5 Undervalued Stocks to Buy During Q2 2024

Susan Dziubinski: Hello and welcome to The Morning Filter. I’m Susan Dziubinski with Morningstar. Every Monday morning, I sit down with Morningstar Research Services chief US market strategist Dave Sekera to discuss what’s on his radar this week, some new Morningstar research, and a few stock picks or pants for the week ahead. So, happy first day of the new quarter, Dave.

Let’s talk about what’s on your radar this week. Looks like a quiet week ahead in terms of earnings slowing down before they gear back up again next week. So, is there anything on the economic front you’re watching this week?

David Sekera: Hey, good morning, Susan. Actually, I hope you had a good spring break. I know I did. Amazing just how fast that week can go by. So looking at this week, there’s only two economic metrics that I’m really going to be paying attention to, and that’s going to be the nonfarm payrolls report and the unemployment rate. And the reason being is that the Fed is going to be paying very close attention to both of these numbers.

They are watching the labor market as part of the valuation for the monetary policy going forward. What we’re all really looking for here is that Goldilocks—not too hot, not too cool—kind of numbers. You sense we want payrolls to be high enough that it indicates that the economy is still holding up even in the face of restrictive monetary policy.

So even though we do think the rate of economic growth is slowing, we’re still looking for that soft landing. But then again, we’re also looking for a number that’s low enough that we wouldn’t be concerned about wage inflation reigniting.

Dziubinski: So let’s move on to some new research from Morningstar. And that’s your second-quarter 2024 stock market outlook. Viewers can access this research via a link beneath this video. So the tagline for your second-quarter report is: Contrarian plays are increasingly attractive. So summarize that for viewers, Dave.

Sekera: Well, essentially, when I look at our valuations, what our valuations are telling me is that what’s worked for the past one and a half years is pretty unlikely to be what’s going to work going forward. So I think to outperform the broader market, investors are going to have to start taking some contrarian positions.

So when I look at the market over the past one and a half years now, generally we’ve had very strong returns at the index level. Yet these returns have been concentrated in just really a handful of stocks. And when I look at those stocks at this point they’re either in kind of that fully valued territory where they’re 3-star-rated stocks or at this point, many of them are now becoming overvalued and they’re now rated 2 stars.

So I do think now is a good time to start looking at contrarian plays, focus on those stocks that over the past year and a half of underperformed, those that have negative market sentiment that we’re calling the unloved, and of course, always most importantly, those stocks that are still undervalued.

Dziubinski: Now, you say in your report that 10 stocks have accounted for nearly two thirds of the market’s return so far this year. Talk about that.

Sekera: Sure. So in 2023, everyone talked about the “Mag Seven,” the “Magnificent Seven” stocks, and for the full year, over half the market return was really just attributed to those seven stocks alone. Now, when we do that same attribution analysis of this year, thus far this year, a little over 60% of the market return can be attributed to just 10 stocks at this point.

But when I look at those 10 stocks, they only account for just under 30% of the US market index. And of course, I do have to point out Nvidia. Nvidia, still huge rally this year. I think it’s up about 90%. That in and of itself accounts for over 20% of the return yield thus far this year, even though Nvidia is only 3.6% of the index.

So when I take a look at the market and whether it’s the Mag Seven or the top 10, in the most part, these stocks are just fully valued or in many cases overvalued. So specifically, when you look at the top 10 that we listed, in our outlook, I would note that half now are 3-star-rated stocks and the other half are now rated 2 stars.

Dziubinski: So then what about the stock market overall today? From a valuation perspective, does that look overvalued?

Sekera: So right now, the US market’s trading at about a 3% premium to a composite of our fair values. And I think this is a good time to remind a lot of viewers, how we look at the market and how we think the way we look at the market is going to be different than what you’re going to hear from a lot of other research providers.

So what we do is we can create a composite of our fair values, those fair values being determined by our equity research analysts, and take all those intrinsic values, compile those together for that composite. And then we compare that to where that composite is trading in the marketplace based on all the current market prices for those stocks.

So a lot of other strategists, they often use a top-down approach. They have some sort of algorithm, some sort of formula that they use. They estimate their earnings for an index. One year out, they come up with some sort of forward multiple that they apply to that.

It always seems like they are always saying that the market is 8% to 10% undervalued. But our view at this point, at a 3% premium, the market is getting to the point where it’s starting to feel a little stretched. I mean, it’s not necessarily in that territory that we’ll consider to be overvalued.

But when I look at our valuations, since the end of 2010, the market’s only traded at a 3% premium or more only about 14% of the time.

