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5 undervalued names despite big fair value downgrades

Lewis Jackson  |  28 Jul 2021Text size  Decrease  Increase  |  
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Five names across four sectors are still undervalued despite big downgrades to their Morningstar fair value estimates since June 2020.

Oil and gas names Z Energy (ASX: ZEL) and Viva Energy (ASX: VEA), utility giant AGL (ASX: AGL), dairy firm a2 Milk (ASX: A2M) and burn treatment provider Avita Medical (ASX: AVH) are still trading in the four-to-five-star range—at least moderately undervalued—despite double digit downgrades to their fair value in the last year.

The Morningstar fair value estimate calculates the long-term intrinsic value of a stock based on the size and uncertainty of a company’s future cash flows.

Analysts can downgrade fair values for a variety of reasons. A recession could lower the likelihood or amount of future earnings; a company could adopt a new strategy.

As Morningstar’s Susan Dziubinski put, a downgrade isn’t necessarily a sell signal, it’s a change in our analyst’s long-term expectations.

“Companies that have experienced downgrades (or upgrades, for that matter) can still be undervalued or overvalued, depending on where the stock is trading relative to our fair value estimate,” says Dziubinski.

“Investors who read too much into downgrades may be missing out on opportunity.”

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To get the names we compared our analysts fair value estimates between 30 June 2020 and 26 July this year to see which companies had their fair values changed the most—both up and down.

Of the ten stocks that had the biggest downgrades to fair value over the period, five remain undervalued, suggesting markets remain more pessimistic than Morningstar’s analysts.

Z Energy and AGL

Z Energy and Australia’s oldest company AGL Energy were the two most undervalued names from the search.

No-moat Z Energy was once known as Shell Oil New Zealand. Today it’s New Zealand’s largest stand-alone retailer of petroleum products and services about half the country’s demand for transport fuel.

Fair value was reduced in last December due to an increase in corporate costs, according to senior equity analyst Mark Taylor. The market is currently pricing in long-term earnings that are about 30 per cent lower than pre-covid levels. Taylor thinks this understates Z Energy’s potential and expects “rational pricing” to eventually return.

Z Energy closed Wednesday at $2.76, a 47 per cent discount to fair value.

Narrow moat AGL Energy is one of Australia’s largest retailers of electricity and gas. It accounts for about a third of the market in the populous eastern and southern states.

Senior equity analyst Adrian Atkins cut AGL’s fair value several times since last June as falling wholesale electricity prices squeezed profits. Wholesale prices have fallen as renewable energy enters the market amid weaker demand. The upcoming demerger of its fossil fuel assets also saw a one-off cut to fair value to reflect demerger costs and equity dilution.

Atkins likes AGL’s defensive earnings, solid dividends, and relatively conservative debt levels. He expects fortunes to turn when wholesale energy prices rise, driven higher by a shrinking supply renewable energy, the closure of coal-fired plants and rising natural agas prices.
Wholesale electricity prices are up nearly 40 per cent since February this year.

AGL closed Wednesday at $7.45, a 51 per cent discount to fair value.

Fewer bargains amongst the upgrades

Of the top stocks that had the biggest upgrades to fair value, only miner South32 is still undervalued.

South32 (ASX: S32) closed Wednesday $2.93, a 19 per cent discount to fair value.

The price of these stocks tended to increase faster than the fair value estimate, helping keep them undervalued. In some cases, such as Afterpay (ASX: APT), the shares were already overvalued.

For example, director of equity research Mathew Hodge upgraded the fair value of miner Mineral Resources (ASX: MIN) by 70 per cent since last June.

But the price is up 189 per cent since June 2020 and trades at a 75 per cent premium to fair value.

Afterpay stands out. The fair value up over 250 per cent since last June, versus the market’s more modest 68 per cent. Equity analyst Shaun Ler upgraded the fair value after upping his forecast for the number of repeat users for the BNPL product.

The top ten per cent of users in Australia and New Zealand use the product 62 times a year.

Despite the upgrade, the buy-now-pay-later giant is still overvalued, trading at a 37 per cent premium to fair value.

Three names were still trading in a range Morningstar considers to be fairly valued—media conglomerate Seven West Media (ASX: SWM), building materials companies Boral (ASX: BLD) and CSR (ASX: CSR)

is a reporter and data journalist with Morningstar. Tweet him @lewjackk or get in touch via email

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