7 Undervalued Innovative Stocks

ARK Investment Management's Cathie Wood has gotten a lot of attention this year--and for good reason. After posting some stellar results at her ARK Innovation ETF ARKK, Wood launched several newer exchange-traded funds that slice and dice the idea of investing in disruptive companies that may change the way we live.

The idea of investing in innovators developing and adeptly harnessing new technologies is certainly compelling. Nevertheless, we at Morningstar aren't willing to overpay for a stock, no matter how transformative a company may be. Today, we're hunting for inexpensive innovators in the Morningstar Exponential Technologies Index.

As background, the Morningstar Exponential Technologies Index is designed to identify companies across sectors in the early stages of developing or using transformative technologies. It features 200 companies identified by Morningstar's equity research team as being positioned to experience meaningful economic benefits as a user or producer of promising technologies.

Morningstar has identified nine technology themes.

Big Data and Analytics: Capabilities with data sets too large and complex to manipulate or interrogate with standard methods or tools. Related subthemes include the "Internet of Things," machine learning, and artificial intelligence.

Networks and Computer Systems: Technology leaps ranging from hyperconnectivity and integrated systems, to service continuity and new software-defined architectures, will have a massive impact on the way people think of connecting applications and software with hardware.

Nanotechnology: The branch of technology that deals with dimensions and tolerances of less than 100 nanometers, especially the manipulation of individual atoms and molecules. We see a range of potential applications spanning medicine, computing, manufacturing, and travel.

Medicine and Neuroscience: Sciences, such as neurochemistry and experimental psychology, that deal with the nervous system and brain. Key advancements in unlocking the human genome have created an infrastructure of biomarkers, while paradigm shifts in biotechnology that can alter the immune system are radically changing the way we treat diseases.

Energy and Environmental Systems: This involves the exploration of renewable energy sources--including solar, wind, water, and batteries. As organizations set processes to help reduce environmental impacts and increase operating efficiency, new avenues for technological advancement across sectors will open up.

Robotics: The branch of technology that deals with the design, construction, operation, and application of robots. Advances in robotics, specifically when combined with other exponential technologies, have seemingly infinite potential applications, spanning technology, industrial, medical, and consumer-facing channels.

3D Printing: A process for making a physical object from a three-dimensional digital model. The emerging trend is ready for mainstream consumption and has ample potential to disrupt several industries, from industrial manufacturing and medicine, to consumer products and retail.

Bioinformatics: The science of collecting and analyzing complex biological data. The "quantified sell" trend of acquiring data to quantify aspects of an individual's daily life has exponential potential to positively affect both the duration and quality of life.

Financial-Services Innovation: The search for and acknowledgement of emerging funding sources, platforms, currencies, and stored and transferred value. We not only think about opportunities to efficiently expand production but also the underlying currencies used (including cryptocurrencies), as well as structural shifts in technology and payment delivery methods.

Analysts score companies within those themes on a scale of 0 (no or little exposure to the theme) to 2 (significant exposure), relying on models to project growth over five, 10, and 20 years. We've isolated the seven highest-scoring companies from the index that our analysts cover and are undervalued by our metrics today. Here's our analysts' business outlooks for each of those companies, as well as what themes each has exposure to.

Roche Holdings RHHBY

Morningstar Rating (as of Sept. 13, 2021): ★★★★ Theme exposure: Big Data and Analytics, Nanotechnology, Medicine and Neuroscience, Bioinformatics

"We think Roche's drug portfolio and industry-leading diagnostics conspire to create sustainable competitive advantages. As the market leader in both biotech and diagnostics, this Swiss healthcare giant is in a unique position to guide global healthcare into a safer, more personalized, and more cost-effective endeavor. Strong information sharing continues between Genentech and Roche researchers, boosting research and development productivity and personalized medicine offerings that take advantage of Roche's diagnostic arm.

