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Market Update

Pullback an Opportunity to Pick Up Undervalued Stocks

Value remains attractive, but time to rotate back into growth … and even some tech.

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It's time to get back into growth and pick through those high-quality companies caught up in the broad market sell-off.

We continue to find the value category attractively priced. However, carnage across growth stocks pushed them down well into undervalued territory. Even the technology sector, which had been one of the most overvalued at the beginning of the year, is now littered with undervalued opportunities.

After the January sell-off, the market is trading at a price to fair value of 0.96 according to a composite of our U.S. stock coverage. This valuation places stocks near the bottom of the range that we consider to be fairly valued.


Source: Morningstar. Data as of Jan. 28, 2022.

Looking forward, we expect volatility will remain higher than usual. At the beginning of January, we published our 2022 U.S. Equity Market Outlook in which we noted that the markets were overvalued and facing strong headwinds coming into the new year:

  • Slowing rate of U.S. economic growth
  • Tightening monetary policy
  • High inflation
  • Rising interest rates

These headwinds have already taken their toll on the markets. Through Jan. 28, the Morningstar US Market Index has dropped 7.93% and we are updating our valuations accordingly as some of what we had expected has already played out, and some still has yet to occur. Much like the cold winter winds blowing off Lake Michigan, these headwinds will remain in our face for months to come.

Growth stocks have been hammered and dropped precipitously in just a few weeks as the Morningstar Growth Index declined 14.65%. This pushed the price to fair value ratio of growth stocks down to 0.92 from 1.05 at the end of 2021. We now see a substantial number of growth stocks that have been unfairly caught up in this broad downdraft are now trading at attractive valuations.

Coming into the year, we noted that the best opportunities for investors was in the value category and small-cap stocks. Compared with the broad market, the Morningstar US Value Index has generally held up during this downturn, dropping 0.47%. The price to fair value of value stocks has remained unchanged at 0.96. Considering we continue to forecast a relatively robust real U.S. GDP growth of 3.9% this year and 3.5% in 2023, we think value stocks still have a strong tailwind behind them.

With a price/fair value of 1.05, core stocks remain overvalued, even though the Morningstar Core Index has fallen 7.73%. At the beginning of the year, with a price to fair value of 1.14, we had viewed core stocks as substantially overvalued.

Across different capitalization levels, the Morningstar large, mid, and small cap indexes have declined 7.47%, 8.71%, and 10.74%, respectively. According to our valuations, at a price to fair value of 0.87, small-cap stocks have become more undervalued, and the large-cap and mid-cap are fairly valued at 0.96 and 0.99, each. Although small-cap stocks have underperformed thus far this year, based on their attractive valuations and our outlook for robust economic growth, we continue to think they will perform well for long-term investors.

Where to Look for New Investments: Trade Up in Quality to Wide-Moat Stocks

In our 2022 U.S. Market Outlook, we highlighted the better relative valuation of companies with wide economic moats compared with those with narrow or no moat at all. Year-to-date, the Morningstar Wide Moat Focused Index has only declined 3.66%.

In addition to the better relative value, we also opined that these stocks will hold up better in an inflationary environment. Wide Moat companies typically will exhibit better pricing power, and have the ability to pass through their own cost increases to their customers. As such, they will be able to maintain margins if inflation remains more persistent than we currently forecast and thus hold their valuations.

Yet, with the downturn in large-cap growth stocks, we note that there is now a rare opportunity to trade up in quality to large cap and growth stocks of companies with wide economic moats. Among small-cap stocks, we note that both narrow and wide-moat categories are attractively valued.


Source: Morningstar. Data as of Jan. 28, 2022.

Scouring the Sectors--Where to Invest Now

At the end of 2021, there were only two sectors that we viewed as undervalued –energy and communications--and one sector that was fairly valued, financials. The others were different shades of overvalued.

Following the sell-off, communications has become further undervalued and the energy sector is now fairly valued. Through Jan. 28, the Morningstar Energy Index soared 16.96%--the only sector to post a positive return. Taking its place, after being especially hard-hit during January, the consumer cyclicals sector has dropped into the undervalued range. Only real estate, consumer defensive, and utilities remain in overvalued ranges as the rest of the sectors trade near fair value.


Source: Morningstar. Data as of Jan. 28, 2022.

Basic Materials

The price to fair value for the basic materials sector dropped to 1.03 from 1.13, placing it within the fair value range. We see value for long-term investors in this sector along three main themes.

>First, is in the industrial gas space. Firms such as Air Products & Chemicals benefit from long-term customer agreements with take-or-pay clauses, prices that are indexed to inflation, and energy cost pass-throughs. These traits help to position these companies to weather inflation and energy price volatility.

Second, is in the specialty chemical space. This is a play on both our forecast for robust economic growth and our above consensus projection on the rate of adoption of electric vehicles. EVs require more specialty chemicals in their manufacturing process than internal combustion engines. We think DuPont de Nemours (DD) is well positioned to take advantage of these trends.

Third, is in the lithium business. We think that investing in lithium is one of the best ways to participate in the long-term, structural shift to electric vehicles.

Communications

Communications dropped 9.46% through Jan. 28 and is the third-worst performing sector so far this year. The sector is highly concentrated as Alphabet (Google) (GOOG) and Meta Platforms (FaceBook) (FB) account for 55% of the market cap of the sector, both of which we rate with 4 stars and trade at 23% and 25% discount to their fair values, respectively.

We also see a number of attractive stocks, both from a thematic perspective as well as idiosyncratic catalysts. One is AT&T (T), which we highlighted in a recent article. AT&T is undergoing a strategic realignment and has taken several actions to shed assets so it can refocus on its core communications business and unlock shareholder value.

