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3 Not-So-Fat Pitches to Swing At

Owning no-moat, high-uncertainty stocks requires a different set of expectations than owning higher-quality names.

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Two weeks ago, we shared a list of high-quality stocks trading at a discount. We focused that list on wide-moat stocks with low uncertainty ratings, trading in 4- or 5-star range. In the past, we've referred to such stocks as "fat pitches," or companies with predictable earnings and long-term staying power trading at significant margins of safety. These companies possess long-term structural advantages over their competitors, and they often cluster in profitable industries.

Today's screen focuses on the not-so-fat pitches: companies that do not have that same predictability of earnings nor the same long-term structural advantages as wide-moat companies do. Nevertheless, these companies are trading at deep enough discounts to fair value to compensate for their higher uncertainty, thereby earning 4- or 5-star ratings.

Why would anyone want to own a lower-quality stock? "There are certain situations when wide-moat stocks can be expensive and no-moat stocks can be cheap," notes senior equity analyst Richard Hilgert. In addition, there are particular industries, including automakers, in which low-uncertainty, wide-moat stocks just don't exist. "Vehicle manufacturing is a very capital-intensive business, but barriers to entry are not as high as in the past," says equity strategist David Whiston. "The industry is already full of strong competition, so it is nearly impossible for one firm to gain a sustainable advantage." That doesn't mean that there aren't opportunities among automakers; it just means investors interested in this industry will need to invest in lower-quality names.

Investing in lower-quality companies demands a different mindset. For starters, these companies often reside in cyclical industries, which may require investors to assume a longer-than-usual time horizon for payoff. "Investors may need to wait longer for the macro story to catch up to the company's fundamentals and wait longer for the recovery," says Whiston. Investors trolling among lower-quality names should also brace for more volatility. "The percentage changes can be a lot more dramatic with a no-moat stock," he adds.

Investors in these stocks also need to precisely identify the key drivers of earnings and cash flow, and monitor those closely. "I've found no-moat, high-uncertainty companies often have exposure to one or two critical variables, and moves in those variables have an outsized impact on earnings typically because of leverage, either operating or financial, or some other factor," says utilities sector director Travis Miller. Investors should not only recognize these critical variables, but they should also make sure they do not overexpose their portfolios to any one single variable.

Dipping a toe in lower-quality names may make sense for some investors, given how relatively few high-quality names are on sale. As of this writing, only 15 wide-moat, low-uncertainty stocks earned ratings in the 4- and 5-star range; there are more than four times as many no-moat, high-uncertainty stocks carrying 4- and 5-star ratings today. Investors who can handle the additional risks involved in these investments may want to expand their horizons and add some lower-quality names to an otherwise high-quality opportunistic portfolio.

To come up with a list of lower-quality candidates, we used's Premium Screener. We focused on no-moat stocks with high uncertainty ratings, meaning that our analysts are less confident in the precision of their fair value estimates for these stocks. (This article includes a detailed look at how Morningstar assigns fair value uncertainty.) As of this writing, 68 stocks with no moats and high uncertainty ratings made the list. Premium Members can access the entire list here. The three ideas below are among our analysts' favorites.

General Motors (GM)
Uncertainty Rating: High | Moat: None
The leader among automakers in the United Sates with about an 18% market share in 2014, GM has been a favorite of Whiston's for a while. "We argue that there is plenty to like in the GM turnaround story, especially in North America," he says. Whiston likes that the automaker can focus its U.S. marketing efforts on just four brands today versus eight brands in the past, and he expects GM to report excellent earnings growth as vehicle demand comes back during the next few years. Whiston also likes the stock's generous dividend and the company's stock-buyback plan. Even after assuming an enormous $7 billion reserve for fines and lawsuits from the recent ignition recall, Whiston argues that the stock is undervalued and misunderstood: "[It's] not given enough credit for what a firm selling 10 million vehicles a year can accomplish."

Fiat Chrysler (FCAU)
Uncertainty Rating: High | Moat: None
"For investors willing to accept the risks of a highly leveraged turnaround company doing business in the cyclical, highly competitive, capital-intense global automotive industry, we think no-moat Fiat Chrysler Automobile has been misunderstood and unreasonably discounted," says Hilgert. In particular, Hilgert believes that the combined firm can achieve greater scale in components, platforms, and capacity. "An array of brands in multiple geographies reduces reliance on any one vehicle category or region," he adds. His $22 fair value estimate takes into consideration improving volume and profitability at the automaker.

Calpine (CPN)
Uncertainty Rating: High | Moat: None
Independent power producers, such as Calpine, lack the foundations for economic moats, because their returns on capital depend on commodity prices. "For Calpine, the critical drivers are power prices and gas prices, and its earnings and cash flow exposure to those variables is amplified by its financial and operating leverage," says Miller. Nevertheless, Calpine's efficient and low-cost natural gas power plants give the company a cost advantage versus its peers. "We think this cost advantage positions Calpine well regardless of how natural gas prices move," says analyst Andrew Bischof. Furthermore, environmental regulation should lead to the closing of older coal units, tightening the supply/demand balance. "Planned coal plant retirements should continue to bolster Calpine's fleet value and margins," Bischof notes.

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