6 Undervalued Stocks to Buy After the Market Rally

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. Now, before we dive in this week, we have a programming note for viewers. We will not be streaming a new episode next Monday, Dec. 25, due to the Christmas holiday, but we will be streaming a special episode on Tuesday, Dec. 26, taking a look back at some of Dave’s stock calls from 2023, those that have worked out well and those that haven’t worked out so well, at least not yet. We hope you’ll tune in. Let’s talk about what’s on your radar this week, Dave and the PCE, or the Personal Consumption Expenditures Price Index, that number for November comes out this week. What’s the market expecting?

Dave Sekera: Good morning, Susan. Following the Fed’s shift last week to a more accommodative posture, the market is definitely looking for inflation to stay on that same downward trend that we’ve been seeing for a while now. The consensus for the headline PCE is to drop to 2.8% from 3.0% on a year-over-year basis. And then the core PCE, which is one that the Fed really is going to be focused on, for that to slow to 3.4% from 3.5% on a year-over-year basis.

Dziubinski: Given the nice market rally that we’ve been experiencing, I almost hate to ask this, but what happens if the number comes out a little hotter than expected?

Sekera: Well, of course, it’s always going to depend on just how much hotter it comes out over consensus. And I hate to joke about it, but if inflation comes out being much higher than expected, I’d say put on your hard hat because stock prices are going to be falling. But all kidding aside, anything that comes out, whether it’s this number or commentary from some of the other Fed officials, anything that would cause the market at this point to really reevaluate that current assumption that the Fed has not only done hiking, but it’s going to actually start moving to make a more accommodative monetary policy by reducing rates, would certainly send the markets plunging, in my view.

Dziubinski: Also on your radar this week are a couple of earnings season stragglers. The first is Carnival CCL. The stock’s run up quite a bit during the past month. What do we think of the stock heading into earnings?

Sekera: Carnival stock is still rated 4 stars, trades at a 15% discount to our fair value, and it is a company that we do not rate with an economic moat. But, in our view, that stock is still undervalued even though it’s up, I think, 70% from its October lows, and it is back to its 52-week high. Now, at the end of last week, I did speak with Jaime Katz, she’s the senior equity analyst on our team that covers the cruise lines, and there’s a couple of things that she’s listening for. The details on occupancy and pricing, both of which, in her view, should still be improving. And I think she’s also going to be interested to see if Carnival has some opportunities to be able to refinance some of that really high-cost debt that they had to take out during the pandemic. But the single most important factor is going to be earnings guidance, and I know she’s forecasting this company will finally be able to start to post positive earnings for the first time since the pandemic this year or into 2024.

Dziubinski: General Mills GIS also reports this week, and that stock’s having a really tough year. What’s been going on there and what do we think of the stock heading into earnings?

Sekera: All the food stocks really have had a tough time thus far this year, but it’s a 4-star-rated stock, trades at a 17% discount to our fair value, and pays a pretty good dividend yield at 3.5%. It is a company we do rate with a narrow economic moat. I did speak with Kris Inton, he’s the equity analyst who covers General Mills for us. And there’s a couple of things that he’s looking for this earnings season.

First, just whether or not margins have turned the corner and are starting to improve. We’ve seen that among a number of other different food companies that have already reported thus far this year. Secondly, the composition of organic growth. Essentially how much, if any, trade-off has there been between volume and pricing as they’ve been increasing their pricing? And then lastly, just some commentary on the promotional environment. For example, are food companies using pricing in order to try and gain market share at the expense of margins, or are they really staying much more rational in this point?

Dziubinski: Let’s move on to some new research for Morningstar. We’ll start off with Morningstar’s take on last week’s Fed meeting. The Federal Reserve left rates unchanged and penciled in three rate cuts in 2024, and the market soared in response. What did Morningstar think of what the Fed had to say?

Sekera: Well, to be honest, we just were not surprised. That’s really kind of what we have been expecting for a while. So Preston Caldwell, who’s our chief U.S. economist, he’s forecast that that first rate cut would be in March 2024. In fact, I think it was in his June 2023 outlook that he first noted that he thought the Fed would start cutting rates here in March 2024. And to be honest, I really have to hand it to him. He’s really stuck with his convictions since he first made that call.

Taking a look at the futures market, just one month ago there was only a 24% probability of a rate cut. Looking at the futures market this morning, the market’s right now pricing a 68% probability of a 25-basis-point cut. In fact, there’s now a 7% probability of a 50-basis-point cut and only a 25% probability of no change.

Now, we’ve also talked in the past about how when the Fed is messaging it has to take it slow and easy. It doesn’t want to make too abrupt of changes, as I think that could shock the markets. The current Fed is now projecting three 25-basis-point cuts here in 2024. But I do recommend viewers to go to Morningstar.com and watch Preston’s recent interview. It’s titled, “We Predict 6 Interest Rate Cuts in 2024,” which is essentially double the amount that the Fed is currently projecting, and he really walks through and explains his assumptions behind that forecast in that video.