Consumer Cyclical

The resurgence of the pandemic has taken its toll on consumer cyclicals, which decreased 13.13%. As new cases of the omicron variant soared higher in early January, investors stampeded out of those stocks tied to in-person consumer activities. Our price to fair value metric dropped to 0.93, placing in it the undervalued range, from being overvalued at 1.08 at the end of 2021.

We continue to forecast that economic expansion and normalization of consumer habits will help support valuations of those companies that have been under pressure from the pandemic in the past two years; however, those companies that benefited from the changes the pandemic brought about will be under pressure.

Consumer Defensive

The consumer defensive sector has lived up to its name as its only down 3.01% thus far this year. In our view, the sector remains overvalued.

Cost inflation is picking up steam and investing in those companies that have the pricing power to pass through those costs will be especially important. We also anticipate that higher food costs could lead consumers to shift away from branded products to private-label goods such as those sold by TreeHouse Foods (THS).

Of our top picks in this sector, some of the most undervalued stocks are alcoholic beverages. The pandemic instigated a sharp drop-off in both in-person celebrations and on-premises consumption last year, and public events have yet to regain steam. As the pandemic subsides, we expect a pickup in on-premises consumption. Based on the low valuation metrics for these stocks, any revenue pickup would bolster investor confidence.

Energy

Energy stocks skyrocketed over the past few weeks as the sector has risen 16.96%. At a price to fair value of 0.86, we identified energy as being the most undervalued at the beginning of the year; however, following this gain the sector is now fairly valued at 0.99. Although there are a few undervalued exploration and production companies left, most of the undervalued stocks are in the services or pipeline sub-sectors.

Financial Services

The financial services sector has not retreated as much as the broader market, only falling by 1.12%, the second-best sector by performance. At a price/fair value of 1.02, this sector is fairly valued. We continue to expect that banks will have good tailwinds behind them as their primary drivers of earnings trend positively for the foreseeable future. These tailwinds include:

  • A robust economy which will boost loan growth.
  • A low unemployment rate which will lower both defaults and net loan charge-offs.
  • A rising and steepening yield curve which will boost net interest margins.

Healthcare

In our 2022 outlook, we noted that healthcare was one of the more overvalued sectors. In January, the sector dropped 8.80%, and at a price to fair value of 1.04 it is in the fair value range, albeit at the top of the range.

The healthcare sector is split between a general undervaluation in the larger biopharma group and an overvaluation in the device and diagnostics industries. Biopharma valuations imply a high degree of risk involving potential changes in U.S. healthcare policies targeting drug prices. While changes in U.S. drug pricing policies to help reduce out-of-pocket costs are likely, we don't envision major moves like international reference pricing. Despite the uncertainty on drug policy, the fundamental outlook for biopharma firms remains strong, with low patent exposure and new innovative drugs in the pipeline. While Pfizer (PFE) will garner a windfall of cash from COVID vaccines, we don't forecast a long tail for that revenue. Instead, we prefer Merck (MRK) and Bristol Myers Squibb (BMY), where we think the market undervalues the long-term potential of their drug pipelines.

Industrials

Industrials performed in line with the overall market and are currently trading at 1.02 price to fair value, having declined from 1.08. The industrial sector will remain under pressure until inflation begins to moderate. In fact, many industrial firms are already struggling to raise prices fast enough to offset inflationary cost increases. Other pressures include difficulty sourcing raw materials and enduring labor shortages. Compounding these factors, if omicron spreads throughout Asia, it could further exacerbate the ongoing supply disruptions and bottlenecks.

The best value are those companies which will rebound along with a normalization in consumer behavior. For example, we project that the number of air travelers will return to pre-pandemic levels in 2023. As such, within the travel industry, we rate both Southwest (LUV) and Delta (DAL) with 4 stars and expect the return in demand will help lift Boeing, which we also rate with 4 stars.

Real Estate

In our 2022 outlook, we highlighted that real estate was the most overvalued sector. Through Jan. 28, it dropped 9.45% and at a price to fair value of 1.10 remains the most overvalued. Where we see value in the sector is in those companies that will benefit from economic normalization such as the travel, leisure, and hotel industries.

Technology

According to our calculations, technology was one of the most overvalued sectors coming into the year. In January, the sector plunged 11.84%. Following this decline, we now calculate that the price to fair value of the technology sector is fairly valued at 0.99. With the sharp drop in prices we are seeing more and more undervalued opportunities for investors, as many high-quality tech stocks were pushed down with the broader sector.

Utilities

The utilities sector was one of the better performing areas of the market, only dropping 4.97%. The sector is slightly overvalued, trading at a price to fair value of 1.05.

Utilities stocks appear poised for steady, but underwhelming, returns in 2022. Investments in renewable energy, electric vehicle infrastructure, building electrification, and energy efficiency are at the core of our 5%-7% annual earnings growth outlook for most utilities. Our top picks have a long runway of clean energy infrastructure growth, above-average dividend yields, and constructive relationships with regulators.

In the short term, the sector could experience volatility. For long-term investors, the greatest risks we see are inflation and a quick spike in interest rates. The recent rise in inflation is already leading some utilities to adjust their spending plans, leery that regulators won't allow them to pass along the higher cost of raw materials. During the last period of higher, more volatile inflation in the 1990s and early 2000s, utilities regularly underperformed when inflation was rising. Utilities are often viewed as a fixed-income alternative, and any impact to either the ability for a utility to generate steady dividend growth or increase in underlying interest rates will have outsize impacts on this sector.


David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.