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With Indexes Rising, Any Bargains Left?

Jeremy Glaser
Michael Holt, CFA

Jeremy Glaser: For Morningstar, I am Jeremy Glaser. As many of the major indexes approach their all-time highs, I thought would be a good time to sit down with Mike Holt. He is our director of equity research for North America. We are going to look at valuations and see if there are any values left today.

Mike, thanks for joining me.

Michael Holt: Thanks for having me.

Glaser: As stocks get closer to these nominal highs, do we think the entire space is just very overvalued? How would you characterize the valuation of stocks right now?

Holt: Even though we're approaching a high as far as the indexes are concerned, when we look at our coverage universe we see that the universe is actually about fairly valued. So, when we look at what our estimates are for all these individual companies are in terms of what we think their intrinsic value is and how that compares with their trading, we see that the universe is trading right at 1.00.

Glaser: So, if stocks look to be fairly valued and fully valued what are some of the assumptions underlying that? Do we think that there could be more productivity gains? Do we expect growth to continue? How are the analysts thinking about that?

Holt: Yeah, implicitly in our models there is basic economic growth built in. That reflects the deleveraging we've seen since the downturn. It reflects stabilization of the housing market, return of consumer spending, those general assumptions.

Glaser: So, with stocks being fully valued you don't get a lot of margin of safety. So when you talk about wanting to buy stocks cheaply and something doesn't go exactly right, you have some wiggle room there. Without that margin of safety, how do you protect your downside? How do you think about that?

Holt: That's a great question because we really want to focus on business quality. So, when you start to see stocks that are fairly valued or even overvalued you want to look at business quality. Our research has shown, though, it's not enough to focus on business quality alone, but you want to add a lens of valuation. So, when you look at business quality and valuation that's where you have a recipe for success over long-term investing.

Glaser: So, business quality being a proxy, for say, an economic moat…

Holt: Absolutely.

Glaser: So, the longer you are able to fend-off your competitors, the better off you are going to be.

Looking across sectors right now, is the valuation pretty much even, or are there certain parts of the market that look maybe a little bit frothy and some that look undervalued?

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Holt: It's actually spread out a little bit with the basic materials and energy sectors both looking pretty undervalued about 0.93 and 0.94 of what we think their fair value estimates are. And that reflects the depressed prices for natural gas and coal and some of the different materials there. Then in contrast you have consumer defensive and real estate sectors where these are looking pretty valued at 1.06 and 1.07 in terms of their current price to what we think they're worth. That reflects people chasing yield and driving up REIT stocks and some of the factors at play there.

Glaser: Does that mean investors should totally disregard sectors that look a little bit overvalued and you [should only look into] the basic materials and energy spaces, or is that individual security selection really what matters?

Holt: Yeah, absolutely, and you shouldn't limit yourself to just certain sectors. We think you can find opportunities across the sectors. It just means there might be more plentiful in some areas than others. And so this is where individual stock selection really comes into play.

Glaser: What about some individual stocks; what are some of

Holt: I'd say one of our favorite ideas is National Oilwell Varco. [It has a Morningstar Rating for stocks of 5-stars currently.] It's trading at a 30% discount to our fair value estimate right now. It's one of the world's largest suppliers of drilling equipment. So, we think they are really positioned for a lot of positive trends in the drilling industry right now. The nice thing about this is it's got a wide economic moat. We've awarded it an Exemplary stewardship rating, and then it's got that attractive discount to fair value.

Glaser: Any other ideas right now?

Holt: One other one I would highlight, and this is from the undervalued basic materials sector, is Cloud Peak Energy. This is a coal miner. If you look at the Powder River Basin where they've got a lot of exposure, we think the coal prices there are at unsustainably low levels. And so we see a lot of upside, and this is a great way to play that rise in coal prices.

Glaser: It sounds like a rise in equity prices hasn't necessarily created a bubble. But security selection still matters, and focus on valuation matters.

Holt: Absolutely.

Glaser: Well, Mike, thanks so much for your thoughts today.

Holt: Thanks for having me.

Glaser: For Morningstar, I'm Jeremy Glaser.