we estimate to account for 87 per cent of operating profits in fiscal 2021,” Faul says. “Although the exact timing of a full reopening of the Australian economy is uncertain, we expect an unwinding of the current favourable sales momentum to occur with the deployment of vaccines in the second half of fiscal 2021.”

Contrast to 2019

It was a stark contrast to last year, in which the median return of the wide moat stocks was 27 per cent versus 21 per cent for the benchmark. Last year, the top performers were the ASX, which posted a return of 35.6 per cent; hearing implant maker Cochlear, which boasted a return of 34.6 per cent and toll road operator Transurban (ASX: TCL), which returned 33.6 per cent. Wesfarmers and InvoCare both returned 30 per cent. The Morningstar eleven is an exclusive club. To gain entry companies must have a competitive advantage of 20 years. They can do that by establishing one or several of the following characteristics. By either having a strong brand; a cost advantage; a product that is good enough to dissuade customers from changing brands and thereby incur the pain of "switching costs"; a network effect, whereby an increase in the users of a product or service results in a corresponding increase in mutual benefits for both old and new users; and efficient scale, which occurs when a market is effectively served by a small number of producers or sellers.

Undervalued names

As for evaluations only three of the 11 wide moat stocks are undervalued. They are pallet maker Brambles (ASX: BXB), InvoCare, and Westpac. Brambles is the largest pallet pooling operator globally, operating in 60 countries throughout the Americas, Europe, and Asia-Pacific under its CHEP brand. And it has long-term expansion opportunities in China, India, and Russia, according to Morningstar equity analyst Grant Slade. “Equity markets currently underestimate the value of Brambles’ option to expand into these attractive markets, in our view, providing an opportunity to the astute investor.” InvoCare remains well positioned to capture tailwinds from Australia’s growing and ageing population, says Morningstar analyst Mark Taylor. It remains the leading funeral service provider with a strong market share of over a third. “We anticipate the firm's "Protect and Grow" refurbishment strategy, along with smaller bolt-on acquisitions, will allow the firm to continue growing its share, bolstering its wide economic moat,” Taylor says. And despite losing share in the home loan market, Westpac is set to boost its capital position, and as the nation’s second largest mortgage lender remains undervalued. “Losing share in the home loan market, rising operating expenses, and the smallest capital buffer, has been enough to steer investors away from Westpac, but we think the bank is undervalued,” says Zaia. “Westpac’s capital position looks adequate and will strengthen post asset divestments. We think the bank will be able to once again be competitive with loan application turn-around times.” Transurban, Auckland International Airport, and the ASX are two stars or overvalued.

Cochlear’s switching costs advantage

Global hearing implant maker Cochlear joins Wesfarmers as the other one-star stock on the list. Cochlear has maintained a 60 per cent market share among the four players within the cochlear implant market. But the bionic ear needs expertise to install, and Cochlear’s wide moat comes from the relationship it has with developed market ear, nose and throat surgeons, who not only know and trust the brand and its products but also know how to install them. Hodge says the share price of Cochlear, like many top companies, has been bid up in part because of historically low interest rates. “Cochlear is high quality and it’s growth and investors are prepared—given interest rates are low—to pay up for those attributes," Hodge says. “And we take a longer-term view around the cost of capital and interest rates. "The installed implant market base is a captive market for its sound processor upgrades and accessories which are not compatible across brands and contribute an increasing share of revenue. We forecast this annuity-like revenue stream to grow from 30 per cent to half of revenues over the next 10 years. “One of the beauties about Cochlear is that if someone gets implanted with cochlear implants they’re on that platform for life. I can’t think of much bigger switching costs that having something drilled into the side of your head. “You’ve got a super long-term customer and about 25 per cent of their earnings comes from various updates to the implants.”

Looking ahead

As 2020 draws to a close, positive news on the vaccine front has come earlier than expected. In Australia, markets are up 10 per cent over the past month. BetaShares chief economist David Bassanese remains bullish on equity markets for the year ahead, noting that it’s likely that equity prices will be higher than they are now in 12 months’ time. “Valuations in equity markets are currently a bit stretched, with high PE values reflecting the low interest rate environment and anticipated earnings recovery," Bassanese said on Tuesday. "But given interest rates should stay low, it implies PE values could also remain relatively high.”