"Roche's biologics focus and innovative pipeline are key to the firm's ability to maintain its wide Morningstar Economic Moat Rating and continue to achieve growth as current blockbusters face competition. Blockbuster cancer biologics Avastin, Rituxan, and Herceptin accounted for 32% of Roche's revenue in 2019, and all three are seeing strong headwinds from biosimilars. However, Roche's biologics focus (more than 80% of pharmaceutical sales) provides some buffer against the traditional intense declines from small-molecule generic competition. In addition, with the launch of Perjeta in 2012 and Kadcyla in 2013, Roche has expanded its breast cancer franchise, and Phesgo, a subcutaneous coformulation of Herceptin and Perjeta, is launching in the United States. Gazyva, approved in chronic lymphocytic leukemia and non-Hodgkin lymphoma and in testing in lupus, will also extend the longevity of the Rituxan franchise. Avastin's lung cancer sales are vulnerable to biosimilars and competition from new therapies Opdivo and Keytruda, but Roche's own immuno-oncology drug Tecentriq launched in 2016, and we see peak sales potential above $10 billion. Roche is also expanding outside of oncology with multiple sclerosis drug Ocrevus ($9 billion peak sales) and hemophilia drug Hemlibra ($6 billion peak sales).

"Roche's diagnostics business is also strong. With a 20% share of the global in vitro diagnostics market, Roche holds the number-one rank in this industry over competitors Siemens, Abbott, and Ortho. Pricing pressure has been intense in the diabetes-care market, but new instruments and immunoassays have buoyed the core professional diagnostics segment."

--Karen Andersen, strategist

Earnings Update: Solid Performance Supports Sales Growth for Roche

Intel INTC

Morningstar Rating (as of Sept. 13, 2021): ★★★★ Theme exposure: Big Data and Analytics, Nanotechnology, Networks and Computer Systems, Robotics

"Intel is the leader in the integrated design and manufacturing of microprocessors found in PCs and servers. With the rise in the interconnectivity of devices, Intel strives to provide the most powerful and energy-efficient silicon solution to any product "smart and connected." The data centers used to facilitate the information stored, analyzed, and accessed by various front-end devices are mostly run with Intel server chips.

"Intel historically differentiated itself first and foremost via the execution of Moore's law, which predicts transistor density on integrated circuits will double about every two years, meaning subsequent chips have substantial power, cost, and size improvements. This scaling advantage was perpetuated through higher-than-peer-average R&D and a capital expenditure budget that allows it to control the entire design and manufacturing process in an industry where the majority of competition focuses on only one phase. However, the firm has had issues with its 10-nanometer process in recent years, and has announced its 7-nanometer process will be delayed until 2023, thus opening the door for competitors such as Advanced Micro Devices AMD to gain share.

"As cloud computing continues to garner significant investment, Intel's data center group will be an indirect beneficiary. Mobile devices have become the preferred devices to perform computing tasks and access data via cloud infrastructures that require large-scale server build-outs. This development has provided strong tailwinds for Intel's lucrative server processor business. We believe Intel will experience continued growth in the data center, though we note competition from Advanced Micro Devices and customers designing their own ARM-based silicon are potent risks.

"The proliferation of mobile devices has come at the expense of the mature PC market, Intel's historic stronghold, with ARM and its cohorts joining AMD as chief rivals. The rise of artificial intelligence has also unleashed a new competitor in Nvidia NVDA for specialized chips to accelerate AI-related workloads. Consequently, Intel has built a broad accelerator portfolio via the acquisition of Altera for field-programmable gate arrays, Mobileye for computer vision chips used in cars, and Habana Labs for AI chips."

--Abhinav Davuluri, strategist

Earnings Update: Intel Continues to Enjoy Robust PC Demand in Q2

Amazon.com AMZN

Morningstar Rating (as of Sept. 13, 2021): ★★★★ Theme exposure: Big Data and Analytics, Networks and Computer Systems, Robotics, Bioinformatics, Financial-Services Innovation

"Amazon dominates its served markets, notably for e-commerce and cloud services. It benefits from numerous competitive advantages and has emerged as the clear e-commerce leader given its size and scale, which yield an unmatched selection of low-priced goods for consumers. The secular drift toward e-commerce continues unabated with the company continuing to grind out market share gains despite its size. Amazon Prime ties the company's e-commerce efforts together and provides a steady stream of high-margin recurring revenue from customers who purchase more frequently from Amazon's properties. In return, consumers get one-day shipping on millions of items, exclusive video content, and other services, which result in a powerful virtuous circle where customers and sellers attract one another. The Kindle and other devices further bolster the ecosystem by helping attract new customers, while making the value proposition irresistible in retaining existing customers. Through Amazon Web Services, or AWS, Amazon is also a clear leader in public cloud services.