Dziubinski: So let’s slice and dice the market a few different ways, starting with looking at it through the lens of market capitalization. Now, small-cap stocks looked far more undervalued than mid- and large-cap stocks as we came into the new year, into 2024. Is that still the case as we’re heading into the second quarter?

Sekera: It is still the case. So small caps have lagged the rest of the market. They’re still trading at about 18% discount to our fair value. So by capitalization, it’s still the most undervalued part of the marketplace today. When I look at mid-cap stocks, those are trading at a 3% discount. But large-cap stocks, where we’ve seen the biggest gains, are now trading at a 5% premium.

Dziubinski: And now let’s look at things sort of through the value versus growth versus core lens. How are valuations breaking down there?

Sekera: Value stocks, still the most attractive part, by a categorization. Those are trading at about a 6% discount to fair value. Core stocks, and of course, core stocks are those that have some attributes of value, some attributes of growth, but they don’t necessarily fit in one category or the other. Those are trading at a 3% premium.

—So in line with the market premium. But it’s those growth stocks that have continued to rally that are now well into overvalued territory, trading at a 8% premium to our fair value.

Dziubinski: So let’s move on to parsing the market by sector, and let’s start with technology stocks. You know, they looked expensive heading into the new year. I imagine they’re still expensive, right?

Sekera: They are. So tech definitely still in that overvalued territory area. They’re trading at about 8% premium to our fair value. Now, I do have to note for the technology sector, we did increase the fair value on Nvidia over the course of the first quarter. So the rate of increase that we increased our fair value there is about the same that the market price has increased at that same point in time.

So that’s really cut that premium for the technology sector at about the same that we’ve seen for the first quarter.

Dziubinski: Now communication stocks were undervalued coming into the new year, and they had a pretty good rally in that first quarter this year. So what happened there? And does this group still look undervalued?

Sekera: Yeah, and I think we need to even look a little bit further back. So communications was by far the most undervalued sector, according to our valuations, coming into the year last year, so at the beginning of 2023. The sector rose 54% last year. I think it’s up a little bit over 14% year to date.

So at this point it is still undervalued, but it’s rapidly approaching our fair value estimate. Trades only at a 6% discount to fair value. And of course, the communications sector is heavily weighted toward Alphabet and Meta. Those two companies make up 65% of that sector now. Now, a year ago in 2023 coming into the year last year, both of those stocks were significantly undervalued here at this point.

Alphabet is a 3-star-rated stock. It does trade at a 12% discount. But in the bottom of that 3-star range. Meta, in our view, is just run too far to the upside. That’s now a 2-star-rated stock. So I think where we see the most value in the communications sector today is still going to be in those traditional communication companies.

For example, you and I, last year, we talked about AT&T and Verizon a number of times. But, even those two stocks are up 36% off their October lows. They are still, however, in that 4-star territory.

Dziubinski: So, Dave, let’s talk about the sectors that look attractive and maybe are the place where contrarians could be doing some hunting today.

Sekera: Yeah. So let me go over three of them. So first is going to be real estate. That is the most undervalued sector. Trades at 11% discount. And of course, commercial real estate overall right now, just the most hated asset class on Wall Street. And a lot of that is really just from the difficulty in trying to value urban office space today.

A lot of investors and traders are still trying to work through and understand the impact of hybrid work and how that’s going to impact valuations for offices is going forward. And of course, real estate is also very negatively correlated with interest rates. Second is going to be the utility sector, also another sector that is negatively correlated with interest rates.

Many investors do use it as a fixed-income substitute. The utility sector, we think it just sold off too much last fall when the 10-year US Treasury yields were surging higher. From a fundamental point of view, having talked to Travis, our equity analyst that covers utilities, he still thinks the utility sector is fundamentally as strong as it’s ever been.

He’s looking for growth coming from the transition to renewable energy sources, as well as investment in the infrastructure for the electric grid. And then lastly, I still like the energy sector here. Now, we had highlighted the energy sector in our March outlook. The sectors caught a pretty good bid here in the past couple of weeks. At this point, it’s now only trading at a 3% discount to fair value.

But again, I think it just provides still a good natural hedge in your portfolio against any increases in geopolitical risk. And if inflation were to stay higher for longer, I think there’s a lot of value for having that in your portfolio today, especially the exploration and production companies.

Dziubinski: Dave, given your stock market outlook, how should investors be thinking about their stock portfolios as we’re heading into the second quarter?

