4 Undervalued Stocks With Momentum
These wide-moat names have all returned twice as much as the market this year but remain undervalued by our metrics.
Here at Morningstar, we talk a lot about the dangers of chasing performance. For instance, our annual analysis of the investor returns of mutual funds illustrates that while the gap between investor returns and total returns has been shrinking, investors still often make timing mistakes--and that drags down their investor returns over time. In fact, we've even studied how adding "unloved" categories (those mutual fund categories that aren't currently popular) to the fringes of a portfolio can add value.
As such, an article suggesting that investors consider stocks that've soared seems out of character from Morningstar. But hear us out.
Outperformance and overvaluation don't always go hand in hand. We base our fair value estimates of stocks on our expectation of future cash flows; we also take into account the predictability of those cash flows, encapsulated in our uncertainty ratings. Recent performance plays no role in our fair value assessment. We're focusing on long-term intrinsic value. And as a result, stocks that have rallied may not have reached our estimate of their long-term intrinsic value.
Today we're looking at high-quality stocks that have done well so far in 2021 and may have more room to run. Specifically, we screened for stocks that have returned more than twice as much as the overall market this year; the overall market has returned 11%, based on the Morningstar US Market Index as of this writing. We screened further to only include stocks that earn Morningstar Economic Moat Ratings of wide and trade in 4- or 5-star range. Despite their recent runups, these stocks still look inexpensive to us.
Here are our analysts' business outlooks about each name. All data is as of May 26, 2021.
Morningstar Rating: ★★★★
Year-to-Date Return: 38.91%
"Alphabet dominates the online search market with Google's global share above 80%, through which it generates strong revenue growth and cash flow. We expect continuing growth in the firm's cash flow, as we remain confident that Google will maintain its leadership in the search market. We foresee YouTube contributing more to the firm's top and bottom lines, and we view investments of some of that cash in moonshots as attractive. Whether they will generate positive returns remains to be seen, but they do present significant upside.
"Google's ecosystem strengthens as its products are adopted by more users, making its online advertising services more attractive to advertisers and publishers and resulting in increased online ad revenue, which we think will continue to grow at double-digit rates after the pandemic and during the next five years. The firm utilizes technological innovation to improve the user experience in nearly all its Google offerings, while making the sale and purchase of ads efficient for publishers and advertisers. Adoption and usage of mobile devices has been increasing. The online advertising market has taken notice and is following its target audience onto the mobile platform. We have seen Google partake in this on the back of its Android mobile operating system's growing market share, helping it drive revenue growth and maintain its leadership in the space.
"Among the firm's investment areas, we particularly applaud the efforts to gain a stronger foothold in the fast-growing public cloud market. Google has quickly leveraged the technological expertise it applied to creating and maintaining its private cloud platform to increase its market share, driving additional revenue growth and creating more operating leverage, which we expect will continue. Regarding Alphabet's more futuristic projects, although most are not yet generating revenue, the upside is attractive if they succeed, as the firm is targeting newer markets. Alphabet's autonomous car technology business, Waymo, is a good example: Based on various studies, it may tap into a market valued in the tens of billions of dollars within the next 10-15 years."
--Ali Mogharabi, senior equity analyst
Dig Deeper: Alphabet, Facebook Remain Attractive
Morningstar Rating: ★★★★
Year-to-Date Return: 24.84%
"Enbridge is an energy distribution and transportation company in the United States and Canada. It operates crude and natural gas pipelines, including the Canadian Mainline system. It also owns and operates Canada's largest natural gas distribution company.
"Enbridge is positioned to benefit from growing oil sands supply dynamics with its Mainline system and regional oil sands pipelines. The regulated Mainline system generates attractive tolls and represents approximately 70% of Canada's pipeline takeaway capacity. The system offers refinery access to various markets, adding to the network's attractiveness. The company also operates regional pipelines that tie directly into the Mainline. Each of these pipelines originates from existing oil sands projects and is underpinned by long-term contracts.
"While crude pipelines are Enbridge's bread and butter, the company operates a diverse energy portfolio. Gas distribution operations benefit from regulated returns and provide the company with reliable cash flows. Enbridge also operates natural gas pipelines that supplement its crude pipeline network and are underpinned by long-term take-or-pay contracts. Renewable projects also offer a growth opportunities from environmental, social, and governance-friendly secured projects but represent about 3% of the company's EBITDA.
