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5 Cheap Value Stocks to Buy

Plus, an update on market valuations and regional banks.

5 Cheap Value Stocks to Buy

Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. Every Monday morning I sit down with Morningstar’s chief U.S. market strategist Dave Sekera to discuss one thing that’s on his radar this week, one new piece of Morningstar research, and a few stock picks or pans for the week ahead. So, on your radar this week, Dave, we have the retail sales report coming out as well as earnings from Walmart WMT and Target TGT. So we should be getting a good read on the mindset of the consumer. What are you going to be looking for in these reports?

Sekera: Good morning, Susan. Now retail sales had actually dropped in March, so this month the consensus is now looking for a rebound of about seven tenths of a percent, and that’d actually be pretty good news for the economy. However, I would note I do think a lot of these macroeconomic reports, they often contain a lot of noise. So when I can, I do certainly prefer to hear directly from management. And of course, as you noted, we do have Target and Walmart reporting this week. So, really what I’m going to be listening for from them will be their view on the state of the consumer, specifically how purchase decisions may have or may not have been changing due to inflation over the past quarter, but also how they might be changing up their merchandising and their strategy to potentially address the softening of the economy.

Dziubinski: Also on your radar this week, or maybe we should say remaining on your radar this week, are the regional banks. First tell us where we stand Monday morning before open on PacWest PACW. The stock was hit hard last week after announcing that deposits were down.

Sekera: First, I would note we don’t cover PacWest, so we don’t have an opinion on the stock or the company specifically. But I would note, as you said, that stock did slide pretty hard late last week, and that came out after they had put out a press release discussing that they did see a reacceleration in the losses of their deposits. And that of course then put pressure on the rest of the U.S. bank sector. That sector, really it’s hard to say that it’s been able to really bottom out just yet at this point. I do think stocks in that sector are still under pressure, but I would note that they are still higher than their May 4 lows.

Dziubinski: Dave, what’s your take on regional banks and then the banking sector in general today?

Sekera: Well, our view from the equity research team is that the U.S. regional banks certainly are under stress, but that the business model is not broken. Now, I would say we are in our models projecting sequential earnings declines throughout the rest of this year before it might bottom out. But I think the way the market is looking at these stocks, they’re pricing in a much more dire outlook than what we have. We do see a lot of very undervalued opportunities in the sector right now, but I do think investors will need to tread cautiously in this sector for at least the next couple of months.

So, I would say really I think the U.S. regional banks are probably at this point really more appropriate for risk-tolerant investors. And I’d also think that when you’re going to invest in this sector, personally I wouldn’t buy all at once, but I would like to keep some dry powder. You might want to start off with a partial position in a stock and then set targets where to buy more if the stocks do sink further. But of course you need to keep a close eye on them and I think you also need to be willing to sell if there’s a material change in the bank that you’re investing in and that makes you change your investment thesis.

From a broader economic perspective, the other reason to keep an eye on this sector that as long as these regional banks are under this kind of stress, I assume they’re going to probably try and limit new loan growth in order to preserve capital. And that in turn of course could constrain economic growth until we see liquidity in that sector start to turn back up.

Dziubinski: Let’s pivot over to some new research from Morningstar, and that’s your latest market outlook, which published last week on Morningstar.com. And in it you talk about both market performance and market valuation. Let’s start out with the broad market. How has the market done this year and are stocks overall overvalued or undervalued?

Sekera: I mean the market’s had a really good year thus far. The Morningstar US Market Index, and that’s our broadest measure of the U.S. market, has risen about 7.5% thus far this year. Now I would say we’re not necessarily surprised. Coming into the year we saw a combination of what we thought were very undervalued levels at the end of 2022. Plus, there were a lot of market technicals pushing the market down at the end of last year, such as tax-loss selling. So, of course once the calendar rolled over, those technicals dissipated, and I think that gave the ability for the market really to start moving back upward. Now, I would say that after this rally, the market is trading at about an 8% discount, and that’s an 8% discount to a composite of those over 700 and some stocks that we cover that trade on U.S. exchanges.

