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Stock Market Doom-Busters

Use this screen to spotlight bargains in a gloomy market.

Haywood Kelly, 09/07/2010

Doom and gloom hang over the markets, so much so that it has become unpopular to voice a note of optimism. But let's do just that. The stock market has produced negative returns over the past 10 years, and, as we all know in our minds if not our hearts, it is following periods of such weak performance that we should expect better returns over the next 10 years. While we don't think stocks in general are ridiculously cheap, we do think the S&P 500 is about 18% undervalued. And we certainly see many stocks that we think are priced to produce excellent returns over the next decade. This screen is an attempt at bringing a few of these names to light.

( (Morningstar Rating = 5 stars)
Or Morningstar Rating = 4 stars And Dividend Yield % Current > 5%)

First off, we look for stocks that sport a high Morningstar Rating, meaning our analysts think the intrinsic value of the stock is significantly higher than the current market price. We either want a stock with a 5-star rating--our highest--or a 4-star rating and a great dividend yield. We know many investors seek income, and they are willing to give up a bit of potential total return to get it.

And P/E Ratio Current < 15

Next, we focus on two valuation metrics that have nothing to do with analyst forecasts. We first require a P/E ratio of less than 15. Fifteen is roughly the long-term average P/E of the U.S. stock market.

Free Cash Flow Year 1 > 10%

One of our favorite valuation metrics is the amount of free cash flow a company generates as a percentage of its market capitalization. If you acquired the equity of the firm in the open market, this percentage tells you what income stream you might expect from your purchase. Free cash flow is the amount of cash each year that's left over after the company has reinvested in its business. So, it's what is left over for owners (boards of directors in practice) to do with as they please.

Morningstar Financial Health Grade >= C

Finally, we require that a company score highly in financial health. After all, a distressed company deserves to be cheap. Morningstar's Financial Health Grade is designed to estimate the probability of financial distress by using market signals--specifically, the level and volatility of a company's asset values. We grade companies on a bell-shaped curve, so a C represents the mediocre middle.

The results of our screen include stocks from all over, crossing sector and industry lines. Some highlights:

General Electric GE
Star Rating: 5 stars
Dividend Yield: 2.8%

Exiting the recession, we think CEO Jeff Immelt finally has the portfolio he wants. Immelt essentially put the company on a diet, trimming the business to an impressive core portfolio. NBC Universal should move out of the picture by year's end, leaving the energy, health-care, and aviation pieces intact. All of these are wide-moat franchises, in our opinion. In a move repeated by many of the diversified manufacturers in Morningstar's coverage universe, GE shifted its growth focus from acquisitions to heavy research and development, giving the company one of the strongest new-product portfolios in recent memory. We expect GE Capital to contribute to parent earnings and cash flows, as delinquencies slow and the firm liquidates noncore assets. We are encouraged by Immelt's recent comments that the dividend will increase by 2011 and share repurchases will be a priority with a stock price target of $22 or less.

Seagate Technology STX
Star Rating: 5 stars
Dividend Yield: NA

Seagate, which makes computer hard drives, has turned around its business, and we believe the period of lagging far behind Western Digital is ending. At present, Seagate still does not possess the lean operating cost structure of its rival. However, we are optimistic the self-inflicted wounds that have characterized the last few years are in the rearview mirror. The biggest reason is Seagate finally rid itself of bumbling CEO Bob Watkins. Back for a second tenure, Stephen Luzco has ended the poor execution of the Watkins era and has forced the company to correct its shortcomings: poor execution of product rollouts and a bloated cost structure. Seagate has made great strides since, and further improvement is achievable. We feel Western Digital remains the better run company, but expect the performance gap between the two will continue to narrow during the coming years.

AT&T T
Star Rating: 4 stars
Dividend Yield: 6.9%
AT&T's exclusive arrangement to sell Apple's AAPL iPhone has been a huge benefit, significantly raising both AT&T's wireless market share and average revenue per customer. While we'd prefer to see AT&T build its business upon things that it can control-- customer service and network quality, for example--we don't believe that the loss of exclusivity will dramatically alter the firm's competitive position. The scale and resources that AT&T and Verizon Wireless enjoy is unmatched in the U.S., and we expect these firms will have a leg up in meeting customers' wireless demands in the future. We aren't as enamored with AT&T's consumer fixed-line unit, but this business constitutes only 17% of revenue, and is shrinking. Also, AT&T's decision to invest relatively lightly in the consumer business looks like the right choice at this point. AT&T's enterprise services unit is a solid competitor, and should benefit as the economy rebounds.

Telefonica TEF
Star Rating: 4 stars
Dividend Yield: 7.6%

Telefonica remains the dominant phone company in Spain. Its very large market share in fixed-line and mobile telephony as well as broadband allows it to generate one of the highest EBITDA margins in Europe. Telefonica's early push into Latin America has provided the firm with significant growth over the past decade and a half, which has enabled it to become the third largest telephone company in the world by number of subscribers. While the huge growth rates of the past are gone, Latin America should still allow the firm to grow faster than most of its Europe-based peers.

Supervalu SVU
Star Rating: 5 stars
Dividend Yield: 4.8%

Supervalu is not a company without operational risks--the firm started on less advantageous footing and is playing catch-up to some of its supermarket peers. We think competitive pressures and a deflationary environment should remain significant headwinds until the back half of 2010 or the beginning of 2011. However, we do believe that the market is sufficiently pricing in a bad scenario: The stock is currently trading at around 7 times fiscal 2011 earnings and 2 times cash flow.

The company is finishing a three-year restructuring program to integrate the old Albertsons stores, which we believe can help the firm make incremental improvements. Supervalu has lowered prices and boosted its private- label efforts, moves that we believe should help it keep share. We also have a more favorable view on the hard-discount Save-A-Lot stores, which stand to benefit in the weak environment.

Haywood Kelly, CFA, is vice president of equity research at Morningstar.

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