4 Still-Cheap Stocks to Buy as the Market Hits New Highs

Susan Dziubinski: Hi, 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 two main things on your radar this week, Dave, the Fed meeting and earnings. Let’s start with the Fed meeting. What is the market expecting, especially after that surprising fourth-quarter GDP number last week? Is the market expecting the Fed to leave rates unchanged or to begin cutting?

Dave Sekera: Good morning, Susan. Between the Fed, earnings last week, earnings coming up this week, some small-cap stock picks this week—we have got a lot to talk about here, so I hope you and our viewers have your morning cup of coffee. Now as far as the Fed goes this week, I don’t think anyone realistically thinks that the Fed is going to cut rates at this meeting. I don’t think that’s really the question. The question is going to be whether or not the Fed is going to start cutting rates at the March meeting, which is our base case, or keep rates higher for longer.

Dziubinski: What are market expectations at this point for when the Fed may, in fact, begin cutting interest rates, and what’s Morningstar’s base case?

Sekera: When I look at the futures market right now, it looks like essentially a coin flip. It’s a 50/50 probability of whether or not they cut in March. And then when we take a look at May, there is a 50% probability that the rates will be in that 5.00% to 5.25% range, which would indicate one cut by then, a 40% probability of 4.75% to 5.00% range, so that would be two cuts, and only an 8% probability that they stay at the current range of 5.25% to 5.50%. So, our base case is still for a cut here in March. However, if they don’t cut in March, we are very confident that they will cut in May.

Now, as you noted, fourth-quarter GDP did come in much stronger than expected, even stronger than I think what we were expecting. However, we also were looking at the Fed’s favorite inflation gauge last week, and that’s core PCE, Personal Consumption Expenditure Index, and that was in line with consensus on a month-over-month basis and actually slightly better than expected on a year-over-year basis. Part of our reasoning here in thinking about when the Fed is going to cut is really thinking about their dual mandate. That dual mandate is to both foster economic conditions that encourage stable prices but also look to have maximum sustainable employment. As far as stable prices go, inflation is still a little bit higher than their 2% goal, but it is definitely on a downward trend. We expect that trend to continue. In fact, talking to our U.S. economics team, we do forecast that April core PCE will be down to 2.1%.

Now as far as the maximum sustainable employment goal goes, the Fed does want a soft landing. They don’t want a recession. When I think about our current forecast rate for economic growth, we are looking for the rate of economic growth to slow each quarter sequentially through the third quarter of this year. And we also do expect inflation to cool. So, we do think that gives the Fed the room to start easing its currently restrictive monetary policy. Personally, my own concern is that if they keep monetary policy too tight for too long, I think that could end up pushing the economy into a recession. And, of course, in a recession, that would lead to much higher unemployment than what they would want.

Dziubinski: What in particular, Dave, are you going to be listening for in Fed Chair Powell’s remarks this week?

Sekera: It’s really going to be all about his outlook for inflation. So when you look at both third-quarter as well as fourth-quarter GDP, both came in much higher than expected, yet inflation was still moderating at that same point in time. So, I don’t think the Fed has to be as concerned as they may have been about higher-than-expected growth leading to a rebound in inflation. And, in my opinion, considering the Fed was very late to the game to start raising rates as inflation began to heat up, I don’t think that they want to take that same potential mistake of not starting to ease rates enough and accidentally put the economy into a recession later this year.

Dziubinski: You’ll also be watching for some earnings reports this week and we have several members of the “Magnificent Seven” expected to report this week, Alphabet GOOGL, Microsoft MSFT, Apple AAPL, Meta META, and Amazon AMZN. Let’s start out with Microsoft and Apple. What does Morningstar think of these two stocks heading into earnings?

Sekera: It’s interesting. I looked at the chart on Microsoft. It’s up 68% since the end of 2022. It’s up 7% just year to date in and of itself, and that stock is hitting new all-time highs. The stock currently trades in our 3-star range, and that means that we think it’s in a range that’s pretty much fairly valued, but after that long run that we’ve seen here, I think they might have to produce guidance that’s going to be at least as high if not higher than what the market expects to keep that rally going much further. And then really the same analysis on Apple. That’s almost up 50% since the end of 2022. Interestingly, that stock peaked last July and it’s been unable really to break through the upside since then. Now we do rate that stock with 2 stars, and it trades at a 20% premium to our fair value. So, in our view, we already think the market is pricing in too much growth for too long. If the company were to provide a weak outlook, I wouldn’t be surprised to see a pullback in that one.

