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14 pockets of value in an overheated US market

Lex Hall  |  06 Jan 2020Text size  Decrease  Increase  |  
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Tech’s overheated, but energy and consumer stocks are going cheap. That’s the one-line takeaway from Morningstar’s US equity outlook for the first quarter of 2020.

And let’s face it, 2019 will be a tough act to follow. It was a year of double-digit returns across the board. China’s blue-chip CSI300 was up 36.1 per cent, while in the US, the tech-heavy Nasdaq rose 35 per cent.

Low interest rates of course had a hand in inflating stock prices, and the signing of phase one of the trade deal between the US and China on 15 January offers hope.

However, there are doubts the momentum will carry on into the new year. Consider Apple for instance. The iPhone maker rose 98 per cent over the course of 2019. But some are wondering whether the fundamentals justify the rise.

“Tech stocks were on fire on 2019, and we don’t see much value in the sector today,” says Jeffrey Stafford, Morningstar director of equity research, North America.

“The median US technology stock is 11 per cent overvalued, and we see no subsectors where the median stock is cheap.”

Peter Warnes, Morningstar Australia head of equity research, shares that bearish sentiment, and fears other factors are at play.

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“How much was driven by the change in fundamental outlook and how much by passive investment algorithms?” Warnes says.

“A year ago, Morningstar’s fair value for the company was US$200. The price to fair value 0.79, a discount of 21 per cent and a four-star (accumulate) recommendation.

“After absorbing the three quarterly results to September and management’s outlook comments, our fair value currently stands at US$220—a 10 per cent increase over the year. The current price to fair value is 1.34, a 34 per cent premium for a two-star (reduce) recommendation.”

A third of stocks overvalued

According to Morningstar’s North America Equity Market Outlook: First Quarter 2020, the median stock in Morningstar’s North American coverage now trades at a 3 per cent premium to Morningstar’s fair value estimate, compared with a 2 per cent discount near the end of the third quarter.

And of the roughly 800 North American stock Morningstar covers, 32 per cent are overvalued (1 or 2 stars).

Only 21 per cent are undervalued (4 or 5 stars).

Only three of the 11 sectors Morningstar covers have a median stock with a price/fair value ratio below 1: energy, consumer cyclical, and the communication services.

“Energy remains the cheapest sector in our coverage,” says Stafford in the North America Equity Market Outlook.

“Consumer cyclical stocks also look relatively attractive. Those looking for a bargain in the sector may want to take advantage of the uncertainty plaguing travel and leisure, which trades at a 12 per cent discount to our valuations.

Following are nine sectors in which Morningstar sees some four- to five-star opportunities among North American equities.

Top picks in Energy

Enbridge (ENB)

We see 20 per cent upside in wide-moat Enbridge’s stock. We believe the market doesn't realize the full potential of the company's growth portfolio, which is highlighted by the Line 3 replacement project. Even though Line 3 continues to face opposition and delays, we expect the pipeline to be built. Additionally, safeguards remain in place in the unlikely scenario that the project is cancelled. Enbridge can recoup the capital spent on the project plus a healthy return on capital through toll surcharges. Enbridge offers an attractive dividend, which is yielding 6.3 per cent at current levels.

Enbridge plant

The market is overlooking the full potential of Enbridge's growth portfolio

Cheniere (LNG)

We think Cheniere looks cheap. Concerns over a slowdown in Chinese LNG demand because of trade tensions and the resulting loss of direct LNG exports to China miss the mark, in our view. Given the destination freedom allowed in U.S. LNG contracts, European demand has simply picked up the slack, and higher Chinese LNG demand has simply been satisfied by other countries as China efficiently avoids U.S. tariffs. We also like Cheniere's capital-allocation efforts as its current plans involve funding its new trains with 50 per cent equity, reducing debt by $3 billion-$4 billion, and buying back $1 billion in stock over the next three years.

Schlumberger (SLB)

Schlumberger remains our top oilfield-services pick. It has the highest international share of revenue among peers, making it the best positioned to take advantage of the coming capital expenditures rebound in international markets, which the market is neglecting. Also, we think the company is poised to gain market share and improve margins via its efficiency-boosting integrated project initiatives (David Meats)

Top picks in Basic Materials

Cameco Corp (CCJ)

The uranium market remains plagued by subdued activity, which has continued to weigh on the uranium price. However, at today’s prices, significant production would be operating at a loss and only continues to operate due to long-term contracts signed at higher prices. Current supply would fail to meet existing demand without significant losses, let alone meet future demand arising from China’s continued nuclear fleet expansion. The still improving supply/demand balance should help increase uranium prices, allowing Cameco to eventually resume full operations at more attractive margins.

Albemarle (ALB)

Narrow-moat Albemarle currently trades at a more than 40 per cent discount to our $120 fair value estimate, as the market is concerned that lower lithium prices will weigh on profits. With low-cost lithium production, Albemarle is well positioned to maintain decent profit margins even as lithium prices fall. Over the long term, we contend that higher lithium prices will be needed to encourage lower-quality supply to meet demand from growing adoption of electric vehicles. The current share price is an attractive entry point for a quality lithium producer.

