3 Undervalued, Well-Managed Firms
In a fully valued market, a steady hand behind the wheel matters more than ever.
Commentary
Margin of safety has become an endangered species. As the long-running stock market rally has stretched valuations, it is becoming harder to find stocks that are trading at steep discounts to their intrinsic values. Given that investors now have less protection against something not going exactly to plan, it is ever more important to focus on firms that are well-run by excellent management teams that will be conscious stewards of shareholder capital.
Good management is valuable in any market or economic environment, but the recession and the slow recovery has created ample opportunities for management teams to shine or stumble. During the height of the 2008-09 crisis, managers had to worry about keeping their companies afloat, managing liquidity as credit markets seized up, and figuring out how to cut costs to keep expenses in line with sharply lower revenues. For the most part, firms handled the crisis well and came into the recovery with much leaner and efficient businesses.
Now a few years in to a (stubbornly slow) rebound, management teams are faced with investment decisions that are going to determine the fate of their firms for years to come. As the economy has improved, many businesses are now producing prodigious amounts of cash as a result of their newly slimmed-down cost structures. But given the uncertainty in the economy and the general low-return environment we are in, there is no easy answer for what to do with this excess cash. The best management teams are making smart moves such as fully funding worthy internal investments, avoiding empire-building (but value-destroying) acquisitions, and returning the rest to stockholders through share buybacks or dividends.
Of course great management alone isn't enough. Investors want to stack the deck further in their favor by making sure they are buying at the steepest discount to intrinsic value they can find and by narrowing their focus to firms that have economic moats. All investors should be aware that even the best management teams can't produce economic profits over time if they are in a highly competitive industry or business; without great structural advantages, these managers will have much difficulty fending off competitors.
Unfortunately, finding many cheap companies that have these advantages is a tall order right now. Morningstar equity analysts think the median stock in Morningstar's coverage universe is 2% overvalued. There are obviously some companies trading at a larger discount, but on the whole it is hard to find much of a margin of safety. For investors this means that there is no valuation buffer in case things don't work out at a company as expected or the broader economy has a negative effect on stocks. There also is not much investors can do to bring prices down, but one thing they can do is mitigate some firm-specific risk by selecting companies with solid management teams that are making good capital-allocation decisions, truly thinking of shareholders as owners of the businesses, and not taking reckless risks.
But despite the current market overvaluation, a handful inexpensive stocks do exist. To find some of these undervalued, well-managed firms we used Morningstar's
Premium Stock Screener. Although as a whole corporate America has been doing a good job recently, Morningstar's analysts have identified a subset of 114 firms that have shown exemplary stewardship over time. We've restricted the screen to only those firms. We also screened for companies that have Morningstar Ratings for stocks of at least 4 stars and wide or narrow Morningstar Economic Moats Ratings. You can run the screen for yourself here. Below are three firms that passed:
Spectra Energy
From the Premium Analyst Report:
Spectra is one of the largest midstream companies in North America, with a favorably positioned asset footprint that should continue to foster attractive internal growth opportunities for years to come. Spectra is a pure play on natural gas demand. Its operations stretch across all links in the natural gas value chain, with the exception of riskier exploration and production. With positions in gathering, processing, transportation, storage, and distribution, Spectra collects a large portion of the economic rents paid to move gas to end users.
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 may hold the title of top destination for online shoppers today, but we believe eBay will remain an important participant in online commerce growth 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.
Gilead Sciences (GILD)
From the Premium Analyst Report:
Gilead Sciences' focus on infectious disease has paid off in spades, and the firm's HIV franchise continues to dominate a growing, global market and drive impressive profitability. While key HIV patents begin to expire in 2018, we think Gilead's newest HIV regimens offer enough of a safety benefit to older alternatives that the firm will be able to extend its HIV-based profitability into the long run. In addition, management is diversifying against this risk with acquisitions, most recently paying $11 billion to acquire hepatitis C drug developer Pharmasset. If Gilead proves it can play in other markets, we think its competitive advantage could extend into wide-moat territory.
All data as of Aug. 9, 2013.