Dziubinski: Let’s walk through the remaining members of the Mag Seven that are reporting this week, Alphabet, Meta, and Amazon. What does Morningstar think of each of these today?

Sekera: So Alphabet, that was actually the last of the Magnificent Seven that was undervalued. That stock is already up 9% year to date, so that’s putting it in the 3-star territory. That stock is only trading at a 5% discount to our fair value. Now when I take a look at Meta, at the end of 2022, you almost couldn’t give that stock away. It was deep, deep in 5-star territory. Now since then, it’s up almost 238%. It’s up 11% just year to date. So that stock’s also now hitting new all-time highs. It’s in that 2-star territory, trades at a 22% premium. So similar to Apple, if the outlook is weaker than expected, I wouldn’t be surprised to see a pullback in that one as well. And then lastly, just taking a look at Amazon, pretty decent growth here thus far this year. Up 5% year to date, but it is up 89% since the end of 2022, and it’s also now in that 3-star range.

Dziubinski: Let’s move away from the Mag Seven but still talk large companies. We have Exxon Mobil XOM reporting this week, and Exxon was one of your picks on the show a couple of weeks ago. What do we think of the stock heading into earnings?

Sekera: This one has had some volatility over the past couple of years. Now there was this big runup in 2022. That moved it high enough to go into the 3-star territory. Saw a modest pullback in 2023. In fact, it was enough to bring it back into 4-star territory last November. It’s still currently trading at a 16% discount. And fundamentally, Exxon is still doing extremely well. I think the market concern here is still about the long-term demand for oil. Now I know our forecast for oil demand is that it will still continue to rise slightly each year through 2030 and then only begin to modestly decrease slightly thereafter. When we think about the oil market supply and demand, even with a higher percentage of global autos becoming electrified over the next decade, there’s still a huge percentage of internal combustion engines on the road and other needs for oil that can’t be replaced by electricity.

Dziubinski: Any other company earnings you’re going to be keeping an eye out on for this week, Dave?

Sekera: I am the U.S. market strategist, but I’m actually going to be listening to Alibaba’s BABA call. And I think what’s going on here is I really want to get an indication from them what’s going on with the Chinese consumer. If you look at the Chinese stock markets, they’ve been on a pretty strong downward trend for the past year. And, depending on which index you’re looking at for China, a lot of them are even below where the pandemic was in 2020. So, really getting beaten up in China. Alibaba, it’s a 5-star-rated stock, trades at a 22% discount. And Alibaba itself is the world’s largest online and mobile commerce company as measured by gross volume. So again, I think this is a good opportunity to hear from them whether or not they’re starting to see a rebound in the Chinese consumer.

Dziubinski: Let’s move on to some new research from Morningstar, and that’s what our analysts think of some key companies that reported earnings last week. So let’s start with AT&T T and Verizon VZ, which we talked about in last week’s show. The analyst didn’t make any changes to his fair value estimates on these stocks after earnings. Any takeaways from the earnings reports? And are the stocks still undervalued today?

Sekera: Both stocks had a pretty strong week after earnings. I think Verizon was up almost 8% last week and AT&T was up 4%, but both stocks are still rated 4 stars. Verizon trades at about a 21% discount to our fair value. It provides a 6.3% dividend yield. AT&T is at a 25% discount, similar yield, that’s 6.4%. And I would encourage readers to go and read [Morningstar director] Mike Hodel’s comments on earnings for both of these companies. I think the general takeaway here in the short term is we are seeing free cash flow growing, we’re seeing margins expand, and we’re seeing growth in subscribers. But even more importantly, I think our long-term investment thesis here is still intact. We’re still seeing signs that the industry is getting away from some of the price competition over the past couple of years that it’s exhibited and really starting to move toward more of that oligopoly going forward that we expect.

Dziubinski: Now we also talked in last week’s show a little bit about Procter & Gamble PG. It looks like earnings were solid, and the stock was up a bit after earnings. What does Morningstar think?

