5 Cheap Stocks to Buy From an Attractive Part of the Market

Susan Dziubinski: Hello and welcome to the Morning Filter. I’m Susan Dziubinski with Morningstar. Every Monday morning, I sit down with Morningstar Research Services’ chief US market strategist Dave Sekera to discuss what’s on his radar this week, some new Morningstar research, and a few stock picks or pans for the week ahead. On the radar this week, Dave, we have inflation numbers with the PPI number coming out on Tuesday and then the CPI following up on Wednesday.

What are the markets expecting?

David Sekera: Good morning, Susan. Good to see you. So, what the markets are expecting, the consensus for core PPI is to hold relatively steady. On the month-over-month basis, that core projection is two tenths of a percent, which would be the same as last month. And then the consensus for CPI, we’re actually looking for a slight improvement. The headline CPI forecast is expected to tick down to three tenths of a percent on a month-over-month basis and slow to 3.5% on a year-over-year basis.

And then, of course, the core CPI forecast on a month-over-month basis, that’s expected to moderate to three tenths of a percent, down from four tenths of a percent last month. And a year-over-year basis declined to 3.6%, it looks like, which would be down from 3.8% last month.

Dziubinski: And then what’s Morningstar’s forecast?

Sekera: Actually, our economics team doesn’t try and forecast the monthly CPI and PPI numbers. We’re actually much more focused on PCE, the Personal Consumption Expenditure Index, as that is the Fed’s preferred measure of inflation. And that’s what they actually use to set monetary policy. So, for core PCE on a month-over-month basis, which is going to be recorded at the end of this month, I believe on the 31st.

We’re looking for that to come in at about two tenths of a percent. And at that two tenths of a percent level, that would actually be consistent with core CPI on a month-over-month basis, coming in between a quarter of a percent to about three tenths of a percent.

Dziubinski: Dave, what could these two inflation reports that are coming out this week mean for the market?

Sekera: It’s really just going to depend on how much they vary from consensus and why they vary. But, generally, I would say higher inflation is going to equal a lower market and lower inflation is going to equal a higher market. The market, of course, just wants to see inflation continue to moderate.

That would then give the Fed enough confidence that inflation is on a long-term downward trajectory. And then the Fed can start to lower the federal-funds rate. Otherwise, if inflation does stay higher for longer, the concern is that tight monetary policy could lead to a recession. Whereas our base case right now is still for that soft landing.

Dziubinski: On the earnings front, we have a few names that you’re keeping an eye on this week. The first is Home Depot HD. The stock is struggling a bit this year. What will you be listening for?

Sekera: Home Depot is still a stock that we think is too highly valued. It trades at a 30% premium right now, putting it in that 2-star rating category. From Home Depot, I’m really just going to be looking for an indication of how things are going in the housing market. And even more specifically, what’s going on in the remodeling market.

From the housing market perspective, I want to see how much high interest rates are taking a toll on activity. But I also want to hear from the remodeling market perspective, how consumer spending is going.

Dziubinski: We also have Walmart WMT reporting this week. The stock price on this discount retailer certainly doesn’t look like a bargain ahead of earnings, does it?

Sekera: No. Walmart is also a 2-star-rated stock at a 20% premium. And again what I really want to hear is from their perspective any additional detail that they can provide on consumer strength. My concern is that after just two years of inflation and kind of how that inflation compounds upon itself over those two years, I think a lot of consumers are really starting to have a lot of sticker shock when they’re going to the stores. And I think it’s really starting to hit the middle-income consumers as well.

Dziubinski: Moving over to the tech sector, Applied Materials AMAT reports this week, and last time I checked, the stock was up about 80% over the past 12 months, riding that AI wave. What does Morningstar think of the stock heading into earnings?

Sekera: I think with this one, it’s really indicative of what we’ve seen going on with a lot of the tech stocks, especially those tech stocks that are considered by the market to be AI plays. AMAT, it was a 4-star-rated stock in the fall of 2022. That stock recovered very nicely throughout 2023.

