4 Undervalued Growth Stocks for 2Q 2023

Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. Every Monday morning I sit down with Morningstar 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.

On your radar this week, Dave, is the quarter ahead of us. But before we get to that, let’s talk about OPEC’s surprise production cut announcement and energy stocks.

Dave Sekera: Good morning, Susan. That was a surprise cut, and I don’t think anyone necessarily really realized that that was coming, and that will probably give a pretty good tailwind to energy and specifically oil stocks this week. What I would note with energy is that at the beginning of the year, we thought the energy sector was the most overvalued of the sectors that we covered, and it was actually overvalued by quite a bit at the beginning of the year.

Now, energy did significantly underperform the broad market over the first quarter, so it actually fell 5%, whereas the rest of the market was up 7.4%. At this point, actually I do think now is probably a good time that if investors were underweight that sector at the beginning of the year because it was so overvalued, now is actually probably a pretty good time that it’s closer to fair value, even the little bit under fair value, to be moving back to a market-weight position.

Dziubinski: You alluded to what happened in the market last quarter, and let’s talk a little bit about that. Give us a recap of what happened in the markets during that first quarter.

Sekera: Well also kind of going back to our 2023 outlook at the beginning of the year, we did note that this year was going to be a combination between stocks coming into the year being significantly undervalued, but we also noted this was going to be a transition year. We had noted that there were four main headwinds in our 2022 outlook that would impact the market last year, a number of those headwinds are starting to abate. But you’d have to say even I was kind of surprised by some of the turbulence that we saw over the course of the first quarter.

So, final numbers: The Morningstar US Market Index, our broadest index of the U.S. stock market, was up 7.4% for the first quarter. But intraquarter we did have a lot of volatility. January started off on a pretty high note, we did have a strong market recovery and I’d say that was coming off of a combination of both being technically oversold in December, we did have a lot of tax-loss selling at the end of last year, and then a combination of those very undervalued levels that we saw. Now in February, we did have a bit of a retrenchment, the market did give back some of those gains. It was really early March that the market had to contend with both the combination of the second- and third-largest bank failures in the U.S., as well that forced bailout merger of Credit Suisse by UBS. And that did bring back what I would consider being a “ghost of financial crisis past” for some investors. But for a number of different reasons, we didn’t think that this was a precursor to a new financial crisis.

And for those that are interested, I did publish an article on March 17 titled “Investment Impact of Banking Crisis,” and we highlighted why we didn’t think this was the beginning of a new financial crisis, then also highlighted a number of nonbank financial stocks that we thought were unfairly sold off with the banks when they sold off in March and brought them into undervalued territory. And then finally here at the end of March, I think markets kind of came around to our point of view and recovered. In fact, the market actually surged 4% just in the last week of March alone.

Dziubinski: Now interestingly, Dave, growth stocks significantly outperformed during that first quarter. What drove that outperformance?

Sekera: Growth stocks were actually the worst performers in 2022 and dropped to levels that we thought were significantly undervalued. In fact, coming into the year, growth was the most undervalued as compared to both value and core stocks. Between being oversold and undervalued, they certainly have had a strong rally thus far this year. And in fact they’re pretty much responsible for all the gains that we’ve seen across the broader market. Now, within those gains, I’d say those gains have been very concentrated. The biggest gainers were also some of the largest market-cap companies. For example, looking at the numbers here, Apple AAPL was up 27% in the first quarter. Microsoft MSFT up 20%, Nvidia NVDA was up 90%. In fact, Nvidia rose so much it went from a 4-star rating, it dropped all the way down into a 2-star rating. Tesla TSLA up 68%, and that actually dropped from a 4-star rating to a 3-star. And then Alphabet GOOG was also up 18%.

Dziubinski: Dave, let’s pivot over now to your stock market outlook for the second quarter, and we just published this new piece of research on Morningstar.com. What can investors expect this quarter, Dave?

Sekera: Susan, has long-term investors we try not to get wrapped up too much into the short-term market movements and really stay focused on our long-term valuations. But having said that, I do think the market could be in for a rough road ahead for the next couple of quarters. It does appear at this point the Fed’s either at or at least very close to the end of hiking interest rates. I’d say Chair Powell noted in some of his commentary that he does think the banks will be tightening lending standards and limiting credit availability, which will have the effect of one or more rate hikes. And in the first quarter the economy has actually been more resilient to monetary policy tightening than I think we originally expected. But we do still think rising interest rates will take their toll on the economy, will slow in the second and third quarter before beginning to reaccelerate later this year, which of course will put pressure on earnings and the economy in the near term.

