4 Stocks to Sell in Q4—and 4 Stocks to Buy Instead

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. Dave, let’s start out by talking about the Israeli-Palestinian conflict and the geopolitical risk it brings to the market.

Dave Sekera: Good morning, Susan. Thus far, the market reaction is relatively muted premarket open. Now there’s definitely negative sentiment in the U.S. equity futures market, but at this point they’re only down about five-tenths to six-tenths of a percent. Now, the U.S. bond market is closed today for the Columbus Day holiday, so we’re not going to see if there’s a flight to safety in the U.S. Treasuries until tomorrow. Now to some degree, I think this is a little bit similar to the Russian invasion of Ukraine in that it’s really going to depend on whether this conflict stays local or if it starts to spread to surrounding areas.

By itself, I don’t think this conflict will have a significant impact on the U.S. economy or corporate earnings, there certainly will be individual Israeli companies that will suffer disruptions, and we could see some selloff in those individual stocks. I think we’ll get to the point where investors probably sell first and ask questions later on those. But from an investment point of view, I think investors really just need to be watching to see if this conflict were to expand, especially if it was to expand into oil-producing nations. And if that happens, then of course we could see a big price spike in oil, and of course that would have a much bigger impact to the U.S. and the U.S. markets.

Dziubinski: On your radar this week, Dave, is earnings season. Seems like we just finished with earnings but here we are again. What are you expecting in this earnings season?

Sekera: I think third-quarter earnings in and of themselves will generally be very strong. Management guidance last quarter probably shouldn’t be all that difficult to beat. And also the U.S. has just remained defiant in the face of tight monetary policy. So, economic growth has been much stronger than we had originally expected. In fact, if you look at our numbers here, we just recently updated our GDP forecast for the third quarter to 3.9%.

Dziubinski: Are there any sectors or industries in particular that maybe look more vulnerable or are more likely to show at least slowed growth?

Sekera: Well, as compared to the consensus estimates, I do think there’s a risk in the banking sector. Banking has been under pressure the past couple of quarters. Short-term funding costs have remained elevated. So, I think there’s probably a risk there. Across some of the other sectors, I’d say the media sector might be also at risk because of the writers’ strikes that we had. And of course the automakers, in light of the strikes from the UAW. And then lastly, probably the consumer defensive sector. While inflation, the rate is moderating, it’s still putting a lot of pressure on purchasing power, specifically for middle- and low-income households.

Dziubinski: What about forecasts, Dave? What are you expecting to hear from companies as far as their expectations, not just for the rest of this year but maybe into 2024?

Sekera: Well, I’m not sure if they’ll give us too much for 2024 yet. Maybe some body language but really no specifics. But the management guidance will be key as far as how that stock is going to trade here in the short term. When guidance is either higher or lower than what the market is expecting, you can certainly see a stock price get whipped around pretty quickly. However, I do want to caution investors, those short-term movements, they’re not always necessarily indicative of changes in the long-term intrinsic valuation of a company. So, I think investors always need to take a step back and really decipher why did that company beat or miss? Was it just a natural short-term variation in its business and that will end up normalizing pretty quickly? Or is it really a paradigm shift that needs to be incorporated into your long-term projections and your investment thesis?

Now this quarter, I expect that guidance, it’s going to be very idiosyncratic by company. And I think a quote from Warren Buffett is very apt for this situation. That quote being, “A rising tide floats all boats, but it’s only when the tide goes out do you discover who’s been swimming naked.” Now, of course, as we mentioned, the U.S. economy has been defiant in the face of tight monetary policy and high interest rates. And this rising tide has helped out a wide multitude of sectors and companies the past couple of quarters. But we do expect that the U.S. economy will start to slow, especially here in the fourth quarter and the next couple of quarters, thus the receding tide. So, we’ll see which companies will be able to successfully navigate the slowing economy versus those that end up running aground. And I suspect this quarter we’ll hear caution from companies in the most economically sensitive sectors. Those will be the ones that start to see this slowdown first and reduce guidance.

Dziubinski: You mentioned banks earlier in your comments, and we do have banks starting to report this week. What are you going to be watching for in those reports?

Sekera: Well, I read some reports and talked to our U.S. bank analyst Eric Compton, and he noted there’s really four main areas that he’s going to be watching closely this quarter. The first is going to be guidance on net interest income. The net interest margins have been under a lot of pressure from those high short-term funding costs. So, I know he’s specifically listening for management guidance as far as when they think it’s going to start to improve. Our current expectation is there’s going to be at least another one if not two more quarters before we start to see that improvement.

