3 Stocks, 1 Potentially Explosive Growth Theme

Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. Every Monday morning I sit down with Morningstar’s chief U.S. market strategist Dave Sekera to discuss one thing that’s on his radar this week, one new piece of Morningstar research, and a few stock picks or pans for the week ahead. What’s on your radar this week, Dave?

Dave Sekera: Good morning, Susan. I think this week is actually just going to be a good time to take a couple of deep breaths and use it as just a catch-up week. For the most part, earnings season is now behind us, looking at the calendar. I really don’t see any economic metrics that I think are going to probably end up changing our economic outlook, and I think it’s going to be next week that the headlines are going to ramp back up again. Of course, we’ll have the Fed meeting, find out whether or not they’re going to hike interest rates one more time or not.

I’d recommend for most investors, take the time, go revisit your portfolios, and where needed, make some reallocations, because just what we’ve seen over the past month and year to date, we’ve seen some really wide divergences in market returns. So, I think now might be a good time to make sure your allocations are where you want them to be.

Dziubinski: We talked about Nvidia NVDA a couple of weeks ago ahead of earnings. Since then, Nvidia earnings came out solid, and Nvidia’s forecast was, frankly, breathtaking. So, Morningstar increased its fair value on the stock by 50% to $300. What’s your take?

Sekera: Well, interestingly, that stock rose so much even after our fair value increase. And I would note our fair value increase, now we’re assuming a 30% compound annual growth rate for revenue for the next five years. So, I mean, I don’t think that we’re necessarily being overly conservative with our outlook here, but it’s a 2-star-rated stock and it trades at a 30% premium to our fair value.

As you mentioned, the guidance here really was just shocking. I mean, I’ve been in this business for over 30 years now at this point, and sometimes I think I’ve seen a lot, but yet the market sometimes never fails to give me a new shock here. And really the amount that revenue is surging here in Nvidia is really just eye-opening. And I think what that tells me personally as well as professionally, I need to spend a lot more time digging into artificial intelligence and really trying to understand what the longer-term ramifications are, what that means both for these individual stocks as well as the market overall.

Dziubinski: Let’s pivot over to some new research for Morningstar, and that’s your new stock market outlook for June. Let’s start out with a recap of what happened in the markets in May and where the markets stand here today.

Sekera: The market was up about a half a percent here in May, but I do have to point out the market really did surge last Thursday and Friday. So, through end of market on Friday, we’re now up 12% year to date. And I would just note the returns have really been almost all completely driven by the growth category this year. The core and the blend area, that’s really lagging far behind. And the value category, I mean, that’s just barely above breakeven at this point.

Dziubinski: As you noted, growth stocks are continuing to dominate. What’s really driving that?

Sekera: I think it’s twofold. In the growth category specifically, I think it’s a combination of a couple things. One, coming into the year, we thought growth was actually very undervalued. So, I think a lot of it is just that catch-up, getting toward where we see long-term intrinsic valuation, but you really can’t underestimate just how much the excitement in artificial intelligence has really propelled those stocks that we think are levered to AI and just the types of returns that we’ve seen in a lot of those stocks are just staggering thus far, this year.

And then on the other side of the coin, I think in the value category there is a lot of concern that that stagnant-to-weak economic growth that we’re expecting here for the next couple quarters will weigh on earnings in that category. I think that’s why value has lagged so far behind.

Dziubinski: You said before that you expect the market to look for an upswing in economic indicators before it will begin to move closer to our long-term intrinsic value. Is that still your expectation? And what are you expecting from the market over the summer specifically?

Sekera: That is still my expectation, and I do think that we could see some market pullbacks over the next couple of months. We are looking for GDP to be relatively stagnant in the second quarter, potentially a small contraction in the third, and then only what I call a sluggish recovery beginning in the fourth quarter.

So, I do think the market will be looking for those leading economic indicators to rebound, probably not until later this summer or this fall, to really start taking that next leg up in the markets. Now, I do have to admit, the market is looking to try and prove me wrong. I mean, last Thursday and Friday, we really did have some just astounding gains, those two trading days. And it looks like the market is trying to break above that trading range that we had been stuck in since last fall.

So, from here, from a technical perspective, again, we’re not short-term traders, and we do want to invest for the long term, but if the market can hold these gains from last week, I do think the next target here on the S&P 500 is going to be 4,300.

