Few values left in global stock market

Morningstar US  |   20/03/2017 Text size  Decrease  Increase   |  
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Jeremy Glaser: After an eight-year market rally it should come as no surprise that there are an increasing number of questions about if the market is overvalued and if there are any attractive pockets left.

Recently, Morningstar's global equity research directors came together in Chicago, and we had the opportunity to talk to each of them about where they see valuations today and what some of their best investment ideas are.

Michael Holt: Globally, if we aggregate the price/fair value estimates, from of all our analysts, we come up with median value of 1.04. Now this is a number that's easy to misinterpret, but the simple version is, there are far more names that are overvalued than we're seeing that are undervalued right now. So, as an investor, you have to be far more selective and make sure you're doing your homework on every name you look at.

Now this valuation is not spread equally across all the sectors. We see a couple, like basic materials and the energy sector, where it looks even more overvalued than the rest of the sector, so you have to be even more selective and do your due diligence in those areas.

Last, I'd just like to add, make sure you understand when a stock is fairly valued, what does that mean? It means that we don't see the margin of safety we'd like to have as an investor to capture that capital appreciation. However, we do expect a 3-star stock, which is fairly valued, to deliver a total return in line with the cost of equity, so there is an opportunity cost to holding cash. So, take a look at the quality of the business. See if they have economic moats and see if you're protected if, through the cyclical nature of the market. That's how you can make good investment decisions.

Elizabeth Collins: Looking at the companies and sectors that the North American equity research analysts cover, we do see a lot of companies and industries that are overvalued. In general, we think that the market is pricing in a lot of optimism and not taking into account a lot of things that could go wrong in the future. Some of the things that are being priced in are things like deficit spending, increased spending on military, infrastructure increases, higher interest rates due to higher inflation expectations and lower taxes. While all of these things would be undoubtedly good for equity valuations, there are things that would come with the cost, and these are things like gridlock in Washington, D.C. might mean that these things don't come to fruition.

Similarly, there could be increased competition. Infrastructure spending that raises commodity prices would ultimately be met with new supply that drives down commodity prices. Likewise, lower taxes that benefit companies' bottom lines should ultimately benefit consumers in the form of lower prices in the absence of strong and sustainable economic moats. Given that, we do think that the market tends to be, in general, fairly valued, though we do see some sectors that have weaker valuations. Those sectors are communication services, real estate, healthcare, and consumer cyclical.

I'd like to give you a couple of our best ideas within the undervalued sectors. First, I'd like to talk about Roche. It's a biopharmaceutical company and they also have a diagnostics business. A lot of healthcare companies are facing the threat of cost containment, but this is actually a threat that plays into the advantages of Roche. Because of their in-house diagnostic arm, they have advantages when it comes to personalized medicine, which should lower cost, all else equal. They also have competitive advantages because of their biologics and the inability of competitors to replicate those biological innovations.

Another best idea that I'd like to talk to you about is Williams-Sonoma. They do the namesake Williams-Sonoma stores, also Pottery Barn and West Elm. This is a category that isn't facing a lot of headwinds, and we do think that the company has a narrow moat thanks to the intangible asset of their brand, which helps consumers decide that their products have higher quality and are worth spending money on. And we do think that they are ahead of their competitors when it comes to things like supply chain management, consumer analytics, and e-commerce. All said, we think that the market is being overly pessimistic about both Roche and Williams-Sonoma and they're two of our top picks in undervalued sectors.

Alex Morozov: Looking across to European equities, if you just look at it from a relative perspective, compare it for example to the US stock market, you can perhaps sense that the European market is relatively undervalued relative to the US It's not necessarily how we look at things, but that from a multiple perspective, European stocks do look a little bit cheaper. There are a couple of reasons, perhaps, for that.

Well, one, probably the most important one is that the growth in Europe is weaker than the US You still have a lot of countries that perhaps are not pulling their weight. Southern Europe is still not out of the woods. There's still a lot of concern about the general growth environment in Europe, and most European companies do have a bit of an outsize exposure to Europe as a continent.

And then a second way of looking at it--perhaps this is more of a headline risk, if you will--there's still a lot of uncertainty over political environment in Europe. Last year, Brexit was a major shock to the system. A lot of UK stocks have really taken a beating, and we still have a number of major political events in Europe that could provide this additional shock.

What we try to do though, we look at the companies that can and will have this sustainable earnings power that could survive whatever shocks the system's is going to provide. So the companies with economic moats are critical. Even though the European market as a whole is probably fairly valued, stock-picking is critical for us as is the case with all the analysts at Morningstar, but in an environment where you see a lot of fairly valued, perhaps even overvalued stocks, we still have a few interesting ideas in this space.

When we look at some of the top picks that we have, it's not surprising those are the companies with economic moats. My favorite name right now--especially considering that this is in the consumer staples space and consumer staples have run quite a bit a lot of the valuations are quite stretched, so not too many ideas that we have in consumer staples--but one that we do have is actually a wide moat, InBev, the largest beer manufacturer in the world. This is the company that last year completed his acquisition of SABMiller and with that, it became by far the biggest beermaker in the world.

The company has a few issues. It's exposed to emerging markets and when you are exposed to emerging markets, you are benefiting from perhaps higher growth in those areas, but you're also much more susceptible to some of the shocks that you see with emerging markets, whether it's currency, whether it's growth volatility, etc., but ABI has a very powerful business model, both given its size, its ability to extract pricing concession from its suppliers. Right now, it's trading about a 10 per cent discount to intrinsic value. It represents a really unique opportunity to buy this wide-moat business that rarely goes on sale.