Sekera: P&G stock had a pretty nice pop after earnings as well. What’s going on here is that they did report 4% organic sales growth, which was in line with our long-term revenue forecast. But I think the biggest differentiation here is that Procter & Gamble reported a 400 basis point increase in their adjusted operating margin, taking it all the way up to 27%. And that compares to our long-term forecast of only 25% operating margins through pretty much the business cycle. So, by way of comparison, P&G’s operating margin over the past five years has only been 22.5%. When I look at our model, our expectation here is that margins will be higher than historical going forward but not nearly at the level we saw this past quarter. That puts our fair value estimate at $138 per share. So where the stock is currently trading at a 13% premium does put it in that 2-star area.

Dziubinski: Netflix NFLX put up some really strong subscriber numbers in the fourth quarter, and our analyst did notch up his fair value estimate on the stock a little bit. What do we think of Netflix after earnings, Dave?

Sekera: I think we talked about this one recently as well. And we did note that we did think that there is going to be very good subscriber growth here in the short term, and that is what we saw. The stock surged 18% last week. They reported significant sales growth driven by those new subscribers, and we also saw higher average revenue per user. Now we bumped up our fair value to $425 per share from $410, but it’s still in that 2-star range.

So, in the short term, Netflix is definitely getting good results. The password-sharing crackdown is working, they’re seeing good growth from that new ad-supported subscription. But we think the market is pricing in too much growth for too long. And I’d also caution investors that Netflix stock in and of itself has a long history of overexuberance both to the upside as well as to the downside. So, we do think it’s trading up too much at this point. And I would caution that whether it’s next quarter or a couple of quarters from now when that growth does start to slow down, we could see a sharp selloff in that one.

Dziubinski: Speaking of slowed growth, Tesla TSLA reported last week, too, and management noted that it expects growth to slow in 2024, and the market didn’t respond well to that news. What does Morningstar think of Tesla today?

Sekera: Tesla sold off 13% last week. It dropped down to $183 a share from $212. We also did lower our fair value slightly down to $200 a share from $210 as we incorporated that lower short-term demand. But I think what’s most interesting here is Seth Goldstein, who’s our analyst that covers this one, noted a couple of key takeaways from the earnings call. And I think first and foremost was his note that the firm is really making a strategic shift and they’re going to start developing and ramp up some new affordable sport utility vehicles. Certainly some higher costs associated with that here in the short term. And the company’s also getting away from their prior strategy of focusing on cost cuts at the expense of its margin on existing vehicles. This is a change from the prior strategy. However, we’ve held our long-term assumptions pretty steady at this point, and so we haven’t changed those long-term views. A slight decrease in our fair value puts that stock in that 3-star category right now.

Dziubinski: A couple more notable companies that reported last week. A chip equipment maker, ASML ASML, put up strong numbers and expects to put up some healthy growth numbers in 2025 after what management expects to be kind of a bumpy 2024. What does that say about the artificial intelligence trend in general and what does Morningstar think of the stock in particular?

Sekera: I think it shows that anything to do with artificial intelligence right now is just still red-hot. So ASML is the leader in chip equipment that can be used for artificial intelligence chips, and they surprised investors to the upside. They recorded very strong bookings of EUR 9.2 billion for 2025. When I look at our forecast here, we are only expecting a slight sales growth in 2024; that is in line with management’s comments, but that’s going to be followed by double-digit growth of about 20% in 2025. At this point, our fair value is $750 a share, but with the stock, I think it closed last Friday close to $867 per share. That puts it in pretty much the top of the fair value range for a 3-star stock right now.

Dziubinski: And then lastly, Intel INTC disappointed on earnings, and the stock was hit pretty hard last week. What did Intel have to say and what do we think of the stock today?

Sekera: While anything to do with AI is still red-hot, I think the opposite is kind of true for semiconductors used more for industrials, autos, and commodity-type oriented chips. Intel was a 4-star stock as recently as last October. It rallied 52%, broke through our 3-star range, and was trading at 2 stars prior to their earnings. While fourth-quarter numbers were in line, management guidance did provide for what we thought was a relatively soft first-quarter forecast. They base that on stronger-than-usual seasonal headwinds as well as a couple of different inventory corrections in some of their different product lines.

