Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. Every Monday morning I sit down with Morningstar’s chief US 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 are a couple of economic reports of the durable goods orders and the personal consumption expenditures number. First, what does the durable goods orders figure tell us, and what’s the market expecting?
Dave Sekera: Hey, good morning, Susan. Durable goods orders as a measure in the total value of new orders for long-lasting manufactured goods, so think of things such as manufacturing, and machinery and equipment, as well as transportation items. It’s used by the market as a measure of economic growth, and it’s really a way to be able to look at how the economy might be expanding or contracting in the short term. If you see an increase in that number, it means businesses and consumers are more comfortable buying big-ticket items, and of course that would be a positive for the economic outlook, whereas a contraction means businesses and consumers might not be feeling like they’re in the financial position to be spending that kind of money on high-ticket items. This month, for May, where consensus is looking for a 1% contraction, I’m not all that worried about it here in the short term. That compares to a 1.1% increase in April and a 3.2% increase in March.
Dziubinski: Let’s talk a little bit about that PCE number. Why is it important, and what’s the market expecting there?
Sekera: Sure. PCE is a personal consumption expenditures index, and within that index, the Fed uses the PCE deflator in order to measure in inflation. In fact, that is the Fed’s preferred measure. So, that’s the one that the market is really focused on here in the short term. For this past month, the headline consensus forecast is for 4.6% increase in inflation. The other part to that is we do also look at the core PCE deflator. That core is going to strip out some of the more volatile components of inflation such as energy, and that’s considered to be more indicative of longer-term inflationary pressures. The consensus is looking for 4.7% this month.
Dziubinski: Now, if either of these numbers come in below or above expectations, what might happen in the market?
Sekera: Again, I have to caution investors here not to read too much into any one individual metric or indicator out there. Now, from a trading standpoint, I’d say a higher than expected durables number is going to have the market go up in the short term. That will be indicative of the economy strengthening. A lower than expected number, you could see the market go down a little bit because the economy might be weakening. Then for the PCE number, a lower inflation certainly would be good and positive for the market. So, we could see the Fed not raising rates again. And then the higher inflation number could mean the Fed is going to raise rates again. Of course, that could be negative for the markets.
Now, from an investing and a long-term standpoint, I doubt either one of these numbers would change my view as far as where we think investors should be allocating their money today. You’d really need to see large divergences in those numbers that really indicate a change in the long-term outlook. I think it’s pretty rare that any one individual data point is going to give you that. It’s really much more looking at the trends that those data points are telling you.
Dziubinski: Let’s pivot over to some new research from Morningstar—a few new companies that Morningstar’s equity analysts have started covering. Before we dig into some of the specific names, let’s first talk about how Morningstar’s equity research team decides which stocks they cover and which stocks they don’t. What factors are at play?
Sekera: Well, the first thing we want to do is make sure that we cover those companies that are most important to investors. Really, we start off looking at the largest, most widely held and liquid stocks that are on the U.S. exchanges. Now, from there, we also want to make sure that we cover those competitors to those companies. We really want to make sure that the equity analysts have a holistic view and understanding of the dynamics of that individual specific sector that those companies operate in. Of course, we also want to have broad coverage of the markets and cover all of the different sectors out there. Now, we also do look to cover those companies that we think have a wide or a narrow economic moat and focus on those. Right now, we cover over 700 stocks that trade on U.S. exchanges. I think that’s one of the largest coverages out there. Even though we do have very substantial coverage of the large-cap space at this point, we are still looking and picking up more coverage and moving more into the mid-cap and small-cap space.
Dziubinski: Let’s talk a little bit about some of the new stocks under coverage. The first one today is Ally Financial. Tell us about it.
Sekera: We launched coverage there with a $39 fair value estimate, and that helped expand our coverage into more nonbank financials. Now, Ally is a spinoff from General Motors, and it is one of the largest auto U.S. lenders out there. Now, we don’t have an economic moat, so there’s a no moat rating here, meaning we don’t think it has long-term durable competitive advantages. We also rate the company with a high uncertainty. It’s trading at a 30% discount to our fair value, and that does place it in the 4-star territory.
Now, looking through our model and thinking through our outlook, we are expecting an increase in consumer defaults. Thinking about the second half of this year, we are looking at the economy most likely stagnating. However, compared with our forecast, it appears the market probably has even a more negative or dour view than what we have at this point. Now, the stock does trade at a pretty large margin of safety to our fair value, but between the no moat rating and the high uncertainty, in my own opinion, I think there’s other stocks out there with better risk/reward profiles for investors to take a look at.
Dziubinski: Now, you mentioned that Ally doesn’t have an economic moat rating, but the next two stocks we’ll talk about actually both earn narrow economic moat ratings for Morningstar. But before we get to them, remind viewers why Morningstar assigns economic moat ratings to companies? What role that plays in our approach to stock investing?
Sekera: An economic moat, at least in my mind, is a very Warren Buffett-type of analysis. What we’re looking is trying to determine whether or not we think a company has long-term durable competitive advantages but also whether or not those competitive advantages are going to allow that company to be able to generate excess returns over invested capital over the long term. We always start off with the assumption that even if a company’s generating excess returns today, competitors will see those excess returns, enter that space, and quickly compete those excess returns away. If a company is rated with a narrow economic moat, we do expect that company will be able to generate those excess returns for the next 10 years. If a company’s got a wide economic moat, we expect that company can generate those excess returns for the next 20 years or more. When we think about what that means for the valuation of a company, the longer a company can generate those excess returns, the higher its intrinsic value is going to be today as compared to if it wasn’t able to generate those excess returns for the long term.
