3 Undervalued Defensive Stocks to Buy—and a Pick You Wouldn’t Expect

Susan Dziubinski: Hi, I am Susan Dziubinski with Morningstar. Every Monday morning, I sit down with Morningstar Research Services’ 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. On your radar this week, Dave, is the Federal Reserve meeting. What’s the market expecting the Fed to do and what about Morningstar’s expectations?

Dave Sekera: Good morning, Susan. From our U.S. economics team, our base case still remains that the Fed is going to be on hold. In fact, they think that the next move out of the Fed is going to be to start cutting rates in the first half of next year. And that expectation is based on their forecast that they do expect that inflation will continue to keep moderating, but that we do expect the economic growth is going to slow over the next couple of quarters.

Right now the market is also pricing in no hike here in November. But what I do find interesting is what the market is pricing in or the probability of potential hikes over the next couple of Fed meetings. I use the CME FedWatch in order to watch what the market is pricing in as far as probabilities, and right now it’s pricing in a 20% probability of a hike coming up here at the December meeting and then a 30% probability of a hike at the January meeting. Now even more interesting is the dispersion across the futures market for the probabilities in next May’s meeting. Right now there’s a 45% probability that the market stays at the current range of 5.25% to 5.50%. There’s a 14% probability of one or more rate hikes and a 41% probability of one or more cuts by then.

Dziubinski: What are you going to be listening for in Fed Chair Jerome Powell’s comments? Is there anything that he might say that could jar markets this week?

Sekera: Sure. Now this is just my personal opinion, but the remarks from the Federal Reserve officials, I mean for the past year they’ve just been laser-focused on inflation, the need to fight inflation even at the expense of the jobs and the economy markets. The Fed officials, I think they need to start shifting their messaging and I think they need to start to begin to prepare markets for when they’re going to reverse course and begin to ease monetary policy.

Two weeks ago, Fed Chair Powell did speak at the Economic Club of New York, and I think his messaging is just starting to reflect that shift toward a more balanced perspective between inflation and employment. That way as the economy slows over the next couple of quarters, the Fed can then start moving to more and more accommodative language before their first cut. Now, the risks of the market this week, I think if the language comes out to be more hawkish than expected or the commentary really remains just too focused on inflation and/or keeping rates higher for longer, if that were to be the case, then I would say look out below because I think the markets would go down on that.

Dziubinski: Morningstar, as you mentioned earlier in your comments, has been forecasting that slowing economic growth and lower inflation will lead the Fed to begin cutting interest rates in the first half of 2024. Just want to confirm that is still our take heading into this week’s Fed meeting.

Sekera: That’s still the take from our U.S. economics team, that we’ll get that first cut by the Fed in the first half of next year. And the way I think about it and how I kind of expect that it would play out based on that forecast is the economy starts slowing here in the fourth quarter. It slows even more going into the first quarter of next year. And I think there would be enough economic metrics pointing that it would still be slowing going into the second quarter.

And then those inflation metrics as they come out, they should continue to keep moderating or at least not get any worse at this point. And as that occurs over the next couple of meetings, I think the Fed officials and some of the commentaries that they would give after the meeting, that focus is going to start turning more toward that slowing economy and to the job market, which also should be slowing in turn. Then they can make that commentary increasingly more accommodative over the next couple of meetings. And I think the reason for that is the Fed doesn’t ever want to surprise the market. I think they’re definitely going to want to signal to the market, their intention to start cutting rates ahead of the time that they actually do so.

Dziubinski: Moving on to earnings, we have some high-profile companies reporting this week with one of the highest profile, of course, being Apple AAPL, which is the largest company by market cap in the U.S. So what will you want to hear about from Apple?

Sekera: First of all, I just take a look at what Apple stock has been doing. It’s fallen 15% from its July 31 peak. That’s actually enough now that it brings it into kind of the top of that 3-star territory that we think it’s in the range of being fairly valued. But I’d note it still does trade at a 12% premium to our fair value estimate. Now, I’ve seen more and more headlines out there that Apple sales are going to be under a lot of pressure just because of the slowdown in China and that could weigh on their top line.

I think the market’s going to want to know just how much pressure there’s been in sales specifically from China, and whether or not they expect that to continue or whether or not they’re expecting to see a rebound there. And so I think the market’s also going to look to see if Apple’s been able to make up that lost revenue with increases in their services and their apps businesses. Generally, I’d say for this third quarter with the economy having been stronger than expected, I’ve been pretty comfortable that most companies are going to be able to meet or beat their third-quarter expectations. But this is one stock that I’m definitely going to be a little bit more cautious of going into earnings. And I think with the stock, at least in our mind, still being overvalued, I think there’s really much hint of a weakness here. I think you could see a lot of traders look to sell first and then ask questions later.