Dziubinski: Speaking of new research, Dave, you’ve begun work on your 2024 stock market outlook, and we’ll be talking about that during our first episode of the new year in January. Let’s walk through what happened in the market in 2023.

Sekera: If you remember, according to our valuations coming into 2023, we noted that we thought the market was significantly undervalued. And when I look at the market over the course of this year, I really think there’s really three main phases that the market underwent. First, at the beginning of the year in January and February, the market did start moving up, but then we had the collapse of Silicon Valley Bank and Signature Bank, and then even Credit Suisse, one of the major international banks failed, and the market did drop pretty hard in March.

The second phase really began in the spring and the summer, and that was the emergence of the “Magnificent Seven” and artificial intelligence. And so we saw the market really march higher, in fact, getting all the way up towards fair value in the fall. And then the third phase was as interest rates continued to climb over the course of the year really wasn’t a problem until we really started getting up toward 5%, and the markets didn’t like that. The markets sold off once we got in the upper four handle, and especially those interest-rate-sensitive sectors fell pretty hard. And that sent us back down into undervalued territory in October as interest rates then started to subside.

The Santa Claus rally began going up earlier this year, starting in the beginning of November. And it’s really continued here now that the Fed is shifting toward a more accommodative policy. And at this point when we look at the market, it’s essentially trading right back at fair value once again.

Dziubinski: Let’s unpack a few of these stories. Remind viewers why we saw a few bank failures in 2023 and then what the implications are for the banking industry moving forward.

Sekera: Well, you have to remember, bank failures are almost always a lack of confidence in the solvency of a bank by its depositors. So in this case, at Silicon Valley Bank, they had a huge amount of long-term debt on their balance sheet that they bought when interest rates were at their lows. As rates started to begin to rise, the value of those long-term bonds fell, and that left the bank with just exceptionally large losses in its hold-to-maturity accounts. Now, some depositors noticed that they started getting to be nervous that the bank was no longer well-capitalized and started to pull their money out, which then once other depositors saw them pulling their money out, they decided to get their money out as well. And it just got to the point where the bank wouldn’t be able to repay all those depositors who were pulling their money out.

So, the Fed had to come in, shut the bank down until it could be restructured and sold off. And of course, that then started the chain. Once Silicon Valley Bank failed, everyone started to look to see what other banks had similar losses in their balance sheets, started pulling money out. Credit Suisse had some slightly different issues, but once deposits there started getting pulled out, that became a self-fulfilling prophecy there, and that bank failed as well.

The end result is that investors decided, and stock investors specifically, didn’t want to risk seeing the value of their stocks plummet, so they then sold first and decided to ask questions later, and that sent the entire U.S. regional sector down. As a lender of last resort, the Fed did step in. They devised a couple of different funding programs for banks that had these hold-to-maturity losses, that then stabilized the banking system. In our view, throughout most of this, we noted that the U.S. banking system, specifically the regional banks, was under stress but fundamentally they weren’t broken. And so we do think that the markets have pushed these stocks down for the regional banks too far during that selloff, and a lot of them are still very undervalued today.

Dziubinski: Turning to the second big story of 2023, and that’s definitely AI and the “Magnificent Seven,” do you expect these seven stocks to continue to dominate markets again in 2024?

Sekera: We don’t. We think that for the most part, these stocks have really run their course. So coming into the year, six of those seven were significantly undervalued. They were rated either 4 or 5 stars, but now five of them are in that 3-star territory, meaning we think they’re pretty close to being fairly valued. And they’re rated 3 stars. Apple AAPL being the only one that’s now overvalued and rated 2 stars. And lastly, Alphabet GOOGL, the parent of Google, is still undervalued and rated 4 stars. But for the most part, I think that that’s really a story of 2023 and not going to be a story of 2024.

Dziubinski: And then again, the last story is really interest rates in 2023. In your midyear bond market outlook, you suggested that investors start to lengthen their durations, and you actually reiterated that view just on last week’s show. So, given what we’ve heard from the Fed, what are Morningstar’s expectations for long-term interest rates in 2024?

Sekera: It was really some pretty crazy price action in the bond market after the Fed meeting. And to be honest, I mean, rarely have I seen moves like that in the bond market in such a short period of time. When I look at the 10-year Treasury, that rallied on Wednesday, the yield fell about 17 basis points, dropped to just above 4%, then it declined another 10 basis points on Thursday to 3.93%, and that’s where it ended up the week. Looking forward, we’re still holding to our forecast. We’re still looking for the 10-year to average, about 3.6% over the course of 2024. But then we also expect it’ll continue to keep coming down, and we’re looking for an average of 2.75% percent over 2025.

