Buying Opportunity in Multiple Sectors as Market Weighs Short-Term Impact
The markets' chills offer a chance to stock up on quality companies.
|Editor’s note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.|
The near-term news is likely to get uglier, but an increased collective effort globally is expected to lead to containment of the coronavirus outbreak sometime over the next nine months. We base our view on a historical analysis of previous pandemics as detailed in "Morningstar’s View: The Impact of Coronavirus on the Economy."
Experience with previous pandemics informs our assessment of a range of likely outcomes for global economic growth in 2020. We expect the near-term impact to be savage, shaving 2 percentage points off global GDP growth. However, we anticipate a vaccine will be ready to be deployed by mid- to late 2021, setting the stage for a return to normality. We expect a quick recovery of the global economy in 2021. The fast and furious monetary and fiscal interventions announced by central banks and governments globally should provide enormous tailwinds for the world economy to grow above trend and undo most of the damage by 2024.
It has been difficult to keep on top of the rapidly shifting environment, but collectively, we find more opportunities to buy than sell shares at current levels. Because this event presents a sharp short-term economic fallout for many companies, we think this crisis will certainly favor companies with economic moats and financial strength. We think there are a number of moaty names that investors should consider adding to their portfolios as well as heavily sold-down stocks that could see a good postvirus bounce. We can’t begin to suggest when equity markets may bottom out, but we like where we see good value versus risk.
Strong Medicine Gives Stock Markets the Chills
Global stock exchanges are retreating as government policies to slow the spread of the coronavirus are infringing on economic activity. Fears of a global recession have triggered reserve banks and governments to respond with monetary easing and fiscal stimulus, respectively.
Many leading economists are concerned that the synchronized slowdown in global trade will lead to recessions in various markets. We don’t disagree. Some economies are likely to slip into a few quarters of negative growth. If a country is able to contain the coronavirus outbreak to four months, it’s possible to avoid a recession, but given the global pandemic spread, there’s a good chance a recession will occur. While the overall global growth rate is slowing, we still anticipate 2020 global GDP growth to be positive and increase by 1.3 percentage points.
In its January 2020 update to its World Economic Outlook, the International Monetary Fund estimated world GDP growth at 2.9% in 2019 and forecast a global economic growth rate of 3.3% for 2020. There was no mention of risks to China’s economy from the coronavirus in the IMF’s update. Therefore, we use this pre-COVID-19 growth forecast as our baseline of an undisturbed state of the global economy.
The intensive countermeasures taken by the Chinese government have hit economic activity hard in the first quarter. We lowered our 2020 China real GDP growth forecast by 250 basis points, to 2.2%, some 100 basis points ahead of the average global decline.
However, the Shanghai and Hong Kong stock exchanges have performed surprisingly well year to date. Among select 12 global exchanges of G-20 nations, the Brazilian exchange underperformed the most. European markets have underperformed U.S. markets. The second quarter of 2020 is likely to be severely affected outside China. While Chinese workers are returning to offices and factories, many G-20 nations are moving to significant curfews on public life and restrictions on economic activity.
China Slowly Returning to Norm, With Next 14 Days Key
Perhaps the reason the Asia markets have lagged the recent rout in European and U.S. markets is that Asia had a head start on this outbreak and its domestic spread cases have generally peaked. We are seeing a second wave in mainland China and Singapore recently from returning residents who picked up the virus on their travels, but the governments appear to be confident that this can be contained at the source through either mandatory quarantines for all returnees and visitors or banning visitors outright. As a result, stores and schools that had been shut are reopening. What will be key is if China has 14 straight days of no local transmitted cases. If that happens, additional lockdown practices may be relaxed.
It’s still too soon to see what the national data may show, but we think some sequential improvement in China consumption data is possible based on individual company guidance. The latest data shared by CK Hutchison-owned drugstore chain Watsons is that at the peak of the virus outbreak in China in February, 64% of its 3,947 stores were closed and store traffic fell 90%. More than 95% of its stores are now open and foot traffic is recovering; while down 50%, it still marks a sharp improvement. If there are 14 straight days with no local cases, we anticipate a stronger recovery in consumer confidence. However, the United States and Europe will still be seeing cases rise, so uncertainty will remain a drag and economic activity will still be sluggish in China on subdued global demand.
Market Fair Value Screening as Attractive
Earlier this year, we estimated the market fair value of Morningstar’s global coverage universe was overvalued by 7%, with a market fair value of 1.07 as of Jan. 17. Following the significant global market downturn, we estimate the global market fair value to be 0.70, or 30% undervalued, as of March 19.
