Types of Stocks to Buy and Sell Before April

Susan Dziubinski: Specifically, let’s look at the market through the lens of the Morningstar Style Box, starting with a look at the valuations of growth stocks versus value stocks. How do things look?

David Sekera: The market overall, with as much as it’s rallied this year, is now starting to trade a couple of percent above our fair value when we look at all of the stocks that we cover and put together that composite. And as you note, when we do break it down into the Morningstar Style Box, growth stocks right now are trading at about a 10% premium, whereas value stocks, which have lagged, are still trading at a 9% discount.

Dziubinski: Has that valuation gap between growth and value stocks widened or narrowed during the past few months?

Sekera: It’s been widening out, and it’s been widening out here for quite a while. At the end of 2022, growth stocks were undervalued, and they’re actually more undervalued than the value category. But when I look at the returns here, growth stocks rose 38.5% in 2023, and they’re up almost another 7% year to date. That does put growth in that premium to fair value. Now, when I look at the value category, that only rose 12% in 2023, and it’s only up about 4.5% year to date. So, value stocks are still trading at a pretty deep discount compared to our fair value.

When I look at the spread between the two, it’s not the greatest that the spread has ever been. That actually peaked in August 2020. But since the end of 2010, when I calculate the current spread versus where it’s been historically, it’s only been this wide or more only 6% of the time.

Dziubinski: Why has this gap persisted, Dave? Is it simply because of the ongoing outperformance of growth stocks?

Sekera: For the most part, it really is due to that outperformance in growth. And specifically, I would say it’s actually the technology sector, which is now one of the most overvalued sectors in our view. In fact, technology was one of the more undervalued sectors at the beginning of last year. And even when I think about growth and when I think about tech, the biggest gainers specifically have been any of those companies that are even remotely tied to artificial intelligence.

And with as much as they’ve risen at this point, most of those stocks are well into fair value territory, pretty fully valued. And some of them are even getting pretty extended now moving into that overvalued territory.

Dziubinski: Moving over to market capitalization, we continue to see large caps trading at less attractive valuations than small caps. How large is the gap, and here, too, is that gap widening or tightening?

Sekera: Currently, large-cap stocks are trading at a 4% premium to our fair value, whereas mid-cap stocks are trading at a 5% discount. But small-cap stocks have really lagged behind in their returns. Those are now trading at a 20% discount to our fair value.

Dziubinski: Similar question here, Dave. Is the gap largely the result of the underperformance of small-cap stocks compared to large-cap stocks?

Sekera: It is. When I look at returns over the past year, large-cap stocks were up 30% last year. They’re up another 8% year to date through last Friday. Mid-caps were only up 16% in 2023 and only up 6% year to date. And small caps were a little bit better than mid-caps last year, up 20%. But this year they’re lagging. They’re only up 2%.

Dziubinski: Given how valuations look across the style box, how would you suggest investors position their portfolios today?

Sekera: Well, just from a broad equity exposure, I would remain fully invested in equity at whatever your target allocation in your portfolio is. It’s not to the point that I would look to underweight equities today. But within that portfolio, I would look to overweight value stocks, whether you want to do that on an individual stock basis or using ETFs or mutual funds. In order to pay for that overweight in value, I’d look to underweight core and growth stocks.

Then from a capitalization basis, I would still look to overweight small caps. That is where we do see the best long-term value, as well as a slight overweight in mid-cap stocks because they are still slightly undervalued but not nearly to the degree as small caps. And, again, in order to pay for those overweights, the area that I’d look to underweight would be the large-cap space.

This is an excerpt from the March 11, 2024, episode of Monday Morning Markets with Morningstar’s Dave Sekera. Watch the full episode, 5 Undervalued Stocks to Buy Before They Rise Further. See a list of previous episodes here.