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Larson: High Quality Is Still on Sale--Including This Pick

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar.

It's Ideas Week on Morningstar.com, and today we're talking about defensive ideas. When I think about defensive stock ideas, I naturally think "wide moats." So, of course, I want to check in with Morningstar's Paul Larson, editor of Morningstar StockInvestor and core stock investing strategist.

Thanks for joining me, Paul.

Paul Larson: Glad to be here.

Stipp: So, defensive stock ideas, the performance trends on some of these stock areas haven't been so hot recently. Can you tell me a little bit about what you are seeing and how some of these wider moat or more defensive areas have performed?

Larson: Well, it's interesting when you look at mutual funds, and you look at the different categories and how they've performed. In general, the small category has beaten the large category by quite a large margin, and then also, growth has beaten value by a fairly large margin. And you look at these categories, and the small growth is actually the best performing category and large value is the worst performing category.

Another way to look at these is to look at Morningstar's economic moat rating. When you bucket our companies by wide moat, narrow moat, no moat, the no moat stocks have actually done the best thus far in 2010 followed by the narrow moats and followed by the wide moats, which have actually done the worst so far in 2010.

This is a trend that we saw start in early 2009, basically March 2009 is when the so-called junk rally began. It was a very sharp reversal from what we saw in 2008, where the defensive stocks, the wide moat stocks, outperformed the no moat stocks by a very large margin. And ever since that early 2009 point, we've seen the exact opposite.

Stipp: It's very good to keep that in context. I think it's easy to forget about some of the performance that maybe we saw before and just look recently and see what performance has been. So, good to keep those wide moat stock ideas in mind for that reason.

What are you seeing on the sector front, because I know that we can also get a sense for where investors are putting their money and what's hot right now, and we're seeing similar trends play out there, right?

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Larson: When you look at the sectors, you're seeing the three best performing sectors are consumer discretionary, industrials, and real estate. These are areas that, obviously, have some discretionary aspect to them or some economic sensitivity. And then when you look on the other end of the spectrum, you are seeing some of the most defensive sectors do the worst.

The worst performing sector is actually health care, followed by financials, which is its own special situation, and then another surprising sector that's done very poorly in 2010: utilities. This is surprising because we've seen an investor hunger for yield, but we've also seen an investor hunger for high-risk stocks, and utilities obviously don't fill that hunger.

Stipp: Seems to be overshadowing that.

So, just a follow-up question then for you, Paul: If we saw the bottom in March of 2009, we've been into the market recovery for a while. What trends might break this? When might we see more attention paid to the higher-quality companies?

Larson: Well, I think that momentum is certainly a very strong force, and it is something that has driven this junk rally to where it is today. For better or worse, a lot of investors look at what has done very good in recent periods, and they assume that that performance is going to continue into the future. Obviously, the higher-risk areas have done very well, and subsequently, I think that there is a bit of momentum.

But I think the momentum is going to break eventually once investors start to look at the discrepancy in valuations, because a lot of these smaller, growthier companies are trading at much higher multiples of earnings and cash flow than you are seeing in a lot of the so-called high-quality stocks, where you see a lot of small-growth stocks that are trading at 25 times earnings where you're seeing a lot of large-cap wide moat stocks that are trading at 10 times earnings, and eventually that disparity is going to narrow.

Stipp: Especially when you start to look at what is the certainty of those earnings in the future and what you are paying for.

So, speaking of valuations, can you give me a sense, then, for what the price fair value ratios have looked like for the wide moat versus the no- and the narrow moat, and what kind of opportunities you might be seeing based on that relative difference?

Larson: Sure thing. When you look at the median price to fair value ratio of these stocks in these different buckets, looking at the economic moat, the wide moat stocks still are the most undervalued, with the median price to fair value in that bucket of 0.95%, indicating that the so-called average wide moat stock is about 5% undervalued. Narrow moat is at 1.02%, and then the no moat stocks, the ones that have done the best recently, are actually the most overvalued in our estimates, overvalued by about 8% with that price to fair value of 1.08%.

And then when you look at the sectors, media is actually the most overvalued sector by our estimates, about 8% overvalued, and business services is the most undervalued. But then health care is an area where I'm finding personally a lot of values, and that is also one of the most undervalued sectors looking at our fair value estimates.

Stipp: So looking at the health-care area, do you have a name for us to consider?

Larson: Sure thing. One stock that I own in the Tortoise Portfolio is Novartis, ticker NVS. This is a Swiss company, but it is a global company, a very diversified health-care giant. It's interesting in that it has a very large pharmaceutical business married to a generic drug business as well as vaccines. The stock is looking very cheap, 10 times earnings, the free cash yield is right around 10%, it pays a nice dividend right around 3%, so get a little bit of income while you're waiting. Our fair value estimate is $71, the stock is in the mid $50s. It's a very wide moat, defensive name, trading on the cheap. I think it looks attractive.

Stipp: Paul, thanks so much for your insights today on quality and how it's been performing, and for the idea.

Larson: Thanks for having me.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.