Our Favorite Stock Picks for IRA Contributions

This presentation is an excerpt from our Premium-member webinar, Top Ideas for Your IRA.

Christine Benz: Welcome back. I am joined now in the studio by Daniel Rohr. He is director of Morningstar's North America equity research effort. He's brought some individual stock picks to share with us today.

Dan, thank you so much for being here.

Dan Rohr: Thanks for having me, Christine.

Benz: Before we get into the specific ideas, I'd like to hear about our coverage universe overall, or our equity coverage universe. Can you talk about whether after nine years into this rally that we've all been enjoying, is the coverage universe still looking a little bit picked over?

Rohr: I'd definitely say so. Just to give our viewers some context here. Of the roughly 930-ish U.S. stocks we cover right now, we only have 13 rated 5 stars, which would be equivalent of a strong buy. A little bit over 1% of our U.S. coverage universe. As far as those 5-star stocks are concerned, that's one of the lowest figures I can recall in my 11 years here at Morningstar. We've got roughly another 180, about 19% of the coverage, rated 4 stars. Collectively, between those 4 stars and 5 stars, you're talking about 20% of our coverage is worth considering. Look at the other end of the spectrum, we've got nearly a third of our coverage rated sell or strong sell. By that measure, we think the market is overvalued, albeit, not extremely so.

Benz: That's something that investors can kind of have in the back of their minds if they're looking at their IRA portfolios today, and have not done any re-balancing recently. That's yet another signal to consider perhaps bumping up your exposure to safe securities.

Let's get into your picks though. You did look into the universe, and looked at some of the higher conviction ideas among the analyst team. Let's start with the first. This is Compass Minerals. The ticker is CMP. It's a 4-star small-cap stock. It lands in the metals and minerals sector. This is not a household name. Let's just start by talking about what this company does.

Rohr: Very simple business model here. It's a company that mines salt from underneath Lake Ontario, sells it to municipalities in the U.S. Great Lakes region for use on roads during the winter.

Benz: This one earns a wide moat rating currently. What accords it that moat?

Rohr: In commodity land what you tend to see is it's all got to come down to costs. That really is for the most part in commodity land, materials more broadly, the main source of structural competitive advantage. Compass has got low costs for a couple of reasons. One is geology. The mine from which they extract the salt happens to have unusually thick seams of salt, which means a lower cost per ton extracted. Layered on top of that geological advantage, you've got a geographic advantage. As I mentioned earlier, that mine happens to be sitting underneath Lake Ontario. For a commodity like salt, where transportation costs comprise a disproportionate share of the total delivered cost to customers.

Benz: Right, salt is cheap, right?

Rohr: Salt is dirt cheap. The transportation cost to get that salt from the mine to customers, in say Cleveland or Chicago, is unusually low, because barge transportation is far lower than say truck or train.

Benz: Whether you're looking at this company from a fundamental business perspective, or you're looking back on its total returns; it hasn't looked that hot. What is Morningstar's forward looking view about why we think it should perform better in the future?

Rohr: You're right, Christine. This stock has been an awful performer for several years now. Why is that? I think it fundamentally has to do with the fact that it just hasn't snowed a whole lot in the U.S. Great Lakes region for the past couple years. Less snow means less salt, which means lower volumes, lower prices for Compass. I think to some extent the market has concluded with this name that because of global warming, the future is going to look a lot like the past couple years. To go about assessing that claim, we took a look at the past 120 years of snowfall in 10 major cities in Compass's operating footprint. We found a couple interesting things with that exercise. First is we found global warming has greatly increased the year-to-year volatility in snowfall. You look back at the past couple decades, and out of that 120-year period, the last couple decades have included both the snowiest and the least snowiest year. That might not be too counterintuitive to our audience.

