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Coffina: Few Screaming Buys After Recent Sell-Off

Matthew Coffina, CFA
Jeremy Glaser

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. There has been no shortage of volatility over the last few days. I'm here with Matt Coffina--the editor of Morningstar StockInvestor newsletter--for his take on what's driving it and if it's opened up any opportunities.

Matt, thanks for joining me today.

Matt Coffina: Thanks for having me, Jeremy.

Glaser: Let's start with your thoughts about what's behind this volatility. I know it's difficult to pinpoint any one cause or any one day's market movement. But what do you think has really caused global stocks to sell off so much recently?

Coffina: Well, it seems like there are a few causes--a lot of which have been simmering for years now. The most immediate cause would be concerns about China's economy. There seem to be some very clear signs of slowing over there, but also to some extent a panic by the central government in their move to devalue the currency to increase liquidity. I think investors are starting to lose faith that the government has a handle on the situation. That's causing a lot of people to be worried, and there are certainly follow-on effects somewhat to the U.S. but especially to other emerging markets and specifically markets that are dependent on exports to China--especially commodities.

Besides that, I think people are also concerned about the Federal Reserve's first rate hike. The Fed really hasn't backed away from raising rates later this year--maybe it'll be in the September--despite these concerns about global economic turmoil. Then, maybe the most important cause is that the market has had such a great run over the last six years here. Stocks were relatively fully valued, in our view, prior to the sell-off. And to some extent, I think that's just left stocks vulnerable. So, investors should expect over an investing career that you are going to see dozens of corrections. It's been quite a while since we've had one, and I think that's a big reason why this particular correction is a getting a lot of attention. Investors sort of forgot what it felt like. But corrections are really par the course when investing in stocks. Investors should be prepared for them and should fully expect them as a totally normal part of stock market behavior.

Glaser: So, there's nothing in this that makes you nervous?

Coffina: Well, again, I think stocks were fully valued before this correction; they look less so now. If anything, I'd say the stock market today looks about as attractively valued as it has in two or three years. But stocks certainly aren't screamingly cheap. I wouldn't say that this is a pound-the-table buy opportunity by any means. But because stocks were fully valued before this, sliding 10% as we have in the last few days sort of brings you back to a fair value kind of range.

A lot of the concerns that are out there--China in particular--I think those are very real concerns and something that investors should be worried about. We've seen a lot of specific sectors sell off worse than most: anything having to do with commodities; energy, in particular, with the slide in oil prices over the last year; there are some sector-specific issues going on in railroads; people are concerned about declining coal volumes and slower industrial activity; media stocks have been selling off a lot because of concerns about cord-cutting; and, again, anything related to China in any way.

So, I think there are good reasons to be concerned, and I think there are fundamental reasons. Arguably, investors have just been too complacent about these risks as they've built up over the last few years. But my message is that it's definitely not a time to go buy everything in sight; it's also not a time to panic by any means. A correction like this is, again, totally normal behavior for stocks, and stocks certainly look more attractive today than they did a couple of weeks ago.

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Glaser: You were talking about sectors like energy and media that have sold off the most. Do you see the most opportunities in those, or were those [sell-offs] really justified by these concerns in China and elsewhere?

Coffina: I see some opportunities in some of the sectors that have sold off the most. But again, I think that there are real fundamental concerns there; investors' concerns are justified to some extent. I think you really have to pick your spot. An example would be that we own Time Warner (TWX) among media stocks--the only media stock we own. I am concerned about cord-cutting. I'm concerned about the secular shift in advertising dollars away from TV and toward digital media. But I think Time Warner is relatively insulated from those trends. They have a very strong lineup of channels. They have HBO, which is a perfect asset to go over the top, direct to consumers. They have minimal exposure to advertising--only about 17% of their revenue is from advertising. So, I see Time Warner in a very different spot from, say, a Discovery (DISCK) or a Viacom (VIA) that have somewhat weaker channels, are easier to exclude from an narrow channel bundle, and are more heavily dependent on advertising.

It's a similar story with China. I think you have to approach China with a lot of caution. We've seen a huge investment boom that's really been driving economic growth over the past five years since the Great Recession. To a large extent, our analysts think that's just not sustainable. They still have a lot more infrastructure than they need--even for today. And a lot of that investment spending is going to have to slow down, which will impact commodities markets. With major industrial commodities like iron ore, a lot of supply has built up during this boom, and so we could be in an oversupply situation for five or 10 years into the future.