But, in our view, it’s now just trading way too high compared to its intrinsic valuation. It is a 2-star-rated stock. It’s close to a 40% premium over our valuation. Now what I would note is with a lot of these AI stocks, it looks like the prices have really stalled out here over the past month. And I think we’re going to need to see some strong earnings and some strong guidance for these stocks to move up much further from here. And, of course, any signs of slowdown or weakness. And I think some of these stocks, this one in particular, are at risk of a relatively sharp selloff.

Dziubinski: The last company reporting this week that’s on your radar is Deere DE. Morningstar’s analyst indicated after earnings last quarter that he didn’t expect demand to improve soon. And he also noted that he thinks this near term is more of a cooling-off period than any sort of protracted downturn. How does the stock look ahead of earnings, Dave?

Sekera: Well, generally, I would say from thinking about both the agricultural market and the construction machinery market from a long-term perspective, we do still have a positive view of the prospects for both of those industries. But I think right now the market is overextrapolating the past three years of growth too far into the future.

In fact, when I open up our model and take a look at it, we’ve had 20% top-line growth from 2021 to 2023. So, very strong growth for a manufacturing company such as this. We are expecting a 14% pullback in the top line this year. We’re looking for flat sales growth in 2025 before things start to grow again.

Now over that same time period for the past couple of years, we’ve seen margins expand pretty substantially. I do think that between slower sales growth, that should actually bring margins back down more toward historical averages. And once we account for that in our discounted cash flow model, we do think the stock’s trading at about a 20% premium to intrinsic value, and that puts it in that 2-star territory.

Dziubinski: Now for something that’s on our radar but at the same time completely different, Morningstar celebrates its 40th anniversary this week. It seems like an opportune time to take a step back and talk a little bit about Morningstar’s approach to stock investing. How would you say Morningstar’s approach differs from that of other firms analyzing stocks?

Sekera: I think one of the biggest differentiators is our focus on investing for the long term. For most investors, the amount of time in the market is going to have a greater impact on your long-term success and building wealth as opposed to trying to time the market or trade individual stocks. Now, I’ve got nothing against trading individual stocks, but personally, I rarely pay attention to those underlying technical indicators.

Our focus here really is on determining what we think that long-term intrinsic value of a company is. And then look for those situations where a stock is trading at a relatively large margin of safety below that valuation. And then we’ll let the market work itself out over time. The other part is, I think a lot of our job here is to filter out noise from signal to really help investors differentiate between what’s a catalyst that actually changes that long-term value of a company versus news that comes out that, while it may be interesting, isn’t necessarily meaningful to the value of a company. At the end of the day, our research and analysis is based on that bottom-up. long-term fundamental analysis with a focus on determining your intrinsic value, which of course the definition of intrinsic value is the value of that stock based on the present value of the future free cash flow stream that that company’s going to generate over its lifetime.

Dziubinski: Dave, let’s do a rapid fire on some of Morningstar’s stock-related metrics. First, the Morningstar Economic Moat Rating. What is it and why does it matter?

Sekera: The economic moat rating, when I think about it, is just a very Warren Buffett or Graham and Dodd type of analysis. We’re looking for. Does a company have long-term durable competitive advantages? And if so, how long is that company going to be able to generate excess returns on invested capital over its weighted average cost of capital before those excess returns get competed away by competition?

Of course, the longer a company can generate those excess returns, the more valuable that company is. When I think about it over the long term, I expect that companies with long-term durable competitive advantages are also going to be able to hold their value better to the downside. If we were to go into any kind of recessionary environment, I would expect that those without long-term advantages, those are going to be the ones that either leave that specific industry or could be a bankruptcy candidate as they’re unable to efficiently compete against those that do have those long-term competitive advantages.

Dziubinski: The Morningstar fair value estimate. How is it calculated and what does it tell investors?

