7 Cheap Stocks for Risk-Takers
These stocks are trading in 5-star range but carry very high uncertainty.
Nik Wallenda is at it again.
This weekend, Wallenda and his sister will be taking a 1,300 foot stroll across New York’s Time Square. But this isn’t just any stroll: They’ll be walking 25 stories above the ground on a high wire, without harnesses or a net beneath them. The “King of the Wire” has crossed Niagara Falls and the Grand Canyon--and a few years ago, he walked a tightrope between skyscrapers in sweet home Chicago, too. Did I mention he was wearing a blindfold for that one?
Daredevils like Wallenda embrace risk and uncertainty. Some investors do, too. They’re willing to “take a flier” on a stock with some big question marks attached to it as long as it’s trading cheaply enough.
So this week, we went looking for cheap stocks for daredevils. Specifically, we wanted to find names that were significantly underpriced according to our metrics, trading at the 5-star level. They also, however, carry very high Morningstar Uncertainty Ratings.
As a refresher, the uncertainty rating represents the predictability of a company's future cash flows--and, therefore, the level of certainty we have in our fair value estimate of that company. We value a company based on a detailed projection of its future cash flows and discount those flows back to today's dollars using a proprietary cash flow model. The uncertainty rating captures a range of likely potential intrinsic values for a company based on the characteristics of the business underlying the stock, including such things as operating and financial leverage, sales sensitivity to the economy, product concentration, and other factors. If the range of potential intrinsic values is narrow, the company earns a low uncertainty rating. If the range is great, the company earns a high uncertainty rating.
Despite their unpredictable cash flows, the stocks on our list are trading at a significant enough margin of safety to qualify as bargains. Seven stocks made the cut. Here’s a little bit about each company’s business and our outlook. Data is as of June 17.
Nabors Industries (NBR)
Economic Moat: None
Discount to Fair Value: 63%
“Nabors is among the top-tier U.S. and international onshore drillers. However, the company's profitability has been curbed since 2014 by a downturn in drilling activity, resulting in lower utilization and day rates than in past years.
"Despite the recovery in U.S. shale activity, the U.S. land rig market today is still marked by overcapacity and low day rates and margins. We expect utilization for even Tier 1 rigs (high-quality AC rigs with 1.5k-plus horsepower and multiwell pad drilling capabilities) to remain below 80% at midcycle. While our view is that incremental global oil supply needs will largely be met by U.S. tight oil, fewer rigs will be needed to meet this requirement than in the past, owing to increased efficiencies. This limits the scope for improved pricing and utilization for all U.S. land drillers, even as overall industry fundamentals recover.
"Not only is Nabors beset by a collapsed U.S. horizontal rig market, it's also lost market share over the years. This is a result of factors that appear likely to persist into the near future. Effectively, Nabors has invested to build a rig fleet that, while expensive and high-spec, is only partly composed of rigs tailored to the drilling trends of the past several years. The company's investment in lower-horsepower, lighter-footprint AC rigs is emblematic of this; while these rigs played well early in the shale boom, they are less well equipped to handle the longer laterals and deeper wells prevalent more recently.
"These bleak prospects on the U.S. side are counterbalanced somewhat by improving international prospects. In particular, we expect Nabors to maintain its nearly one third of Saudi drilling market share, even while Saudi drilling activity grows by about 40% from 2016 to 2022. Additionally, we project a modest recovery in Latin American drilling activity, where Nabors is prominent.”
--Preston Caldwell, analyst
Economic Moat: Narrow
Discount to Fair Value: 61%
“Adient was the automotive seating business of Johnson Controls that was spun off to JCI shareholders in a taxable transaction Oct. 31, 2016. Adient dominates the seating market with just under 40% share in North America and Europe as well as about 45% share in the world's largest auto market, China, and about 33% globally. It is common for a spin-off to be ignored or misunderstood, but we think ignoring Adient just because it is an auto-parts supplier is shortsighted. Seating is one of the stickiest parts of the supplier sector since it is very difficult to take out an incumbent on a vehicle program, and automakers need suppliers that can consistently deliver high-quality seats in a just-in-time system all over the world. Automakers have global platforms and are willing to pay for the right supplier rather than the supplier simply with the lowest price.
"We think some investors may need to reframe their perspective on seating and auto suppliers space by understanding that seating is not a commodity product and that firms such as Adient have a narrow economic moat with sustainable competitive advantages from sources such as intangible assets, switching costs, cost advantage, and efficient scale. It is normal in the seating space, for example, that an incumbent supplier gets the next generation of a vehicle program nearly 100% of the time.
