5 Undervalued Stocks to Buy During Q4

Susan Dziubinski: Hello, and welcome to The Morning Filter. I’m Susan Dziubinski with Morningstar. Every Monday morning, I talk with Morningstar Research Services Chief US Market Strategist Dave Sekera about what investors should have on their radars, some new Morningstar research, and a few stock picks or pans for the week ahead.

Good morning, Dave. There’s a lot for investors to have on their radars this week. We have both the CPI and PPI numbers being released. But before we get to that, let’s first talk about the surprisingly strong jobs numbers that came out last Friday, which suggests that the economy remains stronger than expected. Now, did these numbers lead Morningstar to make any changes to its interest-rate cut expectations for 2024?

David Sekera: Hey, good morning, Susan. It did not. Our Morningstar US economics team is still looking for a 25-basis-point cut in the federal-funds rate for each of the next two meetings. And in fact, they’re still looking for the federal-funds rate to get down to that 3.00% to 3.25% range by the end of next year. However, I would note there is one caveat. That caveat is if employment remains this hot, I think there’s a pretty good chance that the Fed would not end up cutting the federal-funds rate all the way down to our expectations.

Dziubinski: Now, let’s get back to talk about inflation. What could any surprises in those inflation numbers coming out this week mean for the market?

Sekera: Well, considering the Fed did start off with a 50-basis-point move in cutting the federal-funds rate for this policy of easing monetary policy, at this point, I suspect the inflation numbers should be pretty well under control. In fact, if they were to come out higher than expected, I think that probably would lead to a pretty sharp market selloff. It would definitely, in my mind anyways, call into question the Fed’s ability to continue lowering interest rates at this point, especially in light of the surprisingly large payroll print with a higher than expected wage increase print as well.

Dziubinski: Now, also this week, investors will be watching the tensions between Israel and Iran. We haven’t seen this situation escalate over the weekend. It’s Monday morning. But what could happen in the US stock market if it does?

Sekera: If there is any further escalation over the course of the week, of course, it’s really just going to depend on what that escalation is. Now, in a typical situation like this, I would look for a typical market risk-off type of trade. I’d expect growth stocks to sell off the most, with value stocks not selling off nearly as much, which also kind of details or dovetails anyways with our expectations based on valuations. Growth stocks being 13% overvalued, whereas value stocks are still 3% undervalued.

By sectors, the most cyclical sectors would sell off the most. I would expect tech stocks, which we also consider to be overvalued, to sell off. And then consumer cyclicals would probably be also off pretty well.

Now, typically, in a risk-off trade, you’re going to see that rotation into defensive stocks. I’d just be careful if you’re an investor today, some of the defensive sectors in our mind are already overvalued, specifically consumer defensive and utilities. In a situation like this, I’d expect defense stocks to do very well. However, I would note a lot of the defense stocks are either overvalued or at least fully valued in our mind at this point.

For example, I think it was RTX we recommended earlier this year, on April 15. That stock’s already up 25% year to date since then. That’s now a 3-star-rated stock. Stocks like Lockheed are already overvalued at 2 stars. So if you’re looking for that defense trade, I would look at Huntington Ingalls. That is a stock that we rate with 4 stars, but based on the type of products they make, I don’t think that this one would really get that sharp gap up like you might expect otherwise.

Now, unlike a typical risk-off trade, in this case, I think oil and oil stocks would go up. Really, with oil at $76, even if it pops a few more dollars here, I’m not that concerned about how it might impact the economy overall. Just to put that in perspective: Oil was actually trading above $80, I think as recently as July.

Now, I would note that we do think that the energy sector is undervalued, and it should already be overweight. Plus, I like energy because it does provide that good natural hedge in your portfolio for both any further geopolitical tensions or if inflation were to rebound. And of course, if there is no further escalation, the market will keep a watchful eye. But so long as there’s no escalation, I think people are really just going to be focusing back on your typical things: the economy, earnings, and fundamentals.

Dziubinski: What about bonds today, Dave?

Sekera: Well, in that typical flight to safety trade, you’re going to see a rally in bond prices, you’d see the yields drop. And that, in my mind, would really just pull forward some future returns that we were expecting. Our US economics team does still think we’re in the beginning of a multiyear downward trend. Looking for the 10 year to get down to that 3.5% rate on average in 2025 and down to 3% really by December 2026.

