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Long-Term Stocks to Buy: Cyclicals That Aren’t Really Cyclical

Plus, an earnings season recap and why specialty chemicals stocks look cheap today.

Long-Term Stocks to Buy: Cyclicals That Aren’t Really Cyclical

Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. Every Monday, morning I sit down with Morningstar’s 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. Dave, first let’s talk about what’s on your radar this week, which are a last few earnings reports for the season. One that’s likely to get a good deal of attention is Target TGT, especially after Walmart’s WMT weak outlook last week. What does Morningstar think of Target today?

Dave Sekera: Hey, good morning Susan. Good to see you. Target is a 3-star-rated stock and it trades just below our $177 fair value. Now, what I think is actually most interesting about Target is that people may not realize we assign it no economic moat. There’s a couple of different reasons for that. And first, it’s scale. Actually I looked it up, it’s kind of interesting, I didn’t realize it’s less than one fourth the size of Walmart. The other reasons it doesn’t have an economic moat is it, in our view, just doesn’t really have a differentiated business model and it doesn’t have any kind of online dominance compared to other retailers that do have an economic moat.

With the earnings coming up this week, probably the two things I’m going to be most focused on listening on the call is going to be their view on the health of consumers and what they forecast sales to be for this next quarter. As you mentioned, Walmart did provide weaker-than-expected guidance last week. Interestingly, the stock initially sold off after that weak guidance, but it did recover pretty quickly thereafter. I think that the market really has already anticipated and discounted that weak near-term guidance in their valuation analysis. Walmart itself also is a 3-star-rated stock. It trades pretty close to our fair value, but Walmart, in our view, does have a wide economic moat.

Dziubinski: Dave, any other companies reporting this week that are on your radar that you’re looking at?

Sekera: Sure, there’s a handful here. I think after market close today is Workday WDAY. That’s a 4-star-rated stock with a wide economic moat based on switching costs. That one trades at about a 20% discount to our fair value. I know our analyst team thinks that Workday is probably one of the best cloud-related human resources software management programs and platforms out there.

Middle of the week, it looks like we’ve got Salesforce CRM here on Wednesday. That’s a 4-star-rated stock. Its wide economic moat is also based on switching costs, and that trades at about a 25% discount to our fair value. Again, according to one of our analysts, we think that’s one of the best long-term growth stories in software. In fact, that analyst forecast earnings growth of over 20% annually for this company for the next several years.

And then finally later in the week on Thursday, we’ve got Zscaler ZS. That’s a 4-star rated company, narrow economic mode, but again, also based on switching costs. That one trades at a 20% discount to our fair value. So, for people that don’t know or haven’t heard of Zscaler, it is a company in the cybersecurity industry. And as we’ve talked about before, in this age of geopolitical tensions, rising hacking, increases in ransomware, that is an area that we do see long-term secular growth. It’s also an industry that I just think has a lot of especially attractive industry dynamics.

We could see some risk here in the short term of macroeconomic weakness pressuring Zscaler, but we did see pretty solid earnings last week out of competitor, Palo Alto PANW, so I think that’s going to portend well for Zscaler looking forward.

Dziubinski: Now earnings season is really starting to wind down. What are your takeaways from it? Were things as bad as investors might have been expecting?

Sekera: Well, if we look at fourth-quarter earnings in and of themselves, it wasn’t as bad as what the market I think had initially feared it could have been. Economically, I do think we had a better fourth quarter than what most economists had expected. But really what we were listening for on the call was management guidance for the next quarter. I would say that generally it seems like that guidance was softer than what most of the sell side had expected. And as such, when those companies came out and gave that weak guidance, what we saw as those stocks pretty much sold off right away. But then over the course of the next trading day or two, those stocks actually pretty much recovered. That tells me that the buy side had already incorporated this slowdown in their valuations.

As earning season is winding down, I do think we’re going to start seeing the market’s attention start shifting back to the economy, specifically looking at those economic metrics as they come out. They give us some indication of what we think the economy’s going to look like this summer and then of course what that potential impact is going to be on Federal Reserve policy.

Dziubinski: Let’s pivot and talk about some new research from Morningstar, specifically a new report that you authored on the specialty chemicals industry. It actually a published just this morning on Dave, why should investors care about this industry? What’s compelling here?

Sekera: Well, we’ve seen over the past several months is that cyclical stocks in general have been hit pretty hard, especially in the chemical sector. And as you know, cyclical stocks are very volatile. The earnings will swing greatly back and forth based on changes in economic activity. But within that cyclical area, and even within chemicals themselves, what we noticed of that specialty chemical sector was pulled down with the broader cyclicals and broader chemicals. We think that there are reasons to like those chemical and specifically specialty chemical stocks at these depressed levels and of those stocks that we do cover in the specialty area. Most of those do have a wide or a narrow economic moat. We do find that they are leveraged to long-term secular growth themes. So, even in the short term, while we could have some issues with the economy here, we do think that these long-term secular growth themes will really end up helping these companies over the next several years.

