4 Cheap Stocks for Patient Long-Term Investors

Susan Dziubinski: Hi. I’m, Susan Dziubinski with Morningstar. Every Monday morning I sit down with Morningstar Research Service’s chief U.S. market strategist Dave Sekara 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. On your radar this week, Dave, is the Fed meeting. What’s the market expecting? A hold on rates or an increase?

Dave Sekara: Hi. Good morning, Susan. Good to see you again. Right now the market is pricing at no hike at the meeting this week. However, the market is still pricing in a potential hike in November looking for a 30% probability that they hike rates at that point in time. Although following the CPI report from last week, now that’s now down from a 43% probability as recently as I think mid-last week. And then as far as the December meeting goes, before the end of the year, there’s still a 40% probability that the Fed could hike rates at that point in time. However, in our view, we think the Fed has done hiking rates for this monetary policy tightening cycle.

Dziubinski: Let’s talk a little bit about that CPI number that came out last week. It was a little bit higher than expected. Do you think that’s really going to change the Fed’s thinking?

Sekara: We don’t. As you noted, the headline CPI was a little higher than expected, but when you dig into the report, things really weren’t all that bad. I know that Preston Caldwell, he’s our head of our economics team here in the U.S., he noted that core inflation did continue to keep normalizing. Now core inflation does exclude the food and energy components. Certainly lots of arguments as to why or why you shouldn’t include those categories. But either way, it’s what the Fed cares about, and the Fed is going to focus on those core numbers. And when you look at core CPI, it fell to its lowest levels since we’ve seen since March of 2021. That three-month percent rate of change did fall down to 2.4% annualized, which is really getting pretty close to the Fed’s 2.0% target. For people that are interested, I would note you can go to Morningstar.com, we did publish an article, the title is “August CPI Report Shows Good News on Inflation Despite Jump in Gas Prices,” and that’s going to dig into those numbers a little bit further.

Dziubinski: Now we talked a little bit on last week’s show about Morningstar’s outlook for interest rates. For viewers who might’ve missed it, can you give a quick recap about where Morningstar expects rates to finish the year and what our expectations are for 2024?

Sekara: Of course. And I do like breaking it into what we expect for the short end of the curve versus the long end of the curve. Now on the short end of the curve, we do think the Fed is done hiking rates at this point. And in fact, we think that probably in early next year the Fed’s going to start turning around and start cutting rates as the economy does start to weaken later this year. The market, it’s really not pricing in a probability of the Fed starting to cut rates until June of 2024, whereas we’re looking for rates to get cut anywhere from 4 to 5 times next year. So, in our view, we do think that short rates are either at or near their peak and we think they should start declining if not later this year, probably early next year, once the market does see the slowing economy and starts pricing in those Fed rate cuts.

Dziubinski: Let’s talk a little bit about the Arm IPO. Arm ARM went public last week at $51 per share, how’s the stock done since then? And what are some of your key takeaways from that IPO?

Sekara: It was a very successful IPO. It priced in at the high end of the range. Once the stock was free to trade, it rose 25%. Now, it did give back 4.5% on Friday, but that’s not necessarily surprising to me, but I think more importantly this really does open up the window to the IPO market. There were very few IPOs in 2022, in the first half of this year, and so at this point, there does appear to be a pretty large backlog of potential IPOs out there. According to PitchBook, there’s 220 IPOs that should have gone public since 2021. So, I think there’s a high probability there could just be a flood of IPOs in the wings that are waiting to come out over the next couple of months, especially any IPOs that can try and tie themselves to artificial intelligence.

Here in the short term, I do think the next IPO for investors to watch is going to be Instacart. I think they recently boosted their IPO range up following that deal from Arm. And I think overall this does provide a broad positive market sentiment. I would note that the market was up about 1% on no other news other than that Arm IPO.

Dziubinski: Let’s move on to some new research from Morningstar. In your latest stock market outlook column on Morningstar.com, you took a deep dive into several sectors where there are no opportunities either because of market pullback, or because we’ve increased our fair value estimates on some of the stocks that comprise the particular sectors, or both. So first, Dave, remind investors about how we value stocks at Morningstar and what would lead an analyst to increase a fair value estimate out of stock.

Sekara: We do conduct a very thorough bottom-up fundamental analysis on all the companies that we cover, and we do that in order to determine our estimate for intrinsic value. Intrinsic value is really just the present value of all the future of free cash flow that we think a company is going to be able to generate over its lifetime and discount that back at the company’s weighted average cost of capital. In our view, that’s really the only way and the best way to really be able to value a stock. Our analytical team will review their coverage essentially every quarter once earnings are released, and if the results are any different than what they were expecting, we will take a look and see if there’s really any reason to change those long-term evaluations.

