5 Undervalued Dividend Stocks to Buy

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. What’s on your radar this week, Dave, some economic metrics?

Dave Sekera: Good morning, Susan. A couple of economic metrics coming out. I mean, essentially, second-quarter earnings season is over, and I expect the market is going to be pretty quiet until after Labor Day, unless there’s really any specific catalyst that comes out.

As far as economic metrics this week, we have existing and new home sales. We have a services PMI. We have durable goods orders. To be honest, I’m actually really interested to see where a lot of these print. Now, our base case for third-quarter GDP, our forecast is only for a 1% increase in the rate of growth for the economy. However, following those strong retail sales numbers last week and a couple of other economic metrics, taking a look at the Atlanta Fed GDP, now that is a running estimate of GDP based on economic metrics as they release. Of course, it can change over the rest of the quarter, but I do think that as high as that Atlanta Fed GDP expectation is right now, I do think there’s a potential for the economy to surprise to the upside this quarter, similar to what we saw in the second quarter.

Dziubinski: Also this week, Fed Chair Jerome Powell will be speaking on Friday morning from the annual Jackson Hole event. What are you expecting to hear?

Sekera: The Fed’s used Jackson Hole in the past a number of different times. They’ve used that as an opportunity to let the market know if there’s something that they’ve changed their focus on or used that to intimate a change in potential monetary policy. I’m no economist, but I bet it’s going to be a “nothing burger” this year. This time around I don’t expect to hear anything other than really the current narrative.

The current narrative still being inflation is moderating yet still too high. They’re concerned that their job for tightening monetary policy might not be over yet. Of course, they will be data-dependent going further, but again, at the end of the day, I don’t think they’re going to signal anything new.

Dziubinski: You said at the top of the show that earnings season is, of course, winding down. Are there any companies left to report this week that you’re interested in?

Sekera: There are. There’s a couple. First is going to be Nvidia NVDA. I do think the market will be paying attention there. Now, that should be an exceptionally strong quarter for them. But the real question is going to be is it going to be strong enough to satisfy the market with as much as that stock has risen thus far this year and specifically after last quarter? And I do think the outcome here really could drive short-term market sentiment one way or the other. Now, that is a 2-star-rated stock. It trades at a 44% premium. So, I would be cautious of that one going into earnings.

Another one I’m going to watch is Medtronic MDT. We’ve highlighted that one several times. We do think that company will be the beneficiary of long-term secular trends in med tech. It’s a company that we rate with a wide economic moat. It’s rated 4 stars, trades at a 27% discount to our fair value, and pays a 3.2% dividend yield.

And then lastly, there is a Bath & Body Works BBWI. Now, as ridiculous as it sounds, a lot of traders still get that one confused with Bed Bath & Beyond. And of course, that one had filed bankruptcy a while ago. But I do think we have a differentiated opinion on Bath & Body Works. Now, specialty retail, of course, can be very difficult to try and forecast and project in the short term, but there is a very large margin of safety here. It’s a company we rate with a narrow economic moat. It’s a 5-star-rated stock, trades at an over 50% discount to our fair value, and pays a 2.2% dividend yield.

Dziubinski: Let’s pivot over to some new research from Morningstar, specifically from our colleagues in the Morningstar Indexes group. They’ve done some new research focused on dividends. Dividend stocks held up reasonably well last year, but things aren’t looking very good for dividend payers as a group this year. Dave, walk us through the numbers for last year and this year.

Sekera: In 2022, the Morningstar US Market Index overall was down about 19%, whereas the Dividend Composite Index was only down, I think a little bit under 4%. So, dividend stocks, of course, are often in the value category. They just typically don’t have the same high growth prospects as you’ll see in the growth category. And they actually held up very well to the downturn because they have more defensive characteristics last year.

Now, growth stocks, of course, fell more than the market average in 2022. Now, this year’s actually been quite the opposite. The Morningstar US Market Index is up about 15% year to date, but that Dividend Composite Index is only up about 4%. So, what we’ve seen this year is that value stocks have lagged that market rebound really as that market has been driven by growth stocks this year.

Dziubinski: Their new research argues that rising interest rates aren’t actually the culprit for the poor performance of dividend stocks this year. First, explain the theory behind why rising rates are typically thought of as bad for dividend stocks, but then unpack the data that shows that that’s not entirely true.

Sekera: The theory was that when the Fed was running its zero-interest-rate policy in 2020 and 2021, a lot of investors looked to high-dividend-paying stocks as a substitute for fixed income. It was called TINA, there is no alternative. And so, now the interest rates have risen, people expect that those same investors that reallocated their portfolio from equity to fixed income will then rotate back into fixed income again.

Now, this theory has just not panned out at all. In fact, I think the opposite has actually been true last year. So, in 2022, if you look at long-term interest rates, the 10-year went from 1.50% to 3.88%, a 238-basis-point increase. And this year the 10-year is only up about 40 basis points. So, during the rising interest rates of 2022, the dividend index actually outperformed the market by 15%.

