4 Stocks to Avoid in Q3 2023

Susan Dziubinski: I’m Susan Dziubinski with Morningstar. Every Monday morning I sit down with Morningstar research service’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. Dave, on your radar this week is earning season, which is upon us again. What are you expecting this quarter?

Dave Sekera: Hey, good morning, Susan. Yes, it is earning season once again. As long-term investors, first of all, I just want to caution people. Don’t try to get too wrapped up in any one quarterly earnings announcement. For the most part, use these really as good ways to be able to generally look to see whether or not a company is performing in line with your expectations or not. And of course, most importantly, to look and see if there’s any new information that you need to incorporate your investment thesis and your financial model.

Now, typically when earnings are generally in line, we may adjust our fair value by a couple percent up or down, but it’s really we’re looking for when there’s a material change in the business fundamentals or some specific catalyst, and that’s when we see the larger changes in the fair values.

Now having said that, this quarter, I’m looking at earnings from two points of view. So first, according to FactSet, earnings for the S&P 500 are projected to be down in the second quarter again, which would mean that we’re still in an earnings recession. Yet on the other hand, while earnings may decrease, I think they’re going to look pretty good as compared to management guidance and as compared to consensus expectations. The reason for that really being just because the economy has been much more resilient than expected this second quarter, and of course coming into the second quarter, management have provided pretty conservative guidance, so I think that’ll be pretty easy to meet or beat. So, of course, as always, really the key will be third-quarter guidance.

With the economy better than expected and with some conservative guidance in the past, I just don’t think the market’s going to let management teams get away with that and provide conservative guidance again. I do think that if stocks of those companies do end up getting hit pretty hard, it’s going to be those companies that try to get away with providing that conservative guidance to try and look to push the market expectations down. And interestingly, I think what’s going to happen is if companies are going out with guidance that might even be better than people might be expecting, it’s going to set a pretty high performance bar for the third quarter. Now, we expect the economic growth will slow in the third quarter and beyond, and that could actually pressure earnings growth going forward. So as such, I do think third-quarter earnings season, that actually could really be then set up for some fireworks.

Dziubinski: Got it. So, then what are some of the bigger-picture topics for the second half of the year that you’re expecting to hear about during earning season?

Sekera: First, I really want to hear management’s view of the economy and specifically the state of the consumer. I’m curious to see if management teams are thinking the same things that we’re expecting, and that is for the rate of economic growth to slow over the second half of this year and into the beginning of next year. Now, when we look at our forecast specifically, we do expect the consumers spending will slow. And when we look at some of the drivers of spending, those excess savings that had been built up during the pandemic, those have been largely spent down. And then I’m also seeing that consumers are reducing the rate of savings as they have to try and keep up with inflation. In fact, savings rates right now are about half of prepandemic levels, so I’m not really sure that there’s that much more that consumers can cut back in their savings accounts going forward.

Now for international companies, I want to hear about their review on global growth, specifically China. It does appear that the Chinese economy is slowing pretty rapidly. And going back to our inflation topic, inflation is moderating. It is certainly coming down, but I still want to hear about how inflation is playing out within their specific sectors and in their margins. Of course, just really trying to make sure we can determine who has pricing power and who doesn’t. And then lastly, the hot topic du jour, of course, artificial intelligence. Now, a lot of that is specific to the tech sector right now, but I do think management teams need to be thinking about how it may be impacting their own sectors and their own businesses, just to make sure that they’re not left behind as that rolls out.

Dziubinski: Got it. Now, we saw some of the big banks report last Friday. What’s Morningstar’s take based on what we’ve heard so far there?

Sekera: Yeah, so we saw JP Morgan, Wells Fargo, and Citibank all report. I would say for the most part, after reading our equity analyst notes, earnings and outlooks, I think, are pretty much in line with expectations. Now, the earnings were generally better than expected as compared to consensus, and a lot of that was due to higher net interest income margins, but I would caution investors. We think that net interest margins are probably either at or near their peak for this cycle. Other than that, really no surprise in their expenses, no surprises in their loan-loss reserves. So as a result, I don’t think there’s really any change in our valuations. Taking a look at the market reaction, both JP Morgan’s and Wells Fargo were generally unchanged in the markets. I think JP was maybe up a tiny bit, Wells was down a tiny bit, but no material change in the trading. Citibank, however, did sell off. That was down a couple of percent. I think that may be due to management’s reluctance to really comment on declining expenses going forward in their core business.

Dziubinski: This week, we have more banks and some nonbank financials reporting, so give us some of the highlights there.

Sekera: All the regional banks are coming out this week. In fact, I think there’s 10 of them that we cover that are all reporting, so it’ll be a busy week for that equity analyst. Now of course, the regional stocks, those all plunged following Silicon Valley Bank failure and the Credit Suisse failure earlier this year, and those banks have suffered a pretty significant amount of deposit loss just because they’ve been unable to keep up with paying higher interest on their deposits as compared to what people can get in money market funds. And of course, as they have to pay higher and higher yields to their depositors, that does increase their funding costs and lower their earnings.

