Where to Invest Your Money in Q3 2022

Key Takeaways

- Inflation, rising interest rates, slower economic growth, and tighter monetary policy have created headwinds.

- We think the market is trading at a 17% discount to our fair value estimate.

- Large-cap stocks like Meta, Amazon.com, and Disney are on sale.

Susan Dziubinski:

Hi, I'm Susan Dziubinski with Morningstar. The second quarter of 2022 has come to a close. Where can investors find opportunities as we head into the third quarter? Here with me to answer that question and a few others is Dave Sekera. Dave is Morningstar's chief U.S. market strategist.

Stock Market Recap of Q2 2022

Dave, let's start out by talking a little bit about market valuations today based on our proprietary metrics at Morningstar. So, recap what happened with valuations overall in the second quarter and how things are looking as we head into the third quarter.

David Sekera: Coming into the second quarter, what I think we really saw was the convergence of those four main headwinds that we identified at the beginning of the year in our 2022 outlook, and of course, those being the slowing rate of U.S. economic growth, the Fed now tightening monetary policy, inflation running hot, and rising interest rates. So, I think the four of those together, and of course, then you have to put what ended up happening over in Russia and Ukraine on top of that and the effects that we've had there, all of that together. So, we saw a pretty strong downturn in the markets in the second quarter.

Now, coming into the third quarter, we actually think the pendulum has swung too far to the downside. So, we actually think the markets are getting to be pretty significantly undervalued at this point. In fact, when you look at an aggregate of all those stocks that we cover that trade here in the U.S., we think the market is trading at about a 17% discount to our fair value. Now, on a historical basis, that's pretty cheap. So, when I look back over the past 12 years, there has only been a couple of other instances we've seen the market at this low of a valuation. Of course, March 2020, during the emergence of the pandemic, we saw the markets with a big selloff at that point in time. End of 2018, if you remember, there was the big growth scare at that point. The Fed had already been tightening monetary policy for about a year going up into that. And then, you have to go all the way back to March of 2011. And just to remember what happened back then, that was when we had the Greek debt crisis. People were concerned about possible contagion going into Italy and Spain and Portugal, and then even going into the EU banking system. We think that stocks are pretty undervalued at this point in time. And now, it's actually a good time for investors to be, I'd say, judiciously adding to their equity exposures, especially in those high-quality companies, those that we think have a wide economic moat.

Most Opportunities in Small-Cap Stocks

Dziubinski: Let's look at the market then and valuation through a few different lenses, starting first with market capitalization and style. Now, you mentioned in your quarterly outlook that stocks of most sizes and styles are undervalued today as we're heading into the third quarter. But where are some of the best opportunities?

Sekera: Well, among the different styles, I really like a barbell portfolio structure right now between value stocks and growth stocks. So, growth stocks, of course, have got hit the hardest during the second quarter, and we think growth stocks across the different categories are the ones the most undervalued at this point. And then, value stocks, they were best positioned at the beginning of the year. They haven't fallen as much as what we've seen in like the blend stocks and the growth stocks, but we think those are valuable at this point in time as well. So, I like that structure between the two of those categories. And then, among the different market capitalizations, both large cap and mid-cap, pretty much trading at about the same type of valuation. The small caps are where we see the most opportunities for investors today.

Wide-Moat Stocks Hold Edge Against Narrow and No-Moat Stocks

Dziubinski: Then let's pivot over to a little bit of a discussion about economic moats. And how do valuations look when you compare wide-moat stocks with no-moat stocks today?

Sekera: Well, interestingly, what we saw in the second quarter is that the wide-moat stocks, they fell just as much as the rest of the index, and in some cases, they sold off even more than the rest of the marketplace. To some degree, I think maybe over the past month and over the past couple of weeks, there has been some indiscriminate selling in the marketplace. And I think that, with liquidity drying up, portfolio managers got to the point where if they needed to raise cash, they were selling not necessarily what they wanted to, but they were selling what they could, and those high-quality wide-moat companies, of course, will have the best liquidity. So, we think that wide-moat stocks as a category are probably the most undervalued between wide moat, narrow moat and no moat and certainly see a lot of opportunities for investors in that space.

Attractive Large-Cap Wide-Moat Stocks—Meta, Amazon.com, and Disney

Dziubinski: So, then let's focus a little bit more on the wide-moat space in particular. Give us a few names, perhaps among large-cap, wide-moat stocks, that look particularly attractive today. Sekera: Sure. Well, let's go down the list here. First, I would say, Meta META. Meta is probably, I think, our most differentiated call from the rest of the marketplace—so, wide moat, 5 stars, trading at I think about half of what we think that company is worth. So, with Meta, the real problem, what's going on with that right now, is the market has been disappointed by the advertising revenue that they've been able to generate. Earlier this year, Apple put some privacy measures in place, so the advertising right now is a little bit less valuable. So, they haven't been able to get the same kind of fees and growth on that advertising. But when we think about advertising, especially in the digital space, there's a long-term secular growth trend that's not going to stop going on there, and we think Meta is probably one of the best positioned for future growth in that digital advertising.

The next one I would mention would be Amazon AMZN, another wide-moat, 5-star stock. I think, that's trading at about a 40% discount to fair value. Again, the market has been disappointed a little bit on that one. But you have to remember, too, with Amazon, they saw huge amounts of growth during the beginning and throughout most of the pandemic as people shifted their buying to online. So, we're up against really tough two-year comps in that name right now. The thing with Amazon that we think the market is missing is the AWS business, their web services business, and their advertising business. Both of those are very valuable, and we don't think that they're getting the credit for those right now.

And lastly, Disney DIS would be the other one that I would highlight at this point. In the media space, we're seeing an ongoing shift with a lot of these traditional media companies that they're moving their content to their own platforms and now charging for themselves. That has been causing a short-term disruption within that space, but when we think about Disney, we think that they have not only some of the best content out there, but they have some of the best platforms out there and will be able to do the best in that space.

2 Undervalued Mid- and Small-Cap Stocks

Dziubinski: Let's stick with high-quality names, but let's go down the market-cap scale a little bit and look at some mid- and small-cap names that are undervalued. Sekera: Compass Minerals CMP would be the first one that I would mention there. Compass, again, has had some difficulties in that they changed up their capital allocation structure last year. So, they used to be a very high-dividend-paying stock, wide economic moat, very steady business in that they make deicing salt for the wintertime. And so, again, their wide moat was based on being that low-cost supplier and paying that high dividend. Well, they decided that instead of paying that high dividend, the company would rather use that cash in order to start making acquisitions, specifically growing into the lithium space. A lot of investors that had been in that name in the past were those investors looking for that high dividend payment. So, right now, I still think we're seeing a bit of a change going on, where those types of investors are still looking to exit the stock and we're looking for new investors who are looking for that growth that that company hadn't really been producing in the past.

The other name that I would like to talk about would be Equifax EFX. Again, when you think about it, there are three main credit bureaus, a little bit of an oligopoly in that business. And Equifax's wide economic moat is based on the part of the business in which they do income verification, employment verification, and that's really used with the mortgage business. That's probably their highest product margin. With interest rates going up, we're going to see less mortgages going forward, a lot less refinancing going on, maybe a slowdown in the housing market as well. I think the market right now is looking at the slowdown in that part of their business. They're overextrapolating how much that's going to slow down into the future. And so, that's why we think that there's still a good amount of value in that stock.

Dziubinski: Dave, thanks for your time today, your outlook on the third quarter, and of course, your stock picks. We appreciate it.

Sekera: Thank you, Susan.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thanks for tuning in.