But on the other hand, a more consumer-oriented Chinese stock that we own is Baidu (BIDU). In this case, as the Chinese economy weakens, that's certainly not good for online-advertising spending. But on the other hand, the secular shift to online advertising is so strong, and Baidu is very well positioned to capitalize on that with a really commanding share of the search advertising market. The company is also investing very aggressively in some new initiatives, such as like online-to-offline, which has caused margins to contract and has had investors concerned. But if you strip out those investments in online-to-offline, I see Baidu trading at maybe 13 or 14 times earnings right now, and the company is still growing 30% plus, year over year. So, again, if you strip out those investments, the stock looks dirt cheap to me and much more leveraged to the Chinese consumer, which is really where the economy has to go over the long run. We might get some hiccups in the short run. There certainly will be elevated investor fears and lots of volatility in the stock; but in the long run, the Chinese economy has to transition away from investment and more toward consumer spending. More consumer-oriented companies like Baidu or like Alibaba (BABA) will probably be positioned to benefit from that.

Glaser: How about the energy space? Is there anything that you are interested in now?

Coffina: We haven't done well with energy, and I'm very cautious about getting more heavily involved. Certainly, the stocks are cheaper than they have been in the past, but the oil price is down very sharply. So, if the price of oil falls 50%, it's reasonable to expect that most oil producers are going to see their profits erode even more than 50% because there's going to be some negative operating leverage. We're still expecting some degree of recovery in oil prices--maybe to $70 or $75 a barrel--but we don't expect oil prices to go back to where they were a year ago. And if we don't see that recovery, you're going to see some financial distress among the smaller companies, and the larger companies will have investors starting to think their earnings power is really 60% or 70% below where it used be. These stocks aren't screamingly cheap either. They are trading at relatively elevated multiples of their current earnings power, and investors really have to hope and expect that oil prices are going to recover to be really enthusiastic about that.

So, I'm not really investing much incrementally in energy. Two names that I do like are Enterprise Products Partners (EPD) and Magellan Midstream Partners (MMP). The MLP space is usually seen as more conservative and much less exposed commodity prices. But I think investors have been a little bit too complacent about the risk historically, and a number of MLPs have too much financial leverage. They have lower-quality assets; they have more commodity exposure than a lot of people might realize. We actually just put a lot of these companies under review, and we've been cutting our fair value estimates to some. But too much financial leverage and especially too little distribution coverage could put some distributions at risk.

For our portfolios, it's again a situation where we own companies that, I think, are exceptions to the broader trend--which is to say that Enterprise and Magellan both have significant excess distribution coverage. They have conservative balance sheets--especially relative to peers. They have very well-managed, very conservative management teams; they make sure that they own high-quality assets and have relatively little commodity exposure. There's definitely a focus on fee-based assets, and they have a lot of long-term contracts in place. So, I think those two companies are in a position to survive and, in the long run, thrive. They may even be able to take advantage of this distress among some of their peers if those companies are forced to sell assets to raise capital. But more broadly speaking, I would approach energy with caution at this point. I don't see this sector has a pound-the-table buy. Certainly, there are some cheap stocks, and they are cheaper than they use to be; but you really have to have a lot of confidence in oil prices recovering for a lot of these investment theses to work out.

Glaser: On valuations, you mentioned that the market looks like it's about at fair value now after the sell-off. Does that mean that you're not rushing out to deploy capital into new names?

Coffina: Fairly valued might be putting it too mildly. I would say that the market, as a whole, looks undervalued. I think the average price/fair value ratio for the market right now is at about a 10% discount--and that's good to see. It's encouraging after the last three years. I regularly run screens for stocks that meet our investment criteria. Over the last few years, we've often been in a situation where maybe there are only a few dozen stocks that meet even my most basic investment criteria: wide and narrow moats trading at a reasonable discount to fair value with positive or stable moat trends--that sort of thing. Out of those few dozen, we already own the majority of them.

Now when I run a screen like that, I'm finding 200-plus candidates. So, there's a lot more to sort through--and that's a good situation to be in. There are a lot more potential opportunities. We do have actually a little bit of cash in our Hare portfolio. We have about an 11.5% cash position. We don't have any cash in the Tortoise, unfortunately. But if we're using that 11.5% cash stake in the Hare, I'm enthusiastic about putting that to work in some high-quality undervalued stocks. But I wouldn't say that I'm rushing to do it. A market that's 10% undervalued, on the whole, is a good place to be relative to where we've been; but don't forget that during the financial crisis the average stock was trading at a 45% discount to fair value.

So, again, I think investors have gotten used to not seeing the market down over the last five or six years. But they should keep that in perspective and remember that a 10% correction is not that big of a deal in the context market history. Sometimes you'll see the market down 20%, 30%, or 40%--and the market does tend to overcorrect in both directions. It tends to get overvalued, and then it tends to get undervalued. So, I'm more enthusiastic about putting cash to work today, certainly, than I would have been a few months ago; but even so, I'm not necessarily pounding the table at this point.

Glaser: Matt, thanks so much for sharing your thoughts with us today.

Coffina: Thanks for having me, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.