Markets Are Undervalued, and We Highlight Some Cheap Stocks

Ruth Saldanha:

Can your portfolio sail to the green with Norwegian Cruise Lines? How to manage your emotions when fear takes over? And with markets being so attractive and undervalued right now, where should you invest this quarter?

This is Investing Insights.

Welcome to the new Investing Insights. I’m your host, Ruth Saldanha. Let’s get started with a look at your Morningstar headlines.

Norwegian Cruise Line Sails Through a Rough Quarter

Norwegian Cruise Lines says it's managed to navigate the rough current stirred up by the COVID-19 pandemic...with bookings in line with 2019 levels and at higher prices. A unique positioning gives Norwegian the ability to remain the cruise industry’s price leader. The company offers a greater number of upscale berths and a significant number of cabins with balconies. And with future cruise credits stemming from COVID-19 cancellations expiring in December 2022...next year’s pricing shouldn't experience any drag from relocated bookings. Morningstar urges caution when it comes to pricing gains given near-term macroeconomic uncertainty...but expects inflationary pressures to prove short-lived, leading to long-term annual pricing growth of around 3%. And we don’t plan any change to our $28 estimate of what we believe the stock is worth and view current prices as significantly undervalued.

How Can Investors Cope With Fear?

There's no way to cut risk entirely for investors, so learning ways to conquer—or at least manage—their fears is important. Morningstar behavioural economist Sarah Newcomb looks at several ways fear can lead to situations that have nothing to do with market fundamentals. Newcomb says it's normal to experience fear when faced with uncertainty or an uncontrollable threat. For investors, diversifying is a must, but having "skin in the game" when it comes to the market can lead to a lot of anxiety. And because fear and uncertainty are uncomfortable, investors can be drawn into actions to try to reduce uncertainty. Research is one way to cut down on market fears, but Newcomb says investors should practice emotional coping skills...to help combat the potential negative effects of fear on our investment behavior. For more tips and tactics check out the full article, 'Fear Itself' on Morningstar.com.

AMD Dipped in Q3

A drop in PC sales was the main reason Advanced Micro Devices, or AMD, saw a dip in the third quarter. AMD's preliminary results show revenue came in more than a billion dollars less than management's original estimate. While Morningstar had expected PC sales to slow from the high demand seen early on in the pandemic when people suddenly had to work from home....AMD had been gaining market share, allowing it to grow. Many peers—such as Nvidia, Intel, and Micron—have already issued weaker outlooks for the second half of 2022, though AMD's announcement could indicate even greater cuts to PC assumptions. Although we think AMD’s PC exposure will prove challenging over the coming quarters, we think its data center business should continue to show strong growth thanks to superior products relative to Intel. We think long-term investors should find AMD shares attractive at current levels. We're lowering our estimate of what we think the stock's worth by $15 to $115 a share.

Does Your Retirement Plan Need More Annuity Options?

Saldanha:

Retirement plans across the country may finally be getting serious about adding more annuity options, to help the pool of near-retirees allocate to products that will help generate income in retirement—but our research suggests that this may not be the right tactic for everyone. Morningstar’s Associate Director of Retirement Studies Spencer Look is here to tell us why.

Spencer, thank you for being here today.

Retirement plans across the country may finally be getting serious about adding more annuity options. This will help the pool of near retirees allocate to products that can help generate income in retirement. But our research suggests that this may not be the right tactic for everyone. Morningstar's associate director of retirement studies Spencer Look is here to tell us why. Spencer, thank you so much for being here today.

Spencer Look:

Thanks for having me on.

Saldanha:

What's the biggest determinant of the right lifetime income strategy?

Look:

That's a great question. From our analysis, there are a lot of factors to consider. But one of the best ways to tell or assess whether a lifetime income strategy or any annuity-based strategy could be beneficial was by looking at the ratio of wealth to needed annual income in retirement. That denominator piece, needed annual income, that's going to be total needs less Social Security benefits.

