3 Undervalued Stocks to Buy in Q4 2023

Susan Dziubinski: I’m 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. You have a few economic reports on your radar this week, Dave. What are you watching and why?

Dave Sekera: Good morning, Susan. We do have a couple. We have both the ISM and the PMI readings, and that’ll just give us an update as to the state of the economy. Taking a look at the numbers here, on the manufacturing side, it looks like the market is still expecting all of those to be in contractionary territory. Whereas on the services side, it looks like the consensus is all of those should still be expansionary. So, net-net, I think the composite readings here will still show that the economy is still expanding, but probably just barely in positive territory. And I think that’s in line with our economic outlook that we are looking for a slowing in the rate of economic growth beginning here in the fourth quarter, but no recession.

Then we also will have payrolls and unemployment on Friday. And that’s going to give us a sense whether or not the jobs market is starting this slow, and if so, how much? Now, of course, slowing jobs would take some of the air or some of the steam out of wage growth. And, of course, that’s bad for those of us that are still working, but it would be good for keeping inflation down. So, I think that’s what the Fed is going to be looking for.

Dziubinski: The bond market is also on your radar this week. Last week we saw the yield on the 10-year Treasury hit its highest level in 15 years. Why has the yield been rising?

Sekera: Well, it’s always hard to know exactly in the short term, why. Now in my view, I think it’s a combination of just more supply. And I think just investors require higher long-term yields if the Fed is going to keep the federal-funds rate higher for longer. On the supply side, we still have the Fed letting, I think, about $95 billion of Treasuries and mortgage-backed securities mature every month, and, of course, that then needs to get refinanced in the public market. And the government funding requirements are still high as the deficit continues to grow. On the demand side, the Federal Reserve is certainly letting the market know that they think the interest rates are going to be higher for longer. And if that’s true, then I think investors are just looking for higher long-term rates in order to entice them to move further out on the yield curve.

Dziubinski: Given that backdrop, Dave, do you expect the yield to continue to tick up?

Sekera: In the short term, the momentum certainly could push bond prices down further and yields up higher. But from a fundamental point of view, we think it’s probably either at or pretty close to its peak from a yield basis right now. I know our U.S. economics team is forecasting the 10-year Treasury will average about 3.25% In 2024. So, we do expect over the course of next year that rates will come down a pretty good amount. So, again, the market is definitely concerned about that higher-for-longer commentary coming out of the Fed. But in our view, we do think that the rate of economic growth will start to slow here in the fourth quarter. And it’s going to slow sequentially for a total of three quarters. We’re not looking for that rate of growth to bottom out until the second quarter next year. And with yields this high, I think that’s going to start attracting more investors, especially those investors that had invested in high-yielding stocks last year when interest rates were so much lower. I do think we could certainly see some reallocation out of stocks and into fixed income.

Dziubinski: What does a rising yield on the 10-year Treasury mean for the stock and bond markets?

Sekera: Well, the rising yields, that’s going to, of course, lead to greater losses in the fixed-income markets, especially in the longer end of the curve where we have higher duration. And if yields head much higher, I think it also could lead to losses in the stock market. It’s funny, if you remember back in 2022, there were a lot of market commentators who were talking about how the market was falling due to rising interest rates at that point in time. Whereas we said that we thought that the rising interest rates weren’t necessarily what was hitting stocks, but stocks themselves were just overvalued on a fundamental basis because earning expectations were too high. Now, yields are actually even higher than where the market had bottomed out last October. And that was when, according to our valuations last October, the market got to its most undervalued level over the past 10 years.

But a lot of those long-duration stocks, the ones that people thought were being hit the hardest because of rising interest rates, a lot of those have rebounded. They’re actually back to some of their highest levels, and I think it was just a matter of a lot of those valuations got too low last October. So, my sense is that if long-term yields start really getting over 5%, I think that’s the point where interest rates might really start to play a point in equity valuations. That’s probably the area that I think investors start ratcheting up their assumptions on what the long-term risk-free rate really should be.

Dziubinski: Let’s pivot over to some new research from Morningstar, and that’s your fourth-quarter stock market outlook, which is available now on Morningstar.com. First, let’s talk about the performance of stocks during the third quarter. Wasn’t a great quarter for the market in general. Stocks finished the quarter down about 3%.

Sekera: We gave back some of the gains that we had earlier this year. And it could just be as simple as some profit-taking and probably pricing in or starting to price in a little bit of an economic slowdown. It’s interesting, when I look at it intraquarter, our price to fair value just briefly touched fair value right at the end of July, right when the market peaked. At that point in time in our August monthly outlook, we noted that we thought it was a good time to start taking profits on some of those stocks that have become overvalued, overextended. A lot of stocks had probably just run up too far and too fast at that point in time.

