4 Undervalued Dividend Stocks to Buy Before It’s Too Late

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. So, on your radar this week, Dave, are a few straggler companies reporting earnings. We’re getting into the late innings of earnings season. One of the companies in the news reporting this week is Disney. What do we think of the stack coming into earnings, and what will you be listening for?

Dave Sekera: Hey, good morning, Susan. Specifically, I’m going to be listening for any strategic changes that the company might be trying to make in order to recapture any of that old Disney magic. When you look at the stock price here, Disney peaked in early 2021 and since then it’s dropped over 50%. In fact, that stock is now trading all the way back to the same level that was trading in 2013. And when I took a look at the story here, I think the market and investors have just been very disappointed with its streaming business, and its newer content just really hasn’t resonated with its customers.

Bob Iger, he was the CEO from 2005 to 2020, he took control back over again in November of last year. So now that he’s been back in control for the past year, I really want to hear what specific actions he’s taking in order to try and get Disney back on the right track.

Dziubinski: Now, we also have some real economy stocks reporting this week. Tell us about those and what you’ll want to hear about.

Sekera: Sure. And as you mentioned, the earning season is essentially over, but when I look at the calendar, there’s still a few here that I do want to specifically listen to.

First is Celanese, and of course that’s a specialty chemical manufacturer. In fact, that’s a company you and I talked about earlier this year. We talked about the specialty chemicals sector and how we thought that there were several different long-term structural growth themes that would help out some of those companies. Now, that stock has been very volatile thus far this year, but I think our long-term investment thesis is still intact. So its products are very highly tied to electric vehicles. And as we’ve talked about before, we do forecast that electrified, whether it’s a battery or a hybrid vehicle, it’s going to be about two thirds of new global auto production by 2030. And it takes anywhere from two and a half to three times the amount of specialty chemicals to make an electric vehicle as compared to an internal combustion engine. So that stock is rated 4 stars right now, trades at a 24% discount, has a 2.3% dividend yield, and it’s a company with a narrow moat.

Next one up is going to be Air Products, and they make industrial gases, and of course demand for industrial gases can be very highly tied with industrial production. So I want to hear what their perspective is on the economy and what their outlook is. Another narrow-economic-moat-rated company. That stock is down 5% year to date. It’s only trading at about 8% discount right now.

Then next up is Emerson Electric. They sell automation equipment. And they’ve been able to benefit from customers looking to automate their processes in order to lower their costs as well as from a couple of different government spending programs. And that’s actually the part that I want to hear to see if they can give any additional context just regarding how much more government spending we still have from the Infrastructure Investment and Jobs Act and what they expect from kind of that misnamed Inflation Reduction Act. Four-star-rated stock, trades at a 12% discount. That’s one that we rate with a wide economic moat.

And then lastly, I want to hear from D.R. Horton. Now they are the largest homebuilder in the United States. And surprisingly that stock is up 33% year to date. And in fact, it had a really big surge last week as long-term interest rates were following the Fed meeting. So now, while interest rates have started to come down, I do think that they’ve still impacted affordability. So there is a large amount of pent-up demand for single-family homes, and I think that’s what we’ve been seeing playing out this year. So I want to hear how much pent-up demand is still left and how much is high mortgages now limiting affordability. That one’s trading pretty much right at our fair value, pays less than a 1% dividend yield. It’s a company that we rate with no economic moat, and it’s currently rated 3 stars.

Dziubinski: Are there any economic reports to keep up with this week, Dave?

Sekera: Not really. I think from an economic metric point of view, it’s going to be pretty quiet this week. The one thing I would highlight is a Federal Reserve Chair Powell, he is scheduled to speak twice this week. So on Wednesday, he’ll be at a Fed conference, and then on Thursday, he’ll be at an IMF conference. Although to be honest, I really don’t expect to hear anything new or different from him. I think what’s going to be most interesting will be commentary from some of the other Federal Reserve officials. I want to hear what their point of view is and how it may or may not match up with the commentary we heard from Chair Powell last week.

Dziubinski: Speaking of those comments from Chairman Powell last week, Morningstar’s economist Preston Caldwell said in a recent interview that Powell’s comments after the meeting were more balanced than they were from the prior fed meeting. What say you?

Sekera: And I think back, you and I have discussed this pretty in-depth last Monday, and I think his commentary was pretty in line with what we were expecting, which was that they needed to start shifting their messaging. And again, a lot of his remarks up till now have been mainly focused on fighting inflation, even when that was going to be at the expense of the job market and the economy. And thinking about when we do expect the Fed in the first half of next year to start reducing the federal-funds rate. The Fed, just from a calendar perspective, really needed to start shifting in order to prepare markets for that by now.

And I think the market action on Thursday and Friday really is indicative of picking up on what Chair Powell was talking about in a lot of his Q&A on Oct 19. That’s when he had spoke at the Economic Club of New York. That I think was really the early indication of when this messaging was starting to shift and move more toward that balance perspective between inflation and employment. And then thinking through the next couple months, I do expect that they probably start shifting a little bit more and early next year will start being a little bit more accommodative in their language.