Sekera: We use a full discounted cash flow model. Essentially what that means is that our equity analyst team, they’re going to forecast the revenue, the margins, the earnings for each individual company over time that we cover. And they’re going to use those forecasts to project the amount of free cash flow that company is going to generate each individual year.

And then we’re going to take the present value of that in order to come up with what we think the intrinsic value of a company is. A lot of other firms are going to use different types of indicators or shorthand metrics, like a PE ratio, to try and estimate the value of a stock.

Personally, I find that relying on PE ratios is really a poor indicator of valuation overall. And again, we could get into it in a longer discussion, but when I think about the PE ratio, it doesn’t take into consideration a whole number of things, like it doesn’t take into consideration where we are in a business cycle. It doesn’t take into consideration when a company is going to grow and how long that growth is really going to last.

Or conversely, maybe if there’s a contraction within the industry or that company’s individual business prospects. And it also doesn’t measure free cash flow, which again, that to me is really the true value of what a company is. So, in my opinion, net-net, PE ratios I think are better used more for a relative value analysis than they are for really looking at the absolute value of a company.

Dziubinski: Now, the Morningstar Uncertainty Rating. Why does Morningstar think it’s important to consider the certainty with which our analysts calculate future cash flows and therefore their fair value estimates?

Sekera: When you think about the Uncertainty Rating, think about it as really a measure of the range of future potential cash flows of a company. I’d think about it this way: A company like a utilities company or maybe a company in a defensive sector such as Coca-Cola KO, they may have some short-term fluctuations in their business, but over time, they’re going to have relatively steady sales and margins.

But then a company like maybe a mining company in the basic-materials sector or a technology company that’s got some startup technology are going to have a much wider range of potential outcomes. That basic-materials company is going to have big swings over its business cycle. It’s going to have big swings based on whether we’re in an economic expansion or contraction.

And then same thing with a technology company with new tech, you could see a big upswing in revenue for a number of years. Or if competition comes in and their technology becomes outdated, you could see a big, sharp downturn in that company. Those are the companies that you’re going to have a much wider range or a much greater margin of safety before you’re going to be willing to invest in those.

Dziubinski: And then the Morningstar Rating for stocks, what does that represent?

Sekera: We use a scale of 1 to 5 stars to indicate how much we think a stock is either overvalued or undervalued as compared to its intrinsic value. So, for example, 1-star-rated stocks are those stocks that we think are most overvalued, and 5-star-rated stocks are those that are most undervalued. Now within the scale that we use for those star ratings, we do incorporate that Uncertainty Rating.

So, the greater the uncertainty, the more a margin of safety we’re going to want to see before recommending to buy that stock. But conversely, with the wide range of uncertainty, the more we’re going to let that stock rise above its fair value before we’d look to recommend to sell it. So those Low Uncertainty Rated stocks, we actually have a much tighter range around fair value before we would recommend buying and selling that stock.

For a stock with 5 stars, that’s a stock that we would expect to be able to generate an above-average risk-adjusted return over a multiyear period, whereas those 1-star-rated stocks, that’s going to indicate a high probability of what we would expect for a lower risk-adjusted return over a multiyear time frame.

Dziubinski: We’ve covered a lot of ratings and metrics here, Dave. Should investors just buy 4- and 5-star stocks and then call it a day?

Sekera: Unfortunately, things aren’t quite that easy. So, the short answer is no. When I think about investing, it’s really an ongoing process of just continually incorporating new information as it comes out. Plus, you also have to watch what’s going on in the market. So, if you do look at, you know, a 4- or 5-star-rated stock, you buy some for your portfolio.

If that stock does well, and it starts rallying, gets up into that 1- or 2-star-rated range, that’s probably a good time to maybe sell it or at least take some profit. Then from a fundamental perspective, investors just need to continually reassess what they think that intrinsic value of a company is, whether or not there have been any changes to their outlook that could change that valuation.