Secondly, it’s going to be loan-loss reserves. He expects they’re going to be mostly stable, although some additional deterioration in commercial real estate. This is an area that I personally watch very closely. If reserves start increasing meaningfully, that does indicate that the banks might be starting to prepare for a recession.

Thirdly, it’s going to be deposit flows. Now it does appear the megabanks still appear to be losing deposits, but at this point, we expect that the deposit outflows from the regional banks are for the most part over. And then lastly is interest-rate hedges. So, again, this is going to be more important to the regional banks than the megabanks but we’re hoping that management hedged out at least some if not a large portion of their interest-rate risk. We did see interest rates head up over the third quarter, so we’re hoping that by hedging those out, both in their held-to-maturity account as well as their available-for-sale account, that that should put them in a better position than they otherwise would be in.

Dziubinski: Now, are there any particular banks that maybe look more vulnerable for one reason or another?

Sekera: As far as those that are at risk from a profitability point of view, Eric specifically pointed out Comerica CMA, KeyCorp KEY, and Zions ZION being the most at risk, in his mind.

Dziubinski: Let’s move on to some new research from Morningstar, and that’s a recent note by our utilities team about the sector, which really has struggled. What’s going on with utilities, Dave?

Sekera: Year to date, the Morningstar Utilities Index is down 16.8%, but the sector has really just gotten especially killed over the past two weeks. In fact, it’s down 10.4% just from Sept. 25. Now, the utilities sector, of course, is very highly correlated with fixed income. A lot of investors were using the utilities sector as a fixed-income substitute when interest rates were low the past couple of years. Now we just have the combination of rising interest rates, which does lower the value of those high-dividend payments. But also investors now are looking at higher yields in the fixed-income market, so I think we are seeing some of them rotate out of utilities and back into the bond market. I suspect it’s really just a combination: It’s the selloff from the lower present value of the rising rates but also that asset reallocation out of utilities and into fixed income.

Dziubinski: Morningstar’s analysts are arguing that investors now have this rare opportunity to buy utilities stocks at discounts that we really haven’t seen since 2009, I think they said in the report. And Morningstar actually thinks the fundamentals for utilities are excellent today. Delve a little bit into that.

Sekera: When we look at our price-to-fair value metric, on a market-cap-weighted basis, the sector’s getting close to a 20% discount to our fair value estimates. And as you mentioned, the only other time we saw the utilities industry trade at that large of a discount was in February 2009, which was of course the height of the global financial crisis. Now, from a fundamental point of view, in our view, nothing has really changed all that much. We still think earnings growth is going to be robust for many utilities.

In fact, we’re looking for average earnings and dividend growth of about 6%. Balance sheets are still pretty strong, and dividends are well covered at this point. So to me the real attraction right now, as compared to bonds, is that while the current dividend yield might be not as high as what you can get in the fixed-income market, you are buying about almost a 20% discount to our fair value. Dividends in the utilities will grow over time, and should be at least in line with inflation. Whereas of course, with bonds, your interest rates are going to be fixed at the current rate.

Dziubinski: Then share a few names with viewers, Dave. Specifically undervalued utilities operating in constructive regulatory environments.

Sekera: The three that our team pointed out is first, Entergy ETR, it’s a 5-star-rated stock, trades at a 23% discount, has about a 4.5% dividend yield right now. And that’s the one that they pointed out as having the most attractive combination of yield, growth, and value. Second is NiSource NI, also a 5-star-rated stock, 25% discount, 4.1% dividend yield. That’s the one that they noted they think has the longest runway for growth in the sector. And then lastly is Duke Energy DUK, a 4-star-rated stock, trading at about a 17% discount. That one also has a 4.5% dividend yield, and the focus there is just strong growth in renewable energy and infrastructure.

Dziubinski: Let’s move on to the stock picks portion of our program. This week. Dave, you’ve brought us four stock swaps for investors to consider in the fourth quarter, meaning overvalued stocks to sell and undervalued stocks in the same industry to buy instead. Our first stock swap this week involves two drugmakers. You suggest selling Eli Lilly LLY and buying GSK GSK.

