Stocks to Buy in 2023: How’d We Do?

Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar, and welcome to a special edition of our Monday Morning Show. Every week, 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. Today, we’re doing something a little different before we ring in the new year. We’re taking a look back at some of Dave’s stock calls from 2023. Some of the calls turned out to be winners, and some haven’t quite worked out, at least not yet.

Before we start naming names, Dave, let’s take a step back and talk about Morningstar’s approach to stock investing. What would you say in a nutshell are the basics to our approach?

David Sekera: I’d say our approach is a focus on long-term investing and using a combination of quality and valuation to look for investment opportunities. Now, from a quality point of view, we look for those companies that we rate with an economic moat. Since an economic moat is just a Warren Buffett term, looking for those companies that we think have long-term durable competitive advantages, and those competitive advantages will allow those companies to be able to generate excess returns over the long term. We then pair that with valuation. Specifically, we are looking for companies where the stock is trading at a significant margin of safety below its long-term intrinsic value. What is intrinsic value? Essentially, that’s the present value of all the future free cash flows that the company is going to be able to generate over its lifetime. In order to calculate that, we use a discounted cash flow model for that calculation.

Dziubinski: How long, Dave, does Morningstar assume it’s going to take for a stock to hit what we call our fair value estimate?

Sekera: As long-term investors, I think part of our job here is really to try and help people look through that day-to-day, even that month-to-month noise that drives a lot of the market volatility in the short term. So, between that market volatility, between changes in market sentiment, and of course, it’s going to be dependent on a case-by-case basis. But I would say that when our assumptions are correct, we assume that sometimes it can take up to three years for the market price of a stock to converge toward what we think is its intrinsic value. And, of course, it can be a shorter time frame, but I would say three years is the longest that we expect that to occur.

Dziubinski: Morningstar’s time horizon for a stock to reach that fair value is more than a year, but that’s not going to stop us from taking a look back at some of your stock picks and pans from 2023. We’re going to delve into three of your calls that were hits and three that were misses. Let’s start with a miss. This stock was on your list of stocks to avoid this year—I think on it twice. The stock is Nvidia NVDA. Talk about what happened this year.

Sekera: Nvidia was just a wild ride over the course of this year. In fact, if I show the chart here, Nvidia actually started the year as a 4-star-rated stock. That stock at the beginning of the year began to climb higher and higher and moved into 3-star territory. So, it went from undervalued to what we thought was fairly valued, but that stock just kept moving up. And by early May, it moved into 2-star territory, meaning at that point, we thought it was overvalued. Now, later in May, that stock jumped even higher after reported earnings, but specifically, the reason it jumped was because it provided guidance as to the extent of the amount of rapid growth and demand that they were seeing for its GPUs. Those GPUs are what they use in order to be able to power artificial intelligence. At that point in time, our equity research team did increase our fair value by 50%, taking it up to $300 a share from $200. But at that point, the stock had already moved up to $400 per share and remained in 2-star territory. Now, in August, Brian Colello, he is our sector director for the technology team, assumed coverage of the stock. And he really went through and reevaluated our growth and our margin forecasts. And based on his new assumptions, he then moved the fair value of the stock up 60% to $480 a share from $300, at which time that stock moved back into that 3-star trading range.

So, when I look at the story over the course of the year and really think through the dynamics here, in my opinion, I think this is just a case where at first, we really failed to fully understand the scope of the demand and just how much rapid growth for Nvidia’s GPUs there were out there and how long this demand will probably last. I think we also missed just the potential for just how much Nvidia’s margins are going to increase over time. In fact, we’re forecasting them to double over our forecast period. And then just to provide a little bit more perspective of the kind of growth that you’re looking at here. And in fact, I have a hard time thinking of any other companies this large that have seen these kinds of growth dynamics. I mean, this is usually what you’d expect to see in more of like a startup company than anything else. But when we look at Nvidia’s data center business, and that’s where these AI GPUs are located, it’s tripling from $15 billion in revenue in 2022 to $45 billion in calendar 2023. And when we look at total revenue, that’s projected to grow all the way up to $121 billion by 2028. So, again, just huge rapid growth developments in Nvidia.

Dziubinski: Would you say that Nvidia is still a stock to avoid from your perspective as we’re heading into 2024?

