Where to Find Bargain Stocks in an Expensive Market

Ivanna Hampton: Welcome to Investing Insights. I’m your host, Ivanna Hampton. The stock market as a whole may be overvalued, but there are still bargains to be found. Currently, large-cap growth is outperforming other areas, but that doesn’t mean all the stocks from that category are expensive. The opposite is true with small-value stocks. David Harrell investigated whether any stocks are bucking the trend. Here’s my conversation with the editor of the Morningstar StockInvestor newsletter.

Welcome back to the podcast, David.

David Harrell: Thanks for having me.

The Evolution of the Morningstar Style Box

Hampton: The Morningstar Style Box has been around for decades. Talk about how the investing tool has evolved from describing mutual funds to what it offers today.

Harrell: It predates my time at Morningstar, but I think just recently on The Long View podcast with Christine Benz and Dan Lefkowitz, they interviewed our former colleague, John Rekenthaler, and he was talking about the development of the style box. And the idea of using a grid to describe stocks or stock portfolios did not originate with Morningstar, and I think John said back in the ‘80s, investing consultants had come up with this four-square grid, which they would use to describe portfolios as either being large cap or small cap, or value versus growth. Now, John and Don Phillips, who was Morningstar’s very first analyst, were looking at this and thought it was not sufficient to describe, say, something like the S&P 500 or an S&P 500 index fund because it’s neither value nor growth. So that led to their development of the now-familiar nine-segment Morningstar Style Box, which they introduced in 1992.

Originally, it was just to describe mutual fund portfolios, but it soon evolved. We used it for stocks, and then we created the Morningstar Market Barometer Indexes based on that. And eventually it also became the way that we categorized mutual funds, so instead of just categorizing and ranking mutual funds based on how they described themselves, we were going to do it based on how they actually invested.

What Is the Value-Growth Score for Stocks?

Hampton: Can you briefly describe what goes into the so-called value-growth score? And how does it work?

Harrell: It’s gotten a lot more sophisticated. When I started, it was still a very simple measure of, I think, price/book ratio and price/earnings ratio relative to the S&P 500. And it was that way for a number of years, but it’s now evolved into a much more sophisticated score looking at a number of historical and forward-looking value and growth financial measures. And we create a value score, growth score, and then those are combined to create an overall value-growth score, which compares stocks to their peers.

Why Investors Should Look Deeper Than Overall Market Trends

Hampton: And the style box reflects overall trends in the market. Why do you think it’s important for investors to dig deeper?

Harrell: Well, as you said, it’s reflecting overall trends. And if you look at Morningstar.com, for example, you can see on the homepage the Market Barometer. If you click to the markets page, you can see that Market Barometer for multiple time periods. So, one day going all the way up to 10 years, and you’re going to see what areas of the market have had the strongest performance. But as you said, it’s overall performance. Just because large-cap growth has outperformed, it doesn’t mean that all large-cap growth stocks have outperformed.

Investigating Stock Valuation Trends on the Tortoise and Hare Watchlist

Hampton: You investigated the valuation trends of several stocks in the February issue of the StockInvestor newsletter. You researched 120 stocks on the Tortoise and Hare Watchlist. What did you find when it came to those stocks’ valuations? And any surprises?

Harrell: First of all, if you go back to Morningstar.com, you have the opportunity to look at that Market Barometer, not just on performance but on valuation. So, the performance color scale is a red-green color scale. If you switch to a valuation view, you get another color scale, going from orange for overvalued to deeper shades of blue for undervalued. And what I was really hoping to see there was obviously there’s a correlation between performance and valuation. And, in this case, we’re measuring valuation based on price relative to the Morningstar fair value estimates for the stocks in that area of the market. And the better-performing areas of the market have seen the most price appreciation, so the better-performing areas of the market overall, you’re going to see higher price/fair value ratios.

And what I was really interested in seeing was if we went more granular, obviously large-cap growth has outperformed, large-cap growth as an area of the market has higher valuations, trading for these higher prices. But I was looking to see what goes against the grain, what’s swimming upstream? Are there stocks in areas of the market that are as a whole overvalued, but the individual stocks are undervalued?

Small-Cap Stock Findings

Hampton: Let’s talk about some of the trends that surface in your research. First, small-cap stocks: What did you find?