Dziubinski: We also have some more real-economy stocks reporting this week. Which companies will be reporting and what are you going to be looking for?

Sekera: There’s a lot of them. I mean, just looking at the numbers here, we’ve got Caterpillar, Eaton, Hubbell, Rockwell, DuPont. These will be all ones that I’ll be watching as far as what’s going on with the real economy. Now, last quarter I think we talked about how we kind of break them up into two different categories, those that sell short-cycle products, those are the ones where there’s that short time frame between when products are ordered, made, and shipped, that those were starting to feel the economic slowdown over a couple of months ago, actually even maybe even two quarters ago at this point.

Whereas those companies that sell long-cycle products, and those are the products where there’s a long time frame between when the customer makes their order, the manufacturing of that order, and the actual end delivery from it. And those have been of course holding up very well. Now, a lot of those long-cycle companies, that spending has been tied to the $1.2 trillion in the Infrastructure Investment and Jobs Act. So, I want to hear if that spending is starting to wind down at this point, but I also then want to hear whether or not the spending that’s tied to that, the misnamed Inflation Reduction Act, is starting to pick up and take its place.

Dziubinski: We also have companies reporting this week that will give investors a read into the state of the consumer. What will you want to hear about? Give us a little taste of which companies are reporting.

Sekera: The retailers themselves are not going to report for a while yet, but I do think there are a couple of companies here that will give us insight into consumer sentiment and spending, especially as we start thinking about the holiday season. So, there’s both a handful of discretionary and a couple of nondiscretionary consumer product companies that are reporting. First of all, we actually had McDonald’s MCD out this morning. I haven’t had time really to go through it yet, but it looks like they beat, looks like the stock is trading up premarket here a couple of percent. And then we have Yum! Brands YUM, and Yum owns Taco Bell, KFC, and Pizza Hut. So, the things that I’m really going to be looking into with these two companies are the changes in consumption, both in terms of the number of customer count—are as many people still coming into their locations—as well as the average check size, really trying to understand are people still ordering the more premium or higher-end foods or they buying more value-conscious items.

We also have Starbucks SBUX coming up. Now personally I do consider coffee certainly nondiscretionary spending, in my mind, but Starbucks does have a lot of other higher-end beverages, the lattes, the Frappuccinos, and so forth. And those are going to be much more nondiscretionary. So, if consumers are pulling back, I’d expect to see it there first. We also have a whole bunch of nondiscretionary companies. We’ve got Mondelez MDLZ, we’ve got Kraft Heinz KHC, we’ve got Kellanova K. As a reminder, Kellanova, that’s the Kellogg snack business prior to that company breaking itself up. And I think there’s been a common theme that we’ve seen in these companies and it’s really impacted the stocks on those companies. They have been slow in order to be able to raise their prices as much as their own inflationary costs have been going up. And that’s certainly squeezed margins here over the past couple of quarters.

As we do expect inflation will moderate over the next couple of quarters, I do think that those companies will be able to see some normalization in their operating earnings. I’m going to be listening for indications if that investment thesis is playing out. If it is, I would expect to see those stocks start going up and start getting back toward where we think intrinsic value is. But of course, the other concern I have with these companies, with people under pressure from inflation, whether or not people are moving more and more into private-label brands and away from those branded products. And I know this is a long answer, but lastly is going to be Simon Property Group SPG. So again, it’s not a consumer stock per se, but it does operate class eight shopping malls. I want to hear what they have to say about their expectation for foot traffic in the malls going into the holiday season and hopefully some commentary on what they expect for the retail sales that they have for those companies that are in their malls.

Dziubinski: Got it. Let’s move on to some new research from Morningstar, and that will be our analyst’s take on some of the Big Tech earnings that came out last week. Let’s start off with Microsoft MSFT. The stock ticked up after earnings and the company beat on both the top and bottom lines, and it looks like our analyst raised our fair value estimate on the stock a little bit.

Sekera: It sounds like a lot, but to be honest, there’s really not a lot to say about the story here. Microsoft reported solid results, beat expectations on pretty much every measure, and then they also provided very solid guidance for this next quarter. Our analyst, he noted solid growth across all of their business lines, the productivity and the business-process products, personal computing, and most importantly, its cloud business Azure. Now that the Activision acquisition has closed, I’m going to want to see how that works out over time, but I actually don’t think that’s going to derail any of its other businesses. So really solid quarter, good guidance, just everything’s still working for this company for now.