Dziubinski: Heading into June, Dave, do stocks in general look undervalued or overvalued?

Sekera: According to that composite that we’ve talked about before, so those over 700 stocks that we cover, that trade on U.S. exchanges, when we put that composite together and compare that to the market, we still view the market as being undervalued. Now, of course, at this point, it’s a lot less undervalued than it was based on our calculations at the beginning of the year. So, at the end of May, that composite was showing that the market was trading at about an 8% discount to that composite.

Dziubinski: Let’s look at the market through the lens of sectors first. Are any sectors especially frothy today?

Sekera: According to those valuations, when I break them down by sector, I do have to note, technology is now moving into that overvalued territory. Tech actually has gone now from being the third most undervalued sector at the beginning of the year to now being the most overvalued.

At the end of May, it was actually trading at about a 4% premium to fair value. So, again, not a huge premium to our intrinsic value, and we still do see a lot of opportunities in a number of individual stocks, but it might be starting to tell me that that sector, maybe it’s starting to run up a little too far and a little too fast here in the short term.

Dziubinski: Then let’s flip that and look at what sectors might look undervalued and why.

Sekera: Communications is still the most undervalued, yet it is the second-highest returning sector year to date, but it’s trading sat a 21% discount to our fair values at the end of May. And then closely following that would be the real estate sector; that’s trading at an 8% discount. And I’d note real estate is down slightly year to date, and I think a lot of that is just due to concern about the commercial real estate sector, specifically the office sector, which I also do have a lot of concerns there, but we do see a lot of opportunity in nonoffice REITs right now.

And then lastly, I’d note financials. So, that’s at a 17% discount. From a technical perspective, it looks like a lot of those stocks, especially the regional bank stocks, are still in that bottoming-out process following the big falls we’ve seen since the bank failures earlier this year.

Dziubinski: Now let’s look through the lens of investment styles, starting with value versus growth. Now, how do valuations compare between the two styles?

Sekera: We’ve seen some big changes thus far this year. If you remember at the beginning of the year, we’d advocated a barbell shaped portfolio, essentially being overweight growth, overweight value, and then underweight core and blend stocks. And then if you remember last month, we actually updated that opinion to still being overweight value, but we actually thought it was probably a good time to move to more of a market weight in growth and then still remain underweight core.

Now, with as much as growth has jumped again here in May, now might actually be a pretty good time to start taking some of those profits out of growth and reallocate that more into value.

Dziubinski: And then, Dave, what about from a market-cap perspective?

Sekera: With as much as large-cap stocks have outperformed, they’re now trading at less of a discount than the overall market, so again, they’re starting to pull ahead. And mid-cap stocks, they’ve lagged. They’re actually now a little bit more attractive than what we’ve seen the past couple of months; they’re trading at a 15% discount. But of course, it’s still that small-cap space that remains the most undervalued, trading at a 30% discount from fair values.

Dziubinski: Given what valuations look like today, Dave, what might investors be considering for their portfolios?

Sekera: Of course, it’s always going to be based on your own risk tolerance and your own long-term goals. But even though I do think that there is still a pretty good chance that we might see some pullbacks this summer or even early this fall, with the market still at a discount to fair value, I do think investors should remain fully invested at their targeted allocations based on their risk profile.

That way, if we don’t get a pullback, you’re still capturing all of the upside in that equity portion of your portfolio. But if we do get pullbacks, I do think that’s actually going to be a good opportunity then to move back into overweight positions in the equity sectors.

Dziubinski: We’ve reached the picks portion of our program, and you’ve noted, Dave, that we’re likely in a sideways market, and we talked about stocks for a sideways market last week. What other strategies might investors consider in this type of market?

Sekera: Susan, you and I have talked about this a couple of times on our videos here, but I always still like thematic investing and specifically looking for those opportunities where you see a long-term secular growth and can marry that with companies with an economic moat that are trading at a discount to intrinsic value.

Some of those examples that we’ve spoken about in the past have been that long-term secular increase in lithium demand from electric vehicles and consumer behavior normalization.

Dziubinski: This week’s stock picks tie into one of the themes we’ve talked about on the show before, briefly, med tech, and specifically liquid biopsies. In a recent article on Morningstar.com, you called liquid biopsies one of the largest potential market opportunities in the entire healthcare sector. First, tell viewers what liquid biopsies are and why you think the opportunity is so great.