But what we found is that if that ratio of wealth to needed income is 36 or higher, there just wasn't a lot of benefits from annuities. This is a rule of thumb, it's based on our projection model, it's going to be sensitive to our assumptions and our framework, but we do think it's a really good starting place for investors who are grappling with this decision.

What we found essentially is at that level of wealth to needed income, 36 or higher, in our analysis, investors are able to achieve their retirement goal really the vast majority of the time, and that's really our rationale. But investors below that ratio, there's definitely a lot of potential for annuities to provide benefits.

Saldanha:

Spencer, you found that annuities don't add much value for some investors. Which investors are these and why?

Look:

I know I touched on this a little bit on the prior question, but one type of investor that doesn't get a lot of benefits from annuities would be those who've saved a lot of wealth relative to their needed income in retirement. What we found was for these investors, they can more or less self-insure against longevity risk, self-insure against market risk. There's not a lot of value that annuities will provide from that perspective.

That being said, one thing I think I wanted to clarify is that these type of investors, they can benefit psychologically from an annuity, still more stable income. Annuities can also enable these kind of wealthier, more well-funded investors to spend more. So, there are still some benefits. Just one caveat, I think that's good to call out with that.

The other type of investor, though, that we found would not benefit often from annuities would be those who already have a high level of income relative to their expenses from Social Security or other existing guaranteed income sources. I think that's an intuitive one. There's already a lot of guaranteed income, there's just not as much that an annuity can do, there's not a lot of room where annuity can make an impact. So those are the two types of investors that we found in our analysis that wouldn't benefit too much from allocations to an annuity.

Saldanha:

On the flip side, for whom would annuities work?

Look:

That's another great question, Ruth. Using our rule of thumb, I think there's maybe two boxes to check. The first thing would be looking at that ratio of wealth to needed income. If that's less than 36, I think that's one good indicator that an investor could have the right profile potentially to benefit. And then the other thing to check is how much guaranteed income does an investor have? What portion of expenses are covered by existing Social Security benefits or pensions or other things? And long as that amount is not too high, then I think investors with that kind of profile can definitely benefit. I think I touched on this or mentioned this a little bit, but annuities can provide help against market risk, can help hedge against longevity risks. There are a lot more potential for benefits for those type of investors with that profile.

Saldanha:

For these investors for who an annuity could work, what should they do right now?

Look:

It's another great question, Ruth. I think for those investors, it's really important to understand the trade-offs. There's a lot of factors to kind look into, and one thing to mention is some level of personalized analysis is often helpful with this type of decision. But broadly speaking, I think investors need to ask themselves questions such as, "How much do I value income stability? Does that really matter to me? Do I need a higher guaranteed income floor on top of social security? Would I really get a lot of value from that? How important is leaving behind a bequest for my beneficiaries? How important is optionality? Do I want to change my mind potentially later on?"

The different type of annuities, there's a lot of trade-offs with them. There's really two broad categories, income annuities and then deferred annuities. And with income annuities, they tend to provide a higher payout of income, but there's less flexibility and tend to be an irrevocable decision where you can't go back and change your mind whereas deferred annuities tend to provide more flexibility. So, I think answering those questions can help investors confirm one, is an annuity actually the right fit? And then two, what type of annuity, an income annuity or deferred annuity, would be worthwhile considering further?

Saldanha:

Great. Thank you so much for being here today, Spencer.

Look:

Thank you so much for having me on.

Where to Invest Your Money in Q4 2022

Saldanha: Morningstar's U.S. market strategist Dave Sekera thinks the markets are still undervalued, though the cautions investors to expect a lot more volatility in the months to come. If you have some money and would like to invest, where should you look? Dave thinks growth and core values are cheap. But he also sees a lot of good secular tailwinds in med tech. He shares his thoughts with Susan Dzubinski, Morningstar.com's director of content. Listen in!

What Headwinds Are Facing Stocks Today?