So, following how much that stock had risen, the valuation that it got up to, that weak guidance was enough to send that stock down 12% to $43 and change. I’d note here, too, our analytical team is seeing a shift where a lot of cloud customers are very heavily investing in AI accelerators, and that’s coming at the expense of traditional server processors, which I think is more where Intel is geared at. So, we have held our fair value steady here at $40 a share.

Dziubinski: Let’s move on to the picks portion of our program this week. You’ve brought viewers four undervalued small-cap stocks to buy. Now before we get to the stock picks, Dave, let’s talk a little bit about small-cap stocks in general. They’ve underperformed the market pretty substantially. Why?

Sekera: While small caps have underperformed the broad market, performance really wasn’t all that bad last year. When I look at our indices, our index for the broadest measure of the market, the Morningstar US Market Index, was up 26.4% last year. But I don’t think a lot of people realize the US Small Cap Index was up 20.6% last year. So while large-cap stocks got all of the media attention last year, I think a 20% return is still a good return in anyone’s book. So I do think there are a couple of reasons why small-cap stocks did lag on a relative basis, the first being rising interest rates. A lot of people expected that rising interest rates would hit small-cap stocks harder than large cap. The reasoning is that small-cap stocks typically have shorter debt maturities. They rely on bank funding. So as opposed to large-cap stocks where they’re able to term out using long-dated bonds in the public markets, people expected that rising interest rates were going to hit their margins harder and faster than large-cap.

Secondly, while we’ve long been in the camp of expecting a relatively soft landing, a lot of market participants last year were very concerned that there could be a recession. And, of course, in a recession they expected small-cap stocks to get hit harder to the downside. And then lastly, a lot of it just had to do with momentum. Coming into the year last year, we noted that six of seven Mag Seven stocks were significantly undervalued. They were in that 4- and 5-star range. Once those stocks started moving up last year, I think that momentum really kept the focus on the large-cap part of the market.

Dziubinski: You noted in your 2024 market outlook that small companies looked undervalued coming into the new year. Do they still look undervalued today relative to larger companies? And are large companies looking expensive as the market hits new highs?

Sekera: The answer there is yes and yes. Not only are small caps still undervalued relative to large caps, but at an 18% discount, I’d say they’re still just undervalued on an absolute basis as well. And then large-cap stocks, at this point, they’re trading at about a 5% premium to fair value. Looking at the charts, I think they’re kind of looking a little overextended here. So, with five of the Magnificent Seven stocks reporting this week, this actually could be kind of a make-or-break week for large-cap stocks to continue that rally or not.

Dziubinski: Your picks this week are all small-cap stocks, and they all have narrow economic moats. And now notably, none of these stocks have wide economic moats. Are wide moats less common among smaller companies?

Sekera: There’s really no theoretical reason why a small-cap company can’t have a wide economic moat. But yes, when I do look at our coverage, there’s only a handful of small-cap wide-moat stocks that we currently cover. But I would also note that when we look at narrow stocks, there’s a similar percentage of narrow-moat stocks in the small-cap space as there are in the large-cap space. So I’m just going to speculate a little bit here. Maybe to some degree, wide-moat companies are large-cap because over time they have grown larger because of their higher returns on invested capital. It also could be that maybe narrow small-cap companies are working to expand their moat, and as such, maybe over time, they turn into wide-moat large-cap companies. And then lastly, something that we have definitely seen over time is that small-cap companies with a narrow moat are often attractive to buyout candidates from large-cap companies. So, sometimes maybe they’re just getting bought out by those large-cap companies before they get to that wide moat category.

Dziubinski: All right, time to get to the picks. Your first small-cap stock pick this week is Sealed Air SEE. Tell us about it.

Sekera: Sealed Air sells flexible packaging, protective shipping materials, and integrative packaging systems. We do rate the company with a narrow moat, and that’s going to be based on switching costs as oftentimes Sealed Air’s equipment is embedded within the customer’s production process. So, the stock, very attractive in our view right now, trades at a 32% discount to fair value, putting it in a 5-star range. The company pays about a 2.2% dividend yield. I would note that the stock is down about 26% since the end of 2022. And I think this one is a good example of how the pandemic has led to large shifts in the business cycle and has really impacted companies like this. So, that stock ramped really high in 2021, and a lot of that was due to customers just seeing a huge increase in demand for food packaging as well as just a shift to goods and away from services.