Now, if there is no further escalation, I’d note bonds have actually been under pressure since the Fed cut by 50 basis points on Sept. 18. The US Treasury’s backed off, or the 10 year anyways, has backed off over 35 basis points since then. It looks like it’s trading just above 4% this morning. Now, of how much it’s backed off, 13 basis points of that occurred just after the payrolls print on Friday. So I think the market is starting to price in a higher probability of long-term inflationary pressures, but again, our US economics team hasn’t changed their view at this point. They still expect inflation to moderate and looking for inflation to drop below the Fed’s 2% target next year.

Dziubinski: Now, as if all of that’s not enough, we have earnings season kicking off this week with the big banks starting to report on Friday. So you talked a little bit on last week’s show about your expectations for earnings season. Recap that for those viewers who may have missed it.

Sekera: Yeah, earnings, when they come out, I don’t think there’s going to be any problem. I think should be at least as good as your historical average for the number of companies that at least meet, if not beat, their expectations for earnings. When I look at the economy, it’s still doing very strong. In fact, if you look at the Atlanta Fed GDPNow figure, that’s running at 2.5%, which is the same as our forecast, although I’d note we actually just bumped up our forecast from 2.3%.

So we’ll listen for guidance. When I think about guidance, I’d be concerned whether or not management might look to lower the bar for earnings growth in the fourth quarter. We’re looking for fourth-quarter GDP of 1.5%, but to be honest, this quarter, I’m actually not as concerned as I’ve been in prior quarters with the economy still holding up better than expected and some of the tailwinds that we see in the marketplace today.

Dziubinski: So then we have big banks J.P. Morgan and Wells Fargo reporting earnings on Friday. What’s Morningstar’s take on US banks heading into earnings?

Sekera: With these two banks specifically, J.P. Morgan’s a 2-star-rated stock, trades in a 19% premium, so trading pretty far above our long-term intrinsic valuation. Wells Fargo trading a little bit below our $60 fair value, puts that in 3-star territory. Generally, I think we still see much better value for investors among the US regional banks.

The regionals are still recovering from the selloff they had in March 2023 following the failure of Silicon Valley Bank. And I just note the financial sector in general has been doing pretty well and banks in particular have done very well. Right now, just the market right now’s pricing in still a relatively low default rate as we go into the soft landing in the economy. But it’s also, in the past couple weeks, with the Fed cutting, pricing in the benefit of a steepening yield curve and looking for higher net interest margins over time.

Dziubinski: All right, let’s move on to some new research from Morningstar. Nike stock tumbled last week after reporting poor earnings, lowering its guidance for fiscal 2025, and postponing its investor day. So we talked about Nike on last week’s show as looking really undervalued. What’s Morningstar’s take on it after all of this news?

Sekera: Yeah, so last week, we noted that even though this stock was undervalued according to our valuations, according to our analyst team going into earnings, that this might be one where it’s going to take some time for this stock to work. Investors certainly are going to want to see evidence of a turnaround before you really see some meaningful gains.

Now, unfortunately, this short-term situation here is even worse than what our analysts expected. Sales for this current quarter are projected to fall 8% to 10%. I believe that was the management guidance. Before the earnings call, our estimate was only for a 6% decline. Now, our analyst noted in his write-up that he does expect to lower his fair value to take this worse than expected performance into consideration. And from my point of view, I think it just looks like it’s going to take a while for Nike to be able to really revitalize its product portfolio to compete against the new competitions it’s seeing from some of the brands like Hoka, On, and Brooks.

Now, as far as postponing its analyst day, to me that’s actually not necessarily very surprising. Nike did announce that it’s replacing the CEO. So in this case, I think they need to give the CEO, or new CEO that is, time to evaluate the situation. He’ll come up with a new plan. Once he’s done so, I’m sure they’ll communicate that to the market. But in the meantime, this stock might languish for a little while.

Now, hopefully, once that plan is announced, that could be the catalyst for the stock to bottom out and start to recover. But again, this is just one of those situations where I think if you have an interest in Nike and Nike stock, start off with just a partial position. Don’t back up the truck and buy a whole position all at once. And then set yourself a limit so that way if the stock does fall further, it gives you some time to reevaluate what’s going on when it hits that target price to the downside. At that point in time, if you still believe in the long-term investment thesis, then you can buy some more, dollar-cost-average down. Right now, I think we’re still in that reevaluation stage on this stock.

Dziubinski: You also published your fourth-quarter stock market outlook last week, and readers can access your research via a link beneath this video. And also, viewers who’d like to join Dave’s quarterly in-depth presentation about the quarter ahead can register for that webcast, which is taking place this Wednesday, using the link beneath this video.

All right, let’s talk about some of the highlights from your outlook, Dave. Let’s start with the market valuation today. Is the market overvalued or undervalued at the start of the new quarter?