Harrell: Keep in mind that I wasn’t looking at the overall market, I was looking at a subset of the market, and that’s the 120 stocks that are on the Tortoise and Hare Watchlist. Now, these aren’t investment recommendations per se, but there are 120 stocks that have been identified, most of them having wide or narrow economic moats as stocks that might be potential investments for the Tortoise and Hare portfolios that we track in the StockInvestor newsletter. But we don’t have a lot of small-cap stocks in there, there’s actually only four, so that was not a surprise or anything like that because we tend to track larger-cap stocks. But no trends there, per se, but rather that most of the stocks on our list are mid-cap or large-cap stocks.

The one thing I was interested in looking at the breakdown of certain of the market capitalizations of these stocks, is that back when I started at Morningstar, the dividing line between small cap and mid-cap was a market capitalization of a billion dollars. And we considered anything with a market cap greater than $5 billion to be large cap. And, obviously, after 30 years of performance, those dividing lines are much higher. We actually adjust them each month, but it’s around $11 billion to get from small cap to mid-cap, and around $70 billion to get from mid-cap to large cap now.

Are There Any Mega-Cap Stocks on Morningstar StockInvestor’s Watchlist?

Hampton: Things have changed. Well, you also zeroed in on mega-cap stocks to see if any were undervalued compared to their overvalued category. What did you find?

Harrell: Well, first of all, not all the largest stocks are on our watchlist because several of them are actually held in the Tortoise and Hare portfolios. But two of the mega-cap stocks that are on the watchlist are Apple AAPL and Nvidia NVDA. And at the time, Apple was overvalued, and Nvidia was actually trading at something of a discount to fair value, this is at month-end January. But I was checking this morning, and Apple has gone up in price, so it’s a little more overvalued, and Nvidia has crossed over from being undervalued to somewhat overvalued again.

Hampton: And to time stamp that for everyone, we’re recording this Wednesday, Feb. 19.

Harrell: Correct. Correct, so this story was done with data ending at the end of January, so things change.

Hampton: For sure. Now, Morningstar’s value-growth methodology ranges from negative 100 to positive 400.

Harrell: Correct.

Which Stocks Earned the Minimum Value-Growth Score?

Hampton: Talk about a few names that receive that minimum score and are considered undervalued.

Harrell: Sure. So, actually, I’ll show you. This is what we ended up with in the newsletter this month. So, taking the style box methodology and going a little more granular and plotting the individual stocks based on their value-growth scores and market capitalization. And what we see here is we have some stocks that are at the absolute minimum, so they’re as value-y, if that’s a word, as you can get using the Morningstar methodology. And three of them were on that negative-100 line were Pfizer PFE, Chevron CVX, and Devon Energy DVN, and all are trading at discounts to fair value. Pfizer, I think, is close to a 40% discount to fair value, Chevron is around 10%, and Devon Energy is around a 20% discount to fair value currently.

• Nvidia stock value NVDA
• Apple stock value AAPL
• Pfizer stock value PFE
• Chevron stock value CVX
• Devon Energy stock value DVN
• Shopify stock value SHOP
• Insulet stock value PODD

Which Stocks Earned the Maximum Value-Growth Score?

Hampton: Let’s flip it to the maximum score. Which stocks earned that score and are considered relative bargains?

Harrell: There are three stocks on our watchlist that received the maximum growth score of 400. One is Nvidia, which we already discussed. It’s trading now at a premium to fair value. Shopify and Insulet also have that value-growth score of 400, and all three of them are trading at a premium to fair value right now. The one thing I was looking for is when we look at the Market Barometer colored by valuation, obviously, see a lot of orange in the large-cap growth area of the market. But when I looked at our watchlist, I did see the orange stocks here, and these are the ones that are trading at premiums of at least 10% of fair value. They weren’t clustered here; they were spread around the style box. But at the same time, when we look for what’s trading the largest discounts, it does follow that trend that we see for the overall market where as you move toward value and move away from large cap, you’re starting to see the larger discounts to fair value.

Hampton: Well, David, thank you for coming to the table, I really enjoyed our conversation.

Harrell: It was great being here, thanks for having me.

Hampton: That wraps up this week’s episode. Thanks for making this show part of your day. Be sure to subscribe to the StockInvestor newsletter to see the full watchlist. You can go to newsletters.morningstar.com to sign up or just click the link in the show notes. Thanks to senior video producer Jake VanKersen, associate multimedia editor Jessica Bebel, and digital communications specialist Kumudini Devalla. I’m Ivanna Hampton, lead multimedia editor at Morningstar, take care.