So, you have to remember in reality, valuations and fundamentals play a much greater role in performance for stocks and the stock market overall than these short-term swings in interest rates. So, for example, in 2022, according to our valuations, the energy sector was extremely undervalued coming into the year. Now, the energy sector does have a lot of high-dividend-paying stocks, but that sector rose over 60% when the rest of the market had declined.

And then just lastly, from a mathematical point of view, high-dividend-paying stocks, actually should outperform in a rising-rate environment because they do have much lower duration than growth stocks. So, growth stocks from a mathematical point of view should underperform value because the valuation for growth stocks is heavily weighted toward their future free cash flows. And so, when you apply a higher discount rate to those future free cash flows, that actually brings the present value of your intrinsic valuation down.

Dziubinski: Dave, if interest rates aren’t to blame for this year’s underperformance of dividend stocks, what is?

Sekera: In the short term, it’s really based on the composition of what’s in and what’s not in the dividend index as compared to the broad market index. For example, the dividend index has a much higher percentage of stocks in the financial sector than the market. And of course, following the bank failures in March, financials have significantly underperformed year to date, and that’s adversely impacted the dividend index.

Now, on the other side of the coin, the dividend index also has a lower exposure to technology, and of course, technology has significantly outperformed the broader market. And so the dividend indexes have lagged because of that as well. Then you also have to look at a stock-specific basis. So, the dividend index doesn’t contain a lot of those mega-cap technology, mega-cap high performers this year, companies like Apple AAPL and Amazon AMZN. So, the dividend index is also negatively impacted by having higher weight in those stocks, a lot of these value stocks that have underperformed this year, one would be Verizon VZ. So, Verizon itself is down 15% while the market is up 15%. And the Verizon weight in the dividend index, that’s actually 5 times the amount of weight as you would see in the broad market index.

Dziubinski: Dave, what dividend-rich sectors look attractive today based on Morningstar’s aggregate price/fair value measure?

Sekera: The three I would highlight would be real estate. So, the real estate sector overall is trading at about a 15% discount to our intrinsic valuation. However, I’d still note probably to steer clear of the office space, that is still an area where I do think that valuations could come down further. The next would be the financial sector, that trades at about a 10% discount to our fair value. And of course, the traditional media and communications companies, we think those are also trading at very low valuations at this point.

Dziubinski: Dave, what’s the case for dividend stocks in today’s market?

Sekera: Well, individual security selection and valuation is always really the most important driver for long-term returns. And we just see a lot of high-quality companies whose stocks are trading with very high dividend yields, also trading at very substantial discounts to our fair value. So, following the rally year to date, many of these stocks that drove the market higher, they’re actually now fairly valued and many cases overvalued. And lastly, we also forecast that the rate of economic growth will slow on a sequential basis until early next year.

I do think that equity market returns, broadly speaking, will be more muted over the remainder of the year. So, it’s just a combination of the value stocks, stocks with high dividends, trading at a very significant margin of safety. I think that actually also provides a downside buffer, and just in case we do see any kind of market selloff. But yet once the market does start pricing in an economic turnaround, maybe later this year, early next year, these stocks should perform pretty well. In the meantime, you’re getting paid a pretty good yield to wait for that rebound.

Dziubinski: It’s time to move on to the picks portion of our program. And probably to no one’s surprise this week we’re focusing on dividend stocks, specifically value stocks with high dividends. Why value stocks specifically?

Sekera: To some degree, the market has just been so obsessed with growth stocks this year, and specifically anything tied to artificial intelligence. I think value stocks as a group have just been left behind, and it just really leaves them undervalued and unloved at this point. So, I think that provides investors very good opportunities to be able to rotate into a lot of these stocks, sell those that have just become overvalued and overextended. And depending on your risk tolerance, you’ll be able to reinvest in these undervalued value stocks with those high dividends.

Dziubinski: Your first pick this week is a master limited partnership, it’s Energy Transfer ET. So first, Dave, explain briefly how MLPs differ from stocks and then tell us why you like Energy Transfer in particular.

Sekera: So, a typical stock is a share of ownership in the equity of a corporation, whereas an MLP is a unit in a limited partnership, which then in turn is owned by a general partner, and the general partner is the company that actually manages the underlying business.

Now, there are a lot of tax advantages here for most investors. An MLP is actually treated like a limited partnership for tax purposes. So, for example, investors at the end of the year, they’re going to get what’s called a schedule K-1 instead of a 1099-DIV. And that’s reported differently on your taxes. Now, I’m of course by no means a tax expert, so of course, you do need to look into your own tax situation first. But again, a lot of tax benefits for owning an MLP.

Now, Energy Transfer, actually it was just in the news last week, they announced a pretty large acquisition. It seems like the market likes the deal, the stock traded up. We took a look at it, we actually left our fair value unchanged at this point. I do think that Energy Transfer is probably for a little bit more risk-tolerant investors. So, for whatever reason, the market right now just really doesn’t like these midstream companies. These are companies that are typically pipelines and transportation for the energy sector. And I think to some degree the market’s concerned about the long-term demand for fossil fuels and how the decrease in volumes over the long term could impact the value of the company.