Sekera: Well, with the market getting to be in that kind of getting to be stretched but not yet overvalued territory, yeah, I do think that you probably should have a neutral allocation right now in your portfolio. And when I look at the market, for example, since the end of 2010, the market’s only traded at a 3% premium or more only 14% of the time.

So it still can move up from here. But I do think that in the short term, the amount that it moves up is probably getting to be pretty limited. But for long-term investors, I still think that you want to have that full allocation based on your risk tolerances

in the equity market, I’d say you might want to temper expectations a little bit. We are at that a little bit of a premium. It might take, maybe, a couple of years for that premium to dissipate. So based on that risk tolerance, your investment goals, your time frame, I’d be at that market-weight position.

So if you’re a 70/30 or 60/40 investor, I’d have that for investors in the equity market. But what I’d really want to do is make sure that you tilt that equity allocation into those areas and overweight those areas that we think are undervalued and maybe underweight, those areas that we think are overvalued today.

Dziubinski: And then pivoting over to bonds, how should investors be thinking about the duration of their fixed-income positions heading into the second quarter given Morningstar’s outlook for interest rates?

Sekera: Yeah, I mean, the bond market has continued to struggle thus far this year. So the Morningstar US Core Bond Index and again, that’s our proxy for the full overall fixed-income market that’s down a little bit under 1% year to date. And essentially what’s happened here is that we have seen your long-term bond interest rates rise.

And of course, as interest rates go up, that pushes the bond prices down and that more than offset kind of that underlying yield carry that you generate on bonds. But based on our interest-rate forecast, I do think investors are still best serve in what I call longer-duration bonds. You know that five- to seven-year, even out to that 10-year duration, I think looks pretty attractive.

And I think at this point you can lock in kind of the currently higher interest rates that we see. When I look at the yield curve, we do project in the short term that the federal-funds rate yield will fall over the course of the second half of this year, getting down to 4.00% to 4.25% by the end of the year.

But we expect that to fall even further next year in 2025, getting down to a 2.50% to 2.75% range. So you are getting very high yields today in the short term, but I do think that those yields will start going down over time. Now, in the longer end of the curve, our economics team does project that the yield on the US Treasury of the 10-year will average 4% this year, so that does mean that will be going down in the second half of this year. But then the US economic team does look for that still to fall further in 2025, averaging 3% next year.

Dziubinski: So then, Dave, within fixed income, what’s your take today on government bonds versus high-quality corporate bonds versus junk bonds?

Sekera: Well, at this point, I think investors are going to be better served overweighting, US Treasuries in that fixed-income portion of their portfolio. So, again, our base case is still looking for that soft landing here for the economy. But when I look at the corporate bond market, I would say credit spreads there have tightened to the point where I no longer think you’re really getting adequately compensated for the added risk of defaults and downgrades.

So when we ran our numbers for this most recent outlook, the average credit spread of the Morningstar US Corporate Bond Index, which is our proxy for investment-grade bonds, it was only 86 basis points over Treasuries. And then the high-yield index, that average spread was only a little over 300 basis points. So a lot of people may not understand what that means. So by way of comparison, I would just say that at the beginning of this year in our 2024 outlook, we had moved to a market weight in corporate bonds. The investment-grade spread at that point in time was 98 basis points and the high yield spread was 338. And at the end of 2022, when we had recommended an overweight in corporate bonds, the average spread for investment-grade was 130, and the average spread for high yield was 457.

So when I look at, corporate bonds and I look at credit spreads since 2000, so over the past 24 years, when I look at how credit spreads and how tight they are today compared to that time frame, I think only 2% to 3% of the time have credit spreads traded at tighter levels than what we see today.

Dziubinski: Interesting. So let’s move on to the picks portion of our program. At the start of each quarter, Morningstar publishes its analysts top stock ideas in an article called “33 Undervalued Stocks,” and we’ll be publishing that in a couple of days on morningstar.com. But today, Dave bringing us a little preview. You’re sharing with viewers five stocks from that list of 33 that you like today, and your first pick this week is Dow.

Why do you like it?

Sekera: So Dow’s a 4-star-rated stock. Trades at a 16% discount to fair value, 4.8% dividend yield. And as a company, we rate with a narrow moat and a Medium uncertainty. And of course, Dow is just one of the largest chemical producers in the world. And when I look at that stock chart, it’s really been stuck kind of in a range since the end of 2020.