"Additionally, the firm's advertising business is already large and continues to scale, thus offering an attractive option for marketers looking to access a vast audience with a variety of proprietary data points about those very consumers. AWS, advertising, and subscriptions are growing faster than e-commerce with the exception of the 2020 spike in online shopping. We expect these three areas to be the main growth drivers over the next several years. This is critical, as each of these segments drives higher margins than the corporate average, which in turn should allow both operating profit and earnings per share to outgrow revenue as margins continue to expand.

"From a retail perspective, we expect continued innovation to help drive further share gains. We also look for continued penetration into categories such as groceries and luxury goods that have not previously translated into the same level of success as other retail categories. We also see technology advancements in AWS and a bigger push to service enterprise customers as helping to sustain the company's lead there. Overall, we see strong revenue and free cash flow growth for years to come."

--Dan Romanoff, analyst

Earnings Update: Amazon E-Commerce Growth Slows; FVE Steady at $4,200

Merck MRK

Morningstar Rating (as of Sept. 13, 2021): ★★★★ Theme exposure: Big Data and Analytics, Nanotechnology, Medicine and Neuroscience, Bioinformatics

"Merck's combination of a wide lineup of high-margin drugs and a pipeline of new drugs should ensure strong returns on invested capital over the long term. Further, following the divestment of the Organon business in June 2021, the remaining portfolio at Merck holds a higher percentage of drugs with strong patent protection. On the pipeline front, after several years of only moderate R&D productivity, Merck's drug development strategy is yielding important new drugs.

"Merck's new products have mitigated the generic competition, offsetting the recent major patent losses. In particular, Keytruda for cancer represents a key blockbuster with multi-billion-dollar potential: It holds a first-mover advantage in one of the largest cancer indications of non-small cell lung cancer. Also, we expect new cancer drug combinations will further propel Merck's overall drug sales. However, we expect intense competition in the cancer market with several competitive drugs likely to report important clinical data over the next two years in earlier stage cancer settings. Other headwinds include generic competition, notably to diabetes drug Januvia, likely to start as early as 2022.

"After several years of mixed results, Merck's R&D productivity is improving as the company shifts more toward areas of unmet medical need. Owing to side effects or lack of compelling efficacy, Merck experienced major setbacks with cardiovascular disease drugs anacetrapib, Tredaptive, Rolofylline, and TRA, along with Telcagepant for migraines. Safety questions ended the development of osteoporosis drug odanacatib. Despite these setbacks, Merck has some solid successes, including a successful launch for its PD-1 drug Keytruda in oncology. Following on this success, Merck is shifting its focus toward areas of unmet medical need in specialty-care areas, and Keytruda is leading this new direction. We expect Keytruda's leadership in non-small cell lung cancer will be a key driver of growth for the company over the next several years."

--Damien Conover, director

Earnings Update: Merck Reports Solid Q2, Buoyed by Hospital Drug Sales

Tencent Holdings TCEHY

Morningstar Rating (as of Sept. 13, 2021): ★★★★ Theme exposure: Big Data and Analytics, Nanotechnology, Networks and Computer Systems, Financial-Services Innovation

"Tencent has ambitions to expand its leadership in the global gaming industry. It leverages globally popular console and PC-gaming intellectual property of its investees or popular anime IP and develops mobile games for the international market. PUBG Mobile and Call of Duty Mobile are two examples. Investing in the best gaming studios in the world is another strategy to consolidate its leadership.

"Transforming from consumer Internet to industrial Internet is crucial for Tencent, as the latter is underdeveloped in China. Tencent helps industries connect to users through its platforms such as Weixin, which has over 1.2 billion users. Video accounts, mini programs, official accounts, Weixin Pay, and WeCom facilitate communications and transactions between users and industries, allowing companies to monetize their followers in official accounts and private chat groups. For example, in the smart healthcare vertical, patients can find the right medical professionals, register for appointments, conduct video appointments with specialists through Weixin, and settle medical fees using Weixin Pay. Tencent's cloud, security, and artificial intelligence, or AI, capabilities can help hospitals manage their businesses more efficiently. Tencent Meeting, a virtual meeting tool, and Tencent Docs, which allows for multiperson collaboration online, are also gaining traction among enterprise customers. Tencent has a strong position in the social networking and entertainment verticals and is advancing into the finance, government, smart retail, and industrial verticals. This transformation will take time, particularly since Tencent has been more of a consumer-facing company in the past.

"The advertising business benefits from growing products and links between these products and continuous improvement in efficiency and advertising technology. For instance, Weixin Moments' ad revenue continues to grow as advertisers can link their ads with their mini programs to complete transactions. The company launched an integrated advertisement platform that allows advertisers to place ads across all of Tencent's inventory and mobile ad network efficiently."