And some of this pullback could just be in response to how concentrated the market rally had been. When we look at those “magnificent seven” stocks, six of the seven were undervalued coming into the year. At this point, most of them have run up to the point that I think they’re all 3 stars. Except for Alphabet GOOGL, that one’s still a 4-star. And Apple AAPL actually has run too far. Taking a look at that one right now, it’s a 2-star-rated stock.

Dziubinski: Let’s break down that third-quarter market performance by sector. Which sectors were the strongest performers during the quarter? And why do you think that was?

Sekera: Energy by far was the best performer. It’s up 12.7% for the quarter. And a lot of that just has to do with how much oil prices surged. OPEC has maintained their supply cuts, and that’s certainly keeping the oil market very tight here in the short term. Looking at the charts here, it looks like oil itself was up about 30% this past quarter. Other than that, the communication sector is up another 2.5%, largely due to Alphabet and Meta META. And those were really the only two sectors taking a look here that had quarterly positive returns.

Dziubinski: Let’s look at the flip side. Which sectors underperformed during the quarter and why?

Sekera: First of all, you just have to point out the utilities sector. And it’s just really been getting killed by rising interest rates. Of course, utilities being very correlated to interest rates. That’s down over 9% for the quarter and down to over 14% year to date. Next is the real estate sector, that’s down 8.5%. Also, because of rising interest rates. It also is going to be very correlated to interest rates. But also we do have a lot of concern about valuation in the market on commercial real estate, especially for urban office space. And then lastly, I would note tech is down almost 5%. Now, that was overvalued in our view at the end of the second quarter. A lot of those stocks had risen too far too fast. But the one I’d really point out is going to be Apple. Apple stock was down almost 12.5% this past quarter. And just because of the size of its market cap, it’s going to always have a big skew in the technology sector.

Dziubinski: Moving on to look at the market through the lens of investment style and market capitalization, how did things look for the quarter?

Sekera: The growth stock category was the worst-performing. That’s sold off almost 6%. Core stocks were down about 2%. And then value stocks held up a little bit better. I think they were down just under 2%. And then by capitalization, the large-cap stocks held up the best, down about 2.5% percent, whereas mid-cap stocks were down 5%, and then small-cap stocks were down 4.5%.

Dziubinski: Then heading into the fourth quarter, Dave, how does the market look from a valuation perspective?

Sekera: It’s looking a lot better from a valuation perspective. As of Sept. 25, when we ran the numbers for the article that’s up there today, the market was trading at about an 8% discount to our fair value. And the way that we got there from being really close to fair value or actually touching fair value at the end of July, it’s a combination of two things. So, one, it’s the market selloff that we had here in August and September. But I’d also note that we did increase our fair value on a number of different stocks this past quarter as well.

Dziubinski: Which sectors heading into the fourth quarter look the most overpriced?

Sekera: It’s going to be that energy sector. That’s the only one that’s actually trading now in overvalued territory. But even that isn’t that overvalued. It’s only trading at about a 3% premium to our fair value right now.

Dziubinski: Which sectors look undervalued or are the most attractive heading into the new quarter?

Sekera: We’ve still got communications. You and I have certainly talked about the communications sector a lot over the past couple of months. That’s still very significantly undervalued, trades at about a 19% discount to that aggregate of our fair values there. But it’s no longer the most undervalued. That title now goes to the real estate sector.

So, real estate’s now trading at a 21% discount to our fair value. Of course, it’s not going to be for the faint of heart. I do think there’s a lot of volatility still left to come. But at this point, there is a large margin to safety. The real estate stocks do pay some pretty healthy dividends. So, you can clip those dividends while we’re waiting for that rebound. Although in real estate, I’d still be very cautious of urban office space. It’s just an area I still have a lot of concerns about.

And the other real big change this year has been the utilities sector. So, that was overvalued coming into this year. It’s now trading at a 9% discount to fair value. And again, it’s really the rising interest rates that have really pushed the utilities down. But, in our view, we think it’s sold off too much.

Dziubinski: Let’s move on to investment style and market capitalizations. Same questions there. What looks overvalued today and what looks undervalued?