Dziubinski: Let’s move on to some new research from Morningstar. The first new piece of research we’ll cover is our analyst’s take on Apple after earnings. The stock dipped a bit after earnings, and we maintained our fair value estimate of $150. What did our analysts think of the report?

Sekera: When I look at Apple’s results, I mean they did beat consensus on both revenue and earnings per share, but I think the market was disappointed with two main things. First was just weak performance in China. And second, the revenue guidance for next quarter was below consensus. Now the stock traded down a half a percent, but personally I think it would’ve been down a lot more if not for just how strong the market was and how much it traded up after the Fed meeting last week. Apple is rated with a wide economic moat, meaning we do think the company has long-term durable competitive advantages, but we think the stock is expensive. We think investors are paying essentially a growth valuation for a company whose growth has been slowing. At this point, the stock has rated 2 stars, trades at a 18% premium over our fair value, and only yields a half a percent.

Dziubinski: The second new piece of Morningstar research that we’ll talk about today is your November Market Outlook, which was recently published on morningstar.com. Now, stocks had a tough October, they lost more than 2% for the month, and returns across all sectors were in the red except for utilities, which were kind of flat. So given that performance, Dave, do stocks look undervalued in November?

Sekera: The short answer is yes. The stock market still remains undervalued as compared to our fair value estimates. Although following the rally that began Wednesday afternoon after the Fed meeting and continued into Thursday and Friday, already the market is slightly less undervalued than when we published that article. So as of Oct. 31, the market was trading at 11% discount to that composite of our fair values. And historically, since the end of 2010, the market had only traded at that much of a discount or more only 12% of the time. So, “back of the envelope,” based on the market rally, I estimate the market’s probably trading at about a 7% discount this morning. So it’s still undervalued, but when again I do that same analysis, the market’s only traded at this much of a discount or more now 28% of the time.

Dziubinski: Let’s look at the market through the lens of sectors. What stands out to you today, Dave, from a valuation perspective?

Sekera: It’s still that boring old utility sector, I think, is one of the most interesting opportunities today. On our Oct. 9 show, we discussed how utilities had just gotten crushed in August and September as long-term interest rates were rising, but that we thought that the valuations had fallen just too far. And our team and the utilities group, they noted that the amount of undervaluation for utilities as compared to our fair values was at its greatest discount since 2009 and really kind of almost a once-in-a-decade opportunity. Now, we have seen the utility sector take a pretty good bounce here. And to be honest, I suspect this undervaluation probably won’t last all that much longer. So the sector is actually up 10% off of those early October lows, and essentially half of that has just come in the past three trading days.

So right now, back on the envelope, I still estimate the sector’s probably about 10% undervalued, but that’s only half of the undervaluation as far as when the sector bottomed out, I think around Oct. 9 or so.

Dziubinski: Now last month you noted that real estate was the most undervalued sector, and real estate stocks are, like utilities, interest-rate-sensitive. Do you see opportunity in this sector? What’s your outlook?

Sekera: We do. The real estate sector overall is still undervalued. Now, I don’t think it rallies quite nearly as fast as I expect the utility sector to rally with interest rates coming down. So while fundamentals in the utility sector are still strong across the entire industry, there are a number of different areas in real estate where the fundamentals are still much more challenging.

I’d estimate that the overall sector is trading at about an 18% discount to our fair values. Again, I’d still steer clear of the urban office space for now. But there’s a couple of different types of real estate that I would focus on. First just being real estate’s going to be more defensive in nature, specifically thinking about those that are going to be tied to the healthcare industry. I look for real estate where we do see improving fundamentals, Class A shopping malls, the rebound in foot traffic, a couple of different fundamentals there that I think play out and help that area. A couple of deep-value plays, cell towers we’ve talked about a couple of times and why we think those are so undervalued right now. And then lastly, real estate that has long-term structural tailwinds such as the data centers that I do think will have a good tailwind from the emergence of artificial intelligence.

Dziubinski: Now let’s look at the market through the lens of the Morningstar Style Box, which considers market capitalization and investment style. Which parts of the style box look most undervalued today?

Sekera: It’s still the value category. The most undervalued is trading at about a 21% discount to fair value on Oct. 31. So I still think value stocks are the best place for long-term investors to overweight today. The core category: That’s only trading at a 6% discount, so I think that’s actually probably a good place to underweight in order to put those proceeds into the value category. And then lastly, looking at the growth category, that’s only at a 11% discount, which is the same as the market. I think growth would be a good place just to be in a market-weight position today.

Dziubinski: Given market valuations, Morningstar’s outlook for interest rates, and what we’ve heard during earning season so far, how should investors be thinking about their portfolios today, Dave?