Sekera: Lilly is rated 2 stars right now, and it trades at a healthy 54% premium to our fair value, and the yield at this point is under 1%. That stock is up about 70% over the trailing 52 weeks. And that appreciation is from just the market expecting huge demand for its weight-loss drug Mounjaro. Now, I will caution this is not a short idea. I don’t think you should be going short the stock here. And in fact, our analyst Damian Conover noted earnings may actually even be better than expected here in the short term. But we do think that for long-term investors, the stock is overvalued, even when we do incorporate our estimate of its weight-loss drug. And, in fact, I think our estimate is even higher than what consensus is. So, I think it really shows just how highly valued Eli Lilly is at this point. And, of course, with such high expectations, if they were to miss or if there was any negative news regarding the safety of that drug, that stock could gap down quite quickly.

In its place, we do think GSK, formerly known as GlaxoSmithKline, is trading at a very deep discount of about 32% to our fair value, puts it in 5-star-rated stock territory. Its dividend yield right now it’s about 4%. Now, GSK is one of the largest global pharmaceuticals out there. They have a portfolio of drugs across several different therapeutic classes, including respiratory, cancer, antiviral, as well as vaccines. The stock did get hit hard pretty much in mid-2022, looks like there’s some potential product liability from Zantac, but we think the market is greatly overestimating that liability.

Dziubinski: Your next pair of stocks to swap are both oil and gas producers. The swap here is selling Hess HES and buying Devon Energy DVN.

Sekera: Hess is another situation that we agree with the market. It’s a strong company, has very good growth earnings, but our concern is that according to our methodology, the market is overpaying for this growth right now. So the stock is rated 2 stars, trades at a 24% premium, and the yield is I think a little bit above 1% at this point. So, when you look at the valuation metrics, one that we use here is enterprise value to EBITDA. That stock is trading at about three turns higher than its next closest competitor.

We do agree it should trade higher than its competition, but our fair value would place the EV to EBITDA only one turn higher. In this case, I think that’s a good one to sell and swap into Devon. Devon is one of the few exploration and production companies that we still think is undervalued. That one’s a 28% discount in that 4-star rating category. I would caution investors on this one; they do have a variable dividend, so that yield will change over time based on its earnings. But right now that trailing dividend yield is just under 8%.

Dziubinski: Swaps from software are next. You suggest selling overpriced Oracle ORCL and buying undervalued Salesforce CRM.

Sekera: Oracle is a 1-star-rated stock, trades at a 45% premium to our fair value. If you remember, we actually discussed this stock as one to avoid on our July 17 Monday morning show. Now immediately after that, the stock actually traded up slightly since then, but it was hit pretty hard after their earnings report in September. Revenue came in short of expectations, and management provided what we considered to be relatively light top-line guidance. Now following that earnings report later in September, Oracle did have its annual analyst day, but even that failed to halt the slide in that stock, which has fallen even further since then. But we still think that stock is overvalued, and we see better opportunities elsewhere. And that elsewhere is Salesforce, that’s a 4-star-rated stock, trades at a 19% discount. And according to our analyst, Dan Romanoff, he thinks Salesforce has one of the best combinations in technology of top-line growth potential, operating margin expansion, and a strong balance sheet.

Dziubinski: And your last set of swaps this week are from transportation. It’s selling overvalued XPO XPO and buying undervalued Norfolk Southern NSC. And we talked a little bit about Norfolk Southern I think in last week’s show.

Sekera: We did. XPO is a 1-star-rated stock, trades at over a 60% premium to our fair value. That stock’s up 124% year to date. And the reason for that is the market expects that XPO will benefit from the bankruptcy of its closest competitor, Yellow Trucking, which happened earlier this year. And we agree, it will certainly benefit. I spoke to Matt Young, he’s the equity analyst who covers XPO, and he thinks at this point investors are just extrapolating those benefits from the Yellow bankruptcy for just too long and overestimating the long-term growth profile here and their profitability. So, as you mentioned, I think a good one in the transportation sector right now is Norfolk Southern, NSC. It’s a 4-star-rated stock, trades at a 16% discount to fair value, currently pays a 2.4% yield, and it is a wide-moat-rated company.

Now, rarely do railroads ever trade at this much of a discount to fair value, especially for companies that have such strong, wide moats. In this case, the moat being based on its efficient scale and cost advantages. And in fact, I wouldn’t be surprised if Warren Buffett wasn’t taking a look at the stock right now, considering we know he likes railroads. A number of years ago he actually bought out Burlington Northern. The concern here for the market is that the company did experience a train derailment earlier this year in East Palestine, Ohio. And of course, it’s always hard to estimate the amount of legal liability to remediate hazardous chemicals. But our estimate, we think the market is significantly overestimating that liability at this point.

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. 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.