4 Wide-Moat Stocks on Sale

Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. Every Monday morning I sit down with Morningstar’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. I understand you’re traveling today, Dave, so thank you for taking out some time to chat. On your radar this week, we have the Fed meeting. What’s the market expecting?

Dave Sekera: Good morning, Susan. Joining you today from the great state of Tennessee. So this week we do have the Fed, and to be honest, I actually kind of hope viewers took my advice last week to take a bit of a breather because we certainly could see a pickup in volatility this week. Now, since the last Fed meeting, we’ve been of the opinion that the Fed is going to halt hiking rates any further at this point, and it does look like the market agrees with us. Right now, the market-implied probability of another rate hike is only 30%. Now, the caveat there is that we do have CPI coming out Tuesday morning, and then we have PPI coming out Wednesday morning. So, if either or both of those are higher than expected, that certainly could put another rate hike back on the table for the Fed.

Dziubinski: The Fed meets again in July. What’s the market expecting for that meeting?

Sekera: Well, this is interesting here. So, the market is pricing in that they’re going to pause here this month, but then the market probability of a hike then in July is 66%. So, it’s actually a 53% probability that they hike to 5.25% to 5.50%, and then a 17% probability that they hike to 5.50% to 5.75%. Now, my own personal opinion is that I think if the Fed does pause this month, it’s going to hold interest rates there for a while. I don’t think the Fed’s going to want to be seen as really being that reactionary to any individual inflation prints. I think they want to be seen as a steady hand guiding the economy.

Even though inflation, maybe it’s not declining as fast as the Fed would prefer, but I know our U.S. economics team does still expect that inflation will continue to keep moderating over the course of this year. But we do have both that CPI and PPI print coming out, so we’ll see how those turn out. But again, we do think that the Fed is going to pause here and that it will probably pause throughout the end of the year, and it’ll only be at the end of the year that we think the Fed actually could turn around and start cutting rates.

Dziubinski: Let’s pivot over to some new research from Morningstar, and that’s your stock market outlook. In it, you shared some interesting research about what’s been driving the market’s performance this year. Tell us about that.

Sekera: It’s been a pretty good year for the market. The US Market Index is up 12.4%, but the gains this year have been just really concentrated. I mean, almost extraordinarily concentrated in just a handful of names. We did an attribution analysis, and what that shows is that there are only 10 companies that actually account for essentially the entire market return thus far this year.

Dziubinski: Notably, many of these 10 stocks were actually undervalued heading into the new year. So where are their ratings today?

Sekera: Exactly. So of these 10 companies, nine of those 10 were rated either 4 or 5 stars at the beginning of the year, and at this point they’ve run up so much that only one now is rated 4 stars, meaning that we think it’s undervalued. Six of those now are 3-star, meaning that they’re trading pretty close to what we think is fair value, and three are now 2-star, meaning that they’re starting to trade into an area that’s well above our valuation. So, I think that for the market really to continue this rally that we’ve had, what we’re going to need to see is that the rally is going to need to spread out into other areas of the market, and specifically according to our valuations, into the mid-cap and the small-cap stocks and into the value category.

Dziubinski: Let’s shift topic a little bit to discuss the performance of stocks this year through the lens of economic moats. Now, first, remind viewers what economic moats are and why at Morningstar we think they’re important.

Sekera: The economic moat analysis is really a Warren Buffett, Graham-and-Dodd-esque type of analysis. It’s our way to identify those companies that we think have long-term durable competitive advantages that will then allow that company to be able to generate excess returns over its cost of capital for the long term. So, a company that we rate with a narrow economic moat is going to have those durable advantages for up to the next 10 years, and then a wide moat is going to be able to generate those excess returns for 20 years or more.

Dziubinski: How have wide-moat stocks done this year? Have they outperformed the market, underperformed the broad market, and what’s been driving their performance?

Sekera: The wide moat stocks have definitely been outperforming this year. As I mentioned, the broad market has up 12.4% year to date, but the Morningstar Wide Moat Composite Index, and that’s an index of all of those stocks that we rate with a wide moat that’s up 17.7% year to date. And then even more focused is the Morningstar Wide Moat Focus Index, and that’s a composite of the 40 most undervalued wide-moat stocks. That’s up 19.3% year to date. But that outperformance is really driven by a lot of those same factors that we see outperforming the entire market. So again, those undervalued mega-cap stocks that have really propelled the market. I’d highlight specifically Microsoft MSFT, Nvidia NVDA, Alphabet GOOGL, Amazon AMZN, and Meta META as really being the ones that have really performed the best and pushed those wide-moat stocks on the index basis up as much as they have.

Dziubinski: It looks like from a valuation perspective that discounts on wide-moat stocks really have narrowed this year, while discounts on narrow- and no-moat stocks have remained relatively unchanged.