"Adient owns 30% of Yanfeng, the world’s largest automotive interiors company, which along with over 20 Chinese seating joint ventures at times brings Adient nearly $400 million of equity income annually. We think the company can increase operating margin including equity income over the next several years by restructuring its operations to be a better manufacturer. Management also seeks $1 billion of nonautomotive revenue by calendar 2021 from seating areas such as aircraft, trucks, and passenger trains and formed a joint venture with Boeing in January 2018 focused on business class seats. For patient investors who can wait for Adient to restructure itself, we see Adient as an interesting turnaround story capable of eventually generating good free cash flow and resuming its dividend.”
--David Whiston, sector strategist
Economic Moat: Narrow
Discount to Fair Value: 61%
“Spun out of FMC in October 2018, Livent is a pure-play lithium producer, ranking in the top five in lithium production globally. Livent's lithium carbonate production in Argentina is among the world's lowest-cost lithium sources.
"As electric vehicle adoption increases, we expect high-double-digit annual growth for global lithium demand. Livent is looking to expand its Argentine brine-based lithium production capacity from 21,000 metric tons in 2018 to over 60,000 metric tons by 2025 on a lithium carbonate equivalent basis. Furthermore, the company plans to increase its lithium hydroxide capacity from 18,500 metric tons in 2018 to at least 30,000 metric tons by 2025.
"Lithium carbonate is produced by pumping brine out of the ground (primarily in South America) or via pegmatite mining that produces spodumene, which is later converted to lithium carbonate. Lithium hydroxide can be produced either from the conversion of carbonate or directly from spodumene. Producing hydroxide from spodumene typically costs less than starting from carbonate for fully integrated producers and can also be lower cost for nonintegrated producers, depending on spodumene prices.
"While we are bullish on lithium demand, we are somewhat skeptical of Livent’s strategy of focusing on hydroxide production from its brine resources. Lithium hydroxide is a higher-grade and higher-priced product, often produced as a derivative of lithium carbonate. While management believes that a focus on the production of hydroxide will shield the company from volatility in carbonate pricing, we contend that hydroxide pricing premiums will normalize to the cost of conversion as competitors enter the market. Further, as more hydroxide is produced from spodumene, we forecast that Livent's position on the lithium hydroxide cost curve will rise to a middle-cost position, albeit safely below marginal-cost producers.
"However, we are in favor of Livent’s plans to expand its low-cost carbonate production in Argentina. The company's cost advantage there stems from its unique brine assets that provide a high concentration of lithium. This unique geology represents a cost advantage that will prove durable in the long run.”
-- Seth Goldstein, analyst
Laredo Petroleum (LPI)
Economic Moat: None
Discount to Fair Value: 59%
“Laredo Petroleum is an upstream oil and gas company with operations concentrated in the eastern portion of western Texas' Midland Basin (Glasscock and Reagan counties). That's east of the play's Midland County sweet spot, in an area with a lower oil content (translating to lower realized prices). Initial production rates aren't typically as impressive there, either. So, because it does not operate in the core of the basin, Laredo does not share the cost advantage that other Permian producers enjoy.
"To compensate, the firm minimizes production costs. Its acreage is more contiguous than that of its peers, which means it can accommodate wells with longer laterals (and thus superior economics). In addition, management frequently highlights the benefit of its 'earth model,' which enables it to fine-tune the positioning of each well in the target reservoir, boosting flow rates. Laredo also benefits from its production corridor system, which centralizes infrastructure and enhances efficiency, and by utilizing higher-intensity completions it has further enhanced well performance. These innovations keep the firm profitable at midcycle prices (currently $55 a barrel for West Texas Intermediate and $3 per thousand cubic feet for natural gas). But the firm still faces higher break-evens and weaker returns than producers with better-located acreage.
"Laredo has also struggled with well spacing. In 2017 and 2018, it attempted to increase the value of its acreage by squeezing more wells into each drilling spacing unit (1-mile cross-section). But the strategy backfired as the reduced separation between adjacent wells eroded performance, and thus returns. Management has now pivoted back to its original spacing assumption of 16-24 wells per DSU and expects to restore the performance of its wells to the 2016 level.”
--Dave Meats, senior analyst
Fiat Chrysler Automobiles (FCAU)
Economic Moat: None
Discount to Fair Value: 57%
“The market has aggressively punished no-moat-rated Fiat Chrysler's valuation owing to incredulity over management's five-year plan. Global expansion of the Jeep, Maserati, and Alfa Romeo brands, as well as further development of the Ram brand, richens the product mix and bolsters operating leverage. The scale of the combined entity is around 5 million vehicles, making it the seventh-largest car company in the world.