And, of course, if that valuation does change based on where the stock is trading, that may lead you to sell more or actually buy some more as well. So, for example, if there’s a catalyst that comes out, maybe that causes the stock to sell off, but yet your long-term thesis is still the same. That might be a good opportunity to buy some more, leverage into that position at a lower price. Or if you think the value of a company is actually less based on that catalyst, but the stock hasn’t fallen as much, that’s probably a good time to sell some of that stock.

Dziubinski: Let’s move on to some new research from Morningstar focusing on some companies that reported earnings last week. We’ll start with International Flavors & Fragrances IFF, which is a name we’ve talked about before on the Morning Filter. The stock was up after earnings, and Morningstar left our fair value estimate unchanged. What do we think of the stock after earnings?

Sekera: I mean since earnings, that stock has done pretty well. I think it’s up about 10%. But even after that, it still trades at a 25% discount, it’s a 4-star-rated stock, and pays about a 1.9% dividend yield. Now over the past few years, IFF has suffered from a number of what we consider to be self-inflicted wounds as well as some industry volatility from the pandemic.

From the perspective of what we consider self-inflicted issues, IFF made a number of acquisitions over the past couple of years, a lot of these acquisitions just haven’t turned out as planned. Now, they’re divesting a number of these business lines, really getting back to their core competencies. And they’re going to use those proceeds to repay debt and fix their balance sheet.

From an industry perspective, the pandemic led to a lot of volatility in customer ordering patterns. Consumer food packaging companies, they overordered in 2021 and 2022 due to that short-term excess demand from the pandemic. And then we also had a number of shipping and supply chain bottlenecks and those issues.

Companies overordered in response to that in order to get product in the door. Now, in 2023, households used up what was in their pantries, so the packaged food companies saw a big downturn in their business. Plus, we also had consumption patterns normalize as people started going back out to restaurants.

At the end of all of this, we do expect that destocking is coming to an end here in 2024. We’re looking for relatively modest growth this year and a much more normalized growth pattern starting in 2025. Overall, there is no change to our fair value following earnings. The earnings and the guidance both came in within kind of what we expected for this quarter.

Dziubinski: You talked about Realty Income O on last week’s show, noting that it was really undervalued. How did earnings look last week? And is this REIT still attractive?

Sekera: It’s interesting. The stock actually dipped a bit after earnings but then came back by the end of the week. There were a number of different moving parts this past quarter, but nothing that changed our long-term view. And we did reaffirm our fair value. It’s currently a 5-star-rated stock at a 28% discount, with a nice healthy dividend yield at 5.6%.

Realty Income is a REIT that we do think has a number of different defensive characteristics. The company is a triple net lease provider, so they are able to pass directly through all their own inflationary cost increases directly to tenants. They have very long leases that are in place.

So, that lowers the risk of any kind of near-term lease reductions. And lastly, the tenants that I have generally are pretty defensive in and of themselves. They are things like retail, locations, gas stations, drugstores, and so forth. Then the other thing I’d note with Realty Income, of our REIT coverage, it actually has one of the highest correlations to interest rates.

So, this would be a stock that we do expect to outperform if interest rates decline. And in fact, our US economics team does forecast that the 10-year US Treasury yield will probably average about 4.25% this year, but then decline next year down to an average of 3.50%. And this is a top pick by our equity analyst team in the second quarter.

Dziubinski: On the tech front, ARM Holdings ARM reported last week and the stock tanked. The stock looked really overvalued heading into earnings. So, two questions here, Dave: Why did the stock sell off? And is it now in buying range?

Sekera: When I look at our earnings here, they actually beat consensus both on the top line and earnings. But I think what the market was really disappointed by was the guidance that they provided for fiscal-year 2025. And I’d note that their fiscal year ends in March. So, it’s still a 1-star-rated stock, still trades at a 90% premium to our fair value.

We are projecting top-line growth average of 20% over the next five years. We’re looking for 40% earnings growth over that same time period. This is still a pretty high-growth stock. We just think that the market has way too high of a valuation on the stock. So really just let me give you an indication of you know kind of where it’s trading.

