Volatility in Asia, subprime woes take market for a ride.
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T.S. Eliot once wrote that April is the cruelest month, but March hasn't been a picnic for investors. After the markets surged to start the year, Americans awoke on the morning of Feb. 27 to discover that, while they were sleeping, many Asian markets had plummeted roughly 9%. This precipitated a downturn in the U.S. markets, which was quickly exacerbated by a spate of bankruptcies among mortgage lenders specializing in so-called subprime loans. Stocks have since rallied off their lows, with the Morningstar U.S. Market Index recovering to a 2.3% gain for the year through March 22, though it's still in the red for the trailing four weeks.
As often happens when stocks sink, investors piled into bonds, raising their prices and sending the yield on the 10-year Treasury down to 4.6% through March 22 from its nearly 4.9% peak in late January. (Because bonds offer a fixed coupon, their yield--the coupon rate divided by the price of the bond--shrinks as bond prices rise.) The Lehman Brothers Aggregate Bond Index has returned 1.70% for the year, with nearly half of that gain coming in the past four weeks. Former Federal Reserve Chairman Alan Greenspan also contributed to the bond rally by wondering out loud about the possibility for a recession. Current Fed Chairman Ben Bernanke, for his part, hasn't clearly telegraphed whether he fears recession and will lower interest rates or whether he fears inflation and will raise them. Although bond rallies generally reflect pessimism and the anticipation of lower rates, not everyone fears that the subprime debacle will spur recession. Additionally, employment remains robust, and energy prices appear stable for the moment.
If some traders were spooked out of equities, merger and acquisition activity continued with buyout firm Kohlberg Kravis Roberts & Co. and Texas Pacific making a play for Texas utility TXU TXU. Also, British bank Barclays BCS has set its sights on Netherlands-based ABN Amro ABN. Morningstar analyst Ganesh Rathnam thinks the merger would benefit ABN's shareholders much more than Barclays', since ABN has little value that Barclays could unlock. Moreover, Barclays would be harming its shareholders by paying with its stock, which Rathnam thinks is undervalued.
Notable financiers and investors also kept active. Carl Icahn purchased shares of telecommunications handset giant Motorola MOT in an effort to persuade management to repurchase stock. Finally, Warren Buffett published an eagerly read annual shareholder letter on March 1, which disclosed that his company, Berkshire Hathaway BRK.B, had purchased shares of diversified health-care concern Johnson & Johnson JNJ and Korean steel company Posco PKX. J&J is currently on Morningstar's 5-star stock list and boasts a wide moat for its sustainable competitive advantages based on its size and diversified product lineup. Posco is one of the few steel companies garnering a narrow moat from Morningstar analysts, though we view it as overvalued currently.
Surveying the Sectors and Industries
Industrial materials and utilities led the way in the first quarter, adding 7.8% and 6.2%, respectively, for the trailing 13 weeks through March 22. Steel companies U.S. Steel X and the newly combined Arcelor Mittal MT surged 31.5% and 25%, respectively, as investors anticipate continued strong global demand, especially from developing countries. Analyst Scott Burns has significantly raised his fair value estimate of U.S. Steel, forecasting greater earnings from the company's tubular business and lowering the business's cost of capital because of its improved balance sheet. Burns calls Arcelor Mittal the king of the steel world and has awarded the business a narrow moat for competitive advantages derived from its dominant market share in nearly all geographic regions of the world. Unfortunately, its shares don't come cheap right now, according to Burns.
Software and energy brought up the rear, falling 0.04% and 1.33%, respectively, for the trailing 13 weeks through March 22. Security software maker Symantec SYMC declined 18.5% on fears of competition. Nevertheless, analyst Rick Summer thinks threats in the consumer security market are overstated and praises the company's sales distribution. Summer also likes Symantec's ability to bundle storage solutions with security software. Symantec currently trades below Summer's fair value estimate.PAGEBREAK
In energy, Chinese oil and gas companies posted the worst returns. PetroChina PTR skidded 16% for the trailing 13 weeks through March 22. Morningstar analysts expect lower commodity prices to crimp the company's cash flows in coming years, and currently, the business looks roughly fairly valued. Drill bit maker Smith International SII rose nearly 14%. Morningstar analysts have awarded the business a narrow moat, though it is trading well above their fair value estimate.
In keeping with the industrial theme, rubber products and truck makers were among the top performers, with 29.5% and 19% returns, respectively, for the trailing 13 weeks through March 22. While it's difficult to find a rubber products company with a sustainable competitive advantage, analyst Ben Butwin has awarded truck maker Paccar PCAR a narrow moat for its high-quality products, manufacturing efficiency, and technological superiority. However, the stock surged 47% in 2006 and another 19% so far in 2007, putting it slightly above Butwin's fair value estimate.
Homebuilding and food wholesale posted the poorest performances, with 11% and 9% losses, respectively. As casualties of the real estate slowdown, homebuilders have been sold off to levels that make some of them buys, according to analyst Eric Landry. Meritage Homes MTH, for example, shed 26% in the quarter. However, Landry likes its Texas exposure, which provides steadiness against the boom-and-bust markets of California, Florida, and Nevada. Also, according to Landry, the firm hasn't loaded up on land that is declining in value. He thinks the business is trading below book value, while the market unfairly concentrates on its exposure to formerly hot markets.
Our View of the Market
Although we like to discuss some broader economic themes in our quarterly review, ultimately our view of the market boils down to our fundamental analyses of the 1,900 stocks that we cover. Our coverage universe is 4% overvalued currently. This implies that buying the typical stock now would likely yield positive, though single-digit, returns to long-term investors.
However, there are pockets of greater value, in our opinion. Wide moat stocks appear to be 7% undervalued in aggregate. Although the major market indexes have recovered from the February-March sell-off, some solid businesses remain priced at hefty discounts to our estimates of their fair value.
In financials, behemoths American Express AXP, Bank of America BAC, and Berkshire Hathaway all reside on the 5-star list right now, trading at roughly 80% of Morningstar analysts' fair value estimates. Additionally, analyst Justin Fuller thinks Countrywide CFC and Washington Mutual WM are high-quality companies unfairly thrown on the trash heap of subprime lenders. Both stocks trade in 4-star territory.
Another sector containing solid businesses at bargain prices is health care. Both Johnson & Johnson and Novartis NVS currently trade below analyst Heather Brilliant's fair value estimates. Brilliant argues that the market is focused on the short term and not giving these businesses the credit they deserve for long-term profitability. She likes J&J's diversification in traditional pharmaceuticals, medical devices, and consumer products. She also likes Novartis' involvement in generic drugs. Among biotechs, Brilliant thinks concerns over Amgen's AMGN anemia drugs are overblown, making the stock unduly cheap. Finally, medical device firms Boston Scientific BSX and Medtronic MDT, which make cardiac devices such as stents and defibrillators, should benefit from an aging population; both stocks trade in 5-star territory.
Other wide-moat businesses in 5-star territory include Dell DELL, Expeditors International EXPD, Fastenal FAST, Microsoft MSFT, UPS, and United Technologies UTX. Overall, the market may look neither cheap nor dear, but investors who want to own shares of superior businesses for the long haul have some opportunities.
John Coumarianos is an analyst with Morningstar. He has a position in the following securities mentioned above: MSFT, UPS, BRK.B, JNJ.