Sekera: Right now, the market was trading at about a 3% premium to a composite of our fair values. That starts to put it in what I consider to be the upper end of the fair value range. Now, 3% may not necessarily sound like much, but when I look at that premium and I go all the way back to 2010, only 15% of the time have we traded at this much of a premium or more.

Dziubinski: Now, what’s that mean in real world terms for investors, Dave? If the market looks fully valued, what can investors expect in terms of stock market returns moving ahead?

Sekera: Whether it’s the market or whether it’s an individual stock, when it’s trading close to our fair value, that means that investors really should expect, over the longer term, an average market return or an average stock return, which would be in line with the blended cost of equity. So in this case, for the overall market, we’d be looking for that 8% to 9% area. And of course, over the short term, you’re always get a good amount of volatility both to the upside and the downside.

When I look at the market today, even at that 3% premium, which we just don’t see very often, when I look at the market dynamics, I still think that the tailwinds out there probably overwhelm the headwinds. So when I’m looking at the number of tailwinds out there, we’re still looking for moderating inflation, expecting inflation to drop below the Fed’s target. We’re looking for 1.7% next year. We still expect that over the next couple of years, long-term interest rates will decline. US economics team is looking for the 10 year to fall to an average of 3.5% next year, down to 3% in 2026. Of course, now we have easing monetary policy, looking for the Fed-funds rate to get to that 3.OO%-3.25% range by the end of next year. And then most recently, the Chinese announcing their fiscal and monetary stimulus as well. So a lot of tailwinds out there bolstering the market right now.

The only headwind really is that slowing rate of economic growth in the US. We’re looking for 2.5% GDP in the third quarter, slowing to 1.5% in the fourth quarter, another 1.5% print in the first quarter, and then bottoming out at 1.4% in the second quarter, and then looking for kind of that slow rebound thereafter. I’d also note, too, that this rate of slowing is actually much less than what our economics team originally projected at the beginning of this year.

Dziubinski: Now, we also saw some significant market rotation during the third quarter. Do you expect that to continue during the fourth quarter?

Sekera: We do. In our third-quarter outlook, we noted that a lot of the artificial intelligence stocks, specifically those in the large-cap growth category were at least fully if not getting to be overvalued. And from a technical basis, a lot of those stocks were really getting overextended. So in that third-quarter outlook, we asked really what was supposed to be a rhetorical question: Is the AI trade over? And at that point in time, we highlighted just how undervalued small-cap stocks were and value stocks. And in beginning of July, we actually started to see that rotation out of those large-cap growth stocks into small cap and into value stocks.

Now, at this point, both of those categories, small caps and value, remain pretty undervalued, and they’re undervalued on both what I consider to be an absolute basis as well as a relative value basis. So for people that have an interest in that rotation, I’d recommend taking a look at that fourth-quarter outlook. Specifically, I have a couple of charts in there that show where those are trading compared to the broad market average valuation going back to the end of 2010. And you can see, on a relative value basis, just how undervalued they are over the past 14 years.

Dziubinski: Let’s get more specific from a style and market-cap perspective. How should investors be thinking about their portfolios today based on valuations?

Sekera: Based on our valuations by capitalization, we would advocate for an overweight position in small-cap stocks. Those are trading at about a 15% discount to fair value. I’d look to market-weight mid-cap stocks. Those are only trading at a 1% discount, so pretty close to fair value. And of course, in order to pay for that overweight, you’d need to underweight large-cap stocks, those trading at a 4% premium.

And then by style, we look to overweight the value category. That’s a 3% discount. Market-weight core, which is at a 2% premium. And look to underweight the growth category, which is trading at a 13% premium.

Dziubinski: Now, let’s talk about sectors. Most sectors look fully valued to overvalue today, but there are still two pockets that are undervalued, and the first of the two is communication services. Now, we also had, during the past quarter, Morningstar analysts raised their fair values on a couple of big names in that sector that had an impact. Talk a little bit about that.

Sekera: Yeah, so by sector, the communication sector is still the most undervalued. Trades at a 15% discount to fair value. And like you said, you just can’t talk communications without focusing on Alphabet and Meta. Just based on the size of the market cap of those two companies, they account for 40% and 27% of the sector, respectively.

So for Alphabet, it’s a 4-star-rated stock. Trades at a 20% discount to fair value. As you noted, we did increase our fair value to $209 per share. Again, that company is still just hitting on all cylinders. We think the market right now is probably being overly pessimistic regarding some of the antitrust issues there.