Dziubinski: Then Alphabet GOOGL stock did not have a good week. It sold off after the company reported earnings last week. Market Watchers attributed the selloff to Alphabet’s miss on cloud revenue. What do our analysts think and did we make any changes to our fair value estimate on this one?

Sekera: For the week the stock, I think was down about 10%. And as you mentioned, the cloud revenue growth here, it was actually in line with our own expectations, but it was slower than what Microsoft Azure grew at. Azure I think was up 29%, whereas Alphabet is only up 23%. Certainly not that big of a miss but enough that the market sold off on that. So I read through our note here. Ali Mogharabi, who covers the company for us, I think he made a couple of tweaks in his model.

He increased our revenue expectations for Google search business, for their YouTube growth projections, and so forth. Yeah, I think he slightly offset that by lowering some of the revenue in their ad tech business. We also increased our expectations for capital expenditures, and that’s really just due to the growing demand for AI. But when you take all that and put that together, our model adjustments don’t affect our fair value. It’s still $161 a share. So between the selloff and our fair value estimate, it’s a 4-star-rated stock and trades at a 24% discount to our fair value.

Dziubinski: Meta META also reported last week, and the stock slipped after the company reported, but we raised our fair value estimate on this one a little bit, too. What’s our analyst’s takeaway here?

Sekera: And I note that while Meta did fall a little bit after earnings, I think it recouped most of the loss there the next trading day. So I think the market initially may have been a little disappointed regarding the amount of continued spending on the metaverse, and I don’t think the metaverse has really shown any significant progress at this point. I think that was probably what was going on there. But as far as the fundamentals, our analyst noted that third-quarter numbers showed strength on all three fronts that he really follows: that’s user growth, engagement, and monetization. So I know we did slightly increase our fair value. I think we took it up to $322 from $311, and that was just based on a slight increase in our long-term operating margin assumption. But at this point, the stock trades at a slight discount, about 8% to our fair value estimate, and that puts it still in the 3-star range where we consider it to be pretty fairly valued.

Dziubinski: And then lastly, Amazon’s AMZN report was good last week and our analyst noted that the forecast was actually better than expected. The stock did quite well after reporting earnings, and we raised our fair value by about 3%. How does Amazon stock look today?

Sekera: It’s a 4-star-rated stock, trades at a 17% discount of our fair value. As you noted, third-quarter earnings, better than expected, provided above-consensus expectations for the fourth quarter, e-commerce business was solid. Now I’d note AWS was slightly shy of our expectations, but I think that was offset just because management noted they thought their cloud business would improve over the next couple of quarters. Their ad business is still doing very well, continues to outpace its competition there. So, again, everything was going pretty well for this company this past quarter.

Dziubinski: Let’s move on to the stock picks portion of our program, and your picks this week are kind of reflective on your take of today’s markets. First, let’s talk a little bit about today’s market. Volatility has picked up during the past couple of weeks despite some decent earnings numbers. Why is that?

Sekera: I mean, the market was doing very well this year all the way up until July 31, and that’s where the market peaked out. And we’ve seen a selloff since then. And I’d note on July 31, the market actually hit our price to fair value. At that point in time, the market was trading right where a composite of our fair values would aggregate to.

Since then, long-term interest rates have continued to keep moving up. I think the 10-year is up almost 100 basis points, getting close to 5% from 4%. The economic outlook, while third-quarter GDP came in higher than what anyone expected, I still think everyone expects the economy is going to start slowing down. I think it’s just a combination of tight monetary policy, rising interest rates, rising loan standards—it’s all going to take a toll on the economy. The question right now is just how much and how fast is that going to occur? And, of course, now we also have all the uncertainty regarding the conflict between Israel and Hamas and how that’s going to work out, how long that’s going to take. I think traders are really just looking for any indications of how a lot of these factors are going to play out over the next couple of weeks and next couple of quarters.

Dziubinski: Given this uncertainty, your first three picks this week are from what many would consider to be the sort of typical defensive sectors, a first from the consumer defensive sector. Your first pick is Clorox CLX, which we talked a little bit about on the show before a couple of weeks ago, I think.

