Stock Market Weakness Creating Pockets of Opportunity
The market decline this past week hasn't left stocks as a whole cheap, but there are growing opportunities for stock selectors.
Commentary
Last week was a volatile one for the stock market. After some ups and downs the Morningstar US Market Index dropped over 2% on the back of middling earnings and economic growth worries. The decline in the market hasn't broadly left stocks cheap, but there are some growing pockets of opportunity.
Concerns about the global economy came to the forefront early in the week with the release of Chinese economic data. The 7.7% gross domestic product growth rate would have been the envy of any other county, but it was short of expectations for China and a continuation of a deceleration trend. With Europe stuck in the doldrums and the U.S. muddling along, emerging-markets growth was seen as the engine of the global recovery. But if the largest emerging market begins to slow, it becomes harder to forecast what will drive the economy in the coming years.
Earnings also caused investors to rethink their expectations. Generally speaking, earnings weren't terrible, but some management teams raised concerns about the near-term health of the economy. Industrial giant General Electric's (GE) CEO Jeff Immelt said that Europe's economy is still softening, and that is affecting the firm's industrial business. Target (TGT) brought down its estimates for first-quarter same-store sales, blaming the unseasonably cold weather in the recent months. Results in the tech world were more troubling. International Business Machines (IBM) had a major miss with weakness in both its software and hardware businesses. Intel's (INTC) results reflected the continued woes of the PC industry. And eBay (EBAY) posted decent results but provided a middling outlook for next year.
It's hard to generalize too much from these early earnings releases, but there does seem to be an expectation for a softening in the business climate. The big open question is if the weakening is the result of short-term issues and growth will pick up in the back half of the year, or if it's a sign of a broader slowdown. Add in the fact that Morningstar's equity analysts think that stocks are fully valued (the median price/fair value ratio of stocks under Morningstar analyst coverage sits at 0.99), and it shouldn't be too surprising that stocks fell last week. There just isn't a margin of safety built in to valuations to absorb worse-than-expected news.
Has this relatively small drop created many new opportunities? Broadly speaking, no. But there is a greater valuation differential among sector and individual companies than we have seen in some time, providing opportunities for individual stock selection. On the overvalued end, the median price/fair value in the real estate sector stands at 1.13, while that figure is 1.11 for the consumer defensive sector. Basic materials and energy stocks look like relative bargains, with the median stock in those sectors trading at a price/fair value ratio of 0.83 and 0.86, respectively.
Stocks that provide a margin of safety is important because buying at a discount provides some protection against the uncertain economic outlook. If you don't pay too much and the firm falls short of expectations, it won't completely spoil your investment.
To find shares that became more attractive after this week's sell-off we used Morningstar's Premium Stock Screener. We looked for companies that have Morningstar Ratings for stocks of 4 or 5 stars and that fell significantly more than the market last week. We also restricted our search to wide- and narrow-moat rated stocks so that we were only buying firms that have sustainable competitive advantages to fend off rivals. Below are three names that passed. Run the screen for yourself by clicking here.
Canadian Natural Resources (CNQ)
From the Premium Analyst Report:
Canadian Natural Resources has a dominant land position in Western Canada, in addition to a diverse portfolio of other properties. When coupled with its ability to drive down production costs and make opportunistic acquisitions, we believe Canadian Natural Resources has ample opportunities to grow production using a combination of debt and cash flow generated from its assets.
eBay (EBAY)
From the Premium Analyst Report:
During the past 15 years, eBay has grown from a small U.S. online auction marketplace into a central commerce hub. PayPal's role as a leading online payment standard and emergent mobile presence, new innovations in the Marketplaces segment, and complementary acquisitions have reshaped eBay into a major e-commerce player for years to come. Amazon.com (AMZN) may hold the title of top destination for online shoppers today, but we believe eBay will remain an important participant in online commerce thanks to its growing portfolio of large retail partners, adjacent Marketplaces offerings, and PayPal's diverse payment capabilities. Additionally, eBay's broader commerce functionality, including mobile shopping applications and payment services, in-store PayPal point-of-sale tests, and PayPal's partnership with Discover Financial Services (DFS), has not been fully appreciated by the market and we believe multiple expansion is possible as this potential is recognized. With one of the most capital-efficient models in e-commerce and a wide economic moat grounded in a solid network effect, eBay's role as a global commerce facilitator should translate into excess economic profits.
Halliburton (HAL)
From the Premium Analyst Report:
For more than a decade, Halliburton has been working on integrating its drilling services to fully optimize drilling performance while lowering costs. The company began by placing its drilling engineering applications under one roof, including fluids, bits, and directional drilling. Over time, the firm has integrated its services into a single solution, which means that a customer could obtain substantially greater well performance and reduced levels of nonproductive time by standardizing on Halliburton's services rather than mixing services from multiple services providers.
All data as of April 19, 2013.