Meta’s a 3-star-rated stock. We increased our fair value on that one to $560 per share. And the change in Meta was really just because we’re now incorporating what I consider to be a more optimistic outlook on the company’s ability to use AI to improve its ad-targeting business.

And communications, we still think there’s a lot of value in more of the traditional communications names. We’ve long talked about Verizon as being one of our picks. It’s still a 4-star-rated stock, 17% discount, over 6% yield. So even though that one has really increased a lot since we first started advocating for that one, we still think it has further to go.

Dziubinski: Now, energy stocks also look undervalued. Dave, what’s Morningstar’s forecast for oil prices?

Sekera: The energy sector’s the only other sector that we think is still undervalued. Trading a 9% discount to fair value. But as you noted, we actually have a relatively bearish outlook on the price of oil. Looking at our long-term supply/demand curves, we think the midcycle price for West Texas Intermediate is only $55 a barrel. However, I still think that energy deserves a place in everyone’s portfolio, provides that good natural hedge to any other additional geopolitical risk, as well as if inflation, for whatever reason, were to start to rebound.

Dziubinski: So even though we have a bearish outlook, you still think some energy stocks are a buy today?

Sekera: In fact, it’s actually that bearish outlook that actually makes energy look really attractive to me today. So let me explain that a little bit.

In our models, we actually use the market implied two-year strip price, so essentially what the market itself is pricing in for the price of oil for the next two years. And then we’ll take that price and move it up or down depending on where it is on that year two, to what our long-term forecast is for oil prices, in this case $55 a barrel.

Yet, even when we use that bearish scenario, a lot of these stocks are undervalued. So in my mind, if we’re right and oil prices stay here and depreciate over time down to that long-term price, you’re still buying these stocks at a margin of safety. Now, if we’re wrong and oil stays here or moves up higher, I think there’s a lot of upside leverage in a number of these energy stocks. And again, just going back to—it plays a good part in your portfolio as that natural hedge against heightened geopolitical risk or if inflation were to rebound.

Dziubinski: All right, time for the picks portion of our program. This week, Dave has brought viewers five undervalued stocks to buy from Morningstar’s list of analyst picks for the fourth quarter. These names that Dave’s going to talk about today are all new picks, new additions to that list. Viewers can find a link to the complete list of fourth-quarter analyst picks beneath this video.

Dave, your first pick this week is Dow. Share some key stats on this one.

Sekera: Sure. Dow stock is currently rated 4 stars. Trades at 23% discount to our fair value, and currently the dividend yield’s a little bit above 5%. It’s a company we rate with a narrow economic moat, and that narrow economic moat is based on its cost advantages, specifically due to its ethylene and propylene manufacturing operations in North America. And we rate the company with a Medium uncertainty.

Dziubinski: Now, Dow stock has had a tough couple of years. Briefly recap what’s been going on and why now is a good time to dip a toe in.

Sekera: Generally, when I look at the stock and I look at the chart, it’s come pretty much sideways for the past two years. A couple years ago, it definitely suffered from a lot of the supply chain disruptions that we had, but I’d say it’s also just suffered from the broader global economic slowdown that we’ve seen over the past two years. While the US economy has certainly held up better than expected, when I look at the European and the Chinese economies, those definitely have been slower or, in the case of Europe, potentially even stagnant or recessionary.

Now, looking forward, I would just say a synopsis of the investment thesis here is we are looking for a recovery in volumes in the fourth quarter of this year going into 2025. And we’re also looking for favorable unit economics to be able to drive a recovery in the operating margins.

I took a look at our model over the course of the weekend, and I think our top line growth assumptions are actually pretty modest. We’re only looking for an average 3% growth rate each year over the next five years for revenue, but we do forecast its operating margin will expand to where it’s averaged over the past seven years. Now, currently, that stock trades at 21 times this year’s projected earnings, but once we correct for that margin normalization and look at earnings for next year, it’s only trading at 14 times next year’s projected earnings. And in the meantime, you’re clipping a pretty healthy dividend yield of about 5%.

Dziubinski: Your second stock this week is another name from the basic materials sector. It’s FMC. Give us the essentials about this one.

Sekera: A little word of caution here: This is a stock we rate with a High Uncertainty Rating. But again, it’s a 5-star-rated stock, 42% discount, 3.6% dividend yield. Now, we rate this company with only a narrow economic moat. So for those of you that don’t know FMC, it’s what we consider to be a pure-play crop-chemical producer, but its economic moat is going to be based on the patents it has for crop-protection products, which we think provides the company pricing power over the long term.