Sekera: First of all, with just all the movement that we’ve seen between stocks and bonds, I think, take a second, just double-check your portfolio allocations, make sure that you’ve got the correct percentage in equity versus how much you want to have in fixed income. Might need to be making some readjustments there. Within that, equity, again, I’d overweight value, market-weight growth, underweight core. And then when we look by capitalization, we still see the best value in the mid-cap and the small cap-stocks. In fact, I just saw this morning, there was an article published on morningstar.com. The title is Is It Time to Buy Small-Cap Stocks? And I think it’s worth a read for investors.

My takeaway here is I think that investors do need to brace themselves in the small-, in the mid-cap space, so it is the most undervalued area, but I do think market sentiment here might be relatively negative for the next couple of quarters. And the reason for that is I do expect that the rate of economic growth is going to start slowing sequentially each quarter until bottoming out in the third quarter of 2024. I think a lot of investors might want to hide out in the large-cap space, which is going to be a little bit less volatile to the economy than what you’re going to see. I think you’ll see more earnings volatility in that small- and mid-cap space.

But I do suspect that once the market starts seeing the economy starting to bottom out, starts to price in when it’s going to reaccelerate, that I do think those mid- and small caps are going to perform much better at that point in time. So when is that going to be? I would suspect probably middle of next year, maybe more in the spring of next year. Again, a lot of that will depend on just our view for the economy slowing and when it’s going to bottom out and start coming back again.

And then lastly, for bonds, we’ve certainly seen a big rally here for the past three days. Long-term interest rates have come down, yeah, a pretty good amount. We’ve been advocating for investors to lengthen the duration of their fixed-income portfolio. I still think that even after this rally, you can still lengthen out that portfolio. Some of that is just to lock in these high rates because we do expect in the short end of the curve rate cuts will begin by mid-2024, and those rates will start coming down.

Dziubinski: Let’s move on to the stock picks portion of our program. Today you’ve brought viewers four undervalued stocks with solid yields. Your first two picks are from the utility sector, which we’ve discussed is still trading at pretty good discounts that we haven’t seen in a long time, even though they have rallied a bit. Your first pick is American Electric Power. Why do you like it?

Sekera: AEP is still one of the more undervalued utility companies under our coverage. It’s a 5-star-rated stock, trades at a 18% discount, yields 4.4%. A company that we rate with a narrow economic moat. And I would say, I just read our note here, we did reaffirm our fair value estimate after our earnings. They noted here that the company’s been selling nonregulated assets in order to focus more on the regulated utility portion of their business. The company’s been investing in transmission infrastructure, and they think that’s one of the more attractive long-term growth opportunities for this utility because, again, that’s just a way that the utility can benefit from the federal incentives that are out there to improve the efficiency of the U.S. power grid.

Dziubinski: Now your second utilities pick is Alliant Energy. Tell us about it.

Sekera: Alliant also recently reported earnings, and we did reaffirm our fair value estimate there. It’s a 4-star-rated stock, trades at a 12% discount, yields 3.5%. Again, another utility that we do assign a narrow economic moat. And I think the biggest takeaway here is that we’re very comfortable because the company does have a very positive regulatory environment in which it operates.

Dziubinski: Now your next two picks are from the real estate sector, again interest-rate-sensitive. A first is Healthpeak Properties, which is, as its name suggests, a portfolio of healthcare-related properties. Tell viewers about it.

Sekera: Yeah, so Healthpeak is currently rated 5 stars, trades at a 47% discount to our fair value, and yields 7%. And the stock has fallen enough that it’s trading all the way back to below prepandemic levels. Now we do rate it no moat as are most REITs, but it is a Medium uncertainty. And as you mentioned, it does have a diversified healthcare portfolio, mainly medical offices and life science buildings, but a few senior housing and skilled nursing facilities as well. But I do think, in the real estate area, this is a relatively defensive play. Third-quarter earnings were in line with our expectations. We reaffirmed our fair value estimate. Fundamentally, I don’t think our team sees anything wrong here, so I really just assume that the stock has been under as much pressure as it has because of long-term interest rates.

Dziubinski: Now your final pick of the week is Equity Residential, which focuses on urban multifamily properties for higher-income earners. Tell us about it.

Sekera: Yeah, and personally, I always like Equity Residential. Originally, this is the company that was started by legendary Sam Zell, probably one of the most famous investors in the real estate area. Stock is currently rated 5 stars, trades at a 36% discount, and a 4.7% yield. Also, stock all the way back to prepandemic levels. They own 304 high-quality apartment-building communities, mostly in urban and suburban markets located in California, Washington D.C., New York, and a couple of other metropolitan areas. Looking at our earnings takeaway here, occupancy still very high at 96%, average rental rates were up 5%. I think the market might be slightly concerned by some higher write-offs of uncollectible debt here. And I think a lot of it is just that people right now are also just very leery of investing in real estate in some of those metropolitan areas. But when I look at the fundamentals here, that isn’t something I’m necessarily all that concerned about.

Net result here, our fair value is unchanged, extremely wide margin of safety from our fair value, and just a big huge dividend yield you can clip until this stock starts to work.

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 9:00 a.m. Eastern, 8:00 a.m. Central. In the meantime, please like this video and subscribe to Morningstar’s channel. Have a great week.