5 Undervalued Stocks to Buy for a ‘Higher for Longer’ Interest-Rate Environment

Susan Dziubinski: Hi. I am 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.

On your radar this week, Dave, of course, are earnings. Before we get to some earnings reports that you’ll be watching for this week, let’s first talk about what we heard from the big banks that reported late last week. How did things look?

Dave Sekera: Hey, good morning, Susan. The results look better than I think what we had originally expected. And there’s a couple of different main takeaways here that I think investors should be thinking about when looking at these results. First, loan volumes are slowing, and I think that’s a combination of a couple of different things. One, just being a declining demand for loans as the economy is starting to slow, as well as rising loan standards. I do think that the combination of those two does support our forecast that we do expect the rate of economic growth here in the U.S. will start to begin to slow this quarter. Another interesting takeaway, it actually surprised me, there really wasn’t much of a build in loan-loss reserves, and I think what that indicates is that the banks aren’t building up their balance sheets in preparation for a near-term recession, certainly not a deep recession. Net interest income just keeps growing at the big banks. And then lastly, I’d note that investment banking activity, it did start to tick back up, so it’s really not anywhere near it was a couple of years ago. But I do think that might be a good indicator for investment banks, that’s now bottomed out and starting to move in the right direction. So from an investing point of view, JPM stock is rated 3 stars. That one trades near our fair value, but I would note both Wells and Citi are rated 5 stars. Now, we still prefer Wells over Citi. Wells does have a wide economic moat, where Citi is a no-moat-rated company. Citi is slightly more undervalued, but our equity teams noted they think Wells is much further along in its turnaround.

And then we also had regional bank PNC report, and I think that one has a couple of different takeaways than what you see from the megabanks. So they did actually significantly increase their loan-loss exposures for commercial real estate that came in higher than what we had expected, and that might actually be a bad indication for the regional banks that report later this week. Of course, the regional banks do have a much higher percentage of their assets in commercial real estate than what we see at the megabanks.

Dziubinski: Let’s move on to this week. Let’s talk about some companies that are reporting that you’re keeping an eye on. First, we have Tesla reporting this week. That’s always an earnings report investors are interested in. What do we think of the stock today?

Sekera: Yeah, and you have to look, too, I mean Tesla is up over 100% year to date. And following that rally, it’s actually moved now into that 3-star territory, but I’d actually note it’s actually on the verge of tripping into 2-star territory. So it looks like a trade at 251 last Friday. Our fair value estimate on that stock is 215 per share, but I think this quarter it’s really going to be a story of sales versus price cuts. And unlike a lot of the other automakers, Tesla does own its own dealerships, and I think that allows them to be able to quickly react to changes that they see in the supply/demand dynamics within the marketplace. In this case, this past quarter, they did reduce prices, and I think that they’re looking for that to help boost sales volume. But the question is at what price to margins is that going to come at?

Dziubinski: Now, you also mentioned regional banks reporting this week. Which ones are we going to hear from, and what will you be watching for?

Sekera: The ones I’m going to be watching on Thursday are going to be Truist, Fifth Third, and KeyCorp. And then on Friday we have Regions, Huntington Bancshares, and Comerica. Now, from an earnings perspective, we do forecast that the earnings under the regional banks will still be under pressure. In fact, we think they’re going to be under pressure and probably decline for a couple more quarters until they bottom out maybe middle of next year. And that’s a combination of a couple things, but it’s going to be from lower net interest income just because of the higher funding costs that they have to pay as well as losses on commercial real estate. But from a valuation point of view, we do think the market’s already priced all of this in and more, in fact. We think the stock prices on many of these regionals sold off too much early this year. And one potential piece of good news that we’re looking for potentially this quarter is that we think deposit loss may have stabilized, and if so, that could put in a good solid bottom for these stocks. And that could develop a base where we could start to see meaningful recovery in these stocks start moving back up over time to where we think the long-term intrinsic value of these businesses are.

Dziubinski: Now, AT&T also reports this week. Morningstar has had a somewhat differentiated opinion on the stock. We think shares are actually undervalued as we head into earnings. So talk about that and what you’ll be interested to hear about from management.

Sekera: Our longer-term investment thesis on AT&T and Verizon as well for that matter is that over time we think the wireless industry will begin to act more like an oligopoly. So what that means is we expect that they’re going to compete less on price, and that should allow their margins to expand over the next couple of years. So I’m just going to be listening for any indications in the shift in the underlying businesses there, whether or not they’re starting to see higher pricing within the plans themselves or maybe lower cellphone rebates that can help the margins start to get a little bit larger here in the short term.