We’ll dig into why they may have beaten or why they may have missed their earnings guidance. It could be things like is the sector growing faster or slower than expected? Are margins better or worse than expected? And then we’re going to determine whether or not that’s a temporary fluctuation, in our view, or if that really indicates a longer-term change. If it’s temporary, it is probably only going to be a couple percent change to our valuation once we update that model. And in fact, I usually screen out when I see valuation changes of less than 3%. But if it’s really more a large, long-term paradigm shift within the sector, that’s when you really see the big changes to our fair values—5%, 10%, in some cases even more.

Dziubinski: Let’s unpack a few particular sectors. In your column, you note that the technology sector is still overvalued according to our metrics but less overvalued than it was at the start of the third quarter. So what happened there?

Sekara: The change there is really twofold. First and most significantly, we did significantly increase our fair value estimate on Nvidia NVDA. We took that up to $480 a share, and because its market cap is just so large within the sector, it definitely has an outsize impact on the sector valuation. But I’d also note that following earnings, there were a handful of other tech names that we also bumped up our fair values. Of course, there were much smaller changes on smaller companies so they didn’t really have the same impact as Nvidia did.

And then second we did see a selloff in the tech sector. So, it was really a combination of those two factors that took our price/fair value for technology to being 4% overvalued at the end of August, whereas we were 11% overvalued at the end of July.

Dziubinski: Now the utilities sector was just modestly undervalued heading into the third quarter, and it now looks notably undervalued. What happened there? It sounds like this change was due more to utilities stocks struggling rather than any significant fair value changes to the stocks in the sector. Is that right?

Sekara: That’s correct. So, the utilities sector dropped I think just over 6% in August, and across our utility coverage of the 40 utility stocks that we cover, I think we only reduced our fair value on five of those stocks. So, I think in this case it’s a combination of two things. One, the market pricing in higher interest rates, and utilities of course are particularly sensitive to changes in interest rates. But also, and this is just a little bit of my guess here, I do think there was some contagion across the sector from the drop in value for Hawaiian Electric HE. We lowered our fair value on Hawaiian Electric by 67% last month, and the stock really ended up cratering after the fires. And the market is at this point really just trying to understand how to estimate how much liability that company has for the loss of life and for damages.

Dziubinski: Then lastly, let’s talk about the real estate sector. First, what has performance looked like there?

Sekara: Real estate has dropped over 3% last month, and I think year to date it’s pretty close to being unchanged at this point. The market is just very skeptical about valuations for commercial real estate with office space in particular, and like utilities, real estate is also very sensitive to changes in interest rates. And if you take a look at interest rates, I mean they’re really essentially the highest that they’ve been since prior to the 2008-09 global financial crisis.

Now specifically in office space, the market is trying to understand what the long-term impact is of office workers who are now working from home at least a couple of days per week. A couple of the different metrics that I’m looking at. So one is the Kastle Back to Work Occupancy Index. That’s really been stagnant at about 50% for the last couple of months, although there might be some signs of life. Another measurement that we look at is one from Placer.ai, it measures cellphones and where cellphones are going, and it’s starting to register a higher level of office occupant visits. According to their numbers, total visits are only down 35% at this point from prepandemic levels. So, we’ll see how that shakes out over the next couple of months.

Dziubinski: Now it seems like some real estate names were hammered after reporting earnings, but we stood firm on our fair value estimates. Let’s talk about two in particular, starting with Host Hotels & Resorts HST.

Sekara: Host fell 14% in August. Now it looks like maybe that stock has bottomed out. It did try and rebound; I think it’s up about 1% here month to date in September. And as you noted, we did leave our fair value unchanged. So when you take a look at our 2Q results, I think there were a bit of a mixed bag. On the downside, the average revenue per unit only increased 2.7%, and that was well below our forecast for 8.8%. However, on the upside, our analyst noted the operating costs increased at a much slower rate than what he had forecast. So, the bottom line, 2Q-adjusted funds from operations was $0.53 per share, which is pretty much in line with our $0.52 estimate, but I think the market just didn’t like that it was $0.05 below what it had earned in the second quarter of 2022.

Looking forward, I don’t think our forecasts here are overly aggressive. Taking a look at the model here, we’re projecting a 4.7% compound annual growth rate for revPAR, or revenue per available room, over the next 10 years. We’re looking for net operating income growth of about 5.6% over that 10-year forecast period. With those really being what I think are probably the main two drivers for our assumptions here, we’re looking at this being a 4-star-rated stock. It trades at a 30% discount and pays a 3.6% dividend yield.