Sekera: On a relative value basis, that core category, or blend stocks, is still the least attractive. They’re the ones that trade closest to fair value. Whereas the rest of the market is more undervalued. So, the value stocks are still the most undervalued, trading at about a 17% discount to an aggregate of our fair values there. So, I do think that’s an area investors should still be overweight today. And growth now is certainly more attractive. It’s now at an 8% discount to fair value. And in fact, I’d even just highlight that was trading at a 4% premium when we published our August monthly outlook. Taking a look here by capitalization, both mid-cap and small-cap stocks are attractive, trading at 15 and 26% discounts, respectively. And then on a relative value basis, the large-cap stocks are not as attractive. They’re only at a 5% discount to fair value.

Dziubinski: Given all this, given your outlook, Dave, what tweaks would you suggest investors make to their portfolios at the start of the fourth quarter?

Sekera: I think the biggest change here is really in that growth category. And if you remember at the beginning of the year, we started off with a barbell-shaped portfolio where we recommended being overweight value and overweight growth. But then in growth, we went to a market weight in May after the market had really rallied. The market rallied even further, so in July we went to an underweight recommendation. But now that it’s sold off enough, we do think it’s now a good time to move back to that market weight.

Dziubinski: We’ve reached the picks portion of our program. This week, you’ve brought us three stocks to buy for the fourth quarter. And these picks are among our analysts’ favorites for the quarter as well. The first stock on your list this week is Wells Fargo WFC. Now, we’ve talked about a couple of other bank stocks on the show before, but I think this might be the first time we’re talking about Wells. Why do you and our analysts like it?

Sekera: We actually in our list this quarter swapped out Wells Fargo for Citibank C. So, I’d note Citibank still is very undervalued. We still think there’s a lot of opportunity there. But when we compared Citibank and Wells Fargo, our analytical team noted that they think Wells Fargo does have a stronger franchise from a profitability perspective, and that Wells Fargo is further along in its turnaround at this point. And then when comparing Wells to a lot of the regional banks, Wells is not dealing with any of the earnings pressure or some of the capital issues that they’re dealing with in the regional banks. So, when I take a look at Wells here on our charts, it’s a 5-star-rated stock, trades at a 33% discount, looks like the dividend yield is about 3% here, and we do rate the company with a wide economic moat.

Dziubinski: And your second pick this week is Snowflake SNOW. This pick might surprise viewers a little bit since it’s a tech stock. But tech stocks have, of course, pulled back in the third quarter. But Snowflake overall has had kind of a tough year. What’s been going on there? And why do you and our analysts like it?

Sekera: Snowflake was one of those 2020-vintage IPOs. And I think there was probably just too much hype both in the IPO market and maybe even in Snowflake specifically back then. It has fallen enough that it’s now currently rated 4 stars and trades at a 34% discount to our fair value. Although I would note on this one, it doesn’t pay a dividend and it does not have an economic moat. But we do think this is actually a really interesting play on artificial intelligence. So, Snowflake itself is a data management provider. They host the enterprise data in which AI models are used to run.

Dziubinski: Now your last pick this week comes from an industry that we’ve never talked about before on the show, but that Warren Buffett has been a longtime fan of, railroads. So, why haven’t we talked about this before, Dave?

Sekera: Well, a lot of that is really just due to valuation. Taking a look at our coverage here, rarely do railroads ever trade at much of a discount to our fair value. For the most part, I think we rate all of our coverage here with a wide economic moat, and that’s based on two different areas here: one being efficient scale and the second being cost advantages. Now, on the efficient-scale side. For most of those routes that the railroads cover, there’s really only need to have one railroad. I mean, when you think about it, there’s really no reason to have a second rail line that’s going to end up having too much capacity and just wouldn’t be economical. Plus, certainly a lot of barriers to entry to build new rails. I mean it’s going to be extremely hard in today’s environment. And also on a cost-advantage side, rails are still the cheapest way to go over long distances, especially where there’s no waterway that connects the areas that you’re looking to move cargo.

Dziubinski: Your pick here specifically is Norfolk Southern NSC. The company experienced a train derailment earlier this year in East Palestine, Ohio. And the stock’s really struggling this year. Why do our analysts like it?

Sekera: I think the market just as looking at it as just really being very hard to estimate the amount of legal liability that they’re going to have for remediation of the hazardous chemicals from that derailment. But I know our analytical team has looked at it. In our estimate, we think the market is significantly overestimating the current legal liability. So, at this point, that stock has fallen enough. It trades at an 18% discount to that fair value, which is going to include our estimate for that legal liability. It’s a 4-star-rated stock, pays a 2.4% dividend yield, and we do rate the company with a wide economic moat.

Dziubinski: Thanks for your time this morning, Dave. 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 a.m. Eastern, 8 a.m. Central. In the meantime, please like this video and subscribe to Morningstar’s channel. Have a great week.