Susan Dziubinski:

Hi, I'm Susan Dziubinski with Morningstar. U.S. stocks hit new lows for the year during the third quarter. Stocks are down about 25% so far in 2022. Here today to discuss the headwinds in today's market and how investors might fine-tune their stock holdings in the fourth quarter is Morningstar's chief U.S. market strategist Dave Sekera.

Dave, let's talk a little bit briefly about the third quarter. In July and August, stocks rebounded from their lows in June, but then they tanked again in September. Talk a little bit about some of those headwinds that are facing stocks today.

Dave Sekera:

Sure. Well, as you mentioned, the first half of the year the markets were just generally on a downward trend, really sold off in June and got to some pretty low valuations, in our view. Now, what really happened is those four headwinds we've been talking about since the beginning of the year really converged in June, and that's what we think pushed the market down to really kind of very low valuation levels, especially on a historical basis.

Now, in July and August, looking at some of the inflationary metrics and some of the economic metrics, we thought that some of those headwinds were starting to abate. So, between those headwinds looking like they're starting to abate and some pretty low valuation levels, we saw the market recover in July and August. Now, unfortunately, in September, it appears those headwinds really started coming back again, and as they came back, then we saw the markets sell off pretty strong going all the way into the end of September.

Now, at the end of September, the markets really looked like they did get oversold a little bit going into the end of the quarter and the end of the month. So, it's interesting. We've seen a really strong rally the past two days, the first two trading days here in October. So, it's interesting to see how much the market is coming back off of some of those lows. Now, we do think the markets are undervalued still. And I would just caution investors, though. I also expect to see a lot more volatility still in the months to come. So, those four headwinds are still out there. We're still looking to see when those inflationary headwinds are going to start coming down, when we see kind of more of a sustainable longer-term uptrend for the economy. And then, I'm also just watching the U.S. dollar, that's certainly been a headwind here for earnings as well. So, once those are playing out over the next couple of months, depending on how those metrics come out, I do think we can see some of these days where you can certainly expect the markets to move anywhere up or down 1% or 2% or even more based on when those metrics are released.

Dziubinski:

Despite what will very likely be ongoing volatility in the market, you noted in your latest quarterly report that really there have been few other times where stocks have looked this undervalued, according to Morningstar's metrics. Let's talk a little bit about that in a broad sense. How does the market look from a valuation standpoint as we're here in the beginning of the fourth quarter?

Sekera:

Sure. Well, as I mentioned, we think stocks right now are trading at about a 20% discount to a composite of our fair values. Now, we do look at the market differently than I think what you're going to hear from a lot of other market forecasters. So, again, a lot of other forecasters, they take that top-down approach. They have some sort of model that they're going to use to estimate earnings for a broad market index, and then they apply a forward multiple to that to come up with their one-year forward target for the market. We do the exact opposite. So, we cover about 700 stocks that trade here in the U.S. And so, we take a composite of where those stocks are trading in the marketplace today and compare that to that bottom-up intrinsic valuation conducted by our analyst team and compare it to that composite as well. So, that's how we come up with that price-to-fair value metric, which right now is showing stocks are pretty much as cheap as they've been going back through 2010, as you mentioned, only a couple of other instances, like the beginning of the pandemic or maybe going back toward the European sovereign debt crisis in 2011, have we seen valuations get this low.

Dziubinski:

Let's do a deep dive and sort of peel back the onion on valuations in the market. First, let's talk about valuations across different market capitalizations and investment styles. Are there particular market caps or styles that look cheaper than others today?

Sekera:

Sure. So, we do break our valuations down into the Morningstar Style Box. And when we look at it by category, I would note that the growth category and the value category are both the ones that are the most undervalued today, whereas core or blend stocks, they're still undervalued but not nearly as much and closer to fair value than those two. So, I think, from a relative value position, investors might be best-positioned today with what I call a barbell portfolio. So, again, being overweight value stocks, overweight growth stocks and then underweight core stocks. From a market capitalization perspective, I would note that both the large cap and mid-cap are trading at about the same discount to valuations today. So, I really wouldn't necessarily think too much about overweighting or underweighting one or the other of those. But I do note that small-cap stocks are the ones that we think are really trading at the biggest discount from a market-cap perspective.