Dziubinski: Let’s move on to some new research from Morningstar, and that new research is about U.S. banks. Morningstar’s lead bank analyst, Eric Compton, has taken a deep dive into some new bank regulatory proposals. First, Dave, summarize what those proposals are.

Sekera: There’s a number of different aspects here, but generally the most important one is going to be that’s an increase in the required capital levels that the banks are going to have to hold, especially the large banks. There’s some new regulatory calculations for risk-weighted assets, and what essentially that means is they’re going to have to increase the amount of capital that they hold against these assets.

Dziubinski: Eric concludes in his research that these new proposals could lead to a hit in the profitability and growth in the industry, but he calls that hit “manageable.” So what types of banks are more at risk and why?

Sekera: The greatest impact are going to be on the largest banks, those with over $100 billion worth of assets. And even more specifically, he noted that those that derive the highest percentage of their revenue from fee income will be the ones under the most pressure.

Dziubinski: Name some names from the report, Dave. Which banks are most “at risk” for some factor here?

Sekera: From a profitability perspective, he noted that Amex, American Express will see the most pressure. And then from a capital perspective, Citi, Goldman, and KeyCorp, those are the ones that’ll need to increase their capital most in order to be able to get to those regulatory minimums.

Dziubinski: Now, has this research and the findings led Morningstar to reduce fair value estimates on any of the banks that they cover?

Sekera: It hasn’t. So we didn’t reduce any of our fair value estimates, and I think there’s really two reasons as to why. First, there’s a very long time period that the banks have to implement these rules in order to get to those higher capital levels. In fact, the full impact won’t be felt until July 2028. And then second, we do expect that over that time period, the banks are going to readjust their business models, and they will probably increase pricing in order to reflect that higher capital requirement.

Dziubinski: So then does Morningstar still think banks are attractive?

Sekera: The short answer there is yes. We do think that generally the markets have pushed bank stocks down far too much earlier this year. Of course, as you remember, we did have the bankruptcies of Silicon Valley Bank as well as Credit Suisse. I took a look at our coverage here. We do cover 17 banks here in the U.S. that trade on U.S. exchanges. And of those, all of them are rated either 4 or 5 stars except for J.P. Morgan. So that’s the only one that we believe is at fair value; that’s a 3-star-rated stock. And among these large banks, we do see the most value in Wells and Citi, and among the regionals, a couple I’d highlight that we do see significant undervaluation is going to be U.S. Bank, Truist, and Comerica.

Dziubinski: Let’s move on to the stock picks portion of our program. Over the past couple of weeks, we’ve seen a market that seems to be vacillating between the idea of higher-for-longer interest rates and the idea that Fed rate cuts are on the horizon. Where’s Morningstar fall today on that opinion? What’s our opinion on it? Do we buy into this idea of higher-for-longer?

Sekera: No, we don’t. So we’re not in the higher-for-longer camp. We remain of the opinion that the Fed’s actually done hiking interest rates at this point in time. Our U.S. economics team does continue to expect that inflation will moderate not only over the course of this year but well into next year as well. But they also do expect that the rate of economic growth is going to begin to slow here in the fourth quarter. And then we’re looking for three quarters of sequential growth slowing getting to the bottom in the second quarter of next year before the economy can start ratcheting back up again. So we don’t foresee a recession, but we do think that that combination of moderating inflation as well as slowing economic growth, that’s going to give the Fed the room they would need in order to take its foot off the brake and start lowering rates next year, maybe as early as March.

Dziubinski: Let’s do a little “what if” here, Dave? What might cause interest rates to stay higher for longer than Morningstar’s forecasting? And what types of stocks would likely perform best in that higher-for-longer scenario?

Sekera: I think the most likely scenario there is if the economy doesn’t start to slow down as we expect, and that could keep inflation from falling further. And worst case actually if that happened, inflation actually could start to reaccelerate. And so then if we saw that, then yes, the Fed would need to raise interest rates in order to really try and force the economy down and force it to cool off to help bring that inflation back down. Now, if rates were to stay higher for longer, that does raise the probability of a recession and possibly even a deep recession or a hard landing. And in that scenario, I’d look to own stocks in the defensive sectors. That would be the consumer defensive, the healthcare, the utilities, specifically I would look for companies whose products are inelastic, those companies that we rate with either a wide or a narrow economic moat and specifically companies that have strong pricing power.

Dziubinski: Now, we’ve talked before on the show about stocks for a falling interest-rate environment, and we did that during the episode that aired Sept. 11. So today we’re going to do the opposite. You’ve brought viewers five stocks for a higher-for-longer interest-rate scenario. Your first two picks are from the consumer defensive sector … The first is Kellanova, which is the stand-alone global snacking operation of the former Kellogg business. What do you like here?