Top pick in Communication Services

Viacom (VIAC)

The long-discussed merger of CBS and Viacom finally closed in December, leaving management to focus on running the combined firm. ViacomCBS' competitive advantages lie in the CBS broadcast network, a valuable portfolio of cable networks with worldwide carriage, multiple production studios, and a deep content library. We believe that the firm is well positioned to benefit from the streaming wars roiling the industry, since it has its own direct outlet (CBS AllAccess) and the ability to sell content to other platforms, as seen in the recent sale of South Park to HBOMax. The shares trade at a scant 7 times our 2020 earnings forecast (Michael Hodel).

Top picks in Consumer Cyclicals

Hanes Brands (HBI)

We believe Hanesbrands is undervalued by the market, as investors have focused on short-term problems rather than long-term opportunities. Hanesbrands’ Champion brand benefits from the "athleisure" fashion trend, and we believe it is on track to exceed the company’s target of $2 billion in 2022 sales. We also believe the market underappreciates Hanesbrands’ potential for margin expansion. We expect the firm’s operating margins will grow to 16 per cent in 2024 from 13 per cent in 2018, as it reduces production and distribution inefficiencies and instils best practices in its acquired businesses.

L Brands (LB)

As efforts to turn around its struggling Victoria’s Secret brand have yet to take hold, we currently view narrow-moat L Brands as undervalued. While we don’t foresee the Victoria’s Secret brand chalking up any comp growth, we expect the Bath & Body Works segment to grow comps on average by 2 per cent over the next five years. We believe that the segment will slightly offset the issues at Victoria’s Secret because fragrance-based products in the division are more insulated from e-commerce, and therefore, we have more modest sales growth expectations of only 2 per cent on average over the next five years.

TripAdvisor (TRIP)

Competition from Google has incrementally increased marketing costs at TripAdvisor, but we believe the market is underestimating how the expense line may be leveraged by the company’s expansive network. This has ultimately left the company being undervalued by the market, trading at a roughly 44 per cent discount to our valuation. Plans to reduce operating costs by $70 million and higher-than-expected growth in sales in experiences and dining (19 per cent compared with our 18 per cent expectation in the third quarter) make us optimistic about this narrow-moat name, and we expect sales to grow on average by 6.2 per cent over the next five years (Erin Lash).

TripAdvisor exterior w logo

Plans to reduce operating costs by $70m and higher-than-expected growth in sales in experiences and dining are reasons to be optimistic about TripAdvisor

Top pick in Consumer Defensive

Anheuser-Busch InBev (BUD)

We think investors should give wide-moat Anheuser-Busch InBev a look, trading more than 30 per cent below our assessment of intrinsic value. After its dividend cut, we believe the firm is now poised to pay down debt and enhance its financial flexibility. We see growth opportunities for AB InBev in emerging markets, such as Africa and Latin America. AB InBev has fixed-cost leverage and pricing power in procurement in these markets, (especially after acquiring SABMiller in late 2016), which is demonstrated by their excess returns on invested capital and impressive working capital management (Erin Lash).

Top pick in Financial Services

American International Group (AIG)

We believe CEO Brian Duperreault is a good fit for solving American International Group's main operational issue: commercial property-casualty insurance underwriting. He was a primary architect behind peer Chubb's strong franchise that has generated industry-leading underwriting margins. He has pledged that AIG will generate an underwriting profit in 2019 and the company is on track to reach that goal. Given that we see no structural issues in its core operations, we believe AIG is gradually trending toward peer results. The current market price equates to about 0.8 times book value, implying a long period of poor returns (Michael Wong).

Top pick in Healthcare

BioMarin Pharmaceutical Inc (BMRN)

BioMarin's orphan drug portfolio and strong late-stage pipeline support a narrow moat, and we think the market underappreciates the firm’s entrenchment in current markets as well as its potential in new markets, particularly with its emerging gene therapy pipeline. BioMarin has several products on the market to treat rare genetic diseases; these products generally see strong pricing and have limited competition because of a solid combination of patent protection, complex manufacturing, and BioMarin’s close relationships with patients who rely on its therapies for chronic treatment (Damien Conover).

Top pick in Industrials

WESCO International Inc (WCC)

Wesco is poised to benefit from multiple long-term secular growth drivers, including data centre expansion, powergrid modernisation, and increasing demand for outsourced supply chain management. Further, Wesco is embracing digitalization and Big Data to improve its operational and financial performance, and the firm's efforts are already positively affecting results. We view the firm’s improving fundamentals, share-repurchase program, and involvement of a notable activist investor (Blue Harbour Group) as potential catalysts. Wesco’s stock looks cheap, trading at a 40 per cent discount to our fair value (Brian Bernard).

Top pick in Real Estate

Macerich Co (MAC)

Class A malls continue to outperform other forms of brick-and-mortar retail. Over the past 12 months, Macerich's tenants have produced 13.1 per cent sales per square foot growth, and occupancy costs dropped to 11.7 per cent, the lowest point in six years. This has let Macerich continue to push double-digit re-leasing spreads. The stock has underperformed recently because of several tenant closures that will disrupt cash flow in 2019. However, we view these as opportunities to redevelop the assets and replace out-of-favour tenants, which should yield significant returns over the next few years (Kevin Brown).

For tips on how to buy international shares, see the Prem Icon Morningstar Guide to International Investing



is senior editor for Morningstar Australia

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