How Are Valuations Across Different Sectors?

Dziubinski: Let's pivot over and talk a little bit about sectors now. Interestingly, despite rising interest rates and still pretty high inflation, utilities have continued to outperform this year and are really the only sector we cover that we would consider technically to be overvalued. A lot of those defensive sectors like healthcare and consumer defensive are also kind of close to fair value. Talk a little bit about valuations across different sectors today.

Sekera: Well, as you mentioned, utilities is trading at a slight premium to our fair value estimates today. So, that would be one sector that I'd be more cautious in investing in today. It's not terribly overvalued, but it's probably played out, again as you mentioned, it's a defensive sector. I think that's probably what's helped it outperform this year. And those other defensive sectors have also held up relatively well compared to more of the cyclical sectors. It's really those cyclical sectors where we see some of the best valuations today. And so, for investors who are looking at getting involved there, you can certainly take a more broad market or broad sector exposure there. But for investors who are looking for individual stock picks in some of those sectors, I'd really recommend right now making sure that you're sticking with those stocks that are going to be much more levered to longer-term secular themes within those sectors. So, for example, we've talked about the basic-materials sector before because of the long-term structural shift to electric vehicles, we think that lithium is going to be undersupplied for the next decade, so a lot of the lithium producers we think are undervalued. On the consumer cyclical space, again, we expect to see a big shift in spending away from goods and into services as consumer behavior normalizes. So, again, I'd look for those stocks that are going to be levered toward that shift in spending within that sector.

How Do Wide Economic Moat Stocks Look Today?

Dziubinski: And then, lastly, let's talk a little bit about economic moats, which we use as sort of a measure or a benchmark of a company's quality. Are we seeing that wide-moat stocks are more undervalued today than narrow- or no-moat stocks? What's that look like?

Sekera:

So, those wide-economic-moat stocks, those are going to be the companies that we think are very high-quality. Those are the companies that have those long-term durable competitive advantages that are going to help that company over a very long time period be able to outearn its cost of capital. So, as you mentioned, there's really two things going on in the marketplace this year. The wide moat stocks have sold off. And, in fact, depending on which wide moat stocks you're looking at, they've sold off as much, or sometimes even more than the broad market. So, they're actually trading as a group, like, in line on the valuation basis with those no-moat companies, which you wouldn't necessarily suspect would happen. So, from a fundamental point of view, I think what's going on in that sector today is that you're seeing the marketplace kind of undervalue those long-term prospects of the company. So, I think too much of the marketplace right now is probably focused on short-term earnings growth, really thinking about the third quarter and going into the fourth quarter of this year and really, taking multiples down on those stocks, in our view, probably unfairly.

The other thing that's going on is from a technical perspective, those stocks are probably getting hit a little bit harder. I think, right now, a lot of portfolio managers, especially those that have had a lot of redemptions in their funds, they're out there trying to sell stocks in order to raise cash to meet those redemptions. Well, what happens is, those high-quality stocks are going to have a deeper liquidity pool to be able to sell into. So, I think, portfolio managers have to some degree gotten to the point where they started selling, especially here in September, what they could as opposed to necessarily what they would have preferred to.

Dziubinski:

That's interesting. Dave, given that we're seeing stock market valuations very near if not at the bottom that we've seen historically from a discount perspective, is it time to back up the truck on stocks?

Sekera:

Well, it's certainly tempting to, I'm sure. But I think that really is going to depend on an individual investor's risk appetite. So, again, I do think now is certainly a great time for investors to be judiciously adding to the risk exposure, adding to their equity exposure within their portfolios. Personally, I like to layer into positions more. So, again, when the market is trading down, I like to be able to buy into it as the market is going down. Certainly, takes a lot of intestinal fortitude to be able to buy when the market is going down. But then, conversely, when you do see the market take some good up days in a row, that might be a better time to then take some of those gains off the table. Again, I do expect over the foreseeable future, we're going to see a lot of market volatility, at least over the next several months.