Sekera: Of course. So, a liquid biopsy is a noninvasive method for diagnosing and analyzing tumors using things like blood draws. And there’s a lot of new technology out there, and one of them is really the ability to screen for up to 50 different types of cancer in just one blood draw. And our healthcare team thinks this represents just really a paradigm change as far as when cancer is detected and when you can then begin treatment.

Historically, they’ve noted cancer is only detected when the symptoms have really begun, and people are noticing some of those side effects. And at that point, many times that cancer has already begun to spread. So, by detecting it earlier, it’s both cheaper to treat and usually has better outcomes for the patients. And in fact, to quote Julie Utterback, who’s our senior equity analyst on the Morningstar healthcare team, she thinks a pan-cancer screening could actually just be the holy grail of the regular cancer screening.

Dziubinski: There are a few stocks that Morningstar’s analysts cover that are leveraged to this opportunity. Let’s unpack them. The first is Illumina ILMN, which is undervalued.

Sekera: Illumina stock is rated 4 stars. The company is rated with a narrow economic moat and is trading at about a 23% discount to our fair value. Now, Illumina’s base business is that it provides tools and services to analyze the genetic material in the life sciences area and using clinical lab applications.

So, the potential upside here is in its gallery test, and that’s that pan-cancer screening that can detect up to 50 different types of cancer. And this test is currently being used in the market, and it is currently being evaluated, and we think it could get approval from the FDA and some other global government health organizations sometime in 2024 or early 2025.

Now, when we look at the pan-cancer screening market, overall, we think it could be up to a $15 billion market in the next 10 years. So, when we look at our valuation for Illumina, we currently assign a fair value estimate of $269 a share. And the way that breaks down is we look at a $201 share valuation on that legacy genomic sequencing business and assign a $68 per share valuation relating to those liquid biopsy assets.

Dziubinski: There’s risk that Illumina will need to unwind its Grail acquisition. If that happens, what might that mean for Illumina’s shareholders?

Sekera: They had bought Grail and they actually closed the deal before they got through all of their antitrust regulations. So, both the EU and the United States, I believe it’s the DOJ, are advocating for a split up of Illumina and Grail. And I know Illumina’s currently appealing that ruling.

Now, if Illumina is unsuccessful, I would expect that the way that they would structure that divestiture would be in such a way that the Illumina investors are still going to retain that economic interest in the long-term opportunity for Grail. So, they’d probably look to do something like a spinoff directly to Illumina shareholders. So, at the end of the day, the investors in that stock still own both parts of those businesses.

Dziubinski: Got it. Now the second play on this theme is Guardant Health GH, which is also undervalued. Tell us about that one.

Sekera: Guardant’s stock is rated 5 stars. The company doesn’t have an economic moat, but it is trading at a 49% discount to our fair value. While we typically look for companies with those long-term competitive advantages, at this much of a discount, I do think that there’s plenty of margin of safety for investors.

Guardant provides cancer blood tests and analytics for clinical and research use, but the most promising part of its business is its Shield test. And that’s going to be used for the early detection of colorectal cancer. That could be approved by the FDA maybe in the next year. And then the other part of their business, too, is now targeting other individual cancer screening tests and using that for cancer survivors in order to monitor and make sure that cancer’s not coming back. And if they do see indications of it coming back, then they again can start treating that earlier.

Dziubinski: Then the last stock we’ll talk about today isn’t undervalued, so it’s more of a name to keep on a watchlist rather than a stock to buy today. And it’s Exact Sciences EXAS.

Sekera: Exact has really had quite a run thus far this year. I think it’s up almost 70% year to date. In fact, it was a 4-star-rated stock at the beginning of the year, both as much as it’s up, it’s now trading in that 2-star category as it’s about a 30% premium over fair value.

So, Exact Sciences sells the Cologuard screening test, and that’s a stool-based test for colorectal cancer. But they are developing a liquid biopsy test for colorectal cancer, which really builds on its expertise that it already has using that Cologuard product. But they’re also working on a multicancer early-screening test to detect up to 15 different types of cancers in one blood draw.

Dziubinski: Well, thanks for your time this morning, Dave. Be sure to join Dave and I live on YouTube every Monday morning at 9 a.m. Eastern, 8 a.m. Central. And while you’re at it, subscribe to Morningstar’s channel. Have a great week.