Opportunities abound, offering investors material margins of safety. Three fourths of our global coverage is rated 4 or 5 stars. Besides the absolute price/fair value ratio, our uncertainty ratings are the other determining factor of our star ratings. All else equal, a stock with a higher uncertainty requires a higher margin of safety to switch between star ratings. The 40% of our global equities coverage that are 5-star-rated present the most appealing investments on an uncertainty-adjusted basis.
About 7% of our global coverage still screens as overvalued, despite the recent sharp stock market declines, but only 2% are 1-star-rated. We rate 17% of companies covered by Morningstar at 3 stars; these we expect to yield their cost of capital to shareholders but don’t offer a significant margin of safety.
Market Is Extrapolating Soft Short-Term Earnings
Humankind is looking down the barrel of a global health crisis. For most, 2020 is shaping up as a year best forgotten from a personal health as well as a financial perspective, at least for now. However, we don’t expect the world to come to an end.
While we anticipate the coronavirus impact to be taxing on global GDP growth and company profits in 2020, we don’t envisage long-lasting effects. Rather, a strong rebound is highly likely once a treatment and subsequently a vaccination become available. Reserve banks and politicians around the world have learned from the global financial crisis and reacted quickly with monetary easing and fiscal stimulus, respectively. We forecast these tailwinds, together with new infections abating, to underpin global economic growth above trend in 2021-23 before returning to trend growth from 2024.
The market’s view seems to differ from ours. The steep discounts to our fair value estimates in some sectors suggest the market is extrapolating the current weakness to persist much longer. This opens a raft of opportunities for investors willing to cut through the noise and instead, in a disciplined manner, assess the extent to which the pessimism regarding long-term corporate earnings is warranted.
The most heavily sold-off sectors are energy, consumer cyclical, and financial services, all very procyclical sectors. However, as the term procyclical suggests, those sectors are likely to outperform when the economy recovers. Generally, the performance of the 11 sectors categorized by Morningstar is strongly correlated with our average price/fair values of the respective sectors. That is, we estimate those sectors, which have experienced the poorest performance year to date, to be the most undervalued.
We concede that sector-specific issues beyond the coronavirus pandemic come into play, but we surmise that the global health crisis is in most instances the main driver of recent performance.
An obvious outlier is the energy sector, which is grappling with a price war between Saudi Arabia and Russia that is exacerbating already softer demand for crude oil due to a material slowdown in global travel and economic weakness in general. However, a relatively low oil price is likely to benefit the bottom line of companies consuming energy directly by lowering their cost of doing business. The indirect benefit will be to swell consumers’ wallets, which can redirect consumer spending from fuel stations to retailing, healthcare, rent, or other expenses.
Conversely, utilities are at the relatively expensive end, although we see value emerging for the first time in many years. As our utilities analyst Travis Miller wrote , U.S. utilities’ 15% sell-off March 11-12 left the sector cheaper than it’s been since 2009. The U.S. sector is 7% undervalued based on Morningstar’s fair value estimates. The downturn in utilities opens long-awaited buying opportunities, especially for defensive investors. Most utilities are financially strong with attractive growth potential and historically high dividend yields relative to interest rates. We do not plan any significant fair value estimate or moat rating changes for utilities based on coronavirus impacts. Before the downturn, we were among the few who thought utilities valuations were far too rich. U.S. utilities peaked at 21% overvalued in mid-February, based on our fair value estimates. The sector is down 24% since then.
Further breaking down the performance of the individual Morningstar sectors to the Morningstar industry level gives more granular detail. For instance, within the consumer cyclical sector, the market appears to view the auto-parts industry as less exposed than footwear and accessories. We agree that it is more urgent for many consumers to fix a broken-down car than to buy the latest high-end sneakers. Other discrepancies are intuitively not as easily verified. We question why travel services have been hit that much harder than airlines and the lodging industry.
Our Top 10 U.S. Ideas
Following are 10 high-conviction, undervalued U.S. stocks that have either little exposure to COVID-19 or else overstated long-term implications.
Market sentiment has turned against 3M (MMM) for three reasons: slowing organic growth as the wide-moat company matures; recent weakness in the auto, semiconductor, and Chinese markets; and litigation risks related to per- and polyfluoroalkyl substances. As a result, bears now maintain that 3M’s model is irretrievably broken. We disagree. In our view, coronavirus fears now offer potential 3M investors an uncommon opportunity to own the shares of a well-run, defensive franchise that offers safety of principal and yield, as well as the potential for modest capital appreciation. The effects and related fears over the virus will hurt the company’s supply chain and most of its short-term results, given 3M’s material geographic exposure to China. That said, we think the valuation remains too attractive to pass on, based on our $186 fair value estimate. At current valuations, in our opinion, investors are getting nearly any growth in 3M from these levels “for free,” even after servicing its PFAS liability.
