Don’t Go Chasing Recent Returns

On this episode of The Long View, Dave Sekera, chief U.S. market strategist for Morningstar Research Services, shares his thoughts on value versus growth, sectors, and the stock market today.

Here are a few excerpts from Sekera’s conversation with Morningstar’s Christine Benz and Jeff Ptak:

Overvalued Sectors

Jeff Ptak: Let’s talk about sectors. Maybe we can start with the most overvalued parts of the market. What’s looking frothy and what has to go right for these stocks to justify the price that’s being asked?

Dave Sekera: I’m following this huge rally that we’ve had thus far this year and the technology sector that’s now the sector that is most overvalued in our view, trading about a 7% to 10% premium to our fair valuations. And it’s interesting, this is the first time that tech actually has now been in overvalued territory since the beginning of 2022. And to some degree, I think a lot of the valuation right now, certainly what we’ve seen over the past couple of months, it’s a lot of excitement from investors regarding artificial intelligence and how that may end up playing through the technology sector over the years ahead. When I think about artificial intelligence, I think it’s still very early innings as far as how that’s necessarily going to impact stock valuations. I know talking to our equity analyst team that we do think that artificial intelligence will certainly be a positive factor for companies like Microsoft and Alphabet and Amazon. But I also know that our equity analyst team hasn’t changed their fair values based on artificial intelligence just yet. I think what we’re looking at is that artificial intelligence will be additive to those company business models as opposed to necessarily being transformative. So, I think a lot of investors maybe are starting to price in a lot of excitement into those stocks without necessarily really having the fundamental change in the valuations that the market is currently pricing in.

Valuation Mistakes

Christine Benz: Can you think of an instance like this in the past, say, within the past five years or so, where investors were extrapolating good recent performance and positive news flow well into the future beyond what was really reasonable for them to do?

Sekera: There’s a couple of different examples out there. Maybe none of them are really the exact same. But it is interesting that as I look through our valuations on a historical basis here, back at the beginning of 2018, the basic materials sector was the most overvalued sector, trading I believe at like a 25% to 30% premium over our fair values, something that you really don’t see happen very often. And then, when I started digging into that a little bit further, there were even companies that were trading at 2 times or 3 times over what we thought the company was worth. And in that case, what we found is that there were companies like steel companies and building material suppliers that for the past decade had just been making money hand over fist as they were supplying the build out of China, which of course at that point had been going on for at least the past decade. And I do think that’s an instance where investors were extrapolating those growth rates for too long going into the future and paying too much for those individual stocks.

Which Sectors Are Looking Cheap?

Ptak: We’ve asked you about parts of the market that are looking particularly rich, and you cited a current example as well as one in the not-too-distant past. How about the flip side? What’s looking invitingly cheap right now when you scan across sectors and industries?

Sekera: Well, the sector that’s still most undervalued right now is the communications sector. And there’s still a lot of negative sentiment within communications in and of itself. It was the most undervalued sector coming into the year. And the thing you have to remember with communications is that both Alphabet and Meta are in the communications sector weightings. And of course, based on the size of both of those companies, the two of them together, I think about 55% of the market cap. So, anything that those two companies do certainly skew that overall sector return. Meta, I think, has more than doubled thus far this year. It’s gone from being a 5-star stock now to a 3-star stock. Alphabet is up pretty substantially as well. That’s one where we do still see some upside. It’s a 4-star-rated stock. But again, it’s certainly run a lot of the course thus far this year.

But within communications, we still find a lot of the traditional media companies, a lot of the traditional telecommunication companies are still very undervalued. Specifically, companies like AT&T and Verizon—companies where our analytical team is rating those 4 stars or 5 stars because we think that the market really is being very negative in the sentiment on those companies and not thinking through how the changes within that sector will play through. So, for example, I know that there’s been consolidation in the wireless telecommunications area. At this point, there’s really an oligopoly. It’s three main competitors between AT&T, Verizon, and T-Mobile. And so, I know our analytical team is expecting a much more rational competition in the future as far as pricing than what we’ve seen in the past, which should then reflect well in the margins for those companies going forward.