Stocks on Sale in a Strong Market

This article originally appeared in the June/July 2012 issue of MorningstarAdvisor magazine.  To subscribe, please call 1-800-384-4000. 

The U.S. market started the year with a tremendous rally in the first quarter as investors became increasingly optimistic about the economy. This was on top of an already strong fourth quarter of 2011. The S&P 500 was up more than 15% from the start of the fourth quarter of 2011 until the end of the first quarter of 2012, making it much harder for Morningstar’s equity analysts to find undervalued stocks. As a whole, analysts believe the market is about fairly valued, but we should be able to find individual stocks that are trading at a discount to their intrinsic value.

We saw the stock market get off to a similarly strong start in 2011 as the economy appeared to be on a strong recovery. But the market sold off later in the year on European fears and a stalled U.S. economy. To protect ourselves from getting too optimistic, we are going to search for value-oriented stocks, rather than chase growth stocks that investors have become increasingly interested in because of hopes of an rapid economic recovery. We ran this screen in Morningstar Principia.

PE Ratio Current < 12

And Revenue Growth % 3 Year > 5%

Despite looking for value stocks, we still want to find businesses that have good growth prospects. Many of the low-multiple stocks that passed our previous screen may trade at a depressed multiple for a good reason— because revenue is declining or growth prospects are weak—so this test should help eliminate declining businesses.

And Stock Stewardship Rating = Exemplary

Despite looking for value stocks, we still want to find businesses that have good growth prospects. Many of the low-multiple stocks that passed our previous screen may trade at a depressed multiple for a good reason— because revenue is declining or growth prospects are weak—so this test should help eliminate declining businesses.

And Morningstar Rating >= 4

We also restricted our search to stocks that earn a 4- or 5-star rating from Morningstar’s analysts. Morningstar analysts project out future cash flows for each business we cover in order to calculate discounted cash flow fair value estimates. Firms that are rated 4 or 5 stars trade at a material discount to their estimated fair value estimate. This screen should help double-check our search for cheap stocks because stocks that are overvalued or have a weak future should not receive a 4- or 5-star rating.

We performed the screen in April. Here are some of the results.

CME Group CME
CME Group has been the great unifier in the futures exchange business. Founded in the 1800s by a group of butter, egg, and produce dealers, CME Group today operates four futures exchanges—CME, CBOT, Nymex, and Comex—with a broad range of trading products. We view CME Group as well positioned to benefit from additional growth in derivatives trading. We project that the company will continue to see steady volume and revenue gains and gradually improving returns.

A key source of CME Group’s competitive strength is its clearinghouse operation, which effectively prevents its products from being fungible at competing exchanges. This is in contrast to the stock-trading business in which shares can be freely traded across venues. Maintaining control of its clearing operation makes CME Group’s revenue stream more exclusive. It is our view that the success of its clearing arm is a key differentiating factor for CME Group. We would view any credible threat—regulatory action, for example—to this clearing/trading business model as a potential blow to CME Group’s strategic position and earnings power.

Strayer Education STRA
Just 10 years ago, Strayer Education was a relatively small education provider, with 14 campuses in three markets and total average enrollment of around 12,000. After its recapitalization in 2001, the firm brought in the current management team and began adding programs and campuses. Today, the institution serves 50,000 students across 90-plus campuses (both fivefold increases since 2000), but it still emphasizes its core accounting, business, and informationtechnology degree programs while targeting the same large and historically underserved market of working adults. The company has a solid record of producing top-line growth and profits over the years and consistently has delivered returns well ahead of our cost of capital estimate. With fewer than half of its existing campuses considered mature or at capacity, we think there’s still meaningful volume growth to squeeze from the newer locations and online markets over the longer term.

Despite Strayer’s impressive historical growth curve, solid management team, and bright prospects, uncertainty surrounding student demand and the regulatory environment loom large. The Department of Education provided a final ruling on key outstanding issues such as debt ratios, funding, and repayment and default rates in June 2011, which we think structurally increases some costs (across the industry). While the impact will not be felt uniformly across the for-profit sector, the landscape is changing and we believe nearly all industry participants (including Strayer) will need to adapt to potentially game-changing rules.

Xerox XRX
Black-and-white laser-printing technologies have matured to the point where the technology is largely viewed as a commodity. In response, Xerox has a two-prong strategy to continue driving growth and profitability. First, the firm will focus on those areas of the printing hardware market where product differentiation can still drive compelling returns. Second, Xerox is expanding its reach beyond the hardware into adjacent services markets.

Xerox is de-emphasizing segments focused on commodity B&W printing in order to focus its attention on color and production print technologies, two areas where growth and the ability to differentiate on the technology enable the firm to drive attractive returns. Currently, a relatively small portion of pages printed are in color. Even as the cost per page falls for color technologies, the economics and revenue generated remain more attractive than what is generated from each black-and-white page. Therefore, even though growth in color pages cannibalizes blackand- white pages, Xerox is hoping to capitalize on the shift.