We’re projecting adjusted earnings per share in 2025 of $1.41 per share. Based on the current price, it’s trading at a 77 times forward PE. Looking a couple of years out to 2028, our earnings projection there is $2.62. So, that stock is already trading at 41 times 2028 earnings, which even for a high-growth stock like this I still think that is just quite expensive.

Dziubinski: On to the picks portion of our program. In your May stock market outlook, which viewers can access via a link beneath this video, you point out that small-cap stocks remain an attractive part of the market, and you suggest in your report that given valuations, investors should overweight their small-cap stock allocations. And just to clarify, that doesn’t mean to go all in on small-cap stocks.

It just means to overweight that allocation in your portfolio, whatever your allocation range may be for small caps. So, this week you’ve brought viewers five small-cap stocks you like today. Let’s start with one that popped after reporting earnings last week. That’s FMC FMC.

Sekera: And I really like the situation. I think it’s quite interesting. So, FMC was a top pick by our equity analyst team in the first quarter. And there have been two issues that have been plaguing the stock really for the past year, year and a half. So first, during 2021 and into 2022, the agricultural industry just overordered crop-protection chemicals.

And that was in response to some shipping bottlenecks and some supply constraints. So, people wanted to make sure that they had enough inventory. Well, then in 2023, they decided these shipping bottlenecks and supply constraints have been eased. So, they used up that excess inventory, which of course kept revenue relatively low last year. Our investment thesis here is that we think that 2024 is shaping up to be much more normalized.

And we are forecasting recovery in crop-protection products over the next couple of years. And then second, and this is really just specific to FMC, they are losing patent protection on the manufacturing process for diamides in 2026. That is one of their more important products. But we think the market is underestimating a very strong research and development pipeline that they have.

And when we look at their new products that they have coming out, we think that’s going to at least offset, if not more than offset the loss of that patent protection. So, the key takeaway from earnings here is FMC is starting to see the beginning of the end of that inventory destocking. That should lead to improved results throughout 2024.

The stocks currently rated 5 stars, which is almost a 40% discount to fair value, pays a 3.4% dividend yield, and is a company that we rate with a narrow economic moat.

Dziubinski: Your next stock pick this week is a retail REIT. Macerich MAC. Why do you like it?

Sekera: Looks like they reported earnings on April 30. Earnings were below our expectations, but essentially that was due to an increase in bad debt expense. Reading through our stock analyst’s note here, they noted that otherwise, fundamentals, things like occupancy and releasing, were actually better than expected.

So, net-net, we reaffirmed our fair value. That stock has traded up since. The investment thesis here for Class A shopping malls: They were one of our favorite reopening plays after the pandemic. And according to our analysis, we think that the early reports of the death of the shopping mall were just greatly exaggerated.

Now, I’d still steer clear of the lower-quality malls, those that are considered Class B and Class C. But among the Class A, we’re seeing good foot traffic that’s definitely come back to the class malls. These malls have done a very good job of adapting to changes in the retail sector.

They’re revising their portfolio of stores. They’re becoming more focused on which stores they have that actually drive traffic through their malls. But also they’ve just revised the mall experience, making it much more experiential. So, essentially, they’ve gotten away from a lot of retail locations and put things in that can’t be replicated online: more restaurants, gyms, physician offices, things that all help drive foot traffic.

Now, originally when we were looking at our reopening plays, Simon Property Group SPG was one of our original picks. It’s actually moved up to 3 stars. Macerich is still a 4-star-rated stock at a 30% discount to fair value, 4.3% dividend yield. Now, as is typical in the real estate sector, we assign it no moat, but we do think that there is still a pretty good margin of safety for investors here.

Dziubinski: Lyft LYFT is your next stock pick. And the company put up some good numbers last quarter. And the stock was up quite a bit last week after earnings.

Sekera: Well ride-sharing was another one of our favorite reopening plays after the pandemic. And our original pick was Uber UBER. So, we actually look now at a swap out of Uber. And I think at the end of 2023 is when Uber traded up into that fair value territory, whereas Lyft has continued to lag to the upside.

