What are we looking for?
Large U.S. companies that have a strong competitive advantage and solid earnings momentum.
The screen
Companies with robust business models and superior fundamentals can provide higher returns with lower downside risks. Many equity analysts use Porter’s Five Forces of competition (named after Michael Porter of Harvard Business School) to identify companies that able to provide more consistent investment returns because they’re able to produce goods and services more efficiently than competitors. The theory looks at the number of competitors; strong barriers that prevent competitors from gaining market share; suppliers with less ability to influence costs; customers with less ability to negotiate lower prices; and whether there are few substitute products.
Similar to Porter’s Five Forces, the Morningstar Economic Moat Rating uses a methodology to assess whether a company has a sustainable competitive advantage that will allow it to generate profits and excess returns that will last more than 10 years. We used annual earnings momentum, quarterly earnings momentum and the forecast for next quarter’s earnings momentum to find companies that are growing their bottom line.
It’s also important for these companies to consistently report good earnings, so we use the historical earnings variability to find lower volatility in reported earnings per share. Return on equity can help us focus on companies with good internal financial performance; the reinvestment rate to make sure that these companies are successfully reinvesting in their businesses for future growth.
The investment process started off with all 2,009 stocks in our U.S. database. Then we ranked our stocks according to the Morningstar Economic Moat Score, reinvestment rate, annual earnings momentum, quarterly earnings momentum and next quarter’s estimate for earnings momentum.
Next, we applied these screens to create our list of stocks:
- Market capitalization greater than US$9-billion;
- Morningstar Economic Moat Score of five, which indicates a wide moat (a narrow moat is three, no moat is zero);
- Reinvestment rate above 20 per cent (calculated as the trailing earnings per share less trailing dividends per share as a percentage of the company’s adjusted book value per share);
- Historical earnings variability less than 19 per cent, a reading that would indicate more consistent earnings over time relative to most stocks;
- Next quarter’s estimate for earnings momentum that is greater than zero. This compares the three quarters of trailing operating EPS plus the estimated EPS for next quarter with the four quarters of trailing operating EPS.
What we found
U.S. companies with a strong competitive advantage
| Rank | Company | Ticker | Mkt. Cap. (US$ Mil.) | Econ. Moat Score | Ann. Earns. Mom. (%) | Qtly. Earns. Mom. (%) | Next Qtr.'s Estim. Earns. Mom. (%) | Hist. Earns. Var. (%) | ROE (%) | Reinv. Rate (%) | Div. Yld. (%) | 12M Price Chg. (%) | Recent Price (US$) |
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 1 | Merck & Co. Inc. | MRK-N | 213,873.4 | 5 | 31.7 | 15.8 | 11.3 | 4.4 | 47.7 | 23.4 | 3.3 | 13.5 | 84.23 |
| 2 | Aon PLC | AON-N | 68,813.1 | 5 | 22.8 | 10.0 | 4.3 | 4.0 | 87.1 | 226.4 | 0.7 | 27.9 | 317.60 |
| 3 | McDonald's Corp. | MCD-N | 185,027.0 | 5 | 53.4 | 6.1 | 2.7 | 11.5 | 92,800.0 | 40,300.0 | 2.2 | 6.0 | 248.74 |
| 4 | Vertex Pharma. | VRTX-Q | 69,101.5 | 5 | 26.2 | 7.1 | 4.4 | 14.3 | 36.1 | 32.8 | n/a | 23.9 | 267.50 |
| 5 | Apple Inc. | AAPL-Q | 2,640,322.3 | 5 | 63.6 | 7.5 | 0.3 | 14.8 | 149.4 | 123.7 | 0.5 | 23.1 | 160.35 |
| 6 | Texas Instruments | TXN-Q | 159,943.9 | 5 | 44.2 | 5.7 | 4.1 | 11.2 | 67.9 | 30.3 | 2.7 | -4.0 | 174.18 |
| 7 | Hershey Co. | HSY-N | 32,708.5 | 5 | 14.2 | 2.9 | 2.4 | 3.1 | 61.6 | 30.2 | 1.6 | 36.4 | 222.98 |
| 8 | Mettler-Toledo Int'l | MTD-N | 29,206.8 | 5 | 32.6 | 3.9 | 2.2 | 7.3 | 390.1 | 451.9 | n/a | -2.2 | 1,271.87 |
| 9 | VeriSign Inc. | VRSN-Q | 22,590.9 | 5 | 4.6 | 3.9 | 3.1 | 5.6 | 55,347.0 | 55,347.0 | n/a | -5.9 | 207.92 |
| 10 | Costco Wholesale | COST-Q | 253,391.3 | 5 | 14.2 | 3.0 | 1.0 | 4.2 | 31.9 | 21.6 | 0.6 | 53.6 | 560.94 |
| Source: Morningstar CPMS |
| Note: The unusually high reinvestment rate and ROE figures for MCD and VRSN are because the adjusted book value is negative in both cases. |
We used CPMS to back-test the strategy from January, 2006, to March, 2022. During this process, a maximum of 10 stocks were purchased and equally weighted. The portfolio is rebalanced monthly and the strategy produced a total return of 15.4 per cent since inception, whereas the S&P 500 Total Return Index advanced 10.3 per cent. Today, the top 10 stocks that qualify for purchase into the strategy are listed in the accompanying table.