While we do think the market is undervalued, I do think the easy gains this year are probably behind us at least for the next couple of quarters. And I think that we’ve got a rough road ahead. Thinking about why do we expect a rough road ahead, we do expect that the economy will stagnate here in the second quarter, probably contract a little bit in the third quarter, and then only begin what we’re looking for is a relatively sluggish recovery in the fourth quarter. That’s going to put pressure on earnings growth, and I think that could lead to some negative market sentiment. I think what the market’s going to be looking for later this year is for a rebound in leading economic indicators. And I think that’s what the market is going to be looking for to really break through the ceiling that we’ve been hitting, and we’ve been in a trading range since last fall. So to really begin that sustainable or that durable rally up toward where we see intrinsic value, I do think the economy’s going to want to see that upturn.

Dziubinski: Let’s slice the market by market cap. How have large caps performed relative to small caps so far this year? And then, which look better from a valuation standpoint today, larger companies or smaller companies?

Sekera: And large-cap stocks, they have led the market thus far this year. So, the Morningstar Large Cap Index, that’s up almost 10.0%, whereas the Mid Cap’s only up 1.0%, and small caps also have lagged far behind, only up 1.5%. Now, according to our valuation, the small-cap stocks do remain the most undervalued. They trade at about a 27% discount to our intrinsic valuations, whereas large-cap stocks are only trading at a 6% discount to our fair values, so actually a little bit above where the broad market is trading. While small caps are the most undervalued, I’d also note it might take them a little while to really outperform the market. Small caps often lag the economy, and so I think they may not really start to benefit until the economy bottoms out and starts to begin to rebound.

Dziubinski: Let’s look at the market through the lens of investment style. Growth stocks got off to a really strong start earlier this year. How does their performance compare to value stocks for the year today?

Sekera: Growth stocks have really driven the market thus far this year. So the Morningstar Growth Index, that’s up almost 15% year to date, whereas the Core Index is only up about 3%. And value has really lagged—actually, I think it’s down right now, about 1% year to date.

Dziubinski: What’s driven that outperformance of growth stocks, and on the other side, the underperformance of value stocks?

Sekera: Within the growth category, some of the largest-cap stocks—and many of those were significantly undervalued coming into the year—are the ones that have really risen the most. And because their market cap is so large, it does skew the entire category. But just running through a couple of examples here: Apple is up 33% thus far this year; Microsoft MSFT up 29%; Nvidia NVDA almost doubling, up 94%; Alphabet GOOGL up 33%; Tesla TSLA up 36%. And I’d note that these are the stocks that we think sold off way too much last year. Actually coming into this year, Microsoft was a 4-star-rated stock. It had traded at a 25% discount. Nvidia was a 4-star stock, also trading at a 27% discount. Alphabet and Tesla, both of those were 5 stars coming into the year. So, not necessarily surprised to see just how much they’ve run up, but again, they are really skewing kind of that overall growth category return.

Dziubinski: So now let’s talk valuations. Again, growth stocks came into the new year looking undervalued. How do they look today and how does that valuation compare to value stocks?

Sekera: Following the rally, growth is now really only trading at about an 8% discount to that composite of our fair values. And that puts it in line with the broad market average. So, comparatively at the beginning of the year, I think growth is trading at a 20% discount, and value stocks are trading pretty close to the same type of valuation they were coming into the year currently at a 15% discount to fair value.

Dziubinski: Then from a market-cap and style standpoint, if you combine the two, what do you suggest for investors today based on those valuations?

Sekera: I think now is probably a pretty good time to start moving from an overweight position in growth into a market-weight position. And I think you can use some of the proceeds coming out of the growth category and put that into an even greater overweight into the value category. And considering core or blend stocks are still pretty close to fair value, I do think you continue to be underweight that sector, in favor of value stocks.

Dziubinski: We’ve reached the picks portion of our program this week, and you’ve brought along five value stocks you like. How appropriate. These stocks all fall in one of the value squares of the Morningstar Style Box. And your first pick this week is Macerich MAC.

