5 Undervalued Stocks for a Sideways Market

Susan Dziubinski: Hi. I am 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. On your radar this week, Dave, is the debt ceiling. Is this something you’re really worried about?

David Sekera: Good morning, Susan. To be honest, it’s not really something I’m all that worried about. I think there’s going to be a lot of sound and fury but, at the end of the day, it really signifies nothing. Maybe I’m just getting cynical here at my old age, but I fully expect both political parties are going to use this as a way to try and score some political points with their base. The media’s going to end up hyping everything up and print a lot of dire-sounding headlines and negotiations I fully expect are going to go right up to the wire. But at the end of the day, I fully expect that the two political parties will come up with some sort of agreement or plan and that they will continue to pay interest on the principal on the U.S. Treasuries as they come due.

Dziubinski: Theoretically, Dave, what are the ramifications for the markets of the U.S. defaulting on its debt obligations?

Sekera: This is one of those events that I consider to be pretty low probability but still a very high severity if it were to occur. If there were an actual payment default, based just on the size and the scale of the amount of U.S. Treasuries that are outstanding, I do think that this could be something that really could hit the markets pretty hard, but I don’t think this is going to be anything like a typical sovereign default that you might see.

For investors that do own U.S. Treasuries, I don’t think you’re going to end up suffering any loss of principal, and I fully expect that once the debt ceiling gets raised, you will get your principal and interest. In fact, I could even see the U.S. government paying you any extra interest until you get that principal payment back. There’s really no way to know exactly what would happen, and I don’t think anyone really can understand the full ramifications of it.

But, personally, my biggest concern is going to be in the funding markets and specifically those that use U.S. Treasuries as collateral. A lot of these funding agreements are going to have language in there that you can’t use defaulted securities as collateral. That could then result in a large unwind to these facilities, or these facilities could collapse, such that either those borrowers become forced sellers or the people that lend under these facilities could essentially take the securities that are in there and sell those out in order to make sure that they can get down to the required collateral levels. Either way, there would be a lot of forced sellers in the marketplace, and, of course, that much extra supply in a very short time period could end up pushing markets down.

Dziubinski: Then do you expect that ongoing uncertainty around the debt ceiling is going to contribute to market volatility this week?

Sekera: It’s actually a really hard question to answer, and I think most institutional investors expect that a deal is going to end up getting done. However, as we do get closer to the date that the Treasury actually does run out of money, I do think that you’d see a lot of short-term investors and traders that probably just don’t want to take that risk, exit their positions, and that could pressure markets here in the short term. We could also see some investors maybe buying out-of-the-money short-dated puts just in case there were a default. But as long-term investors, I think you just need to be prepared to hold steady, stick with your investment allocations, and if there is a pretty substantial market drawdown, in fact, I think that’d actually probably be a pretty good opportunity to then put more money to work.

Dziubinski: Then also on your radar this week, Dave, we have Nvidia’s NVDA earnings report. Now the stock is up more than 100% this year, so what are you looking for?

Sekera: With Nvidia, I think we need to take a step back and take a little bit closer look at the fundamentals here. Nvidia, at this point, is now rated a 1-star stock, and it trades at a large premium, about 58% to our fair value. Now, this stock does have a history being particularly volatile. For example, near the end of 2021, it was also a 1-star-rated stock back then. It fell, I think 50% or so in 2022, and actually fell enough that it went into the 4-star territory at the beginning of this year.

Now, it’s doubled, as you mentioned. It’s back to that 1-star area. My concern here is just if the company were to miss on their earnings or maybe give any kind of disappointing guidance as far as their artificial intelligence, which is a big reason why I think we’ve seen the stock rally thus far this year, any disappointment there really could lead to a very swift selloff in the short term.

Dziubinski: Let’s pivot over to some new research from Morningstar, and this is related to commercial real estate. Now, Morningstar recently increased its uncertainty ratings on office REITs. What does that mean for commercial real estate in general?

Sekera: First, let’s just take a step back and just you have to remember that much of real estate is going to be under different varying lengths of leases. And so, you have the very short-term leases like in apartments where they’re only going to be one year, and we really haven’t seen much of a change in performance like in the apartment space. Retail leases often range three to five years. We’ve seen some softness there, but that really hasn’t been that concerning thus far.

As you mentioned, it’s really the office leases where we have the greatest concern regarding their long-term valuations at this point. Even within the office lease space, I’d say the greatest area of concern is going to be in the urban area. Of course, office occupancy rates have been under a lot of pressure since the emergence of the pandemic. Right now, I think we’re still in the relatively early stages of seeing a lot of those office leases starting to come due. As they come due, we’re seeing rental rates drop just because there is more supply out there than the amount of demand for urban office space.

