Be Thankful for These 3 Stocks
Equity valuations are becoming further stretched, but there is still a case for holding high-quality companies for the long term.
Commentary
There are plenty of things to be thankful for this year, but one thing you aren't likely to hear around the Thanksgiving table is an outpouring of excitement over the current state of equity valuations.
And that's for good reason. As the major stock indexes keep hitting new (nominal) highs and earnings growth continues to lag, valuations of the U.S. stock market keep getting further stretched. As Morningstar ETFInvestor Sam Lee discussed earlier this week, several valuation metrics from the Shiller P/E to the Dividend Growth Model seem to be pointing to above-average levels and returns are likely to be more muted in the future.
Morningstar's equity analysts see the market as being somewhat overvalued on the whole, too. They think the market is trading for about 5% more than its intrinsic worth at the moment. This number comes from gathering all of Morningstar analysts' company-level research. For every firm we cover, an analyst builds a discounted cash flow model, which estimates the future earnings of a business, to arrive at an estimate of the intrinsic value of a company. We can then calculate how undervalued or overvalued a security is by comparing that fair value estimate with the current stock price. For example, a price/fair value ratio of 1.0 would imply the stock is fairly valued, a ratio of 0.95 would imply a 5% discount, and a ratio of 1.05 would imply a 5% premium. By calculating the median price/fair value ratio of all rated stocks, we can then get a sense of what the entire market looks like. Five percent is hardly a tremendous overvaluation, but it is a far cry from the near 20% undervaluation we saw in late 2011 or even the more modest 6% undervaluation a year ago. The last time we thought stocks were this overvalued was in May 2011.
Looking at the market on a sector-level basis doesn't turn up many pockets of value either. Three sectors currently look undervalued. But two of those (communications services and energy) are less than 3% undervalued. Basic materials looks the cheapest with a median price/fair value ratio of 0.93, but that discount was more than 20% just a few months ago. On the flip side, a number of sectors (technology, industrials, and consumer cyclical) now appear to be more than 10% overvalued. You can see all of Morningstar's market fair value data here.
What are the consequences of the market as a whole not providing any screaming opportunities and very few sectors offering big discounts? Does it mean it is time to exit equities? We don't think so. It's next to impossible to draw any near-term market predications from our current valuation outlook. Stocks could very well continue their upward climb, or we could see a major correction in the coming months. Trying to time the market and swing in and out is exceedingly difficult, and a task that most investors haven't been able to pull off with any success.
That doesn't mean you need to be excited about stocks. The truth is there just aren't very many good investment options right now. There is no secret, massively undervalued asset class. Instead investors are faced with a number of less-than-stellar options. There are headwinds in almost every market. But remember, investing decisions are not made in a vacuum. Yes, stocks were more attractive a year ago or two years ago, and returns are likely to be more modest from here. But when compared with the lack of alternative options out there, it still makes sense for investors with long-term horizons to own great businesses as part of a balanced asset-allocation plan. (See here for more information of creating an appropriate allocation.) Stock selection will be crucial, however. It's important to select the right securities and stay defensive in an environment like this than when the whole market is trading at a significant discount. There is simply less room for error.
Investors can stack the deck in their favor in a few ways. First, look for companies that have strong competitive advantages, or economic moats. These solid firms will be able to keep compounding their earnings for years to come and often produce more predictable cash flows throughout the economic cycle. Second, look for a reasonable dividend-payout ratio and for signs that the dividend could grow. If returns are going to be limited by current valuations, getting more of your total return from dividends is a strategy that makes sense. Finally, pay attention to valuation to make sure you are paying a fair price. Just because there aren't a ton of values doesn't mean you should wildly overpay for a security. That's unlikely to be a winning strategy.
We identified a few stocks that meet the above criteria using the Morningstar Premium Stock Screener. You can run the screen yourself here. Below are three names that passed.
Unilever (UL)
From the Premium Analyst Report:
We think Unilever's wide moat stems from its expansive global distribution platform and its portfolio of essential products. Despite these competitive advantages, the firm remains on the offensive and continues to put resources behind product innovation (launching new products that span the gamut of its portfolio with Knorr Stock Pot bullion, Dove repair expertise hair care, Persil concentrated liquid detergent, and Lipton Yellow Label with tea essence), marketing, and cost savings initiatives. In our view, this spending is driving balanced and profitable growth (in contrast to several of its peers), as sales reflect higher prices and increased volumes--a notable achievement in this difficult operating landscape.
Southern (SO)
From the Premium Analyst Report:
Southern's total-return proposition remains appealing for patient investors in a world of few decent income alternatives. This giant utility of the Southeast enjoys some of the best regulation in the United States and strong, consistent regulatory relationships in its key service territories of Alabama and Georgia. The company is in the middle of a huge investment program aimed at phasing out or retrofitting its massive coal fleet, building a low-carbon coal unit in Mississippi, and constructing the first new nuclear plant in the U.S. (in Georgia) after a more than 30-year freeze.
Chevron (CVX)
From the Premium Analyst Report:
In recent years, Chevron concentrated its exploration efforts on a few key areas that have yielded a high level of exploration success. Discoveries in those key areas of the Gulf of Mexico, West Africa, northwest Australia, and the Gulf of Thailand have already begun to contribute to production and will serve as the growth engine for Chevron in the years to come, setting it up for peer-leading growth beginning in 2014-15. Success in each of these regions also demonstrates Chevron's ability to thrive in a highly competitive environment with limited access to resources.
All data as of Nov. 27.