I really think the key this quarter is going to be how many more deposits have these banks lost and has that deposit run really come to an end at this point? And of course, I think the market’s also going to be looking for additional details on their commercial real estate loan book. As a group, we do expect earnings will decline over the next three quarters for the regional banks before the bottom is out next year. However, when we look at where these stocks are trading, we generally think they’ve sold off too much, even after we incorporate those lower earnings over the next couple of quarters into our financial models.

Looking at our list of stock coverage here, it looks like first up is going to be PNC. I think that’s going to be the one that probably sets the tone for the rest of the week. Now, that’s a 4-star-rated stock. It trades at a nice 28% discount to fair value and pays almost a 5% dividend yield at this point. Following that is going to be US Bank. That’s actually one of our top picks in the sector. It’s a 5-star-rated stock. We do rate the company with a wide economic moat. That one trades at a 33% discount to our fair value and has a nice 5.4% dividend yield.

Now in the middle of the week, I’m going to be watching Zions and Truist. Now, those are two that are on the riskier side, and I think those are ones that we really want to get a good gauge on what’s going on with their deposit base. Now, having said that, both are 5-star-rated, and they do trade at pretty substantial discounts and high dividend yields. Although I had note, Zions is a no-moat-rated company. Truist does have a narrow moat, though. And then we’re going to wrap up the week with Comerica. That’s a 4-star-rated stock, narrow economic moat, trades at a healthy 38% discount to fair value and a 6% dividend yield.

As you mentioned, we also have some nonbank financials coming out this week, and it is just one of those things. The entire sector sold off, and they were caught in the downdraft earlier this year, so the two that I’m going to highlight here for investors would be Schwab and Discover. Schwab was the name that we had highlighted when all of these stocks were coming down but had maintained our long-term investment thesis. It’s a 4-star-rated stock, wide economic moat, trades at a 16% discount. And just from a technical perspective, it does appear to me that that stock has bottomed out and is starting to recover, even though it’s still well off of its pre-sell-off highs.

And then Discover, that one we also had highlighted during the selloff. Now interestingly, that stock’s pretty much fully rebounded looking at the charts here. It’s actually back to its highs, yet we do still think it’s undervalued. It’s a four-star rated stock, narrow economic moat, 19% discount to fair value. I think generally the market is still just overly pessimistic regarding the potential consumer defaults and charge-offs as the economy softens.

Dziubinski: Let’s move a little bit beyond the financial-services sector. Are there other companies reporting this week that investors should be watching?

Sekera: A couple here I’m going to highlight where I’m just cautious and I would say investors should tread lightly before earnings; I do think these are set up that if they do disappoint, there could be a sharp selloff. So, for example, Tesla. That actually started the year as a 5-star-rated stock, but at this point, the stock’s up 120% year to date so it’s actually now dropped into that 2-star category as it trades at about a 30% premium to our fair value. A kind of a similar story is Netflix. That was a 4-star-rated stock about a year ago. It’s doubled since then. So it’s now in the 2-star category, trades at about a 40% premium to our fair value. And lastly, looking at Intuitive Circle. Let’s see, it’s a wide economic moat stock. That stock’s up 70% in the past 52 weeks. It’s now trading into 74% premium to our fair value and is in 1-star territory. Yeah, it’s interesting. It’s a wide economic moat stock. It’s a company that I’ve followed for a while. I think it’s a really high quality, but just one of those cases where the valuation has just gotten too high.

Dziubinski: Let’s pivot over to some new research from Morningstar. We had a lot of news come out last week about some pretty high-profile companies, but from Morningstar’s perspective, the news around these companies didn’t impact our outlooks and valuations. Let’s talk a little bit about some of these stories and why they really didn’t have that significant impact on our long-term views for these companies.

Sekera: Sometimes news is noise, and I wouldn’t necessarily call it purely noise in this case, but as you mentioned, the news when it came out didn’t really impact our long-term valuations for these companies. First of all, we did have Meta. They launched their new Threads platform that’s going to be a competitor to Twitter. Our fair value is unchanged, and I think the equity analyst has talked about that one, and he’s really waiting to see whether or not those users stick with that platform and whether or not they drive engagement, which of course you need that combination of engagement and users to then drive ad revenue.

There was a court ruling regarding Microsoft and its acquisition of Activision. So I think that court ruling now bolsters the case that Microsoft can make that acquisition and close on it. But again, while it bolsters their gaming division, it’s not going to change our fair value.

Berkshire, one of our more favorite stocks around here, that acquired some assets from Dominion, but really the assets that they acquired, it’s too small really to move the needle there. And taking a look at Dominion, the price of that transaction was in line with our valuation, so it doesn’t change anything with that stock either.