And I think what happened is a lot of customers over-ordered products from Sealed Air as well just due to the shipping bottlenecks and just trying to get that product in-house. Then in 2022 and 2023, results were under pressure because customers were using up that excess inventory that they bought. But we also saw a spending shift back into services and away from goods. Taking a look at our model here, I think our revenue growth is pretty modest. We’re only looking for 2.0%, actually a 2.4% compound annual growth rate. So, our real differentiation here between ourselves and the market is going to be based on our projections for operating margins. We are looking for operating margins to average about 16.0% over the long term, and that compares with the 10-year historical average of 13.9%. This is, as well as all of these small-cap companies, a pretty deep research view that’s embedded within our outlook here. So, I do recommend for any investors interested in this small-cap stock or some of the others to read our research on Morningstar.com before you invest.

Dziubinski: Next up is Stericycle SRCL. Why do you like this one?

Sekera: Again, we rate the company with a narrow economic moat. The cost advantage is the primary moat source here, but they also do have secondary moat sources, both from intangible assets, based on their licenses and permits, as well as some switching costs, which are embedded here. For those that don’t know the company, it’s the largest provider of medical waste disposal here in the U.S. And then they also do primary paper shredding for document destruction. It’s a 4-star-rated stock and trades at a 16% discount. However, this company doesn’t pay a dividend.

Taking a look at our model here, they do have a compound annual growth rate that we’re forecasting for top-line revenue of only 3%. And that’s actually at the lower end of management’s 3% to 5% target range. But similar to Sealed Air, where we are different from the market is our forecast for their operating margins. We do expect that as the company is going through some restructuring right now, they’re going to divest some of their lower-margin businesses. That combined with some productivity initiatives is going to, in our view, lead to higher margins. We’re looking for their adjusted EBITDA margin to improve from about 16.0% in 2022 all the way up to 23.5% by 2027. And that 23.5% is our view for what we think is kind of that normalized through-the-business cycle level of profitability for the firm.

Dziubinski: Ingredion INGR is next. What’s our thesis on this one?

Sekera: I actually looked. We first discussed Ingredion in February of last year. Now that stock has only risen 10.2% since then. So, if you didn’t catch us talking about it that last time, what Ingredion does is they manufacture starches and sweeteners, additives for different types of food products. And what we’re seeing in the food industry is a transformation away from high-fructose corn syrup into different types of specialty starches and sweeteners. Now, for example, on the natural side, we’re seeing a move into stevia and we’re also seeing still an increase in the demand for gluten-free items. The company is executing slowly but surely, they are transforming themselves, but it’s not necessarily been an overnight switch. It’s currently rated 4 stars, trades at about a 10% discount to fair value, and I think the dividend yield is just a hair under 3% right now. So looking forward, we do forecast the company will increase its sales mix over time into more higher-margin specialty products, and that, in turn, will continue to keep driving additional operating income growth.

Dziubinski: And then your last small-cap stock pick this week, Dave, is Vontier VNT. Tell us about it.

Sekera: Not a very well-known company. Taking a look at what they do here, they are what we consider to be industrial tech. They do have a portfolio of transportation and mobility solutions for their customers. Includes things like fueling equipment, sensors, point-of-sale systems, equipment used by mechanics, and so forth. Strong performance in the stock. It’s up almost 80% since the end of 2022 but still trading at about a 10% discount. So this puts it in the 4-star range. Now they do pay only a minimal dividend yield here. And let me explain why.

Our analyst team likens Vontier’s business model to a company called Danaher DHR. They focus on acquiring what they think are moatworthy companies. And once they buy these companies, they’re able to boost their operating margins through a number of different efficiency measures, different types of continuous improvement, and then they reinvest that cash flow back into additional M&A. So, it’s definitely more of a roll-up type strategy. In our view, we do think the company has a narrow economic moat, and that’s going to be based on their customer switching costs as well as some intangible assets.

Dziubinski: Well, 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. We hope you’ll join us again 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.