So, I do think that at this point we’re probably closer to the top of the trading range that we’ve seen for the past couple months, and I think it’s going to take a recovery and long-term economic indicators, especially those leading indicators, for the market to break through that ceiling.

Dziubinski: Let’s talk a little bit about valuation. How does a stock market overall look from valuation perspective as we’re heading into this new quarter?

Sekera: At this point I’d say stocks still look pretty undervalued to us. When we put together a composite of the valuations of those 700 stocks that we cover that trade on U.S. exchanges and we calculate our price/fair value ratio, as of March 23, stocks were still trading at a 12% discount to fair value. Now, I’d note that we have had a pretty strong recovery since then. So, when you incorporate that recent rally, I’d say the market’s probably more like an 8% to 10% discount. So still relatively undervalued compared to our valuations. But having said that, based on our expectation for the economy and earnings growth slowing, I do expect the markets could be under pressure for the next couple of quarters. For investors, the way I would think about it is that considering how much of a margin of safety the stock market is trading, I do think that you can use pullbacks in order to increase equity exposure to overweights. And then when the market does end up rising, you can then reduce that exposure, take some profits, and then move back toward your target allocations.

Dziubinski: So what about growth stocks specifically, Dave? Given that runup during the first quarter, are growth stocks looking overvalued, undervalued, fairly valued? How do they look?

Sekera: Growth stocks are up almost 15% in the first quarter, whereas the broad market is only up 7.4%. So at this point, growth stocks are trading at about a 10% discount, which is much less than a 23% discount that we saw at the beginning of the year. So, growth is not as undervalued as the value category, that’s currently trading at about a 17% discount to our fair value, but still better than the core category, which is close to fair value. For investors I think a barbell portfolio is probably still the way to go: being overweight value stocks, still overweight growth, and underweight core. Although I would note that with growth being less undervalued, some investors may want to move more toward a market-weight position compared to where they would’ve been at the beginning of the year.

Dziubinski: For your stock picks this week, you are focusing on a handful of undervalued growth stocks, and the first stock on your list is Uber UBER. And Uber ties into one of the investment themes we’ve talked about previously on the show.

Sekera: It is. Uber is still rated 5 stars, the company does have a narrow economic moat, and that stock trades it just under half of our fair value. And the way I think about Uber is it’s really still a play on consumer behavior normalization and that transition in consumer spending back into services and away from goods. So, as we do see people are going back out more and more often, we expect to see an increase both in the number of users as well as the number of rides per user.

Dziubinski: And then your second pick this week is Zscaler ZS, which ties into another theme that we’ve talked about: cybersecurity.

Sekera: Zscaler stock is still rated 4 stars, that company also has a narrow economic moat, and the stock’s trading at about a 30% discount to fair value. Now, I do think that there is a positive long-term secular growth trend in the cybersecurity industry, and then cybersecurity in and of itself I think has very attractive dynamics. For instance, cybersecurity is a small percentage of IT budgets overall, but for a company it does have huge costs if it does suffer a hack or a ransomware attack. So, when I think about it, that’s an area that I just don’t think management is going to look to cut costs even if we were in a recessionary environment.

Dziubinski: Your third growth stock pick for the week is Tyler Technologies TYL. What do you like about it?

Sekera: Tyler’s stock is rated 4 stars, that company has a wide economic moat, and the stock’s at about a 25% discount to our fair value. Of course this is a name that not many investors may necessarily have heard of, but what Tyler does is it provides software solutions and services for local government entities. While it’s a growth name, I also think it does have some defensive attributes as even in a recession government entities will rely on those software products and I think are unlikely to pull back spending.

Dziubinski: Dave, your final pick this week is in a stock that some investors would think of as a growth stock, given that it’s in the financial-services sector, and it’s Discover Financial DFS.

Sekera: Discover’s stock is rated 4 stars, the company does have a narrow economic moat, and it trades at about a 30% discount to our fair value. Now, Morningstar does use a quantitative analysis of financial metrics to determine a stock style orientation. And when we look at that, Discover does fall into the growth category. So, Discover stock, it did pull back in March along with the overall financial sector following the value of Silicon Valley and Signature Banks. And Discover does use deposits to fund a percentage of its operations. But I’d also note that they do have a lot of other alternative financing options in case they do experience deposit flight. For example, as a credit card company they’ve historically used credit card receivables to be able to fund themselves in the asset-backed securitization markets. And I do think this is just one good example of how investors can take advantage of those dislocations that we saw in the financial sector following those recent bank failures.

Dziubinski: Well, thanks for your time this morning, Dave. Be sure to join. Dave and I live on YouTube every Monday morning at 9 a.m. Eastern time, 8 a.m. Central time. And while you’re at it, subscribes to Morningstar’s channel. Have a great week.