3 buy the dip candidates with wide moats

Joseph Taylor | Morningstar

Companies with durable competitive advantages are more likely to compound in value over long stretches of time. This is because this advantage or moat protects their profits and returns on investment from competition.

Shares in businesses of this quality usually trade at a premium price. The only real chance investors will have to buy shares at lower valuations is when some kind of problem – real or perceived – arises and investors sell the shares.

"Buying the dip" can prove beneficial if the problem turns out to be temporary and the business recovers. If the problem turns out to be permanent, though, the purchase could end up proving too expensive.

The challenge, then, is figuring out whether it is a temporary or permanent issue.

The three stocks covered in this article have all been assigned Wide Moat ratings. This means our analysts think they have structural advantages enabling them to earn excess returns on capital for at least 20 years.

All three companies have had a tough time of it recently in the stock market. But in all three cases, our analysts think that the shares have now fallen to a level significantly below Fair Value. As a result, their weak share prices could provide an attractive “buy the dip” opportunity for long-term investors.

Before we start, I would like to remind you that buying any investment should only follow the construction of a deliberate investment strategy. You can find a step-by-step guide to forming your strategy here. 

You can also find an explanation of terms like Moat, Star Rating and Fair Value at the foot of this article. Now, onto the shares.

Spirax Group (LON: SPX)

• Economic moat: Wide
• Fair Value estimate: GBX 9650 per share
• Share price November 29: GBX 7,160
• Star rating: ★★★★★

Spirax Group provides industrial companies with components that are essential to their operations. Their various business segments provide everything from electrical heating and cooling components used in factories and operating equipment, to valves and pumps used to manage the use of steam and fluids in industrial processes.

Our Spirax analyst Matthew Donen has assigned the company a Wide Moat rating stemming from intangible assets and switching costs.

Spirax’s direct-to-consumer sales model leverages the engineering knowledge of its employees to gain in-depth knowledge of customers' industrial processes. This helps them develop customised solutions that become deeply embedded in these processes.

If that wasn’t enough, these essential components carry a stellar reputation for quality but represent a trivially low portion of a customer’s operating costs. Combine all of these things and you set the scene for high retention rates and the ability to raise prices without much pushback.

This has been reflected by Spirax running an exceptionally profitable business for many years, with operating margins averaging more than 20% over the past five years before tailing off a bit recently. The company’s shares, however, haven’t had a great time of things and have fallen around 60% from their peak in late 2021.

Some of this has been down to weakness in a couple of Spirax’s main end markets and lower profit margins as a result. One example here are the company’s biotechnology customers, many of which overstocked during Covid and needed to work through those supplies buying more.

Markets also appear to be unconvinced by the company’s recent capital allocation decisions, which have seen the company’s debt level rise to fund acquisitions that haven’t, as of yet, performed especially well.

Donan thinks that softer demand in Spirax’s key markets is cyclical rather than structural, and that a recovery could help margins towards where they were previously. On the capital allocation front, he has also been encouraged by management’s renewed focus on organic growth and small bolt-on deals rather than major acquisitions.

Overall, Donan believes that Spirax can continue to outpace global industrial growth while reaping attractive economics thanks to its moated position. At a current price of roughly GBX 7160, the shares traded around 25% below his Fair Value estimate.

Rentokil Initial (LON: RTO)

• Economic moat: Wide
• Fair Value estimate: GBX 620 per share
• Share price November 29: GBX 397
• Star rating: ★★★★★

Rentokil Initial’s two biggest businesses are pest control services (roughly 80% of revenue according to Pitchbook) and hygiene services (around 16% of sales).

Both of these are highly localised, route-oriented businesses where greater scale brings substantial savings on a per-job basis and therefore a cost advantage. It is the scale of the Rentokil pest control segment, which is the market share leader in over 50 of the 87 countries it operates, that underpins the combined firm’s Wide Moat rating.

Despite Rentokil’s substantial size, the global pest control business is still fragmented and is the target of roll-up acquisition strategies from several players. Rentokil is very active in this regard and has spent an average of GBP 300 million per year on tuck-in deals between 2018 and 2023.

That number excludes the much larger 2022 deal to buy Terminix, which propelled the group to market share leader in the US – a market in which the company has struggled recently. Lacklustre sales growth well below that of the broader US pest control market’s growth has weighed heavily on the shares, and investors seem to have little hope of the situation reversing.

Our Rentokil analyst Grant Slade thinks this is overly pessimistic, and he is optimistic on the group’s overall growth prospects. He thinks Rentokil Initial can grow its pre-tax profits at a 10% annual clip over the next decade, helped by more pest control M&A and robust organic growth in both the pest control and hygiene services markets.

His Fair Value estimate of GBX 620 per share is some 60% higher than the current market price.

Endeavour Group (EDV)

• Economic moat: Wide
• Fair Value estimate: $6.10 per share
• Recent share price: $4.35
• Star rating: ★★★★★

Closer to home, Endeavour is Australia's leading omnichannel liquor retailer, operating the largest network of brick-and-mortar stores in the country across the well-known Dan Murphy's and BWS brands. Endeavour also has substantial interests in hotels and electronic gaming, operating more than 12,000 gaming machines across its portfolio of over 300 hotels, pubs, and clubs.

Around 85% of Endeavour’s sales and 65% of its pre-tax earnings come from liquor retailing, and this segment has struggled a bit recently as consumers reign in spending. This has resulted in softer demand and more discounting, both of which have hit sales growth and margins in this business.

Our analyst Johannes Faul thinks that this is merely cyclical weakness and that Endeavour is well placed for an eventual recovery. Why? Because Endeavour’s advantages in liquor retailing appear to be very much intact.

Endeavour’s near 50% share of Australia’s off-premise liquor market through BWS and Dan Murphy’s makes it around three times larger than its closest integrated peer Coles Group and almost twice as big as wholesaler Metcash’s base of customers. This dominant scale lets Endeavour fractionalise distribution, administration, and marketing costs in a way that smaller competitors cannot. In turn, this has translated into materially higher operating margins than its peers for several years. It has also historically grown its liquor sales faster than Coles Group.

Moreover, Faul thinks the immediacy of most alcohol consumption and Endeavour’s extensive brick-and-mortar network make Endeavour less susceptible to online disruption. Most customers don’t want to wait for online delivery and Endeavour’s retail footprint offers a huge choice of click and collect venues.

Faul expects consumer demand for alcohol to be relatively steady through the economic cycle, exhibiting attributes of consumer defensives. The Australian hotels market will predominantly be driven by the same factors as the off-premises retail liquor market, namely population growth and inflation.

Endeavour’s numbers for the September quarter clearly disappointed investors, however, Faul kept his Fair Value estimate at AUD 6.10 per share. At current price levels, this suggests that Endeavour is more than 25% undervalued.

Remember that before you get to choosing investments, we recommend you form a deliberate investing strategy.

Terms used in this article

Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. 

Uncertainty Rating: Morningstar’s Uncertainty Rating is designed to capture the range of potential outcomes for a company. An investor can think of this as the underlying risk of the business. For higher risk businesses with wider ranges of potential outcomes an investor should consider a larger margin of safety or difference between the estimate of what a share is worth and how much an investor pays. This rating is used to assign the margin of safety required before investing, which in turn explicitly drives our stock star rating system. The Uncertainty Rating is aimed at identifying the confidence we should have in assigning a fair value estimate for a stock. 

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