In fact, one of the things I watch is the Kastle Back to Work Barometer. Kastle is a company that does key cards for a lot of office buildings. And so, they put together an index, and that index right now is showing that across 10 of the largest U.S. cities, occupancy still is only around 50%. We’re not seeing that same kind of demand destruction in the other areas of commercial real estate as we are for the offices.

Dziubinski: Then how does that affect Morningstar’s view on regional banks today?

Sekera: Let’s quickly walk through the math for offices and the regional banks. First of all, when we look at the regional banks, I think we estimate that commercial real estate is only up to a third of their total loan book, and in many cases is actually much less than that. And then, the loans that are made specifically for offices are only 10% to 20% of that commercial real estate exposure. That’s only 3% to 5% of their total loan book is going to be in offices.

And then, of course, the bank only loans a percentage of the value of the offices in the real estate to the lender. Therefore, the equity is going to end up having to take hits before we can see any losses in the banks themselves. Now, most regional banks operate with common equity Tier 1 ratios of 9% to 10%. That regulatory minimum is 7%. Even if the regional banks were to start taking some losses on that office space, we do think that there’s plenty of capital there to be able to absorb those losses.

Dziubinski: We’ve reached the picks portion of our program, and we’ve talked quite a bit on this show about your expectation that the stock market will likely continue to trade kind of sideways until it sees a clear improvement in economic indicators. With that in mind, you’ve brought along five stocks you like for a sideways market. These are all wide-moat companies with pretty reliable sales and cash flows, offering attractive dividend yields, and their stocks are undervalued. Your first stock that fits this bill is Altria MO.

Sekera: To pick these stocks, actually what I did is I just conducted a screen of all of our stock coverage, picked out those that had 4- and 5-star ratings, those with a narrow or a wide economic moat, but then also looked for those stocks that had a Low or Medium Uncertainty Rating, and then also a relatively high dividend yield. The first one you know is Altria. Now, personally, I don’t like investing in tobacco stocks, but I did want to highlight this one for people. It’s currently a 4-star-rated stock, has a wide economic moat, and a Medium Uncertainty Rating, and pays a really large dividend yield of 8.3% right now. Of course, as a tobacco stock, it does have very relatively steady cash flows.

Dziubinski: Now, your second pick this week is Crown Castle CCI. That’s a specialty REIT focusing on communications infrastructure.

Sekera: Crown Castle, as you mentioned, is a REIT and they own, I think, about 40,000 cellphone towers, and they also own 85,000 miles of fiber. They do have very steady cash flows and their client base, for the most part, are going to be the big three companies like Verizon VZ, AT&T T, and T-Mobile TMUS. Those are all investment-grade-rated companies, so no concerns there. It’s a 4-star-rated stock. Trades somewhere near a 20% discount to fair value right now and has a Medium Uncertainty Rating.

Dziubinski: Your next pick for a sideways market is Duke Energy DUK. Why?

Sekera: Duke Energy is a 4-star-rated stock, trades at over a 10% discount to fair value and pays a dividend yield of 4.3%. As you would expect from a utility company, it does have very steady cash flows, has a narrow economic moat, and a Low Uncertainty Rating.

Dziubinski: CME Group CME is your next pick, and CME reported good first-quarter results.

Sekera: CME is the old Chicago Mercantile Exchange, and it also operates several other financial exchanges now. It’s a 4-star-rated stock, trades about a 15% discount to fair value, a wide economic moat, medium uncertainty rating. Now, this one’s interesting in that they pay a dividend of $1.10 per quarter right now, but they also pay a variable dividend at the end of the year. Right now, their trailing dividend yield is 4.7%.

Dziubinski: Your last stock pick this week is a familiar name, Kellogg K. What do you like about it?

Sekera: Kellogg is one of the few stocks in that consumer defensive space that we still see good opportunity and upside value for investors. It’s currently rated 4 stars, trades close to an 18% discount to fair value. It’s a company with a wide economic moat and a Medium Uncertainty Rating. Their dividend yield right now, I believe, is about 3.4%.

Now, the thing with Kellogg is I would note that the valuation we have is based on the intrinsic value of the entire company. Now, there could be some noise here in the short to medium term. The company is planning on splitting up into the snacks business and the cereal business. Really, this is a way that management is attempting to try and unlock that intrinsic value and increase value for investors. Now, we’re kind of skeptical that spinoff really makes much of a difference in the short term but, overall, we do think that investors will have a good valuation here going forward, owning both parts of those businesses.

Dziubinski: Well, thanks for your time this morning, Dave. Dave and I will be taking next Monday off to enjoy Memorial Day. But be sure to join us again live on YouTube in two weeks, on Monday, June 5 at 9 a.m. Eastern, 8 a.m. Central. While you’re at it, subscribe to Morningstar’s channel. Have a great week.