We think the market is also discounting short-term catalysts in the stock. 3M possesses a historical ability to retool its operations to capture higher-growing portions of GDP amid short-cycle headwinds. We point to 3M’s personal protective equipment division, where global demand for its N95 respirators now exceeds supply and could drive greater-than-expected division revenue growth.
Long-term secular drivers include an aging population, urbanization and industrialization trends, and a rise in chronic disease and surgical procedures. We expect that the more stable portions of the company’s portfolio should allow 3M to trade like a consumer healthcare stock, and we would not be surprised by a rerating in line with its historical norms.
As one of the global leaders in online commerce, wide-moat Amazon (AMZN) finds itself in a unique position amid the global coronavirus outbreak. As containment efforts hasten and more consumers isolate themselves, we believe certain Amazon services will see increased adoption. The most obvious example is online grocery, which has accelerated “significantly” in recent weeks based on our discussions with logistics industry executives. With a spike in telecommuting, Amazon Web Services also stands to benefit from increased enterprise cloud computing, storage, networking/content delivery, and digital security usage. On top of increased enterprise-level cloud demand, we anticipate Amazon will benefit from increased demand for entertainment content, either directly (its own content portfolio) or indirectly (AWS functionality for Netflix and other content providers).
While Amazon finds itself well positioned to capitalize on coronavirus-related demand, it could also face obstacles. At the top of the list is reduced discretionary spending. The company has done a better job diversifying its product mix toward more consumer staples in recent years, but a material consumer slowdown would still affect top-line growth. While we would expect online retail to outperform physical retailers during a quarantine situation, online retailers would not be immune to potential disruptions stemming largely from logistics staffing availability. Additionally, we expect supply chain disruptions for Amazon (including its own hardware) and its third-party sellers to result in some shipment delays and product availability. Still, we expect consumers to prioritize online shopping in the months to come. Amazon currently trades at a significant discount to our $2,400 fair value estimate.
BioMarin Pharmaceutical’s (BMRN) orphan drug portfolio and strong late-stage pipeline support a narrow moat. We think the market underappreciates the company’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 the company’s close relationships with patients who rely on its therapies for chronic treatment. BioMarin currently trades at a significant discount to our $119 fair value estimate.
No-moat CenturyLink (CTL) has dropped in recent weeks to trade at about half of our $19 fair value estimate with a dividend yield above 11%. We think the stock has been hit especially hard because the market has become fearful of companies with highly leveraged balance sheets. However, we believe the transformation in CenturyLink’s business following the Level 3 acquisition has left the company in a better position than most investors realize.
CenturyLink was aggressive in refinancing debt during 2019, pushing its maturities further into the future. We don’t expect the company will need access to credit markets until 2022. In addition, we don’t believe its business, which primarily provides networking solutions for enterprises and governments, is especially sensitive to the economy, so we don’t expect a substantial downturn in the event of a global recession. We still expect the company to earn about $3 billion in free cash flow in each of the next two years, a time during which it has a total of $3.3 billion in debt maturing. CenturyLink’s current dividend requires $1 billion of the cash each year. We think the dividend would be on the chopping block only if financial market conditions remain depressed and the company becomes concerned about its ability to refinance a portion of the $4.4 billion in debt coming due in 2022. We don’t think CenturyLink has a compelling business growth story, but we see it as too cheap for a company that is relatively stable. CenturyLink’s equity is currently trading at about 3 times trailing free cash flow.
Wide-moat Comcast’s (CMCSA) core cable business (more than half of consolidated revenue and about 70% of consolidated EBITDA) is in great shape and should see minimal impact from COVID-19. The theme park business will be hurt, but it was only 5% of revenue and 7% of EBITDA in 2019. Longer term, the park business is a key asset behind Comcast’s media efforts. The Sky acquisition added to Comcast’s debt load, but the balance sheet remains solid. Net debt is at 3.0 times EBITDA versus around 4.6 times EBITDA for cable peer Charter and 5.3 times for Altice USA. Comcast’s valuation isn’t as attractive as early 2018, during the battle for Fox, but the stock is still trading at a 30% discount to our $49 fair value estimate. The company is trading at 7.5 times trailing EBITDA, down from more than 9.0 times in mid-February.