And when I look at our narrow economic moat rating, I’d note that it’s really going to be based on the cost advantage for where their operations are. 75% of their capacity comes from North America, and it benefits from using a low-cost natural gas feedstock here in the United States. So I do think that this is well-positioned for an economy that is going to be in that soft landing and then look to pick up over the course of the next few years.

Dziubinski: Now, your second pick this week is a large-cap name in one of your contrarian sectors, energy, and the stock is TC Energy.

Sekera: Yeah, this one’s interesting. So TC Energy probably not very well-known among US investors, but I think it’s going to be pretty widely recognized by our Canadian viewers. It operates in the natural gas oil and power generation, I think mostly in Canada, but some in the US as well. Over 60,000 miles of oil and gas pipelines. 650 billion cubic feet of natural gas storage, 4,300 megawatts of electric power. So pretty good diversified portfolio. And when I read our note here, Stephen Ellis, who’s our analyst that covers this one, noted he thinks this company has what he called a utilitylike earnings profile. So essentially what he meant by that is the preponderance of earnings here are either in highly regulated areas or under longer=term contract.

So I do like that profile for this company. We rate the company with a narrow economic moat and a Medium uncertainty. It’s currently rated 4 stars, trades at a 14% discount to fair value, nice healthy dividend yield at 5.25%.

Dziubinski: And your next pick is Stericycle. Here it looks like we have a cheap stock in a pricey sector, which is industrials. Tell us about it.

Sekera: Yeah, this is actually one you and I have talked about before. We highlighted Stericycle as one of our small-cap stock picks on our Jan. 29 livestream. I took a look: The stock’s up about 6.5% since then, but it is still a 4-star-rated stock, trading at a 12% discount to fair value.

And our analyst team actually just added it to our top picks. For the second quarter, we do rate the company with a narrow economic moat based on its cost advantages and switching costs. For those that don’t know the company, it is the largest provider of medical-waste disposal services, here in the US. And I think looking forward here, I think the catalyst is that we are just looking for the divestitures of their low margin businesses that they’ve made over the past couple of years really to help lead margins much higher looking forward.

Dziubinski: Now, your next stock pick this week is Adobe. Now, we talked about Adobe a couple of weeks ago on the show, and the stock was hammered after earnings and Morningstar thought after earnings that management’s guidance wasn’t terribly clear. So this seems like a little bit of a change of heart here on this stock. Dave, is this one an April Fools’ joke?

Sekera: Well, really, what I wanted to do is provide investors a large-cap growth stock in the tech sector that even though that’s the part of the market that we think is one of the most overvalued parts of the market today, pretty much there’s always going to be something that’s still undervalued.

So as you mentioned, Adobe Stock did fall after earnings. I think it’s down about 12% since then. And in this case, the first-quarter results were fine. Our analyst said that they were good, but the market was reacting to the guidance from this company. But we do think in this case the market’s probably overreacting to the downside.

So, Dan Romanoff specifically put in his note that he thought guidance was what he called “perplexing.” And again, that’s a word that should never be attributed to management for their guidance going forward. He also noted that management didn’t reiterate its full-year outlook specifically, but yet he repeatedly said management was saying that they felt really good about the year.

So I do think there is some areas of the market that are disappointed by how management talked about guidance. But at the same point in time, Dan noted there was really nothing definitive for him to go on to change his model. So our fair value is unchanged, following the earnings and the guidance. It’s a 4-star-rated stock, 17% discount to fair value. For dividend investors, I’d note this one does not pay a dividend, but it’s a company we rate with a wide economic moat. However, it does have a High uncertainty. So I think really the whole intent here is for investors that do want to keep some exposure to large-cap growth stocks, and specifically the tech sector, this would be our pick for that part of the market today.

Dziubinski: And then your final stock pick this week is Duke Energy. Duke is a large electric utility. Nice yield on the stock today. And we’ve talked about the name before, this name before on The Morning Filter. So remind viewers why you like it.

Sekera: Yeah, 4-star-rated stock, 15% discount to fair value, 4.3% dividend yield. It is one of the higher-yielding utilities out there today. Like almost all of our utility coverage, we do rate it with a narrow economic moat and a Low uncertainty. And specifically what our analyst team has called out on this one is that when they look at the capital investment plan here for the company, it is very focused on renewable energy and infrastructure upgrades.

So after divesting their unregulated parts of their businesses, we do think that this company has a pretty clear pathway toward growth over the next few years.

Dziubinski: Well, 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, we hope you’ll join us for The Myouououdfdn next Monday at 9 a.m. Eastern, 8 a.m. Central. In the meantime, please like this video and subscribe to Morningstar’s channel. Have a great week.