Healthcare Stock Picks

Dziubinski: Dave, for those investors who may want to judiciously add to their stock weightings as you say, what are some ideas that Morningstar has today? What are some stocks we like?

Sekera:

Well, as we talked a little bit about earlier, in a volatile environment like this, I really do like sticking with those stocks that you really are confident in that are leveraged to those long-term secular themes, and I think that helps give investors the confidence to stick with those investments through the ups and downs of the marketplace.

So, one that I've actually been recently doing some more research and working with our analyst team is in the med tech space. We think there are certainly a lot of good secular tailwinds within med tech, but we see a lot of undervalued opportunities there today. So, while healthcare overall is one of those sectors that's much closer to fair value than some of the cyclical sectors, I think within that med tech space, we certainly see a couple of undervalued stocks. For example, the first would be Zimmer Biomet ZBH. So, that is a 5-star-rated stock, trades at a 36% discount to our fair value. One of the things that's going on there is, during the pandemic, you had a lot of patients that had been putting off procedures, different type of large-joint replacements over the past couple of years. So, I know our analytical team has taken a look at the backlog for the company. They estimate that backlog, based on those kinds of delayed procedures plus just kind of the natural growth in that sector, is up to two years. So, again, that would be one stock I like in that space.

The next one is going to be a little bit of a riskier situation, but I think it does have some really good strong longer-term catalysts, and that's Illumina ILMN. So, Illumina is rated 4 stars right now, trades at a 35% discount to our fair value. This is one I would recommend. Though I do think that investors [should] go ahead and dig into the company to some pretty good degree, make sure you understand some of these catalysts. But this is one of those stocks that we've identified that we do think could have exponential growth possibilities in the future. So, specifically, they do have a product in the liquid biopsy space that we expect to come to market over the next couple of years. It can screen for, I think, up to 50 different types of cancers and that really could be a game changer in cancer screening.

And then, lastly, in the healthcare space on a totally different track would be Zoetis ZTS. So, Zoetis is actually, in our view, the leader of innovative pet therapeutics. That stock is a 4-star-rated stock, trading at a 20% discount to our fair value. And when our analytical team has looked specifically at that space in pet care, they're really seeing that over time that a lot of pet owners have really been shifting their attitudes on how much they're going to be willing to spend on their pets and their pet healthcare. So, that's an area where we do see long-term secular growth.

Dziubinski:

Well, Dave, thank you for your time today, for your perspective, for your stock ideas, and we'll do it again at the end of the fourth quarter. Nice to see you.

Sekera:

All right. Well, thank you, Susan.

Saldanha:

Thank you Susan and Dave!

Also, subscribe to Morningstar’s YouTube channel to see new videos about market news, personal finance, and investment picks. Thanks to podcast producer Jake VanKersen who puts this show together.

I’m Ruth Saldanha, an editorial manager at Morningstar. Thank you for watching “Investing Insights.”

Companies mentioned in this episode.

Norwegian Cruise Line Holdings Ltd NCLH

Advanced Micro Devices Inc AMD

Nvidia NVDA

Intel Corp INTC

Micron Technology Inc MU

Zoetis Inc ZTS

Zimmer Biomet Holdings Inc ZBH

Illumina Inc ILMN

Read about topics from this episode. Fear Itself AMD Stock Is a Bargain Your Guide to Annuities A Down-Market Survival Guide for Pre-Retirees Is an Annuity Right for You? Utilities Brighten Under Cloud of Recession, but Future Dim at Lofty Valuations As Pendulum Swings, Stocks Go From Overvalued to Undervalued 3 Lessons for Investors From the Third Quarter What a Strong U.S. Dollar Means for Investors What's Next for the Stock Market? Read what our team is writing. Ruth Saldanha Susan Dziubinski David Sekera