Dziubinski: Got it. The next stock that’s new to coverage that does have a narrow economic moat rating is Interactive Brokers. Tell us about the company and where the stock is trading today.
Sekera: Yeah, so for Interactive Brokers, we did launch coverage with $113 fair value estimate. We do rate that company with a narrow economic moat and a high uncertainty, and it’s trading at about a 30% discount to our fair value estimate. That does put it in that 4-star territory. The company is essentially an online brokerage, and they make their money off of commissions and net interest income. Specifically, they serve investors that actively trade a lot, and that includes individual investors as well as hedge funds and some institutional investors as well. In this case, it’s economic moat is based on a combination of its cost advantage from its scale as well as its low operational cost.
Dziubinski: Now, the last new company that we’ll talk about today that’s new to coverage is Checkpoint Software. That one also has a narrow economic moat, and it ties into a theme we’ve talked about before cybersecurity. Tell us about the stock.
Sekera: We launched coverage on the company at $150 fair value estimate, also rated with a narrow economic moat, but in this case a medium uncertainty. It’s trading at a 15% discount to our fair value. Even though it’s a little bit less of a discount than the other two, because of that medium uncertainty, it does fall into that 4-star territory. Now, the company provides cybersecurity solutions for network, endpoint, cloud, and mobile apps. Yeah, I just like the long-term nature of the cybersecurity industry in and of itself. I think has very good secular dynamics, and I think it also has some very good growth prospects.
Now, one of the things I really like about cybersecurity is that spending for cybersecurity is a relatively small percentage of the overall IT budgets for companies. But if a company was to succumb to ransomware or hacks, that’s a very high cost to the company. It’s an area where even in a stagnant or even recessionary environment, it’s not an area that I think management’s going to be willing to cut corners. Now, since we spoke about cybersecurity earlier this year, many of those stocks have generally traded up. At this point, this company is really the only one that’s still rated 4 stars. The other ones under our coverage are now in that 3-star territory.
Dziubinski: Now, we’ve reached the stock picks portion of our program. Now, two weeks ago, Dave, you highlighted Medtronic as one of your favorite wide-moat stock picks, and it’s one of your favorites this week, too. I saw on your Twitter feed last week that there was an update on this stock, so fill us in.
Sekera: Sure. What happened was at a recent investor conference, United Healthcare, which is a healthcare insurance provider, had noted that they’ve seen a surge in healthcare services and demand in the second quarter. Now, we think that could be a very positive indication for the medical-device makers. What it might mean is that we’re possibly seeing a pickup in deferred procedures such as joint replacements. I continue to think Medtronic is probably one of the better plays out there for the combination of medtech and the demographic aging in the United States. It is rated 4 stars, trades at about a 22% discount to our fair value, wide economic moat, medium uncertainty, and also pays over 3% dividend yield.
Dziubinski: Now, are there other wide-moat stocks that can benefit from the same trend as Medtronic?
Sekera: Yeah, so the other one we highlighted was Zimmer Biomet, and that’s a 4-star-rated stock at a 17% discount to our fair value. Again, a wide economic moat, medium uncertainty, although in this case they do pay a little bit less than a 1% dividend yield. Now, I’d note both of these stocks did have a nice pop in the market after that announcement from United Healthcare, but based on our fair values, we still see a pretty good margin of safety in the potential for price appreciation in both of these stocks from here.
Dziubinski: Now, both of these stocks are, of course, healthcare stocks, and healthcare stocks tend to be defensive investments. Given that you expect a good deal of uncertainty to persist in the market for the rest of this year, you have a couple of other picks this week that are wide-moat stocks in healthcare with defensive characteristics. Of course, we have Medtronic and Zimmer Biomet. You also like Gilead Sciences. That’s one of your picks this week, too. Why?
Sekera: Gilead is rated 4 stars and trades at a 19% discount to our fair value. Company is rated with a wide economic moat and a medium uncertainty. The company’s portfolio is focused on HIV as well as hepatitis B and C, but I’d also note they are expanding into pulmonary and cardiovascular diseases and cancer, as well. One of the aspects that caught my eye on this recently was that our equity analyst in one of her write-ups had noted she thinks that the company’s pharmaceutical portfolio is posed for what she considers to be maintainable growth. With the forward dividend yield here at a very healthy 3.9% and a payout ratio of only 50%, I don’t think the company’s going to have any problem maintaining its dividend. What I like here is that combination of that good margin of safety from the long-term intrinsic value and that high dividend yield.
Dziubinski: Your last wide-moat stock pick for this week on the defensive healthcare sector is GSK. What do you like about it?
Sekera: Yeah, so GlaxoSmithKline is currently rated at 5 stars and trades at a 36% discount to our fair value. We rate the company with a wide economic moat and a medium uncertainty. Now, GSK is a U.K. company, but it’s actually one of the largest global pharmaceutical companies, and they have a portfolio of drugs across several different therapeutic classes including respiratory cancer and antiviral as well as vaccines, although, I had note they weren’t involved in the mRNA COVID vaccines. They’re in the midst of launching a traditional RSV vaccine with what we consider to be a multibillion-dollar market potential. I’d note with this one, too, that stock got hit pretty hard in mid-2022 and that was really from product liability from one of their prior products, Zantac. However, at this point, we think the market is greatly overestimating the potential liability that they may suffer from that.
Dziubinski: Well, thanks for your time this morning, Dave. Dave and I will be back next Monday live at 9:15 a.m. Eastern, 8:15 a.m. Central. We’ll be talking about the second-quarter recap and looking ahead to the third quarter. Be sure to join us. And in the meantime, subscribe to Morningstar’s Channel. Have a great week.
Sekera: Thank you.
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