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Friday Five: Market Pain, Little Gain for Bargain-Hunters

Jason Stipp
Jeremy Glaser

Jason Stipp: I'm Jason Stipp for Morningstar, and welcome to The Friday Five, Morningstar's take on five stories in the market this week.

Joining me with The Friday Five is Morningstar markets editor Jeremy Glaser.

Jeremy, thanks for being here.

Glaser: You're welcome, Jason.

Stipp: We just ended a bad quarter for stocks. Stocks had their worst quarter in four years. How should investors reflect on the last three months?

Glaser: A lot of investors are probably happy to see the third quarter in the rearview mirror. Most major indexes were down around 7%, and I think there is a lot building up to this … it barely was a correction … but to this downturn.

You look at some of the pressures building in terms of valuations. In many areas of the market, things were looking quite stretched when it comes to that metric. All of a sudden, the market decided that China was a much bigger worry than it had been before. That was precipitated by the devaluation of the Chinese currency, which got investors very worried all of a sudden. Of course, everyone was also watching the Fed. It seemed like no matter what the Fed did, it was bad news for the market. If they decided to raise rates, people were afraid that was going to have a negative impact on asset prices. But if they didn't raise rates, which obviously they didn't, that was a sign the economy was too weak for a rate increase, and that was a sign of concern as well.

You put all these factors together, and maybe we shouldn't be totally shocked that we finally saw a pretty major sell-off--as you mentioned, the worst that we've seen in four years.

But even after the sell-off, it's not like the market as a whole looks incredibly cheap right now. We're basically still in fairly valued territory. Some more pockets of opportunity have opened up for sure. We'll talk about some of those pockets during the rest of the segment, but it definitely has not created a new huge opportunity. Investors are still going to have to be vigilant and ready to deal with volatility in the quarters to come.

Stipp: Alcoa announced this week that it's splitting itself in two. What is the rationale behind that move, and what does it mean for investors?

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Glaser: Alcoa has had these two businesses: An upstream business, which is very much your traditional making of raw aluminum, and that's very sensitive to commodity prices. Whatever the price for aluminum is--and a lot of that is driven by China--that's what you're going to be able to get for those products.

But Alcoa also has a more value-added business, include some of the rolled products and the other services that they provide. That's much less sensitive to commodity prices and may be seen as a better business, but investors might have been hesitant to buy that because of the commodity risk.

So, by splitting those two businesses, Alcoa is hoping that they'll be able to unlock some of the value that's been hidden there. Our analyst thinks that actually is the case and that Alcoa has been undervalued for some time. After this move, we're not changing our fair value estimate but it's still in 5-star territory, still looks attractively priced, and the market may, over time, see value in both of these businesses.

Our analyst also thinks that investors shouldn't just totally discount that upstream business, either. It's going to be for investors who are able to stomach those commodity price changes. But if you're looking for something that's in deep-value territory, if you have a very long-term perspective, that upstream business could potentially be attractive as well.

The split is scheduled to happen some time in 2016--so nothing imminent. But the firm as a whole does look undervalued right now.

Stipp: In the energy space, in MLPs, Williams has agreed to merge with Energy Transfer Equity. What's our take on that deal?

Glaser: After attempting to get this deal done in June, the two are going to merge now at a price of $43.50 a share for Williams. I should note, that's down from $64 a share that was talked about in June. That just gives you a sense of how much pressure the energy industry has come under, in just a few short months.

I think there's some pluses and minuses to this deal. On the plus side, as our analyst Peggy Connerty points out, there really are some good corporate synergies here that could help get a lot of costs out of these businesses, could help build a lot of cash flow. There are other complementary assets that really could help here.

But on the down side, it really doesn't help reduce the complexity in the Energy Transfer companies, which has been hanging on the shares for some time. Investors have hoped to see the business become simpler to add more transparency to really see what's going on here. This actually will have a new entity created, Energy Transfer Corporation, which will be buying Williams Companies in order to make it a more tax-friendly deal. That doesn't help on [the transparency] front.

Management had said they were working toward this goal [of transparency], but they admit this is moving in the wrong direction. We think that's one of the reasons the shares of Energy Transfer sold off on this deal--because it was a move away from transparency.

So this deal probably makes sense from a strategic standpoint, but I think over time, investors are still going to demand more simplification of the structure to really understand what's happening in the business.

Stipp: Health-care stocks sold off this week. What was behind the pessimism and are we seeing any bargains emerging?

Glaser: There were some concerns about drug pricing. A handful of politicians started talking about some of the problems with drug pricing--some high-profile, high drug prices--which got this chatter going. We saw something similar happen in 2014 as well, when there was some talk about this.

I think investors need to take a step back and not look at some of the more radical proposals that are unlikely to come to pass and instead maybe look at the few issues that have the potential of [negatively impacting companies], like shortening the exclusivity period for biologics. That was one that was floated that you can see potentially being implemented.

But for the most part, we think this [sell-off] did create a buying opportunity. When we look at our fair value estimates and our economic moat ratings, what we think of the competitive advantages of these firms, that just isn't going to be impacted by these relatively small changes. There already is a layer of uncertainty built into that. We don't assume there's not going to be any pressure on drug prices forever. You're buying these firms at a discount. If you get a deep enough discount to our fair value estimate, that allows some of this stuff to happen without it blowing up your investment thesis.

On the big pharma side, Merck is our favorite name right now. And on the biotech side, we think Biogen and Amgen look attractive.

Stipp: Lastly, Apple announced that it had a really good first weekend for the launch of their new iPhone, the iPhone 6S. Expectations were also high, though. So what's our take on those sales?

Glaser: They said they sold a record number of launched iPhones, at 13 million; that's up from 10 million the year before. That record isn't a surprise given that it's launching in more countries this year, and there are fewer supply constraints, and also the pre-order window was longer, so you'd expect to have more people order.

But even if you think this demand was just kind of flat from the previous year, it shows the power of Apple's network effect; they really are getting people locked into their ecosystem. The iPhone 6S has mostly incremental changes, features that people want but probably aren't driving people who maybe upgraded last year to go ahead and upgrade again. But it's enough to get people interested and to shell out the money in order to get these new phones. Particularly the way that the cell phone carriers are now pricing them, you really see the price of that phone again. So this large [sales] number is certainly heartening.

Brian Colello, who covers Apple for Morningstar, says that right now Apple shares are priced to suggest iPhone revenue has peaked--that the growth story is over and that you're not going to see a lot of upside from here. He thinks that if you buy Apple shares at today's level, and they are in 4-star territory, any upside with iPhones is going to be gravy for you, something that could help juice your returns and juice Apple's earnings over some time.

Stipp: It's always worth dialing into The Friday Five. Jeremy, thanks for joining me.

Glaser: You're welcome, Jason.

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