Sekera: I think that really just depends on the type of investor you are. At this point, Nvidia is probably trading pretty close to our fair value. So, what that means for investors is that if you’re to buy that stock today, we estimate that you would essentially earn its cost of equity over the long term, which right now for Nvidia is 9% if our base case is accurate. Now, I’d also note we do rate Nvidia with a Very High Uncertainty Rating. It’s just very difficult to forecast these kinds of situations in the short term, much less even over the long term. So, when I think about Nvidia, there still could be a lot more further upside if Nvidia is able to maintain their dominance of GPUs for AI over the next couple of years. But there also could be some pretty significant downside if a competitor is able to roll out a competitive product and start taking away some of that market share. So, personally, I just expect there’s probably going to be a lot more volatility in this company’s stock price over the next couple of years, really as the demand for those GPUs and how AI evolves over the next few years.

Dziubinski: Like you said, it seems like a lot of uncertainty there. So, let’s move on to one of your winning stock picks from 2023. This winner is a mega-cap stock from the “Magnificent Seven,” and it was also one of your picks on our very first show in January 2023. It’s Tesla TSLA.

Sekera: So, with Tesla, I think, first of all, you need to remember, the value of Tesla is not going to be based on the number of cars they produce this year or even the number of cars they produce next year, but really on those growth assumptions of just how fast and how far can this company grow over the next decade. So, again, when we think about this company, we’re really looking at how many cars we’re projecting this company will make in 2030. So, as such, with all of that growth in the future, that makes Tesla’s stock extremely volatile. If we look at Tesla’s performance over the past couple of years, it was up 50% in 2021 and dropped 65% in 2022. In my opinion, 2023 was really a story about valuation as well as fundamentals. So, according to our valuations, the stock came into 2023 being very undervalued. It was rated 4 stars. It was trading at a 35% discount to our fair value when we highlighted it on that Jan. 23 show. And of course, over 2023, production was growing. Tesla has, I think, really been able to prove out its ability to be able to make cars that consumers want and be able to grow quickly as its production is expected to grow quite significantly over the course of the next decade.

Dziubinski: What do you think of Tesla today? Is it too expensive?

Sekera: Our fair value on Tesla stock is $210 per share and it’s currently trading at a premium to that fair value. So, for investors that want to buy that stock today, we estimate that if our base case is accurate, it would actually earn slightly less than its cost of equity, which is 9%. Of course, that return could be greater if growth is faster or greater than what we expect. Or that return could be lower if growth is slower here. I’d also note Tesla is also a Very High Uncertainty stock. Personally, I think this is a stock that’s probably still most appropriate for investors that have a pretty high risk tolerance.

Dziubinski: Let’s move back over to a call that was a bit of a miss, at least so far. It’s a company that fits into one of the themes we talked about more than once on the show, and that’s med tech. The stock is Illumina ILMN. What happened here?

Sekera: Yeah, Illumina, I mean, it’s really been quite the story stock this year. I mean, we’ve even had activist investor Carl Icahn get involved in this one. So, our original investment thesis here was Illumina had acquired another company called Grail, and Grail makes a liquid biopsy product. It’s currently in testing. And this test can screen for up to 50 different types of cancer in one blood draw. So, if it’s approved, we think this just has huge total addressable market potential. In fact, according to our analyst team, we think that this liquid biopsy product really is a game changer as far as when cancer is detected and when you can start treating that cancer. So, our valuation on this company was really a combination of, one, just the value of the legacy business of Illumina, and then valuing what we thought was the upside potential for Grail, and the combination of those two valuations was much higher than what the market price has been.

In November, we did lower our fair value by 15% to $228 from $269 a share. And part of that was just due to guidance on Illumina’s legacy business that I think was kind of disappointing from what we were expecting. But over the course of the year, there’s been a lot of regulatory issues here as well. So, the regulators in both the U.S. and the EU have ruled that that acquisition is anticompetitive. So, at this point, Illumina management is essentially kind of throwing in the towel on that acquisition and is going to end up divesting Grail in 2024.

Dziubinski: The stock looks really undervalued today. How do you feel about it?

Sekera: The stock is still significantly undervalued. It trades at a very deep margin of safety from our intrinsic valuation. It is a company that we do rate with a narrow economic moat, meaning we do think they have some long-term durable competitive advantages. So, right now, we estimate that the legacy Illumina business is worth $180 a share, and Grail is worth $48 a share. So, in 2024, I think it’s going to largely depend on how Illumina decides to divest Grail. Now, our opinion is that the best outcome for investors will be to spin off Grail to existing shareholders. We think that that’s probably the best way to preserve the value of Grail. The downside here would be if management decides to make just a quick fire sale, which in the current market environment, we don’t think that they would probably recognize the full value of Grail. So, after the divestiture, I do think that the stock might have some better performance as investors can better evaluate each business as a stand-alone, again, with our hope that they end up spinning it off, so investors still own the legacy business as well as still have the upside potential in Grail. And of course, at that point, when those two companies are separated, we won’t have that regulatory overhang.