And then lastly, we heard from Exxon. They announced an acquisition of some assets from Denbury, specifically some assets regarding carbon capture and storage. And again, it’s just one of those acquisitions that while it may end up being a good move for the company, from our point of view, it’s just too small to move the valuation needle.

Dziubinski: Now we’ve reached the picks portion of our program. And a couple of weeks ago you told viewers about four of your favorite stocks to buy for the third quarter, but today we’re going to do the opposite. We’re looking at four stocks you think investors should avoid during the third quarter. Your first three stocks to avoid are all from the tech sector. Why?

Sekera: In our view, the tech sector has moved up so far so fast that it’s now trading well into overvalued territory. It trades at about a 10% premium over a composite of our fair values. And of course, there’s always the old adage in the market, no one ever went broke taking a profit. I do think now is a good time to take at least some profits, especially on those names that we think are overvalued and overextended.

Dziubinski: Your first stock on the list of stocks to avoid this quarter is a name that’s up a stunning 200% this year, Nvidia.

Sekera: Nvidia, it’s really just the poster child for exuberance in the artificial intelligence space right now. At its last quarterly earnings call, it substantially raised its guidance just to a huge influx of orders for its AI products. In fact, we revisited our model. We bumped up our fair value all the way to $300 a share from $200 a share. And when I look at our assumptions, I don’t think we’re being overly conservative. We’re looking for 50% revenue growth this year. We’re looking at a 23% compound annual growth rate for the next five years. Essentially, we’re looking for revenue to triple over the next five years. We’re also at forecasting operating margins to surge higher. In fact, I think they’re getting to new all-time highs in our model. When I look at earnings, they’re going from $3.34 cents a share this year, all the way up to well over $16 a share in 2028. Essentially what that means for investors today, they’re paying essentially 28 times 2028 earnings right now. At this point, Nvidia is rated 2 stars and it trades at over a 50% premium to our long-term valuation.

Dziubinski: Your second stock to avoid is Oracle. Why?

Sekera: Oracle was a 3-star stock last October when the market’s bottomed out. That stock is up 80% since then, so that puts it in the 1-star territory. It trades at about a 57% premium to our fair value. Now, we do rate the company with an narrow economic moat. The company has had good performance since then. However, our equity analyst has concerns that there’s really more limited upside to the cloud infrastructure market than I think what the market is currently baking in.

Dziubinski: Your next stock to avoid is actually the largest stock in the U.S. by market cap, and it’s a favorite of Warren Buffett’s for its moat. It’s Apple.

Sekera: Apple, again, we do rate the company now with a wide economic moat. However, it trades at a 27% premium to our fair value, which puts it in that 2-star category. In my view, taking a look at Apple’s last couple of quarterly earnings: I don’t think there’s really anything special about their performance. I know we haven’t had any change in our long-term outlook or investment thesis, yet that stock is up 46% year to date. I think this might just be a case of that stock getting caught up with the surge that we’ve seen in those large-cap growth stocks, especially in the technology sector.

Dziubinski: And then your last stock to avoid is from the energy sector. Now, energy stocks came into 2023 overvalued, but because they’ve struggled as a group this year, the energy sector overall looks undervalued, but Hess still looks overvalued. So talk about why that is one of your stocks to avoid for the quarter.

Sekera: As you mentioned, energy did come into the year being pretty significantly overvalued, not selling. After that selloff, the sector is now trading slightly below fair value, but where we do see the opportunities now, they’re still concentrated in the services and the pipeline areas. And many of the oil companies in and of themselves are maybe still overvalued and some are now just getting down to fair value. Now, Hess is an interesting case in and of itself. It is currently rated 1-star, trades at about a 60% premium. And again, it’s one of these situations, and I think we reviewed this already, where we do think that the company is a very high-quality company, has great assets, great growth prospects, and does deserve a high valuation, but we think that the market valuation right now is just too high compared to its net asset value.

In this case, talking to our equity analyst, we think there’s probably two main differences in our view as compared to the market. When we do look at some of the metrics here like enterprise value to EBITDA, which is a pretty common metric used in the energy sector, that stock is trading at about a 9 times metric. Now, its next closest competitors only 6 times. Now, taking a look at our fair value, we would put that at about a 7 times multiple. It’s still higher than its competitors, but below our market valuation. And then second, our forecast for oil is that while oil does remain tight in the near term and that should support the current prices, we do forecast the oil prices will end up coming down over the long term. Here in the short term, our model uses about $72 a barrel here in the short term, coming down to $66 a barrel in 2024. But over the long term, when we look at our supply demand forecast, we do think the oil will come down to about $55 a barrel in the long term.

Dziubinski: Well, thank you for your time this morning, Dave. Dave and I will be back next Monday live at 9 a.m. Eastern, 8 a.m. Central. In the meantime, “like” this video and subscribe to Morningstar’s channel, and have a great week.