Their earnings looked good. Bookings came in ahead of guidance I think they’re up 21% year over year. We look at cash flow like adjusted EBITDA that came in at $59 million. That compares to the high end of their guidance, which was $55 million. The company reiterated its full-year guidance. We think the company still remains well on track to meet our full-year expectations.

So, at a 30% discount, it is a 4-star-rated stock, a company that we rate with a narrow economic moat. Although I would caution this is still a stock that we have a Very High Uncertainty Rating on.

Dziubinski: Your next pick is Chart Industries GTLS: narrow-moat company, stocks trading at a pretty good discount, even though the stocks having a pretty good year, performance-wise. Tell us about this one.

Sekera: If you remember initially we highlighted this stock back on the March 11 show. And what initially caught my eye back then as I read through the stock analyst note published by Stephen Ellis, he specifically noted that he thought consensus estimates remained far too low for 2024. So, Chart Industries, a company probably not too many people know, provides cryogenic equipment for storage as well as for distribution for industrial gases as well as liquefied natural gas.

They reported strong first-quarter results. Sales were up 17%. The adjusted operating margin expanded by 620 basis points to 18%. That led to an increase of 73% in EBITDA. Management reaffirmed their guidance for the year that’s well above where consensus is right now. We think this is just a good situation where we have a good combination of your fundamental underlying growth as well as a tailwind. The Street has to catch up to that management guidance at this point.

It’s a 4-star-rated stock at a 23% discount. They don’t pay a dividend, unfortunately, but it is a company we rate with a narrow economic moat. But, again, I do want to caution investors, as with a lot of these small-cap stocks, this is a company with a Very High Uncertainty Rating.

Dziubinski: And then your final stock pick this week, Dave, is a familiar name with an interesting story: WK Kellogg KLG.

Sekera: This was one of our top picks back on our Jan. 8 show. The stock is up 53% since then, but we still think it’s undervalued. So, just to provide a little bit of background here, last year Kellogg split up into two different businesses. So we have Kellanova, ticker just the letter K.

That’s the higher-growth part of the business from Kellogg. That’s the business that’s in the higher-margin snacks business. Whereas WK Kellogg, which is the slower-growth business, it’s a lower-margin business. It’s in the cereal business. But this is one where I found it was interesting last year that the technicals worked against that stock after the split.

So, WK Kellogg was really considered to be an orphan stock back then after the split. The market cap was only $1 billion. At that size, it fell under the radar of most institutional money managers. There’s really no sponsorship behind that name at that point. A lot of small-cap managers didn’t know the name.

And I think there was a lot of institutional selling. A lot of companies that owned it presplit just sold it after the split, irrespective of what the price was in the market. Over the past seven months, I think we’ve really seen a lot of this stock rally as small-cap investors, especially institutional small-cap managers, have done their homework.

They’re now buying into the story. When I look at the fundamentals here, the management focus is to drive margin improvement over time. They’re doing a very good job getting us some of these supply chain efficiencies that they originally pointed out. Now they did report earnings last week. We saw the stock dip just a little bit.

I think really it just could be some profit-taking just because the stock was up so much. Erin Lash, our analyst, she reaffirmed our fair value estimate here. Currently trading at a 19% discount to fair value puts it in the 4-star range. The dividend yield, with as much as it’s risen, is now at 2.9%.

So, a pretty average yield for a pretty decent dividend-paying stock. Now it is a stock that we rate with no economic moat at this point in time. But we at least have a Medium Uncertainty on this one.

Dziubinski: Well, thanks for your time this morning, Dave. Viewers interested in researching any of the stocks that Dave talked about today can visit Morningstar.com for more analysis. We hope you’ll join us for the Morning Filter again next Monday at 9 a.m. Eastern, 8 a.m. Central. In the meantime, please like this video and subscribe to Morningstar’s channel, and have a great week!