"In 2018, management issued new five-year plan objectives. In 2022, the final year of management's plan, revenue is forecast at EUR 157 billion versus EUR 110 billion reported in 2018, the first year of the new plan. The company expects 2019 adjusted EBIT of more than EUR 6.7 billion for an adjusted EBIT margin above 6.1%. In 2022, management targets adjusted EBIT and margin of EUR 13 billion-16 billion and 9%-11%, respectively. Additionally, plan guidance forecasts a net cash position in 2020 of EUR 20 billion, up from net cash of EUR 1.9 billion at the end of 2018.
"As a market leader in Brazil (low 20s share), Fiat will benefit from a rising middle class. However, the company was late to Russia, India, and China and lags already-established competitors' market shares. The performance of Jeep, Alfa Romeo, and Maserati in the Chinese market has been disappointing. Even so, we expect Fiat to participate in the above-industry-average growth in emerging-market and Chinese demand.
"We applaud management's efforts to unlock shareholder value and focus corporate resources on the assembly and marketing of automobiles with the divestiture of the Magneti Marelli automotive-parts business. The company expects the sale to Calsonic Kansei to close in the second quarter for EUR 6.2 billion, subject to certain adjustments. Management expects to make an extraordinary dividend payment to shareholders of EUR 2.0 billion with the proceeds from the sale.”
--Richard Hilgert, senior analyst
Economic Moat: Narrow
Discount to Fair Value: 57%
“We think Sina is undervalued, as the market values the company at only 52% of its net asset value (the sum of its 46% stake in Weibo and ex-Weibo net cash) at the time of writing. Other than a holding-company discount and concerns over corporate governance, we note that the loss-making non-Weibo business is a drag on the value of Sina as a whole. We think Sina should step up its efforts to eliminate the discount. This could include improving the operations of the non-Weibo businesses, improving its corporate governance, repurchasing Sina shares, or spinning or splitting off Sina’s Weibo stake to shareholders.
"We have seen some early signs of improvement in the non-Weibo portal advertising revenue (20% of net revenue in 2017) in recent quarters. The portal advertising revenue reverted to year-over-year growth starting in third-quarter 2017, as the growth in mobile ads can now offset the decline in PC ads.
"The non-Weibo non-advertising business revenue, mainly consisting of online finance, accounted for 7% of net revenue in 2017. The business has grown rapidly at 64% year over year in 2017. However, tightened micro-loan regulations took effect in the fourth quarter of 2017, and the year-over-year revenue growth rate declined to 78% in the fourth quarter from 89% in the third quarter of 2017. With more expected tightening in fintech, we expect to see pressure on micro-lending and indirectly on online payment revenue.
"We are not confident enough to forecast that the non-Weibo business will be operating margin positive within our forecast period. Although the non-Weibo operating margin swung back to positive in second-quarter 2017, it retreated to negative in the third and fourth quarter. Management guided for the operating margin for the non-Weibo business to deteriorate in the near term due to higher marketing expenses for Sina mobile properties and uncertainty in the fintech business. Given the weak network effect associated with the non-Weibo businesses, we think non-Weibo marketing costs could be elevated, putting pressure on long-term margins.”
-- Chelsey Tam, analyst
Surgery Partners (SGRY)
Economic Moat: None
Discount to Fair Value: 56%
“Born out of a private-equity-backed roll-up strategy that has left the firm saddled with a sizable debt balance and a less-than-optimal collection of surgical and ancillary service assets, Surgery Partners has struggled to meet public investor expectations since its IPO in late 2015. The acquisitions of NovaMed in 2011, Symbion in 2014, and National Surgical Healthcare in 2017 represent the core of Surgery Partners' operations, with investors concerned about the entity's ability to grow at market like rates on an organic basis going forward. In our view, this is set to change after a wholesale replacement of top management during 2018. With former Anthem CFO Wayne DeVeydt now at the helm, we think investors will likely benefit from his mega-cap company mindset and commercial payer expertise. We think management's initial portfolio assessment has begun to chart the right course for the firm, focusing on divesting noncore facilities and de-emphasizing its struggling ancillary services. However, stabilizing assets is only the first step in DeVeydt's vision for the business, as he expects to return to a steady pace of acquisitions in the coming years. Though we expect them be smaller tuck-in opportunities rather than the transformational deals that define Surgery Partners' past, we still think the firm's highly indebted balance sheet will remain a focus for shareholders. In the near term, DeVeydt will have to prove to them that allocating capital toward inorganic growth, rather than debt reduction, is the better use of shareholder funds.
"Ultimately, we see little opportunity for the firm to build a structural advantage that would culminate in a defensible economic moat. Low entry costs, negatively skewed negotiating power, and a dearth of scale advantages make moats in the provider industry, and ambulatory surgery in particular, exceedingly rare. We think the firm is more likely to be of strategic value to a larger, comprehensive health system, and we wouldn’t be surprised to see a sale after core operations begin to run more smoothly.”
--Jake Strole, analyst
Susan Dziubinski does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.