Sekera: Wide-moat stocks have staged quite the rally. At the beginning of the year, wide-moat stocks were actually trading at a greater discount to fair value than the overall market. But now following that rally, as a category, they’re now trading in line with that same broad market discount. And a substantial amount of that is due to that concentration that we’ve seen that’s driven the returns year to date. Of the top 10 companies that account for almost all the return thus far this year, seven of those 10 were rated with a wide economic moat. And just as an aside, I’d also note that those other three were actually also rated with a narrow economic moat. We’ve really seen a big pickup in quality thus far this year.

Dziubinski: Got it. We’ve reached the picks portion of our program this week, and today you’ve brought viewers four of your favorite undervalued wide-moat stock ideas. Now, before we get to that, talk a little bit about why Morningstar considers being able to buy wide-moat stocks at a discount is sort of a sweet spot, so to speak.

Sekera: When I think about investing, there’s really two parts to Morningstar’s approach to really be a successful long-term investor. First, of course, is identifying those strong high-quality businesses, those that will generate excess returns over the long term as we think those will be the companies that over different economic cycles will be best positioned to be able to weather those slowdowns as well as be able to put through cost increases in inflationary environments. But, of course, no matter how high quality a business is, if you don’t buy it at the right price, you’re not going to be successful. So, really it’s that combination of being able to buy those stocks that we believe have that wide economic moat or even narrow economic moat at valuation when we do our discounted cash flow, that also provides enough margin of safety to be able to protect investors during those market downturns.

Dziubinski: Your first undervalued wide-moat stock pick this week is a bank. It’s U.S. Bank USB. Now, Dave, many bank stocks are undervalued these days. Why do you like U.S. Bank specifically?

Sekera: US Bank is currently rated 5 stars and it trades at a 38% discount to our fair value. It does have a wide economic moat, and it does trade in the value category, plus it also has a Medium Uncertainty Rating and also pays a 3.5% dividend yield. So, all of those attributes I think are just really positive for investors right now. And of course, what happened here is that U.S. Bank did get caught in that downdraft of the regional bank selloff following the bank failures earlier this year. And with U.S. Bank, it’s not as large as a JPMorgan JPM or a B of A BAC, but it is much larger than most of those other regional banks. So, we don’t think this one’s going to be at nearly as much risk of deposit flight as some of the smaller regional banks.

Dziubinski: Dave, your second stock pick of the week fits one of the growth themes we’ve talked about on the show before. That growth theme is med tech and the stock is Medtronic MDT.

Sekera: Medtronic stock is currently rated 4 stars, and it trades at a 25% discount to our fair value. Again, it’s another wide-moat-rated stock with a Medium Uncertainty, and it does trade in the value category, and it’s got a 3.3% dividend yield. It’s really, I think, one of our better picks in that med tech area and in the healthcare space in particular because it does have a lot of good exposure to those products that will benefit those medical needs of the aging baby boomer generation.

Dziubinski: Your third undervalued wide moat stock pick is Kellogg K. Kellogg plans to spin off its cereal business from its snack business. What should investors make of that, and why do you like the stock?

Sekera: Kellogg’s rated 4 stars and trades at a 20% discount. It also has a wide economic moat and a Medium Uncertainty, and it is a consumer defensive stock, which I do think people will look at positively in this uncertain environment. It also pays a nice 3.5% dividend yield. Now, we have seen the stock under some pressure from cost pressures from inflation, but we do expect that those pressures will moderate over time. As you mentioned, there is some negative sentiment in the market right now surrounding that plan to split up into the cereal business and the snacks business. But from an economic perspective, that really just doesn’t change the intrinsic value of those two companies. At the end of the day, the investor, when it does split up, will still end up owning stock in both of those businesses, the combination of which we do think is undervalued.

Dziubinski: And then your last stock pick of the week is a less familiar name: Tyler Technologies TYL. Tell us about that one.

Sekera: Tyler Technologies is rated 4 stars, trades at an 18% discount, wide economic moat, Medium Uncertainty. Now it is in the technology sector, but really within the technology sector, I think it’s still more of a defensive play. As you mentioned, it is a little-known company, but it provides software solutions and services to local and state governments and other government functions. So, even in a severe recession, I do think that this is one that would hold up pretty well to the downside. Just government entities, when you think about it, they’re still going to be able to continue to pay their bills, and we do see that there are good switching costs within their economic moat, which keeps their customers from moving to competitors.

Dziubinski: Well, thank you for your time this morning, Dave, and safe travels.

Sekera: Thank you.

Dziubinski: Dave and I will be taking next Monday off due to the market holiday. But be sure to join Dave and me live on YouTube on Monday, June 26 at 9 a.m. Eastern, 8 a.m. Central. And while you’re at it, subscribe to Morningstar’s channel. Have a great week.