Dziubinski: Let’s move on to the picks portion of the program. You’ve brought viewers six top stocks to buy that tie into the three market catalysts we’ve just talked about today. All of these names still look undervalued even after the market’s rally. Your first two picks tie into that “Magnificent Seven” mega-cap theme and the picks are Alphabet, which you mentioned, and Exxon Mobil XOM. Tell us about them.

Sekera: Alphabet is still rated 4 stars, trades at about an 18% discount to our fair value, and it is a company that we do rate with a wide economic moat. The question here is what do we think the market is missing? And I think it’s really a combination of the three main profit drivers all working together at the same point in time. When we look at search advertising, that’s still doing very well. When we look at YouTube, the company’s been increasing their ability to monetize that, and we’re looking for better operating margin performance in that division. And in the cloud business, the rate of growth there has been starting to slow, but we still think that there’s a long pathway there of additional growth yet to come.

I think the other problem with Alphabet, so I think that there’s a perception in the market that it’s fallen behind in the race to develop AI. And I talked to Ali [Mogharabi, Morningstar senior analyst] and that’s certainly not his view here. He’s noted that Google has been developing its own AI for a very long time. He also pointed out a recent demonstration that they’ve done of Gemini, and he thinks that proves the point that they’re not falling behind in AI. Plus, I also note, just based on the size of Alphabet, I mean they have the capital and the resources to develop AI like very few others out there.

As far as Exxon Mobil, or Exxon, again, that isn’t a “Magnificent Seven” stock, but I do think that it is large enough, has enough market cap, and it’s undervalued enough that if we really start to see that stock move up toward our fair value, we do think that that will be enough to skew the markets higher in 2024. It’s a 4-star-rated stock, trades at a 20% discount to our fair value, 3.8% dividend yield. And the story here is, I think it’s just production we do expect we’ll continue to keep growing modestly through 2027. And I think really what we’re looking for here is an increase in profitability over that same time period based on a mix shift to higher-margin-producing fields.

Dziubinski: Now your next two picks tie into the banking story from 2023, and the picks are U.S. Bancorp USB and KeyCorp KEY. Why do you like these two names in particular?

Sekera: Starting off with the U.S. Bank, it’s a 4-star-rated stock, trades at an 18% discount, has a 4.3% dividend yield. And this has really long been one of our better picks in the regional bank sectors. I’d also note it is one of the few banks that we do rate with a wide economic moat. Again, all the regional banks have come under pressure from higher funding costs from deposit loss earlier this year. But we think U.S. Bank is probably the one that’s best positioned to be able to mitigate these deposit losses.

Now, KeyBank is a little bit of a different story. It is a 4-star-rated stock. It’s the most undervalued of our regionals, trades at over a 30% discount to our fair value, pretty high dividend yield of 5.7%. But I would caution investors we do not think it has an economic moat, but it does have a couple of attributes that I think the market is missing.

First I would say KeyBank does have several net interest hedges that have depressed their earnings over the past year or so, and those should begin to roll off in 2024 and into 2025. That should help earnings growth as those roll off. And second, KeyBank is more levered to investment banking revenue than what we see among the other regional banks. And investment banking activity has been pretty muted in 2022 and 2023, but I do think that investment banking should begin to recover in 2024, and I think that’s also going to help boost profitability at Key.

Dziubinski: And then your final two picks this week tie into the catalyst of interest rates. Both of them are from sectors that are sensitive to interest rates, and that’s utilities and real estate. The picks are NiSource NI and Realty Income O. Tell us about them.

Sekera: First in the utilities sector, we’ve talked a number of times about Entergy ETR and NextEra NEE, so I wanted to bring something different. NiSource is a five-star-rated stock, trades at an 18% discount, and it has a 3.8% dividend yield. And like most utilities, it does have a narrow economic moat. I went and I spoke to Travis Miller, he’s the strategist on our utilities team, and he noted that he thinks that NiSource just has a superior runway of growth. Really what he’s looking at is growth in renewable energy in the Midwest specifically, and he thinks that supports at least a decade of faster-than-average growth in the utilities sector.

And then lastly, I’d like to highlight Realty Income. It’s a 5-star-rated stock, trades at a 26% discount, and has a 5.4% dividend yield. Now, like most REITs, it does not have an economic moat. But one thing that I like here is Kevin Brown, he’s the equity analyst who covers REITs for us, recently did an analysis of the entire REIT sector looking at how the REITs perform under different interest-rate environments. And he found that Realty Income is going to be the stock in our REIT coverage that’s most highly correlated with interest rates. So, as rates continue to come down, this is the one that we think has probably the best leverage to the upside.

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. Dave and I wish all of you watching a lovely holiday season. We’d also like to extend our thanks and holiday wishes to our video producer Scott Halver, who brings us to you live on Monday mornings. As a reminder, tune in next Tuesday, Dec, 26, at 9 a.m. Eastern, 8 a.m. Central for a special edition of the show where we’ll be taking a look back at some of Dave’s stock calls from 2023. In the meantime, please like this video and subscribe to Morningstar’s channel. Happy holidays.