Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm joined today by Matt Coffina--he is the editor of Morningstar StockInvestor newsletter--to look at some notable equity ratings changes.
Matt, thanks for joining me.
Matt Coffina: Thanks for having me, Jeremy.
Glaser: Let's start with energy. What kinds of changes have we seen to fair value estimates or moat ratings in the energy sector with the oil-price slide?
Coffina: Some of the changes we have seen were, for example, a dramatic cut in our fair value estimate for Core Laboratories (CLB). I think we were just much too optimistic before, even without the slide in oil prices, but the slide in oil prices has really exacerbated the longer-run growth outlook. It's probably not as robust as we had previously believed, and so we cut our fair value estimate pretty steeply there.
Another example would be National Oilwell Varco (NOV). Our fair value estimate has come down but so has our moat rating. By the way, this is a stock we own in our Hare portfolio. We now think the moat rating is narrow instead of wide. We think that the moat trend is stable instead of positive. We even cut our stewardship rating to standard instead of exemplary. And what is really going on with NOV is that this is a company that benefited very much over the past decade from this once-in-a-generation build-out of deepwater rigs that was facilitated by high oil prices but also by the fact that we built very few rigs in the 20 years leading up to the 2000s.
So, after the oil-price crash in the early to mid-1980s, we had an oversupply of high-spec rigs and we built very few rigs for 15 or 20 years there. That meant that the rig fleet was very old going into this upcycle for oil prices, and NOV was able a role up the industry to a significant extent and really take advantage of that. I think this is an example where we maybe mistook a cyclical upswing--and a very prolonged cyclical upswing lasting decade or more--for a secular growth trend. The reality is that in a more normalized environment, especially with oil prices where they are today, our former forecasts for NOV were probably too optimistic.
One other aspect of the story here is that the company is so acquisitive that the balance sheet has really swelled over time, and that has depressed returns even without the oil-price slide. Now, with this new overhang of high-spec deepwater rigs and the oil-price slide, it is going to be much harder for NOV to generate wide excess returns. We think the company can still generate returns above its cost of capital, but we are much less confident that those will be sustained 10 and 20 years into the future, which is really what we require for a wide moat.Read Full Transcript
Glaser: So, we have seen these big cuts both in fair value estimates and also in moat ratings in some cases in the energy space. Are there any opportunities there, even with the cuts? Do some stocks seem like they still have sold off too much?
Coffina: I think National Oilwell Varco is still a good value. It is less attractive now in my view as a long-term holding, now that we don't think that it has that wide moat. But from a valuation basis, we think that it is still reasonably valued, trading for a single-digit multiple of peak earnings, probably around a mid-teens multiple of trough earnings--and in all likelihood, oil prices won't stay as low as they are currently, indefinitely. We think that current oil prices are unsustainable. Maybe our old oil-price forecast of $100 a barrel was too high, but I think $50 or $60 a barrel is probably too low, given where marginal costs of extraction are. So, in all likelihood, we will see somewhat higher oil prices over time, and that will create some opportunities.
Schlumberger (SLB) is another example of a company that we think is undervalued currently, and probably the stock can do well even with $80- or $90-per-barrel oil. We don't necessarily need a recovery all the way back to $100. There are a lot of other names in our energy sector that look relatively undervalued; but again, it really comes down to those long-term oil-price forecasts, and we are still evaluating those as we speak. So, to some extent, I would say I'm approaching the sector with caution and just sort of waiting to see how things shake out here and see perhaps, with lower oil-price assumptions, which stocks are really going to be the best values.
Glaser: Turning to cost of equity, which is one of the key components of our valuation methodology, we have made some changes there that could have an impact on fair value estimates. Could you explain just what cost of equity is and what kind of impact it could have?
Coffina: Cost of equity is a component of the discount rate, and the discount rate is a key assumption in any discounted cash flow model. We use the discount rate to basically discount back future cash flows to present value to determine what a company's cash flows three or five or 10 years in the future are worth today. The higher the cost of equity, all else equal, the lower the fair value estimate. And similarly, the lower the cost of equity, the higher the fair value estimate.