More interestingly, what we found is stability in the typical year. You look at the typical year in say the most recent decade. Compare that to the typical year back in the 1950s. Not a whole lot of difference. It seems that while global warming's increased the year-to-year volatility of snowfall, the typical year is going to bring a similar amount of snow. On that basis, we're pretty comfortable with our forecast that eventually we will see a rebound in snowfall. We'll see a rebound, as a result, in salt demand, salt volumes for Compass, prices, and profitability.

Benz: Your next pick is 4 stars. It's Procter & Gamble. This is going to be quite a familiar name to most of our viewers. It's a mega-cap stock, operates in the consumer staples sector, obviously. What doesn't the rest of the investing population know about P&G that Morningstar thinks it does? What's our competitive edge in recommending P&G?

Rohr: Christine, I honestly think it's related to our long-term focus. The market, as a whole, generally tends to be a bit more short-term oriented. You look at the short-term results, P&G short-term hasn't been great. In the most recent quarter, which I think they reported late January, organic sales growth of 2%, flattish operating margins, so not a whole lot to get excited about. If you were to assume that the future looks a lot like the most recent quarter, then the market's right. This stock is trading exactly where it should be.

We do not think that 2% sales growth and stagnant margins are a sign of things to come. Our optimism is predicated on the prospective benefits of what's been a really massive overhaul of this company's product line. That's going to take some time to bear fruit. This is a company that's shed more than 100 brands over the past several years to narrow its focus on what are really the best opportunities. We think that's going to result in better capital allocation across brands, yielding better innovation, and as a result better top-line growth and some margin expansion as well.

Benz: I think when people are looking at kind of stable, defensive companies like this, they really have not performed all that well in the kind of risk-on market that we've had over the past several years. It seems like there's reason to believe that in some sort of broad market downturn, you might see these stable growth companies do relatively better. First, do you agree with that? Then second, if a down equity market is accompanied by some sort of recessionary environment, or that's the catalyst, is there the potential for consumers to trade down in terms of some of their choices? Are they more likely to look at the store brand paper towels versus the Bounty? What's your take on both of those questions?

Rohr: Very good questions. I would expect this stock to outperform in a market downturn. That's certainly what we had occur in the great recession. That's largely because just looking at the fundamental economic forces behind that, even in recessions, consumer spending tends to hold up a bit better than the investment side of the economy. Then you look at within the broader consumer spending category, staples, which is what P&G sells, of course tend to hold up better in terms of demand than discretionary purchases, like autos, appliances, jewelry. You're right that there probably will be some trading down in that eventuality. That's certainly what we saw in the great recession, but not enough in our view to offset the relative strength of consumer staple spending versus other areas of the economy.

Benz: The last pick, which I hope you can cover pretty quickly because we do want to take some questions, is Dominion Resources. The ticker is D. This is a 4-star stock. It lands in the utilities sector. Let's talk about what this company does. It's a large-cap company, but not necessarily a household name like P&G.

Rohr: It's a household name if you live in Virginia.

Benz: That's your power company?

Rohr: Yeah. It owns power plants. It owns the lines that move that power to consumers. It owns natural gas gathering, transmission, and distribution pipelines. It's also nearing the completion of a liquified natural gas export facility in Maryland.

Benz: A little bit of a stumble on the return front recently, although very good long-term results from this company. Do you think that the interest-rate sensitivity that bedevils so many utilities is what has hit this company recently?

Rohr: I think that's a big part of what's been going on. As you note, a lot of investors have treated dividend paying stocks, including utilities, as something, rightly or wrongly, as a bond proxy. When we have low rates, you get a lot of folks buying utilities to get those income streams that they can't otherwise obtain from bonds in a lower rate environment. With rates on the upswing, you start to see that unwind somewhat.

Benz: Dan, great to hear your insights. Thank you so much for being here to share these stock picks.

Rohr: Thanks.

Benz: We'll be right back with Jeremy Glaser. He's going to come out and share with me some of the questions that you've been submitting as we've been talking here. Stay tuned, we'll be back momentarily.