Sekera: First of all, I’d note that the defensive sectors, they’re all still trading pretty close to fair value. So from a sector perspective, we’re not seeing a lot of undervaluation. I think a lot of people are hiding out in a lot of the defensive stocks for right now. But there are a number where I think you are seeing some rare opportunities to be able to buy some very strong businesses at significant discounts to fair value. And I think Clorox is really a great example of that. The Clorox stock, it skyrocketed early during the pandemic. But what we’ve seen over the past years, that stock has really plunged. In fact, it’s gotten down to a level that’s even lower now than before the pandemic.

The short story here is we had very rapid growth in 2020 and 2021, but following a couple of years, you’re lapping that strong growth, sales growth looks like it is stagnating. Plus, Clorox, similar to a lot of the other companies in the consumer sector, they’ve had a tough time raising their prices as fast as their own inflationary costs have gone up, and that squeezed margins here in the short term.

Now as inflation slows, I do think Clorox will still be able to bring their prices up, and that’ll end up helping them normalize their margins, get them back to more of a historical average where they’ve been. We are looking for operating margins to get back to that 18% to 19% area. It’s currently in the low teens right now. And when I look at our financial model, I think it’s actually kind of conservative. In our financial model, we’re not projecting it to get back to that 18% operating margin until 2031, so still quite a number of years away. Now, I do have to mention with Clorox, if you do take a look at the name, you’ll see they did suffer a cybersecurity breach here in August, took some of its IT systems offline, that did disrupt their operations. But I talked to Erin Lash, she’s our analyst who covers this one, and, in our opinion, that is a temporary issue and really didn’t impact our long-term valuation. So net, after that long answer, it’s a 4-star-rated stock, trades at a 30% discount, and it has over a 4% dividend yield.

Dziubinski: Let’s move over to the healthcare sector, which is again, thought of as defensive. Here, you like a dividend aristocrat actually, Medtronic MDT.

Sekera: Medtronic, it’s the largest pure-play medical-device maker. We really think it’s a strong company. We do rate it with a wide economic moat. It’s a 5-star-rated stock, trades at a 38% discount to our fair value, and yield is 4% on its dividend right now. And just generally, I think the takeaway here is, according to our team, we think it’s probably the best-positioned med-tech company for the continued aging of the baby boomer generation and the type of products and services that it provides.

Dziubinski: Let’s move over to the utilities sector again, thought of as defensive. Utilities stocks have really gotten hammered this year, but in that sector you like NiSource NI specifically, why?

Sekera: There’s actually a lot of undervalued utilities stocks here to pick from. That sector has gotten hit hard over the past couple of weeks. NiSource is currently rated 5 stars, trades at a 24% discount, about a 4% dividend yield. And the reason for picking this one is talking to our team, this is just the utilities stock that they think has the longest runway for growth over time.

Dziubinski: And then your last pick this week is what maybe somebody would call a “one of those things just doesn’t look like the other” stock. Your last pick is not from a sector that’s viewed as defensive, and the stock isn’t terribly undervalued, either, Dave. It’s Microsoft. Why do you like it?

Sekera: So, not a defensive sector, it’s still considered a growth stock, but sometimes it’s just a matter of sticking with what’s working. As we talked about earlier, Microsoft posted very strong earnings. The stock traded up after earnings. It did give back some of those gains just because the geopolitical conflict has been weighing on market sentiment. But when I look at Microsoft, we do rate the company with a wide economic moat. It’s rated 4 stars. Not only does it trade at an 11% discount, but it’s a stock that we do have a Medium Uncertainty Rating on it. And like a lot of these other Medium Uncertainty companies, when I look at it over time, rarely has it really traded all that much or all that below fair value. So, I do think this is a good opportunity to be able to buy that stock below fair value.

And part of the reasoning here too is that if the market does remain volatile or if it even becomes more volatile, I think this is a name a lot of institutional investors, certainly those that have to remain invested, they’re going to be looking for stocks that they can hide out in in a time of market turmoil and volatility until they can see better clarity is how these risks are all going to shake out. And I think Microsoft, based on strong earnings, good guidance, still at a slight fair value discount, it’s just one stock that I think could see a lot of strong market sentiment from those institutional investors.

Dziubinski: That’s really interesting, Dave. Well, thank you for your time this morning. Viewers interested in researching any of the stocks that Dave talked about today can visit Morningstar.com for more analysis. Dave and I will be back live next Monday at 9:00 a.m. Eastern, 8 a.m. Central. In the meantime, please like this video and subscribe to Morningstar’s channel. Have a great week.