Sekera: Yeah, and we’ve talked about that one a couple of times. That’s a REIT that invests in Class A shopping malls, and it’s a 5-star-rated stock, trades a huge 65% discount to fair value, and at this point it looks like it’s paying over a 7% dividend yield. Now we think the death of the shopping mall has been greatly exaggerated. Consumers are returning back to the malls. We are seeing a pickup in in-person shopping. But I’d also note malls, specifically Class A malls, have evolved over the past couple years, and they’ve become a lot less reliant on just retail sales. They’ve become much more experiential. They’re bringing in new and different types of services to drive that foot traffic. So, again, we’re seeing a big increase in things like restaurants, health clubs, physician offices, any of those services that can’t be replicated online.

Dziubinski: Your next few picks are value stacks that tie into one of several growth themes, some of which we’ve talked about that you’ve identified. The first theme is the normalization of consumer behavior after the COVID-19 pandemic, and the stock pick is Carnival CCL. Why do you like this stock in particular?

Sekera: I’d note that all the cruise lines are undervalued according to our valuations. But yes, our pick here is going to be Carnival, a 5-star-rated stock, trades at a 55% discount to fair value. And so I know talking to our analyst that covers the cruise line industry, she noted that bookings do continue to keep building, and we do see that Carnival is able to put through price increases. And in fact, she’s also noted that she sees a big uptick in consumer deposits. She thinks that it does indicate the willingness for consumers to commit in advance to travel, and we still see pent-up demand for travel. And then lastly, I’ll just say over the next year or two, some of the current headwinds in that sector that have been pressuring margins should start to alleviate, specifically the biggest two have been fuel and currency. So, as those begin to normalize, that’s going to allow margins to continue to normalize and expand, going back toward historical averages over the next year or two.

Dziubinski: Now your next value stock pick ties into the theme of vehicle electrification, and it’s BorgWarner BWA.

Sekera: And it goes back to a long-term secular theme that I think you and I have talked about a number of times. When we think about auto production, our current forecast is that we think that by 2030, two thirds of global new auto production is going to be electrified, whether that’s a hybrid or battery electric vehicle. Now, in our opinion, BorgWarner has probably one of the stronger portfolios of products specifically geared for electric vehicles. So, irrespective of whichever auto manufacturer ends up with the best market share in electric vehicles, we think BorgWarner is going to benefit from that long-term trend. That’s a 5-star-rated stock, and it trades at a 45% discount to our fair value.

Dziubinski: Dave, your fourth pick this week fits the med tech theme. And it’s Medtronic MDT.

Sekera: Medtronic itself is the largest pure play medical device maker. So, the stock is currently rated 4 stars, trades at a 20% discount to our fair value, and has a 3% dividend yield. Now, we also do rate Medtronic with a wide economic moat and a couple of the different other aspects of that stock that I do think will benefit investors that we do still see a backlog of deferred procedures from the pandemic, which are still coming through. And lastly, I’ll just note, we think this is probably one of the best-positioned stocks for playing the continued aging of the baby boomer generation.

Dziubinski: Now, your last value stock pick doesn’t play into a particular theme, but it is a name that Morningstar has been pounding the table on for quite a while, and it’s Citigroup C. What do we like about it?

Sekera: Citigroup stock is rated 5 stars and it trades at about a 40% discount to fair value. Now, I would note that we don’t rate the company with any kind of economic moat. So again, typically we prefer looking for stocks that we do think have long-term durable competitive advantages, which in this case we don’t. But when I think about the investment thesis here, I’m actually very comfortable with it. So, Citibank stock itself trades at about a 40% discount to its tangible book value. And when I think about what we expect looking forward, we’re really not looking for much. We’re not really looking for any strong earnings growth with the company. And in fact, as it goes through its turnaround strategy, it may even have to take a couple of small hits to capital.

However, what we do expect is that over time, Citigroup will be able to earn its cost to capital. And as such, that over time that stock will accrete upward toward that tangible book value over time. Comparatively, I would note that the other three mega banks all trade at or above their tangible book value. And in the meantime, while you’re waiting for that stock to accrete up toward that tangible book value, yeah, you’re going to be collecting a nice 4.5% dividend yield.

Dziubinski: Well, thanks for your time this morning, Dave. Be sure to join Dave and I live on YouTube every Monday morning at 9 a.m. Eastern, 8 a.m. Central. And while you’re at it, subscribe to Morningstar’s channel. Have a great week.

The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.

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