3 of the Best Contrarian Investments Today

Susan Dziubinski: In your March stock market outlook, you say that now is a good time to begin to invest in contrarian plays, but you say that’s not just for the sake of being a contrarian. Unpack that for us.

Dave Sekera: Maybe I’m a little on the early side to this one, but based on our valuations, I do think now’s a good time to start breaking away from the herd. And just to give you a bit of background, thinking about the trend that we’ve had for the past 15 to 16 months, in our 2023 outlook, we did note that both growth stocks as well as technology stocks were very undervalued. Technology was one of the most undervalued sectors at that point in time. And then also coming into 2023, when you look in the “Mag Seven” stocks, six of those seven were either 4- or 5-star-rated stocks. Since then, the growth category is up. Tech’s up even more. And when we look at those Mag Seven stocks, three of them are now overvalued, three are fairly valued, and only Alphabet GOOGL is undervalued.

Taking a look at it by growth, the growth categories are at a 3% premium, and tech is at an 8% premium. While not the most overvalued that each of those has traded, I do think it’s a good time to take some profits in those areas. Of course, the question is, if you take profits, well then what do you do? Where do you put that money? So, I started looking for some of those areas, some of those stocks specifically that have underperformed this market rally, are currently unloved by the market, and are, in our view, undervalued. We looked across all of those sectors and stocks and essentially tried to find where have they lagged the broad markets to the upside, where do we see a lot of negative market sentiment, and which ones are now trading at a good margin to safety from their intrinsic valuation.

Dziubinski: In your outlook, you outline three good places for investors to look for these contrarian plays. As you say, these places are all underperforming, unloved, and undervalued. The first is real estate. Recap what’s been going on in the sector and why you like it.

Sekera: Commercial real estate has got to be probably the most hated asset class across the Street right now. First, there is still a huge amount of uncertainty regarding valuations for urban office space. And secondly, real estate has been adversely affected by the increase of interest rates over time. And both of those have brought valuations down across the entire real estate sector. The real estate index did drop 25% in 2022. It only rose 2% last year, and it’s actually down again 2% this year. Personally, I’d still steer clear of urban office space, but other areas we do think have gotten pulled down with that urban office space too much, especially those real estate sectors that we think have more defensive type of characteristics. And then lastly, I would note the Morningstar US economic team does project interest rates will decline later this year. We’re looking for the entire yield curve to decline over the course of this year and next. And I think those declining interest rates would then provide a good tailwind for the real estate sector.

Dziubinski: You also suggest investors look for contrarian ideas in the utilities sector. Why?

Sekera: It’s just a combination of three things: one, valuation, two, fundamentals, and three, interest-rate expectations. Now utilities were only up 1.6% in 2022. They were down 7.0% last year in 2023, and now they’re down again over 2.0% year to date. That puts the sector now at a 10% discount to our fair values. And fundamentally, when you talk to our equity analysts, they think the utilities space is as strong as they’ve ever seen it. They see a long runway of growth here for the transition into renewable energy. We’re seeing a lot of government investment in the electrical grid infrastructure. That should all provide some pretty good growth for the utilities space over the next couple of years. Plus, we do think that the tailwind behind declining interest rates will be positive for them over the next few years.

Dziubinski: And your last contrarian sector is energy. Explain the dynamics of what’s been going on there and why it’s undervalued.

Sekera: When I look at energy and look at our oil and gas stocks, what’s embedded in our models is that we project oil demand should peak later this decade and then start to gradually decline thereafter. We also project a midcycle oil price of $55 a barrel for West Texas. So, again, we’re not looking for really a lot of upside here from a fundamental perspective, but even based on those assumptions, the energy sector is trading at a large discount to fair value. The downside here would be if demand falls faster than what we currently expect. However, I don’t think that we’re being all that aggressive. I think we’re probably one of the more conservative forecasts on the Street for demand. And, of course, the other downside would be if oil prices were to fall more than what we’re currently projecting.

Now to the upside, if those assumptions that we currently have in our models do come to fruition, energy is one of the more undervalued parts of the market today. And, of course, if oil prices stay higher or if demand is better than what we expected, I think there’s a lot of upside leverage here. And then lastly, I do think the energy stocks could also benefit if we see a rotation in the value stocks, higher demand for higher dividend-paying stocks. And then lastly, I do think the energy also acts as just a good natural hedge in your portfolio, not only for inflation but for any other additional geopolitical risk.

This is an excerpt from the March 4, 2024, episode of Monday Morning Markets with Morningstar’s Dave Sekera. Watch the full episode, 3 Stocks to Sell and 3 Stocks to Buy in March. See a list of previous episodes here.