Is It Time to Buy Mega-Cap Stocks?

Key Takeaways

• For a stock to be considered a mega-cap stock, a company would need around $200 billion of equity market capitalization.
• In our view, some mega-cap stocks were far overvalued coming into the year, so it's not a surprise to see how much of these stocks have really sold off year to date.
• Amazon stock, Meta Platforms stock, and Alphabet stock are trading at a significant discount to what we think the stock is worth.

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. At the start of 2022, we were warning investors about the price risk inherent in some of the market's largest names. Many so-called mega-cap stocks were trading well above what Morningstar's analysts thought they were worth. By the end of the third quarter of 2022, many of these stocks had sold off dramatically. I'm here with Morningstar's Chief U.S. Market Strategist, Dave Sekera, to find out if there's opportunity among mega-cap stocks today.

So, Dave, let's start out by defining our terms. What makes a stock a mega-cap stock?

Dave Sekera: Well, it's one of those terms that can mean different things to different people in the industry. But for myself, when I was coming up with those mega-cap stocks, I used $250 billion of equity market cap as our threshold. The only thing is, I'd note that now with as much as the market has sold off year-to-date, probably $200 billion is going to be closer to that right threshold to consider a mega-cap stock.

Dziubinski: So, let's talk about why mega-cap stocks and identifying them is somewhat important. I mean, they really do have an outsized influence on the performance of the market, right?

Sekera: They do. And when I think about how we mathematically calculate our fair value of the marketplace, we take a composite of the intrinsic valuation of the companies that we cover, and we compare that to a composite of the market cap of the entire universe of stocks in the Morningstar index. And so those mega-cap stocks mathematically—just a small percentage move in any one of those individual companies is really going to be a huge movement compared to relatively small companies. So, one way to think about it would be, Microsoft MSFT has about a $1.7 trillion market cap. So, really a percentage movement in Microsoft is going to be worth about a 1% movement as well in 17 different companies that would have a $100 billion market cap.

Dziubinski: That's significant. So, now some of the year-to-date losses among these mega-cap stocks that you identified at the end of last year are really stunning. You look at Netflix NFLX, down more than 60% through the end of the third quarter. NVIDIA NVDA was down more than 58%. Nike NKE 42% for the year. So, what happened to some of these mega-cap stocks?

Sekera: In our view, they were just so far overvalued coming into the year that to us it's not a surprise to see how much of these stocks have really sold off year-to-date. So, for example, in the case of Netflix, specifically at the beginning of the year, we had rated that stock with just 1 star. It was trading double what we thought that that company is worth at the beginning of the year. Now, over the course of the year, we've actually slightly increased our fair value up to $280 a share from $275. So, realistically, we've really kind of held our view stable while the rest of the market has come down, and in fact, following that 60% selloff year-to-date, that stock has now gone to being a 3-star rated stock.

Similarly, NVIDIA is another one—it was rated 2 stars at the beginning of the year. Traded at a 50% premium to our fair value. It also has sold off about 60% year-to-date. Our fair value is up a little bit. It's up to $200 a share from $194 at the beginning of the year. So, that actually puts that stock in the 4-star category. Right now, we're—now we actually think it's getting to be undervalued.

And lastly, Nike, so again, started off as a 2-star stock at the beginning of the year. Traded at a 30% premium. That stock is down about 50% year-to-date, and we've held our fair value pretty steady on that one as well. It's now rated 5 stars.

Dziubinski: Wow. So, now a few of the mega-cap stocks that came into the year looking kind of overvalued to us, a few of them have done relatively well. You're talking here UnitedHealth UNH and Eli Lilly LLY. Now, is that largely because these are stocks that fall in the healthcare sector and the healthcare sector is thought to be more defensive? Is that part of the reason for their performance this year?

Sekera: Well, it could be. It's always really hard to know exactly what the market is pricing in. To some degree, I think, you are right that because they are in the healthcare sector, and of course, that's considered to be a much more defensive sector as people are rotating their investments throughout the year, I'm sure that they were moving more money into companies such as those. But at the same point in time, it also could be that investors in those companies, they just might be modeling that company with higher revenue and higher growth estimates than we are. So, in the short term, it's really hard to necessarily attribute the performance to just one or the other. More likely than not, it's probably a combination of both.

Dziubinski: And then, lastly, Dave, talk a little bit about some mega-cap stocks that we like today that look undervalued to us.

Sekera: Sure. Well, topping the list right now is going to be Meta Platforms META, the parent of Facebook, and Alphabet, the parent of Google GOOG. So, both those stocks right now are trading at significant discounts to our fair value. In the case of Meta Platforms, it's a 5-star rated stock. It trades at less than half of what we think the long-term value of that company is worth.

Alphabet also is a 4-star rated stock. That trades at about a 40% discount to what we think that that company is worth. Now, besides that, Amazon AMZN is another one that we have on that list. It's rated 4-stars. It trades at a 40% discount to our fair value. I think what the market right now is missing is that, they’re looking at your growth prospects this year and they're looking specifically at the retail business, and the amount of growth that they're going to experience this year, it was going to be less than I think what people are necessarily hoping for.

We also have to realize, too, that we had two years of just extraordinarily strong growth in Amazon because of the pandemic and because of more people shopping online. I also think the market is missing some of the growth prospects of the company. So, their AWS business is still growing exceedingly fast. And I also really like their advertising business. That's really a strong part of their business that I think the market is underestimating today.

And then, interestingly, on the list, there's actually two banks now, so JPMorgan JPM and Bank of America BAC. So, Bank of America, a 4-star rated stock trading at a 20% discount to fair value. JPMorgan, certainly one of the strongest banks out there, 4 stars, trading at a 28% discount to fair value.

So, I think this year what's happened in the financials and the banks specifically is that a lot of investors have been ratcheting up their expectations for the amount of loan losses, just considering we did have negative GDP growth on the first half of the year. It’s still kind of unclear exactly how GDP growth is going to evolve over the next couple of quarters. So, I think people are concerned that if we do enter a recession and depending on how long that recession lasts, how deep that recession may be, they're bringing their loan-loss reserves up, but we think they're bringing those loan-loss reserve expectations up too far. So, we have actually increased ours as well. We brought them back up to what we consider to be more, historically, normalized levels. And based on that, we think both of those stocks are undervalued today.

Dziubinski: Well, Dave, thanks for your time today, the insights into mega-cap stocks, why they're so important for the market performance, and of course, your stock ideas. We always like to hear those.

Sekera: All right. Well, thank you, Susan.

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

Dave Sekera provides more investment ideas in 3 Top Stocks for Q4 2022 and Where to Invest Your Money in Q4 2022.