As always, investors are encouraged to conduct their own independent research before purchasing any of the investments listed here.
Phil Dabo, MFin, is a vice-president of business development at Morningstar Research Inc.
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As a seasoned financial analyst with a focus on equity research and investment strategies, I bring a wealth of experience in evaluating large U.S. companies for their competitive advantage and earnings momentum. My expertise extends to the application of renowned frameworks such as Porter's Five Forces and Morningstar Economic Moat Rating to identify companies with robust business models and superior fundamentals.
In the realm of equity analysis, Michael Porter's Five Forces has been a cornerstone for discerning sustainable competitive advantages. This framework systematically assesses the competitive landscape, considering factors like the number of competitors, barriers to entry, supplier and customer power, and the threat of substitute products. This allows for the identification of companies capable of efficient production, translating into more consistent investment returns.
Parallel to Porter's Five Forces, the Morningstar Economic Moat Rating employs a methodology designed to ascertain a company's sustainable competitive advantage over a prolonged period—specifically, a competitive moat that can endure for more than 10 years. To gauge this, I rely on indicators such as annual earnings momentum, quarterly earnings momentum, and forecasts for the next quarter's earnings momentum, which collectively reveal a company's growth trajectory.
To ensure a well-rounded assessment, historical earnings variability is considered to identify lower volatility in reported earnings per share. Additionally, metrics like return on equity (ROE) provide insights into a company's internal financial performance, while the reinvestment rate is scrutinized to ensure successful business reinvestment for future growth.
The investment process outlined in the article initiated with a comprehensive database of 2,009 U.S. stocks. The stocks were subsequently ranked based on Morningstar Economic Moat Score, reinvestment rate, annual and quarterly earnings momentum, and the estimate for the next quarter's earnings momentum. Screening criteria included a market capitalization exceeding US$9 billion, a Morningstar Economic Moat Score of five (indicating a wide moat), a reinvestment rate above 20%, historical earnings variability below 19%, and a positive estimate for next quarter's earnings momentum.
The result of this meticulous screening process yielded a list of U.S. companies that exhibit a strong competitive advantage. Notable companies meeting these criteria include Merck & Co. Inc. (MRK-N), Aon PLC (AON-N), McDonald's Corp. (MCD-N), Vertex Pharmaceuticals (VRTX-Q), Apple Inc. (AAPL-Q), Texas Instruments (TXN-Q), Hershey Co. (HSY-N), Mettler-Toledo International (MTD-N), VeriSign Inc. (VRSN-Q), and Costco Wholesale (COST-Q).
Moreover, a back-test of this investment strategy using CPMS from January 2006 to March 2022 demonstrated compelling results. The strategy, involving the purchase of a maximum of 10 equally weighted stocks, achieved a total return of 15.4%, outperforming the S&P 500 Total Return Index, which advanced by 10.3%.
In conclusion, the application of rigorous screening criteria and established frameworks has led to the identification of a portfolio of U.S. companies with a strong competitive advantage, poised for sustained growth and returns. Investors are, as always, encouraged to conduct independent research before making investment decisions.
