12 undervalued stocks if you're worried about volatility

April was a month of recovery. The All Ordinaries Index enjoyed its first monthly gain since COVID-19 struck in February, rallying 9.5 per cent. This represented the best monthly performance on record since March 1988.

However, the economic outlook remains uncertain and analysts are urging caution. April job figures showed to extent of the damage to the economy. The unemployment rate jumped to a seasonally adjusted 6.2 per cent, but limited by an “unprecedented” drop in the participation rate to 63.5 per cent.

This means that of the 594,300 people that left employment, only 18 per cent of these people become unemployed—which means actively searching for work and applying for jobs —with 80 per cent of people leaving the labour force, explains AMP Capital senior economist Diana Mousina.

In this environment, it's difficult to predict companies' future earnings and cash flows with any kind of certainty. Many are throwing their guidance out the window, slashing dividend payouts, or rushing to secure additional equity or debt to shore up their balance sheets.

Morningstar analysts say there are almost 100 companies currently trading below their intrinsic value. However, only a dozen of those have carved out solid (and in some cases growing) competitive advantages that will allow them to thrive for years to come and have low or medium fair value uncertainty ratings—meaning companies analysts feel they can estimate future cash flows with a higher degree of confidence.

These include stock transfer company Computershare (ASX: CPU), superannuation administration services provider Link Administration Holdings (ASX: LNK) and funeral home operator InvoCare Ltd (ASX: IVC).

To find stocks to fit the bill, we screened for the following:

Economic moat: First, they need to boast wide Morningstar Economic Moat Ratings—and their Morningstar Moat Trend Ratings must be stable or positive. In other words, these companies have competitive positions that are steady or even improving.

Discounted: Second, the stocks of these companies must be trading at a decent discount to our fair value estimates—selling at Morningstar Ratings of 4 or 5 stars.

Fair value certainty: Third, we need to have a high degree of certainty in our fair value estimates for the stocks of these companies, limiting our search to stocks with fair value uncertainties of medium or low. This rating represents the predictability of a company's future cash flows.

Top notch steward: Finally, we tossed out companies with Poor stewardship ratings, preferring to ride along with management teams that have a proven record of being good stewards of investor capital.

Don't think of this as a list of "buys," though. Instead, think of it as a collection of names to investigate further. See the individual stock pages for full analysis.

"A 5-star rating does not suggest that the stocks won't drop further," says Morningstar director of equity research Johannes Faul. "Our aim is not to pick the bottom, but to highlight to investors that they can pick names up at a discount."

Quality stocks trading at a discount

This is a snapshot of how these stocks stand at the time of writing: 15 May 2020. Given the current market volatility, the valuations could jump around.

Source: Morningstar Direct

A little more on uncertainty

The future of a company can follow several paths. In estimating a fair value, analysts assess which of those paths have some reasonable likelihood of occurring, assign reasonable probabilities to the various scenarios, and reach an expected fair value for the company's shares.

The Morningstar Uncertainty Rating represents the analysts’ ability to bound the estimated value of the shares in a company around the Fair Value Estimate, based on the characteristics of the business underlying the stock. This includes an assessment of operating and financial leverage, sales sensitivity to the overall economy, product concentration, pricing power, and other company-specific factors.

For example, spray on skin maker Avita Medical (ASX: AVH) is currently trading well below its Morningstar fair value at 5 stars. This is because analyst Nicolette Quinn thinks the company stands to gain significant share in the burns-treatment market with its ReCell product. However, Quinn has rated Avita's fair value uncertainty as "very high risk" due to the unpredictability around the pace and success of the rollout.

At the opposite end of the spectrum, consider Ansell (ASX: ANN), which manufactures protective industrial and medical gloves. Quinn has a low fair value uncertainty rating on the company. She says despite the industrial half of the company’s revenue being exposed to global economic cycles, the healthcare segment revenue is resilient.

"We believe the range of outcomes for Ansell is not wide," she says. "As evidence of the limited cyclicality, the company grew per-share earnings through the global financial crisis."

Morningstar Premium subscribers can access the full list of undervalued Australian stocks here. The latest Australian and New Zealand Best Stock Ideas list can be found here.