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All sectors are undervalued: Morningstar quarterly equity market outlook – part one

Nicola Chand  |  28 Jun 2022Text size  Decrease  Increase  |  
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Six months into the global equity market sell off, Australian stocks are the cheapest they have been in two years, according to Morningstar analysts in the latest quarterly equity market outlook, published on Friday.

Losses on the S&P/ASX 200 accelerated in the second quarter, falling 9.8% over the last three months, taking full year losses to 10.9%. All eleven sectors of the market are currently undervalued versus just one undervalued sector for most of 2021.

Analysts believe Australian equities remain attractive for long-term investors with many large listed firms negligibly exposed to, or even benefiting from, the rising inflation and interest rates wracking markets.

"We recommend investors look through short-term macroeconomic risks and instead focus on intrinsic values based on likely long-term economic variables," says Morningstar equity strategist Gareth James.


Basic Materials

As commodity prices slump sharply amid jitters over slowing growth in China, Morningstar analysts warn the extractive sector has not yet hit “bargain levels.”

The broader basic materials sector has fallen over 15% since its record peak in early April 2022 due to the impact of Chinese lockdowns and the broader selloff.

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Fair value downgrades across the mining sector are likely if prices for iron ore, coal and base metals continue falling, says Morningstar director of equity research Matthew Hodge. Major miners, especially Fortescue, remain expensive.

“It appears the market is beginning to factor in further price declines beyond current levels, which we think is reasonable and likely,” says Hodge.

Building materials companies such as Boral and James Hardie remain materially undervalued. Hodge expects strong a strong 2022 underpinned by residential housing demand in Australia, New Zealand and the US.

Boral (ASX: BLD) is trading in the five-star range and Morningstar backs management’s focus on the core Australian construction materials business, where it has cost advantages and a large pipeline of work.

Communication Services

Morningstar believes the essential nature of telecommunication services like Telstra or TPG Telecom should insulate earnings from rising rates and economic uncertainty. Media will be less lucky.

Telcos should also benefit from the ongoing expansion of 5G, a jump in roaming revenue as international travel resumes, and the of years of falling earnings following the introduction of the National Broadband Network, according to director of equity research Brian Han.

Media companies, especially in free-to-air television and print, are vulnerable to advertisers slashing spending if the economy slows. Earnings are also at risk in the other direction from inflationary pressure on content, talent, and labour, adds Han. Digital and subscription-based media businesses will be more resilient.

Nine Entertainment Company (ASX: NEC) is trading at a substantial discount to fair value and Han says growth in the structurally resilient and digital-centric units, such as Stan and Nine Now, is gaining momentum.

Consumer Cyclical

After a savage selloff wiped all out all of 2021’s gains, Morningstar analyst Angus Hewitt believes the consumer cyclical sector is now undervalued. The sector is down 21% to date this quarter.

Hewitt highlighted the impact of a global shortage in semiconductors on local automotive players, including dealer Eagers and accessory manufacturer ARB. While dealers are benefiting from the shortage of cars in the short-term—orders outstripped deliveries at Eagers by 34% in the year to April—this should normalise as supply chains reknit.

Hewitt likes Myer (ASX: MYR), which is currently trading at a 51% discount to its fair value of $0.70. He expects earnings to grow at an annualised rate of 26% over the next five years as margins expand and management transitions online.

“We see little reason for Myer’s shares to trade at a steep discount to our fair value estimate,” he says.

Energy

Record energy prices should see oil and gas company earnings double this calendar year relative to the last, even as Morningstar analysts warn high prices will be transitory.

Up more than 400% since March 2022 lows, current Brent crude prices are “extremely healthy” for oil and gas companies such as Woodside and Santos, says Morningstar senior equity analyst Mark Taylor. Asian natural gas prices hover around 15 times their 2020 lows.

Taylor left his long-term price forecasts (from 2024) for oil and natural gas on hold in the belief today’s ructions will eventually fade. He also stressed earnings forecasts remain dependent on the outcome of Russia’s invasion of Ukraine. “There is considerable uncertainty in our high company earnings forecasts for 2023. Will the Russia-Ukraine war end in a week, one year, or five? It is anybody's guess,” says Taylor.

Top pick Beach Energy (ASX: BPT) could be a target for merger or acquisition, with Kerry Stokes’ Seven Group sitting on a 30% stake. Shares are trading at an 34% discount to the fair value of $2.70.

Consumer Defensive

Rising rates and expectations consumers will slash spending has hit swathes of the consumer staples sector although supermarkets Coles and Woolworths remain overvalued.

Morningstar currently views the consumer defensive sector as “slightly undervalued” with the average consumer defensive stock trading at a 3% discount to the fair value estimate.

Food and liquor retailing should be more resilient to falling consumer spending relative to electronics or sporting goods retailers, says Morningstar director of equity research. Much of the benefit looks to be priced in, with the major supermarkets and liquor retailer Endeavour trading between 22% and 45% above fair value.

Top pick G8 Education (ASX: GEM) weakened over 2020, due to the covid-19 related economic downturn. However, increased demand for childcare, government support and a large equity capital raising means G8 Education enters 2022 in good shape. The stock is currently trading at a 46% discount to its fair value of $2.00.

is a wealth and finance journalist with Morningstar

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