I would just note we already take that into account in our valuation. Specifically looking here at some of our forecasts, we do project the oil volumes will peak in the latter part of this decade, and they’ll start to slow and probably decline relatively steadily thereafter. But you also need to put that in context. So, the demand for oil according to our numbers was 99 million barrels per day in 2019. And we do forecast that will decline but only decline to 88 million barrels per day by 2050. So, in this case, it’s a stock that’s rated 4 stars, trades at a 26% discount, and pays a hefty 9.6% dividend yield.

Dziubinski: Your second pick comes from one of the undervalued yet dividend-rich sectors you talked about earlier in the program, financial services, and the stock is AllianceBernstein AB. Tell us why you like it.

Sekera: AllianceBernstein, I would say, is on the smaller size for being an asset manager, and it has had a pretty tough first half of the year, and that was really just based on the combination of slightly lower revenues than what we expected and slightly higher expenses. But our analyst did note that he thinks that they’re going to face easier comparables in the back half of the year and that will then benefit margins and let things normalize going forward. It’s a 4-star-rated stock, trades at a 15% discount, and pays an 8.6% dividend yield.

Dziubinski: Your next dividend stock pick also is from the financial-services sector, and it’s a name we’ve talked about before on the show, U.S. Bancorp USB.

Sekera: Well, before we talk with U.S. Bancorp specifically, I just know about two weeks ago, I think, Moody’s announced that it was looking at the entire U.S. banking system from a corporate credit point of view, and that they may look to downgrade the entire U.S. banking system. All the bank stocks have retreated since then. To be honest, personally, I’m really not all that worried about it.

When I take a look at U.S. Bank, it’s currently rated A3/A, so a downgrade could cost them an extra couple of basis points in their funding for the funding that they do in the bond market. But I did speak with our analyst, and he doesn’t think that would be enough in order to materially change our valuation. So, U.S. Bank, it has been one of our picks among the regional banks for quite a while now. And I’d also note it is one of the few banks and one of the only regional banks that we assign a wide economic moat.

So, all the regional banks, yes, they are under pressure from higher funding costs. That’s really mainly coming from deposit loss as people take their money out of the banks and put it into higher-yielding instruments like money market funds. But we already forecast lower earnings and lower earnings sequentially for the next three quarters before things start to bottom out and then rebound.

Yes, the sector is under stress, but again, the sector isn’t broken. Over the long term, we do forecast that margins will normalize over time, and that really is our investment thesis. So, in this case, it’s a 4-star-rated stock, trades at a 30% discount, and has a 6% dividend yield.

Dziubinski: Now we’re going to pivot over to another undervalued dividend-rich sector for your next pick. The sector’s real estate, and your pick is Crown Castle CCI.

Sekera: Yeah. And it’s interesting, so Crown Castle is a REIT that invests in cellphone towers. And for years all of these cellphone tower REITs were significantly overvalued, and, in fact, we couldn’t even figure out why the market was applying such a high valuation to this subsector. Now, they did start coming down in 2022. Those stock prices have continued to come down in 2023, and we think that they’ve come down enough that they’re actually starting to look pretty attractive.

Now, in this one specifically following second-quarter earnings, we did cut our fair value, but only by about 2% to $137. And that was just based on some slightly softer near-term projections, but still, it’s a 4-star rated stock, trades at a 27% discount, pays a 5.5% dividend yield, and we do rate the company with a narrow economic moat.

Dziubinski: And then your last pick is actually a longtime holding of Warren Buffett’s Berkshire Hathaway BRK.B. The stock is Kraft Heinz KHC. What do you like about it?

Sekera: Kraft Heinz, I would note that for a food stock, it’s actually been pretty volatile for the past two and a half years, and right now it’s trading really close to that two-and-a-half-year low. We rate it 5 stars. Based on where it’s trading, it’s a 36% discount to our intrinsic valuation, pays a pretty good dividend of about 4.6%, and we do rate the stock with medium uncertainty. But I would caution investors, we don’t think the company does have an economic moat, but at this amount of margin of safety, I do think it is a pretty good opportunity for investors looking for something in that consumer defensive space.

Now, most recently, our analyst noted that she thought that second-quarter performance was pretty solid. Sales did continue to climb. We saw a 4% increase on an organic basis, and the operating margins also expanded. However, that really this performance was based on pricing. They really did take a large increase in pricing across their portfolio. So, the good news, they were able to actually put these price increases through and they stuck. But I think the market is looking at it as a little bit of bad news also. So again, she did note that they did lose some market share here in the short term. A lot of competitors were much more promotional in order to be able to move their product.

So, in our view, this short-term fluctuation in the market share really isn’t all that concerning because again, with inflation and with people trying to catch up with inflation, we do think that competitors over time will need to raise their prices to be able to restore their margins. And of course, then we’d expect market share to normalize thereafter.

Dziubinski: Well, thanks for your time this morning, Dave. Dave and I will be back next Monday live at 9 a.m. Eastern, 8 a.m. Central. In the meantime, like this video and subscribe to Morningstar’s channel. Have a great week.