When There’s No Competition

Unless you’re a repo man, it’s tough to find uplifting news in the economy these days. Sure, the market’s seen a few rallies this year, but unemployment is rising and house prices are falling. And most analysts’ outlooks for corporate profits this year aren’t exactly rosy. “There isn’t a lot of faith in earnings right now,” says Alec Young, an equity market strategist for Standard & Poor’s.

But not every stock will limp out of this recession as Wall Street’s walking wounded. Companies with strong, defensible businesses may actually be able to grow during these rough times, says Morningstar equities strategist Paul Larson. Such firms tend to have a “wide moat” around their business, which keeps their profits up and rivals out. They may operate in industries with high barriers to entry — think defense contractors and biotechnology. And as weaker competitors falter or go out of business, they can pick up market share and thrive as the economy rebounds. “These are stocks that may bend with the headwinds but not break,” says Larson.

There’s some evidence that these companies consistently beat the market, too. Morningstar tracks a few dozen stocks it considers to have wide moats, and from 2004 through 2008 the group gained 13.2 percent, versus a loss of 10.5 percent for the S&P 500. Such stocks tend to have high returns on capital, a measure of profitability that Wall Street loves. And they tend to benefit from “economies of scale” — being so large, they can keep their costs down and beat the competition on pricing.

Of course, wide-moat stocks don’t always shine. This year they were down 4.1 percent through the first three months, still better than the S&P but behind stocks with no moats, like retailers. Several large financial firms are on Morningstar’s wide-moat list, and their stocks have been hammered. And some companies’ moats erode over time — just ask anyone who invested in General Motors thinking its size would protect its market share indefinitely.

Yet with the downturn in full swing, many pros are emphasizing wide-moat companies for their ability to ride out the recession and even boost their bottom line. Justyn Putnam of Gabelli & Co., for one, likes Apollo Group, one of the nation’s largest for-profit education companies. The company can charge tuition rates similar to those of state schools and community colleges but still manages to operate very profitably. Enrollment has been rising as more folks head back to school. And the stock looks cheap, trading at 13 times estimated fiscal 2010 earnings, below its historical average. They have “tremendous cash flow,” Putnam adds, and the flexibility to raise prices.

Some experts also see opportunity in smaller firms that have strong niche businesses. Eric Ende, comanager of the FPA Perennial fund, likes Copart, one of the largest auctioneers of crashed, or salvage, vehicles. Copart’s business isn’t easy to crack, he says, since it operates salvage yards across the country and has developed a sophisticated Internet auction system. Profits have come down a bit as prices for used cars and scrap metal have fallen. But the firm is expanding into the U.K., and its virtual auctions reach buyers in Eastern Europe and other parts of the world where demand is stronger. Analysts also like the company’s balance sheet, with no debt and a growing cash hoard — which should help keep it chugging long after the recession ends.
Our Picks

Companies with solid, defensible businesses have strengths that should give them an edge when the economy rebounds.

Apollo Group (APOL: 60.00*, -1.12, -1.83%)

    * Price: $62
    * Market Value: $9.9 billion
    * 2008 Sales: $3.1 billion*
    * 2009 P/E: 15

Apollo owns and operates the University of Phoenix, a for-profit education giant with nearly 400,000 students nationwide. Enrollment is up this year, as more folks take courses to sharpen their job skills, says analyst Justyn Putnam of Gabelli & Co. The stock looks pricey based on fiscal 2009 earnings, but analysts expect profits to grow 20 percent, to $4.77 a share in fiscal 2010, making the stock more reasonably priced. (SmartMoney.com)

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