Dziubinski: You talk a bit in your report about these themes, so let’s walk through them a little bit here. Three of them are somewhat related, those being the electrification of vehicles, the increased use of semiconductors, and the move toward plastics. Sort of walk us through those three growth themes.

Sekera: They’re all leveraged to the changes that we see coming up in the auto sector. One of the overarching long-term secular themes that we see is the transition in autos to electric vehicles from internal combustion engines. And, in fact, according to our projections, by 2030 we expect that two thirds of all new auto production will be electrified, whether that’s a battery electric vehicle or a hybrid vehicle. What that requires is several different things.

First, EVs in and of themselves require anywhere from 2.5 to 3.0 times as many specialty chemicals in their manufacturing process. Second, EVs do require a greater number of semiconductors. And then lastly, in order to maximize battery range in EVs, they do need to be lighter in weight, and that’s often accomplished by transitioning from metal parts into lighter weight plastic parts.

Dziubinski: Then your last two themes of the five are scarcity of freshwater and an increasing demand for healthier and more natural prepared foods. Talk about those two themes.

Sekera: Sure. As far as freshwater goes, we do see that costs there are increasing pretty dramatically, and in fact by 2030, we think the cost of freshwater will end up doubling. What that’s going to end up forcing to happen is those cost increases are going to force industry and manufacturing processes to become more efficient, and to do that, they’re going to have to recycle water. Of course that requires chemicals and filters in order to be able to decontaminate water that’s used in the manufacturing process. The other long-term trend that we see in the consumer space is that consumers do want healthier prepared and convenient foods, but at the same time, they’re not willing to give up on taste and texture. We do see an increase in the usage of flavorings and starches, different products like that, that are used to make those types of products.

Dziubinski: Let’s move on to the picks portion of our program today, Dave. In your article, you highlight six undervalued specialty chemical stocks that look attractive today. Let’s talk about three of them right now, the first one being Eastman Chemical EMN. Tell us a little bit about what growth theme or growth themes this stock fits into and what you like about it.

Sekera: Sure. Eastman is actually rated 5 stars right now, and it trades at I think a little over 35% discount to our fair value. It does have an economic moat. And it’s tied to two different themes, the first theme being the electrification of automobiles and second being that transition to plastics. Based on its specialty chemical portfolio, we do think it’s going to be one of the most positively leveraged to the long-term structural shift to EVs. In addition, we also think it’s going to benefit from that shift to more environmentally friendly plastics as well, just as people need to recycle plastics as well as convert those recycled plastics into new plastic products. And then also, that stock does pay a 3.6% dividend yield, and that’s one of the higher yields that we see in this industry.

Dziubinski: Your second pick this week is DuPont DD. This company also fits into a couple of different growth themes, right?

Sekera: It does. DuPont’s stock is currently rated 4 stars. It trades I think a little bit over a 20% discount to fair value. We do assign the company a narrow economic moat. That’s really going to be leveraged to the increase in demand and usage semiconductors, as well as the scarcity of freshwater. When we look at their industrial and their electronic segment, that’s going to increase from the number of semiconductors that are just used generally in consumer products from that rising adoption of what we call the “Internet of Things” type of technologies. And when we look specifically at the company’s forecast, we project the company’s annual EBITDA growth is going to increase in the high-single-digit rate after this year, and we do forecast a similar growth weight in their water business driven by the increased need for water filtration.

Dziubinski: Then your last pick this week is Ecolab ECL, which you said stands to benefit from the theme of the scarcity of freshwater. Talk about that one.

Sekera: That stock is a rate of 4 stars as well. That trades at about a 20% discount to our fair value. We do rate that company with a wide economic moat. This one really is tied to that scarcity of freshwater theme that we’ve been talking about. Now, in its most recent quarter, taking a look at the results there, I think that’s going to be a pretty good example of what we’re looking for going forward. Their water business grew 14% year over year. They just continue to win new customers with their products. I think when you think about this company, when you think about the value proposition here, is that their chemicals and their products are used in order to help recycle water and then reduce the cost of water recycling and actually also lowers their energy expenses, so that ends up being a good value proposition that the cost of their products are lower than the cost of freshwater and the use of water in their products over time.

Dziubinski: Thanks for your time this morning, Dave.

Be sure to join us again, live on YouTube, next Monday at 9 a.m. Eastern, 8 a.m. central. And while you’re at it, subscribe to Morningstar’s channel. Have a great week.

The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.

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