Morningstar has its own proprietary system for assigning cost-of-equity ratings. So, we assign every company to one of three systematic risk buckets, we call them. Actually, there are four systematic risk buckets: Below average, average, above average--those would be the most common three--and then we also have a very high bucket for companies that are very, very cyclical.
But in any case, each of these cost-of-equity buckets corresponds to a specific cost-of-equity rating. Our old ratings were 8% for below-average systematic risk, 10% for average systematic risk, and 12% for above-average systematic risk. Now, we have lowered those assumptions across the board. So, we are at 7.5% on the low end, 9% in the middle, and 11% on the high end. So, adjustments ranging from 50 basis points to a percentage point within that range--and the majority of our coverage universe falls within those three buckets.
The reason that we've done this is that we have looked back over the past 50-plus years of returns from the stock market--we have looked at current earnings growth and dividend yields and the kinds of expectations that investors seem to be baking into the stock prices--and we have concluded that 10% is just too high for a long-run return expectation. Our average now is going to be more like 9%. And for some very low-risk consumer staples or utilities, we think investors should be satisfied with a 7.5% long-run total return. Keep in mind that that is still well above current interest rates and would imply a very wide equity risk premium spread. But this change is not really predicated on current interest rates being sustained indefinitely. Actually, we are baking in a long-run interest-rate environment--call it a 10-year yield--around 4% or 5% based on 2% or 2.25% inflation. But even under that long-run normalized interest-rate scenario, we think that 9% is a respectable return for investors to expect from stocks.
Glaser: So, those costs of equities are coming down. Does that mean we are going to see a lot of fair value increases?
Coffina: So, again, holding all else equal, you would expect most fair value estimates to rise modestly. The increases I have seen are mostly on the order of 1% to 5% as a result of these lower cost-of-equity assumptions. Again, I think our former cost-of-equity assumptions were just too high. So, you shouldn't think of this as necessarily a reaction to the low-interest-rate environment so much as just recalibrating our historical analysis and concluding that 10% is too high of an expected return from stocks.
But all else equal, you would expect most fair value estimates to increase modestly. I would say there are also some offsetting factors, so all else is never equal. And you have to keep in mind that, for example, the dollar has strengthened quite a bit in the past quarter or two, and that's going to affect earnings of companies with foreign operations. Economic growth has been weak internationally, and so our analysts are going to be updating all of their assumptions at the same time. Some of those other factors--especially the stronger dollar, maybe also weaker energy prices--are going to have a downward effect on our future cash flow forecasts, which at least to some extent is likely to offset the lower cost-of-equity assumptions.
Glaser: Finally, we updated our rating on the combination of Zillow (Z) and Trulia. Can you talk to us about that?
Coffina: So, Zillow and Trulia were the two main real estate portals, and they recently closed their merger. They received approval from the regulators, and they were able to close the merger. We think this really is going to strengthen the competitive position of the combined company, now called Zillow. Previously, these two companies were competing head to head to try to win the market outright. Neither was really able to gain an edge, and this resulted in some very fierce competition for agents and for advertising, such that real estate agents advertising on these platforms are earning returns on investment of something like seven to 10 times--which is really just a staggering return on investment. We think that what's prevented Zillow and Trulia from capturing a greater share of the value they are creating for agents is really the competition between the two firms.
Eliminating that competition by having those two firms come together should really result in a somewhat more rational pricing environment for advertising, and we think that returns on investment for agents that advertise on the site could fall to maybe the 4% to 6% range, which would still be a great value proposition for the real estate agent but would also mean more value accruing to Zillow. So, we think that Zillow has a narrow moat. We think that the competitive advantage is strengthening over time as more and more consumers get used to using the service and it becomes more of a must-have advertising destination for real estate agents. So, we think that the moat is expanding over time. The only downside is that the valuation now looks fair as the market has already anticipated the benefits of the merger. We would probably wait for a wider margin of safety before becoming interested in the stock.
Glaser: Matt, thanks for these updates today.
Coffina: Thanks for having me, Jeremy.
Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.
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