The other ideas from Europe I have are in the aviation industry. One of them is the plane manufacturer Airbus. The other one is the aviation parts manufacturing company called Safran. Airbus has a narrow economic moat. Safran has a wide economic moat. Both benefit from a transition to the narrow body planes that we're going to see over the next 10, 20 years. Both are also companies that have gone under significant transformation, their operating model. We see a lot of upside in both of those companies. We see significant potential for margin uplift, earnings growth. Most importantly, those are the companies that regardless of what happens in Europe in terms of the political turmoil, weaker than expected growth, those the companies that we're confident and comfortable with our forecast for the next 15-, 20-plus years. And that gives us confidence in our recommendation of those two wonderful businesses.

Adam Fleck: We view the Australian market as particularly overvalued right now, trading at about a 9 per cent premium to our amalgamated fair value estimates. There's really a couple of key reasons for that. In Australia, of course, the financial services industry and the materials market make up the bulk of the tradable assets. In particular, we see commodities as overvalued right now. BHP and Rio are two of the largest that we have 1- and 2-star ratings on. And really, what has happened there is we continue to expect significantly lower commodity prices, particularly those that are related to the steel industry, over the long run as China's economy slows and rebalances, leading to a sharp fall in the several years to come.

So, it's really no surprise that we see the Australian market as overvalued right now. However, we still think there are some pockets of opportunity, especially as you look outside the materials space. They're somewhat few and far in between, but I wanted to share a few with you. The first, when you really look for undervalued names, you start to see some names that perhaps are not of the highest quality. One such name might be Ten Network. This is a no-moat company that we think has poor stewardship and very high uncertainty, but nonetheless trades at a 44 per cent price/fair value ratio, a substantial discount to our fair value estimate.

This is one of three commercial TV networks in Australia. And it's come under pressure recently as the company expects negative EBITDA this year, given some of the increased competitive pressure and pressure from the advertising market more generally. However, we're supportive of management's investments in content in this business. It's already paid off with some rising market share, up to 24 per cent from 21 per cent a few years ago. We expect that to get up to about 25 per cent over the long run, and see EBITDA returning to a positive long single-digit rate, which drives our fair value estimate.

If you start to look at 4-star names, you can see some opportunities and some higher quality stocks. One would be Brambles. This is a wide-moat stock that trades at 4 stars. It is the largest, global provider of pallet and reusable plastic crate pooling services. And unlike Ten, we think Brambles has a wide economic moat, based on its global scale and cost competitiveness and cost advantage. This is a business that's been hit hard from increased competition recently. It's also seen some inventory destocking at the customer level, and e-commerce has had some negative impacts as well. However, we see the company re-investing in its pallet quality. It's done so in the past. That's typically taken 12-18 months or so, but as it does that and feels the benefit of that longer term, we don't see a threat to the company's wide economic moat. And with retail sales continuing to improve, particularly in the US where this company has a nice presence, we see the market undervaluing the name right now.

Lorraine Tan: Return of risk appetite in Asia has led to a narrowing of upside gains that we see in equities. Having said that, we still think there are a lot of buying opportunities in selective stocks. There are also areas, whereby on a midterm basis, that will still benefit from some of the key themes and developments that will continue on for the next few years.

Starting with China, we look at that. A lot of the buy calls that we had in the financials and real estate space have run up but we still like the Industrial and Commercial Bank of China. The bad news over the past few years on the potential NPLs are still probably there, but we're seeing a uptick in macro activity, particularly on the infrastructure side, that should sort of alleviate some of the pressures going on for some of the financial institutions. In this regard, we thing there's still upside potential for ICBC on a midterm basis.

The other area that we're quite keen on in terms of the China policy developments is essentially factors that involve the environmental aspect, whether it's on the clean energy side or whether it's in terms of the reform that's going on in terms of tariff pricing for a number of the utilities and activities there. The key names that we like, we have a couple of ideas here. These include one of our best ideas, which is Guangshen Railway. We think the government will need to increase tariffs to help alleviate the debt situation for the former Ministry of Railway, and that will help improve the returns that companies like Guangshen Railway will see. The company's in a nice net cash position as well, so we think that's a relatively safe bet to have in a portfolio.

Companies such as ENN Energy and Beijing Enterprises, the latter being another best idea, will also benefit from situations of continued encouragement in terms of the gas usage in China as they move away from coal. That means also more reforms in terms of gas pricing and continued growth in terms of fairly strong growth in this sector and these companies are all enjoying pretty high returns on investor capital at this stage.

Turning to Japan, Japan has had a good runup, mainly because of the yen factor. But we are actually seeing some situations of companies actually benefiting from longer term corporate restructurings that are going on. We like in particular the Mitsubishi UFJ financial group. This is a bank, the leading bank in Japan, and the reflating story will definitely benefit MUFJ, and the fact that it's also still trading below its book value means that there's still some upside potential. It's got a fairly diverse global flow of revenue and we think that will also give the bank some additional opportunities in terms of driving loan growth.

For the rest of the other Japanese stocks, we also like Murata Manufacturing. It's for a longer basis in terms of its passive components. It not only gets a benefit from what's going on in terms of what's going on in terms of the smartphone demand, which will continue to grow in terms of LTE and 5G activities, but we think its movement in terms of the more passive components for the auto industry will also drive future demand for its output.

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