Sekera: We’ve talked about Kellogg’s a number of times, and we do think that that business is undervalued. Now, Kellogg did split up into two businesses. So we have Kellanova and then W.K. Kellogg. Kellanova still trades under the ticker K, and that’s the former Kellogg ticker, and W.K. Kellogg trades under the ticker KLG. Kellanova consists of all of the snack brands of Kellogg’s. So that’s going to be Pringles, Cheez-It, Eggo, Pop-Tarts, and Rice Krispie Treats. And in fact, those brands, those alone are about 50% of the company’s sales mix. And then WLK, that’s the legacy cereal business of Kellogg. In our opinion, we do think that both stocks are undervalued, but my pick here is really the snacks business. And the reason for that is it does have much higher growth potential in our view, and it does have much higher margins, plus a high percentage of its sales are in the faster-growing emerging markets. So I think that one is better set up for long-term investors. That stock is currently rated 5 stars, and it trades at a 34% discount to our fair value.

Dziubinski: Now your second pick from the consumer sector is a familiar brand. It’s Clorox.

Sekera: Yeah. And this one, it’s really just a great example of how the stock market can overreact both to the upside and to the downside. Early during the pandemic, Clorox stock just skyrocketed. Back then, if you remember Clorox Wipes, they were like gold back in early 2020. But now the pandemic is behind us and the stock’s really just plummeted. In fact, the stock is lower now than it was prepandemic. I think the short story here on the investment thesis is that sales growth is of course now stagnating, and it’s just really coming down from that rapid growth we had in 2020 and 2021. And that’s also combined with a lag in their ability to increase prices fast enough to keep up with their own inflationary cost increases. And that squeezed its margins here in the short term. Now, taking a look at our model, we do forecast margins, we’ll normalize, and get back toward historical levels in that 18% to 19% area. Currently, it’s fallen as low as into the low teens. Now in that model, we don’t get back to 18% until 2031. So, we’re looking for a very gradual increase in those margins, and that seems pretty conservative to me. Now the other thing with Clorox, I do have to note here in the short term, they did suffer a cybersecurity breach here in August that did take some of their IT systems offline, and it did disrupt operations. But in our opinion, it is just really a temporary issue. It doesn’t impact the long-term intrinsic value of the underlying business. At this point, the stock is rated 4 stars, trades at 27% discount, and I think the dividend yield’s almost 5% at this point. And I just note with Clorox, I mean rarely has that stock traded at such a high discount to our fair value.

Dziubinski: Let’s move on to healthcare sector, which as you alluded to, is also defensive, and for your third pick this week and that’s Gilead Sciences. Why do you like it?

Sekera: Gilead is rated 4 stars, trades at a 20% discount to our fair value, and I think that one’s got a dividend yield of about 4%. We do rate the company with a wide economic moat, and we rate it with a medium uncertainty. Gilead’s portfolio is focused on HIV and hepatitis B and C, but they’re also expanding into pulmonary cardiovascular diseases as well as cancer. And one of the aspects that caught my eye here was that our equity analyst, Karen Andersen, who by the way is probably one of our more experienced healthcare analysts, she noted that she thinks the company’s pharmaceutical portfolio is poised for what she calls maintainable growth. Currently the payout ratio there is 50%, so I don’t think they’re going to have any problem maintaining that dividend. Overall I just like the combination of trading at a good margin to safety from our long-term intrinsic valuation, a stable growth outlook, and a pretty high dividend yield.

Dziubinski: And then, your final two picks this week are from the utility sector, and we talked about last week’s show about utilities. The sector is trading at the most attractive discount that we’ve seen in really a long time. Your first pick in the sector is Dominion Energy. Why?

Sekera: Utility stocks have sold off, they were pretty much down and to the right pretty much all year, but they’ve really just gotten crushed and just really the past two weeks here. And according to our team, the utility sector is now trading at pretty much the … greatest discounts to our fair value that we’ve seen since, I think 2009. So from a fundamental point of view, nothing’s really changed in the utility sector overall. Dominion itself: The stock is rated 4 stars, trades at a 25% discount. I think it’s slightly over 6% dividend yield at this point. Dominion operates in Virginia, and the demographics there have been growing faster than pretty much the rest of the United States, and it’s got very good growth prospects in its renewable energy outlook.

Dziubinski: And then, your second utilities name and last pick for us this week is Entergy. Tell us about it.

Sekera: Entergy stock is rated 5 stars. It’s a 22% discount to our fair value and about a 4.5% dividend yield. And according to Travis Miller, and Travis is a very experienced equity analyst, I think he’s covered utilities for over 15 years now—in his view, he just noted Entergy just has the most attractive combination of yield, growth, and value.

Dziubinski: 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. Dave and I will be back live 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.