Wide-moat Corteva (CTVA) is trading at a significant discount to our $40 fair value estimate. The pure-play agriculture inputs company generates around half of its profits from seeds and the other half from crop chemicals. Corteva manufactures all of its seeds locally, resulting in minimal exposure to international supply chain disruptions. In crop chemicals, the supply chain is more global, with manufacturing sites around the world for the company’s intermediate and finished products. However, this footprint is well diversified and not reliant on any single country. Further, the company currently has around a year of inventory on hand, which should provide some buffer.
Corteva’s largest market is U.S. farmers, who account for around half of revenue. Following 2019, which saw the lowest U.S. acres planted in over a decade, farmers are expected to plant more crops this year, which should translate to sales and profit growth in 2020. Outside the U.S., our current expectation is that farmers will plant crops as usual in 2020 and Corteva should see normal demand, particularly for its premium products that help farmers increase yields by controlling pests. Additionally, we think the market is undervaluing the launch of eight new crop chemical products and the Enlist GMO corn and soybean seeds. These products should drive revenue growth and profit margin expansion in the years to come.
We believe narrow-moat Hanesbrands (HBI) is in better shape to ride out the COVID-19 crisis than many other international apparel manufacturers. In contrast to many of its peers, Hanes has minimal product sourcing and sales in China, so it should suffer limited direct impact from the most affected nation. Hanes’ sales will certainly suffer if the crisis causes severe economic downturns in North America, Europe, or Australia. However, the company remained profitable throughout the 2008-09 financial crisis and its business rebounded nicely in 2010-11. Hanes sells replenishment products that people buy regularly, regardless of the economy. Over the long term, we still believe the company can improve production efficiency. We forecast operating margins of 15.3% in 2024, up from 13.7% in 2019, and estimate that Hanesbrands will generate approximately $3.9 billion in free cash flow to equity over the next five years. Although the company is prioritizing debt reduction, it pays an annual dividend of $0.60 per share and plans to repurchase $200 million in shares in 2020. Hanes currently trades at a significant discount to our $27 fair value estimate.
A recession would negatively affect narrow-moat Macerich’s (MAC) results for the next two to four years, and a permanent change in consumer behavior would lower the company’s long-term growth potential. The mall owner-operator is also facing a potential dividend cut as it tries to finance both a very high dividend and its renovation plans. That said, we still like the company and think it screens as extremely attractive at current prices. We believe that Class A retail will be the winner among brick-and-mortar retail and see positive growth over the next decade, while the major bankruptcies and store closures will occur among the Class B and C properties. Macerich’s renovation plans should unlock a lot of value at its properties and provide significant tailwinds for earnings growth starting in late 2021. Also, because it trades at such a massive discount to net asset value, it could be a target of a takeover offer. The shares are currently trading at a significant discount to our $51 fair value estimate.
Norwegian Cruise Line Holdings
Narrow-moat Norwegian Cruise Line (NCLH) has a wide margin of safety to our $42.50 fair value estimate. Fears surrounding the coronavirus outbreak have weighed on travel stocks, and oversupply concerns have echoed through the cruise marketplace over the past few years, bounding share gains. While 2020 has a dour outlook, we believe the impact from COVID-19 will begin to diminish in 2021 as Norwegian’s brand power should still resonate with consumers. However, we have placed a very high uncertainty rating on the stock, given the uncertain duration of the COVID-19 outbreak and the lasting impact it could have on traveler perception. We forecast yield to decline 25% in 2020 but believe Norwegian should still print positive earnings per share, with costs declining by around half that amount. At the end of 2020, we forecast the EBITDA/interest ratio will be at 4 times (down from 8 in 2019) and net debt/total capital will be at 50%.
In our opinion, current concerns are transitory and plenty of global demand remains untapped to support industry growth once the virus abates. Cruise companies are expanding the aggregate demand pie by tapping into new geographies and demographics via wider market segmentation than in the past. With Norwegian’s compelling value-added bundling and market-to-fill strategies, we think the company is poised to pivot nimbly to capitalize on evolving consumer trends and increase average EPS growth again in 2021 as COVID-19 concerns dissipate.
We believe the market is underappreciating wide-moat Pfizer’s (PFE) next-generation drugs, which should drive strong long-term growth. Further, the company’s pipeline drugs focus on areas of unmet medical need where pricing power is strong. Pfizer is facing very few major patent losses over the next five years, which should also support steady growth. Lastly, the divestment of established products group Upjohn to Mylan creates a new entity with robust cash flows, likely supporting a strong dividend. The shares are currently trading at a significant discount to our $46 fair value estimate.
Lorraine Tan does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.