"We think that investors are mistakenly worried about underutilization of the Mainline pipeline system because of production cuts and the construction of competing pipeline expansions. Even if the pipelines are built, we expect only minor underutilization of the Mainline until Canadian crude supply ramps up to our forecast levels once crude prices normalize to our $55 per barrel West Texas Intermediate midcycle forecast. Accordingly, we expect the Mainline to be operating near full capacity. We recognize that our bullish thesis is driven by our long-term forecasts for production growth and pipeline utilization. As such, it could take years for the market to come around to our way of thinking. However, the long and winding road brings significant upside potential for long-term investors."
--Stephen Ellis, strategist
Morningstar Rating: ★★★★
Year-to-Date Return: 38.23%
"Polaris is one of the longest-operating brands in powersports. We believe that its brands, innovative products, and lean manufacturing yield the firm a wide economic moat and that it stands to capitalize on its research and development, solid quality, operational excellence, and acquisition strategy. However, Polaris' brands do not benefit from switching costs, and with peers innovating more quickly than in the past, it could jeopardize the firm's ability to take price and share consistently, particularly in periods of inflated recalls or aggressive industry discounting.
"Polaris had sacrificed some financial flexibility after its transformational acquisitions of TAP and Boat Holdings, but debt-service metrics have been rapidly worked down via EBITDA expansion and cost-saving scale benefits (with debt/adjusted EBITDA set to average less than 1 times over our forecast). This unlocks Polaris' ability to continue to serially acquire strategic businesses (with opportunities likely in the boat segment and parts and accessories segment), which could help stimulate incremental demand. For now, we anticipate a 19% top-line organic lift in 2021, as Polaris continues to backfill dealer inventory, before returning to more normalized mid-single-digit industry growth in 2022. International (low-double-digit percentage of sales) expansion also remains promising and could drive demand upside, particularly as Polaris increases its global operating presence with a wider physical presence abroad.
"As evidenced by solid returns on invested capital (at 18%, including goodwill, in 2020), Polaris still has topnotch brand goodwill in its segments, supporting consumer interest and indicating the firm's brand intangible asset is intact. However, with constraints in the supply chain, 2021 could see some volatility in market share gains, depending on the availability of certain products at retail. We plan to watch market share trends unfold to ensure market share stabilization persists, signaling the firm's competitive edge is intact."
--Jaime Katz, senior analyst
Morningstar Rating: ★★★★
Year-to-date Return: 54.41%
"Wells Fargo remains one of the top deposit-gatherers in the United States, even after the bank's scandals and an asset cap, with the third most deposits in the U.S., behind JPMorgan (JPM) and Bank of America (BAC). Its strategy historically rested on deep customer relationships and sound risk management--and being perfectly positioned for the mortgage market after the global financial crisis didn't hurt, either. We don't see the boost from the mortgage business ever coming back, and the bank's operational competence has been questionable for years, but we still see a bank with the right fundamentals in place and the potential to improve over time.
"Wells Fargo arguably has one of the best branch networks in the U.S., excels in the middle-market commercial space, and has a strong advisory network. This gives the bank many of the right pieces for a solid franchise, but operational execution, satisfying regulators, and restoring some operational efficiency remain issues that need to be solved. We expect it will take many years before Wells has fully optimized its current franchises. This is not dissimilar to what many of the largest banks went through after 2008, where it took years to fully recover and optimize operations and returns.
"The first step in Wells Fargo's continuing road to recovery is getting the asset cap removed. We expect this may be a 2022 event, and we're hopeful it may be in the first half of 2022. Once the cap is removed, it will once again be able to grow the balance sheet and return to some form of offense instead of constantly being on defense. Along the way, the bank needs to become a more efficient operator. This will be a multiyear process, and management has outlined roughly four years of initiatives that should save billions of dollars along the way. We expect that even after these programs are complete, the bank will still remain one of the least efficient operators under our coverage, but returns should improve over time nonetheless, and we wouldn't be surprised to see more cost savings identified along the way.
"Wells Fargo remains a work in progress and is also very sensitive to interest rates, and it will take years to better optimize the franchise."
--Eric Compton, senior analyst
Dig deeper: Wells Fargo Releases Reserves in Q1
Susan Dziubinski does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.