Editor’s note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.
The S&P 500 ended the first quarter with a stunning 20% loss. We think stocks overall are undervalued: The median stock in our North American coverage universe traded at 22% discount to our fair value estimate at quarter's end.
“Of the roughly 800 North American stocks we cover, a hefty 67% have an undervalued rating of 4 or 5 stars, whereas three months ago, only about 20% were undervalued,” observes Jeffrey Stafford, Morningstar's director of North American equity research, in his latest stock market outlook.
Energy remains the cheapest sector in our coverage universe, and we think the sell-off in consumer cyclical stocks is overdone, adds Stafford. Standard recession-resistant sectors--technology and utilities--now trade at discounts to our fair values after being overvalued at the start of the year.
Here are some specific undervalued stocks across sectors that are among our analysts' best ideas.
Basic Materials More than 70% of the stocks we cover in the basic materials sector traded in 4- and 5-star territory at the end of the quarter reports director Kris Inton. We're seeing attractive risk-adjusted opportunities in the building materials and agriculture industries, which have less exposure to the current macroeconomic environment.
“We see little demand impact across the agriculture sector, as our base case for 2020 assumes farmers will still plant crops globally,” explains Inton. “As such, we continue to expect a significant rebound in U.S. acres planted following 2019's lowest total plantings in over a decade due to flooding.”
Communication Services Overall the sector held up a bit better in the first quarter than the rest of the market, observes sector director Mike Hodel. In particular, heavyweight Alphabet GOOG GOOGL lost only about 15%. And although advertising spending will take a hit, we don't expect Alphabet's market dominance to wane.
“The stock now looks more attractive to us than it has since the short-lived market downturn in late 2018,” he argues.
Hodel adds that we expect telecom to hold up well in the face of recession, and several high-quality firms in the traditional telecom sector--including AT&T T, Comcast CMCSA, and Verizon VZ--are on sale. And despite closing its parks, Disney DIS should manage reasonably well given its strong content franchise and solid balance sheet.
Consumer Cyclical The median stock in the sector was trading at a 33% discount to our fair value estimates at quarter's end, and 80% of the stocks we cover were trading in 4- and 5-star territory, says director Erin Lash. Travel and leisure firms have been among the hardest hit this year, she adds, and as a result, are trading at much steeper discounts.
“We expect travel demand to wane in the short term due to expanding travel restrictions, but when considering the impact of SARS (2003), we believe any impact will reverse over a longer horizon,” argues Lash. We think travel demand will remain weak through the second quarter before rebounding in the latter half of the year. We also think restaurants have been unfairly punished. Specifically, restaurants that have made technological advancements, those that are value-oriented, or operate with a franchise system with healthy balance sheets are well positioned to weather near-term headwinds, she concludes.
Consumer Defensive After trading at premiums during the past few quarters, the median stock in our consumer defensive coverage was trading at a 14% discount at quarter's end. In particular, the tobacco and beverage (nonalcoholic and alcoholic) industries look particularly attractive, remarks director Erin Lash.
COVID-19 has certainly affected consumer behavior, notes Lash. Food producers should benefit as food consumption shifts to the home, but we don’t expect these gains to persist over a long timeframe. Online grocery ordering could boost retailers with an omnichannel presence, but because digital sales remain more costly than in-store transactions, bolstered adoption could lead to a pre-existing profit headwind, she concludes.
Energy Director Dave Meats admits that the energy sector "sits in a precarious position heading into the second quarter." Indeed, the Morningstar US Energy Index fell 49% last quarter, driven by reduced demand due to the COVID-19 outbreak and worries about OPEC+ production cuts.
“In the near term, investors have every reason to be worried,” concedes Meats. “We project 2020 oil demand will fall 2.8 million barrels per day (2.8%), the largest single-year drop in nearly 40 years.”
However, we think that long-run oil demand will be unscathed by the pandemic after a near-complete recovery, and therefore find plenty of opportunity in the sector, which traded at a 49% discount to our fair value estimate at quarter’s end.
Financial Services Financial services stocks as a group underperformed the market last quarter by nearly 7 full percentage points, reports director Michael Wong.
“The recent underperformance of the financial sector is understandable, given that two of its primary earnings drivers, interest rates and asset prices, have been in freefall over the past several weeks because of the coronavirus outbreak,” he explains. And he thinks financial sector earnings are poised for a significant decline.
That being said, the median financial services stock traded at a 27% discount to our fair value estimates at the end of the first quarter, suggesting that there are opportunities despite the uncertainty.
Healthcare The sector hasn't been immune to the broad market sell-off, says director Damien Conover; in fact, the sector was trading about 14% below fair value at quarter's end.
“We believe concerns about a global recession due to the coronavirus disruption are weighing on returns, but the defensive nature of healthcare is supporting returns on a relative basis,” he observes.
Near-term, we expect fewer elective procedures to negatively affect device makers and service providers, and higher-than-expected medical costs related to coronavirus may weigh on the profitability of health insurers. We expect there to be less impact on drugmakers in general, notes Conover, though clinical development timelines may be delayed due to coronavirus disruptions.
Industrials The median stock in our coverage universe was trading about 20% below fair value at the close of the first quarter, with industrial conglomerates, construction, and aerospace and defense among the most undervalued industries, says director Brian Bernard.
“We think defense prime contractors are a smart play for investors concerned with unfavorable cyclical turns,” asserts Bernard. These companies aren’t vulnerable to the business cycle since they’re largely funded by government spending, he emphasizes--and increasing focus on great-powers competition suggests that the military will continue to modernize. Bernard also points out that U.S. agricultural output is unlikely to be affected by coronavirus.
Real Estate The median stock in our coverage universe was about 29% undervalued at the end of the first quarter, notes analyst Kevin Brown.
“As a result of the recent equity sell-off, dividend yields have dramatically increased,” explains Brown. “We currently believe that most REITs will continue to pay their dividend, making these high yields very attractive to investors.”
The hotel industry has been especially hard-hit, as have mall companies and healthcare companies exposed to senior housing. However, we think these industries will rebound and see years of strong growth once the crisis ends.
Technology Tech stocks slumped in the first quarter but outperformed the broader market. The median stock in our coverage universe was about 13% undervalued at the end of the quarter, with opportunities across all subsectors, relays director Brian Colello. Although hardware is the cheapest industry, we're particularly fond of high-quality software names that are on sale.
“Each of these firms generates revenue on a subscription basis with little risk of cancellations, even as work shifts to homes and away from the office,” he explains.
Cybersecurity firms are also appealing, not just because of their subscription models, but for the additional cybersecurity demands from people working from home.
Utilities After a long period of being the market's darlings, utilities fell to Earth in the first quarter. Shares are the cheapest they've been since 2008--and yields are historically attractive relative to interest rates.
“Now utilities are back where they belong on defense,” remarks strategist Travis Miller. In fact, the sector is especially attractive to investors seeking defense and yield ahead of economic uncertainty, he adds.
Granted, utilities may be temporarily affected by the pandemic and economic slowdown: Electricity and natural gas use may drop if factories and stores struggle to reopen, and the group may find it difficult to fund growth projects. But the sector overall is much less vulnerable than others today, confirms Miller.