Dziubinski: Now we also stood by our fair value estimate on Ventas VTR, even though the market wasn’t thrilled by what it heard on the earnings front there.

Sekara: Ventas was down 10% following earnings, and it’s still sliding. It looks like it was down to about another 2% here in September. And again, we did hold our fair value estimate unchanged. At this point, it’s a 5-star-rated stock, trades at a 37% discount, and has a 3.8% dividend yield. Now for those of you that don’t know Ventas, it has a diversified healthcare portfolio. Looking through here, it has senior housing, medical offices, hospitals, life sciences, and skilled nursing facilities. So, it’s something that I consider to be much more on the defensive side.

Now looking at our results, earnings did miss estimates, although not by all that much. So, if we look at the second-quarter net operating income growth, it was 7.0%; we were looking for 7.4%. And funds from operations was up 4.5% to $0.75 per share, which is only $0.03 below what our estimate is. So looking forward, management did make some guidance calls here, which I think really help out for the long-term story. They expect demand growth for senior housing to be 2 times higher over the next four years as compared to the prior economic cycle and then will double again over the next four-year period. Whereas when they look at the amount of construction ongoing right now as a percent of overall inventory, it’s at its lowest level since 2011. I think that does bode well here for the long-term outlook.

Dziubinski: It’s time to move on to the picks portion of our program. This week, you’ve brought us four cheap stocks for patient long-term investors. Why do investors need to be extra patient with these names, Dave?

Sekara: I would consider these to be what I call deep-value names. All have been on a long-term downward trend. Some of them have been sliding for one or even more years over the past couple of years. Now the stocks are trading at multiyear lows, but the stocks are down for a good reason. Now for each of these stories, the fundamentals have all been under pressure, but of course for different reasons. At this point, we think the market has overreacted to the downside, but I do think it could take some time for these stories to play out. As with any stock, but specifically with story stocks, I think investors really need to do their homework here and really understand what the underlying dynamics are before they take a position because in some of these cases, it may still get worse before it starts to get better.

Dziubinski: Well, your first pick this week is a stock we’ve talked about on the show before, and it’s International Flavors & Fragrances IFF. Morningstar cut its fair value on the stock and raised its Uncertainty Rating after the company reported earnings and the stock plummeted. So, what happened and why do we still think there’s opportunity here for long-term, patient investors?

Sekara: I have to note we actually cut our fair value twice this year, that most recent cut being by 7%. So, at this point the stock is rated 5 stars, trades at about half of our fair value estimate, and pays a 4.25% dividend yield. However, I think what’s going on here is a lot of investors just feel burned, and they’ve just thrown in the towel, and they just want out of the stock at this point. It’s not just because of the tough near-term fundamentals, but I think some investors are just losing confidence in management. They’ve reduced their guidance three times over the past three quarters. So the results have been disappointing thus far this year, but I think in this case you need to dig pretty deep into the specifics of the results to understand this story. Our analyst that covers this stock did note that he does see some positive indications here.

First of all, he did note there’s a significant difference between the company’s specialty ingredients products versus their commodity-oriented ingredients. On the specialty side, he did see an improvement in margin as they have been able to increase prices faster than inflation. However, on the commodity side, volumes are still falling. I think they fell about 20% this past quarter. So, he did update our model. He reduced our forecast here for the short term on the commodity side to take that into account and then is only looking for relatively modest growth in the commodity side thereafter. But for the most part, our projections for the specialty part of the business are essentially unchanged. So, we are forecasting that International Flavors & Fragrances will be able to raise prices in that business fast enough to recover cost inflation, but it will take some time. Taking a look at the stock right now, it’s trading at about 18 times 2023 earnings, but it’s a much more modest 14 times when we take a look at 2024 earnings.

Dziubinski: Your second cheap stock pick this week is Scotts Miracle-Gro SMG, which like International Flavors & Fragrances is from the basic-materials sector. Now the stock took a hit after earnings and we brought down our fair value estimate by 9%. What happened and why is it one of your picks for patient investors?

Sekara: I think this is actually the first time that you and I have talked about this stock. Scotts did very well in 2020 and early 2021. As you remember, the pandemic just led to a large pickup and demand as homeowners spent more time at home, spent a lot more time, much more money on their lawns and gardens. But since then, the stock has round-tripped all the way back to prepandemic levels. Last quarter, adjusted EBITDA did fall by 35% year over year and is a combination of a couple of different things. We had the impact of cost inflation, lower volumes, and the two of those then reducing plant capacity utilization. So, that all really brought down the margins.