Dziubinski: Moving on to your second winning pick this year that we’re going to talk about, which is a tech stock. The stock was one of our technology team’s top ideas for both the first and second quarters of 2023. The stock is ServiceNow NOW. How did it work out?

Sekera: It worked out very well. According to our tech team, ServiceNow just had the best combination in the tech sector of top-line growth, some of the highest margins in the industry, and a very strong balance sheet. Fundamentally, ServiceNow has posted just very solid performance all year long. In fact, looking forward, we still forecast robust demand for its products and its services, and we’re still looking for even further margin improvement derived from its very tightly focused operations.

Dziubinski: Dave, is the stock still a pick today, or has it become too expensive?

Sekera: Well, unfortunately, following this runup, it is starting to look a bit expensive, in our view. I mean, it’s not as overvalued as some of the other tech names have become in the last couple of weeks of the year here. But, essentially, at this price I’d probably look for other opportunities that trade at a discount to our fair value instead.

Dziubinski: Your last miss that we’ll talk about today is a stock that ties into another growth theme we’ve discussed on the show a couple of times during the year, and that’s the move toward electric vehicles. The stock is Albemarle ALB. Why hasn’t this stock panned out?

Sekera: Well, as you can imagine, as one of the largest lithium producers, Albemarle can get swung around in the short term based on what’s going on with lithium prices. And lithium prices, they had just skyrocketed higher in 2022. In fact, they were well in excess of our long-term price forecasts, only for lithium to crash here in 2023, and are actually now currently trading below our long-term forecasts. So, this is one of these stories whereas a long-term investor, I think you need to look past these short-term fluctuations. So, the investment thesis here is that we have modeled out the amount of lithium that’s currently produced and the amount of lithium that’s projected to come online over the next decade. And then we compared that to our projections for demand. And we just don’t think there’s going to be enough lithium supply over the next decade to be able to keep up with the amount of demand and as such, that’s just going to keep prices well above their marginal cost of production, at least all the way out till 2030.

Dziubinski: Do you think the stock is still a good opportunity from your perspective?

Sekera: We do. We think it’s a very good opportunity. In fact, we think that investing in the lithium producers is probably one of the better ways actually to invest in growth and EVs. And not just EVs. Lithium is also needed in those batteries that are used to store renewable energy. Again, a lot of demand over the next decade for that as well. So, the stock is significantly undervalued here. It trades at a very deep margin of safety from our intrinsic valuation. And looking at the charts here, and don’t necessarily hold me to this in the short term, but it does look like lithium prices are starting to bottom out here and could be poised to begin to start recovering in 2024.

Dziubinski: The final pick we’ll discuss today turned out to be a winner. It, too, ties into a growth theme we talked about on the show this year more than once. That theme is cybersecurity, and the stock is CrowdStrike CRWD.

Sekera: The theme here is just thinking through all the geopolitical events that we’ve been through over the past couple of years, looking at the increase in both cybercrime and hacking out there. The need for cybersecurity, unfortunately, just does have a long-term structural tailwind behind it. So, at the beginning of 2023, all of the cybersecurity stocks, in our view, were generally undervalued. And one of the things I really like about cybersecurity is that the spending on cybersecurity itself is still a pretty small percentage of your overall IT budget. But the cost of succumbing to some sort of cyber event has huge monetary and reputational costs. So, as such, this is just one area that management teams, they’re not going to cut back spending, even in an environment where maybe the economy is slowing. So, I do think that there is a good, steady tailwind for this business, both from a fundamental point of view as well as a long-term thematic point of view.

Dziubinski: What do you think of CrowdStrike as an investment today, Dave?

Sekera: Well, unfortunately, this is another one where it’s run up so much thus far this year, that it’s now trading at a pretty significant premium to our $220 fair value. So, I do see better opportunities elsewhere for investors. But I would keep this one as well as a number of the other cybersecurity stocks on a shortlist to watch. And if you do see some good pullbacks here, this would be one area I would like to get back invested in for the future.

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. As a reminder, we will not be streaming a new episode next Monday, Jan. 1, due to the New Year’s Day holiday. But tune in on Monday, Jan. 8 at 9 a.m. Eastern, 8 a.m. Central, for our first show of the New Year, where Dave and I will discuss his expectations for stocks in 2024. In the meantime, please like this video and subscribe to Morningstar’s channel. Happy New Year.