--Chelsey Tam, senior analyst

In the News: Amid Regulatory Crackdown in China, Tencent Is a Buy

Zimmer Biomet Holdings ZBH

Morningstar Rating (as of Sept. 13, 2021): ★★★★ Theme exposure: Big Data and Analytics, Robotics, 3D Printing

"With the addition of smaller competitor Biomet, Zimmer is the undisputed king of large-joint reconstruction, by far. We expect favorable demographics, which include aging baby boomers and rising obesity, to fuel solid demand for large-joint replacement that should offset price declines. However, Zimmer stumbled into a series of pitfalls in 2016-17, including integration issues, supply and inventory challenges, and quality concerns that caught the attention of the U.S. Food and Drug Administration. But new management has tackled these issues, and the firm is poised to ramp up its growth.

"Zimmer's strategy is two-pronged. First, it is focused on cultivating close relationships with orthopedic surgeons who make the brand choice. High switching costs and high-touch service keep the surgeons closely tied to their primary vendor, and the surgeons bring in enough profitable procedures to keep hospital administrators at bay. This close relationship and vendor loyalty also explain why market share shifts in orthopedic implants are glacial, at best. As long as Zimmer can launch comparable technology within a few years of its rivals, it can remain in a strong competitive position. Nevertheless, we think surgeon influence will inevitably erode, as the practice of medicine changes in response to healthcare reform. Over the long term, it will be more difficult for surgeons to run private practices profitably, and more of them will be open to employment at hospitals.

"Second, the firm aims to accelerate growth through innovative products and improved execution. The latter is critical, in our view, to realizing the firm's potential. Despite a range of structural competitive advantages, Zimmer Biomet under previous management had failed to shine in operations, which dragged down returns. With CEO Bryan Hanson at the helm, we've begun to see signs of progress. We are keeping an eye on Rosa robot placement and related consumable product pull-through. Additionally, we like the firm's more expansive view of where it can flex its advantages, including extremities, trauma, and collaborations that involve sensor and digital technologies to improve workflow."

--Debbie Wang, senior analyst

More ideas: Top 10 Holdings of Our Ultimate Stock-Pickers' Index

Baidu.com BIDU

Morningstar Rating (as of Sept. 13, 2021): ★★★★ Theme exposure: Big Data and Analytics, Nanotechnology, Networks and Computer Systems, Financial-Services Innovation

"Baidu has not developed another industry-leading business other than its mobile search app for years. Its share of mobile time spent fell to 8.0% in December 2020 from 8.9% the previous year, as per QuestMobile. Its flagship Baidu app (202 million daily active users in December 2020) can serve a wide range of users' needs, such as reading, watching videos, livestreaming (it is acquiring YY Live), and so on, but it is less of a super app compared with Tencent's Weixin (1.2 billion monthly active users). It has copied the strategies of its peers by launching a mini program (414 million monthly active users in December 2020) and short video apps (30% year-over-year increase to 127 million monthly active users< in March 2020, as per Fastdata).

"There is high uncertainty regarding the timing and scale of commercialization of Baidu's artificial-intelligence-based services, such as voice assistant platform DuerOS, autonomous driving platform Apollo, and AI cloud services, owing to the high uncertainty of these businesses. We have no doubt that Baidu is an AI leader in China. Search is driven by an AI-powered algorithm, giving Baidu a good foundation in this segment. Baidu is also one of the largest and earliest companies to start AI investments in China. Currently, Baidu uses AI to recommend feeds to the app’s users to generate advertising revenue. It has the highest number of miles tested in China for autonomous driving and has launched its robotaxi services in Beijing, Cangzhou, and Changsha.

"IQiyi, Baidu's online video platform, had been a key growth driver stemming from increasing willingness to pay for premium content in China and continuous advertising demand on iQiyi until short video platforms took mobile time share. It accounted for 28% of Baidu's revenue in 2020.

"In the near term, Baidu will invest heavily in AI while strengthening its mobile business. While meaningful monetization is uncertain, we expect Baidu to increase or maintain its R&D expenditure, which was 18% of sales in 2020. We expect Baidu's margins to be under pressure in the near term as the AI businesses and iQiyi have lower margins than the search business."

--Chelsey Tam, senior analyst

Read more: 4 Very Undervalued Wide-Moat China Stocks

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