Now, we did lower our outlook. We are now expecting that this slowdown will last longer than what we originally anticipated. But I’d note here, the stock is now trading pretty close to our downside scenario. In that downside scenario, we assume revenue is going to be flat and that margins would actually remain below prepandemic levels. Now over the long term, we do think that Scotts’s brand leadership in the lawn and garden segment is still intact and it’s still one of the best brands out there. So, we are forecasting the business will return back to kind of that mid-20% operating margin area as the company works through its high-cost inventory. At this point it’s a 4-star-rated stock, trades at a 45% discount to our fair value, and pays a 4.4% dividend yield.

Dziubinski: Then your next pick is also from the basic-materials sector. It’s Compass Minerals CMP. The stock sold off a bit after earnings, but we stood by our fair value estimate of $65. What was the market responding to and why do you like the stock for the long term?

Sekara: This is one where a lot has changed with this story over the past couple years. So, Compass itself mines salt, that salt mainly used for de-icing roads in the wintertime. And we’d note that part of the business, they are the low-cost producer and that’s the basis for assigning a wide economic moat to this company. In fact, in the basic-materials sector, this is one of only a few companies that we do rate with an economic moat. Now, prior to 2021—actually prior to December 2021 specifically—the company always paid a very large dividend, had a relatively high dividend yield, and a lot of the investors that own that stock really didn’t care much about growth. They were really focused on that dividend is what they wanted out of this story. Now management then cut their dividend and cut it very significantly, and they started using that cash to invest in building out their capacity to produce lithium, which is a byproduct of brine.

The result is that the stock began to really sell off at that point in time. A lot of the existing investors really just dumped that stock. And growth investors at that point, they didn’t know the name, so they weren’t willing to pay up for it. Now of course as de-icing salt, it’s going to be relatively volatile year to year because of how much inventory local governments need based on the winter. We did have a relatively mild winter last year. So the governments didn’t use up all of their salt, and we did have some excess inventory coming into this year. So, this most recent quarter, the stock dropped. I think the market was disappointed, they were only able to push through a 3% increase in salt prices. And management noted that we expect to see a 5% decline in volume this winter.

So again, I think this stock, you’re going to have to weather this short-term volatility. But we do think that over time winters will end up normalizing. And when we look at the long-term value here, we think the stock is trading pretty close to our bare case scenario, that downside scenario we assume permanently lower long-term salt volumes and profits. We assume material lower profits from the plant nutrition business. And essentially in that downside we don’t even give them any credit for that future lithium production. Of course, we do have a long-term positive view on lithium. At this point, it’s a 5-star-rated stock, trades at less than half of fair value, trades at a 55% discount, and pays just under a 2% dividend yield.

Dziubinski: And your last pick this week is a consumer defensive stock, Dollar General DG. Now, Dollar General tanked after earnings, and although we did trim our fair value estimate on the stock, we trimmed by far less than the stock sold off. What happened and why do you like the stock for patient investors?

Sekara: This is another one. I mean they did actually very well throughout the pandemic, but this year they’ve given up all of those gains, and the stock is now trading back to the same prices in 2019. To some degree, I think this is really just a story of they have not been able to raise their prices fast enough to keep pace with inflation, and then with inflation going up and economic weakness on the horizon. Specifically, a lot of their stores are in rural areas and they serve low-income consumers, which have been some of the consumers that have been under the most pressure with inflation. And then on top of that, we also have to add in the widespread rising problem of shoplifting. So, again, it’s under a lot of pressure, and I think the story here is actually going to look pretty rough for at least the next couple of quarters before it gets better.

But when I take a look at our long-term assumptions here, I think they’re actually relatively modest. So, our analyst, for the top line, he’s modeling in same-store sales growth averaging 2.5%. Again, not really looking for much more growth over what we think the long-term rate of inflation is going to be. And then he’s also modeling in a 4% increase for annual square footage growth from the company opening new stores every year. And then we’re looking for the operating margin to gradually rebound. It’s currently at about 6.7%, some of the lowest I think that it’s had, and getting back to 9.1%, but not until 2032. The average operating margin is actually 9.2% over the past 10 years. So again, a 5-star-rated stock, trades a 34% discount to fair value, although it only yields 1.4% at this point.

Dziubinski: Well, thank you for your time this morning, Dave. Viewers interested in researching any of the stocks that Dave talked about today can visit Morningstar.com for more analysis. Dave and I will be back live next Monday at 9 a.m. Eastern, 8 a.m. Central. In the meantime, please like this video and subscribe to Morningstar’s channel. Have a great week.

Simonne Stigall

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