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Are Equity Fair Values Teetering on the 'Cliff'?

A lot of companies are very well positioned regardless of how the fiscal cliff gets resolved, as long as it gets resolved, says Morningstar's Heather Brilliant.

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Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.

As the debate over the fiscal cliff continues, many stock investors are wondering what it could mean for their portfolios if a deal is reached or if it isn't.

I'm here with Heather Brilliant. She is the global director of equity research for Morningstar, and we are going to look at industries that could be particularly affected by a fiscal cliff deal.

Heather, thanks for talking with me today.

Heather Brilliant: Thanks for having me, Jeremy.

Glaser: By now most investors are familiar with the fiscal cliff, the tax increases and spending cuts that are scheduled to happen on Jan. 1. Is this the kind of situation where once we hit Jan. 1 if there is no deal, we are going to see an immediate deterioration of corporate fundamentals, or is it more nuance than that?

Brilliant: It's definitely more nuanced than that. There is nothing that's going to get implemented on Jan.1 that's going to cause company balance sheets to be materially impacted. This is the kind of the thing that frankly would have to be rolled out over time. There is something in there to cut defense spending by $500 billion, but no one has any idea how that would actually be implemented.

So, a lot of these things would require a lot more planning before they would actually impact company balance sheets and cash flow statements.

Glaser: But even if we do reach a deal, it sounds like some of that uncertainty is already impacting decision-making certainly in the executive suites of lot of companies?

Brilliant: I think, that's fair to say. When you see the uncertainty that is going on right now with people not knowing whether the fiscal cliff will be resolved, people do hold back on spending--both companies in terms of investments, and also individuals in terms of consumption.

So, both of those have the potential to impact the underlying companies, even if there is a resolution relatively soon. So, the longer that uncertainty goes on, the more people are worried about what's going to happen.

Glaser: So, if that worry turns into a lot of stock price volatility, it certainly seems like a possibility--we're already seeing it to some extent. Is there going to be a big change to that intrinsic fair value estimate? Should investors broadly see that sell-off as an opportunity or is it a cause for a concern?

Brilliant: So generally speaking, if you believe there will be a resolution to the fiscal cliff eventually, even if it might take them a few more months, beyond January 1, then I think it's a great buying opportunity. A lot of these companies are very well positioned to do well regardless of how the fiscal cliff gets resolved, as long as it gets resolved. So I think that as long as you believe it will be resolved eventually, as long as the government doesn't say on Jan, 1, "we will never resolve the fiscal cliff," then it looks like a buying opportunity to us.

Glaser: So, do you think the market is pricing in a deal happening, or is that too hard to say?

Brilliant: I think generally speaking the market does seem to be pricing in a deal happening. People are expecting this will get resolved; otherwise, I think you would see a lot more stock price volatility than we have seen lately, and a little less of a rally than we have seen lately.

But it certainly will have a disproportionate impact on some industries versus others. For example, aerospace and defense--that is a sector that really relies very heavily on government spending. So, to the extent there is a very large amount of budget cuts for the defense industry baked into what is the fiscal cliff, if those are intended to be implemented and the government has to start working on actually making those cuts, then I think you'll see some meaningful downside in aerospace/defense stocks.

Glaser: On the health-care side, there is certainly some talk about entitlement reform, that often means trying to reduce expenditures for Medicare and other programs. Is that going to have a big impact on hospital operators and other people in the space?

Brilliant: I think the long-term trend for hospitals is clearly not good. And there are some things about Obamacare that could actually help hospitals in terms of making sure that everyone is paid for at some level, but at the end of the day, we see spending toward hospitals coming down over time.

So, if the fiscal cliff doesn't get resolved, that could happen faster, and that could be negative for hospital budgets. But it's so likely that hospital budgets will get cut that we are already baking in a 50% chance of that happening into our fair value estimates.

Glaser: How about life sciences firms? They obviously need the NIH to provide a lot of their funding. Is that something that could potentially go away, deal or no deal?

Brilliant: So, in the life science industry, we actually think there is some potential upside if the fiscal cliff gets resolved quickly. And the reason is that people are pretty negative on NIH spending already, and so if things get resolved in favor of these life science firms, there could actually be a pop in the stocks.

We particularly think that life sciences, and Thermo Fisher look pretty interesting; Alumina could also be affected. So, we think there is some opportunity there.

The other thing to keep in mind with life sciences is that, generally speaking, less than 20% to 25% of these firms' revenues come from government-related revenue, and so they are very well diversified against this risk.

Glaser: Are there any other industries that maybe have a lot of exposure to federal spending that could be potentially hurt by any fiscal cliff deal?

Brilliant: I think the for-profit education industry is one to keep on the radar with regard to this. More than 90% of their revenue comes indirectly from the government through grants and loans and programs like that. And so, if there were to be some cuts to Pell grants or other types of student loan programs, that could be very damaging for for-profit education.

Glaser: So, looking across the equity universe of the stocks that we cover, you wouldn't expect a lot of wholesale fair value estimate changes, no matter what happens in terms of the fiscal cliff?

Brilliant: That's correct. We … have largely built it in as a possibility into our fair value estimates where we think it's a major risk for the business, and otherwise speaking, we don't think it will have a material impact.

Glaser: Heather, thanks for talking with me today.

Brilliant: Thanks for having me, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser.

Jeremy Glaser does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.