Dziubinski: FMC stock is down 49% since the start of 2023. So why does Morningstar like the stock? And when do we expect a recovery?

Sekera: In general, the market is still very cautious as to timing of the recovery for that crop-chemical production. Now, specifically for FMC, the market’s also very concerned about some patent expiration risk that they have for their diamide products. Those products generate about half of the company’s profits at this point.

In our view, we think the market is underestimating the company’s research and development product pipeline. In our view, over the next couple of years, as the company rolls out new premium products, that’s actually going to help boost their operating margin and get back toward what we consider to be historical normalized averages.

So looking forward, the synopsis here is we are looking for recovery in volumes in the second half of this year, moving into 2025. Taking a look at the model here, we’re looking for some pretty decent top line growth. I think we assume about a 6.5% average growth rate over the next five years, but it’s really that operating margin expansion where we’re looking for the upside in this stock. This one also trades at 21 times this year’s projected earnings, but if we’re correct about margin expansion next year, it’s only at 14 times 2025 projected earnings.

Dziubinski: Now, your third pick this week is a REIT that I don’t think we’ve talked about before on The Morning Filter. It’s Sun Communities. So what’s our thesis on this one?

Sekera: Not only have we not talked about it, it’s actually one I hadn’t really known myself, so I did have to spend some time this weekend to do my own research on morningstar.com, reading through our notes, and looking at our financial model. The company’s what we consider to be a residential REIT company, focuses on owning, manufacturing housing communities, communities for residential vehicles or RVs, as well as marinas.

The investment thesis here is that we expect to see above-average same-store net operating growth, or net operating income growth, over the next couple years. And I think it’s just going to be a matter of the market will take some time to recognize this strong growth here. And I think going into an environment where interest rates should start coming down over the long term, the combination of those two things could provide the catalyst for this stock.

Dziubinski: Now, run through the key stats on Sun Communities, Dave.

Sekera: It’s a 4-star-rated stock at a 25% discount, although it’s only a 2.9%. I think this is one where you’re really looking to buy it for that 25% margin of safety. Now, I would also note that this is a company that we rate with no economic moat, although that is pretty typical in real estate. There’s, in our view, few real estate plays that have those long-term durable competitive advantages in which you’d award an economic moat, but it’s a stock we rate with only a Medium Uncertainty Rating.

Dziubinski: Now, CNH Industrial is your next pick. Give us the top line metrics on this one.

Sekera: Four-star rated stock, 25% discount from fair value, pretty healthy dividend yield at 4.3%. Company we rate with a narrow economic moat, and that’s based on a combination of its intangible assets as well as switching costs. Although a company we do rate with a High uncertainty because it is going to be definitely on the cyclical side.

Dziubinski: Talk a little bit about the headwinds that CNH is facing today.

Sekera: CNH makes heavy machinery, and that ranges anywhere from the really large agricultural equipment to construction equipment. Now, when I take a look at what’s happened over the past couple of years, I would note their sales just soared in 2021, I think they’re up about 30%, and this is based on a couple of things that were happening.

At that point in time, agricultural commodity prices—corn, soybean, wheat—they all soared toward their highest levels over the past decade, so that gave a very good boost for their agricultural equipment. And construction sales actually were doing very well, as the government was funding a lot of infrastructure projects that were going to come to fruition over the next couple of years.

So to some degree, I think when I look at what’s going on with the company today, it’s under pressure because those sales in 2021 pulled forward a lot of future demand. And of course, these are the type of products that have very long lives.

Now, of course this was, or what’s going on now is we’re seeing commodity prices at some of the lowest levels since before the pandemic, when I look at the same things, corn, soybeans, and so forth. So we do think that sales will still be pretty sluggish or even slightly down here in the near term. However, they should bottom out in 2025 and begin to recover thereafter. And as those sales start to recover, we’re also looking for the operating margin, which is low right now, to start to normalize and move back up toward its long-term historical averages.

Dziubinski: So what, in a nutshell, is Morningstar’s long-term thesis on CNH?

Sekera: Well, long-term, we’re just constructive in our outlook for the agricultural business. We think that ag business has a pretty favorable replacement cycle, and we’re also looking for some incremental opportunities in precision agriculture that this company does very well in. Now, I’d say when I look at the model here, it’s one where we’re actually not expecting very much earnings growth over the next couple years, but even still, it’s definitely a value stock, trades at only 8 times earnings today.

Dziubinski: Now, your last pick this week is Estee Lauder. This stock has really gotten hammered. It’s down 74% since the start of 2022. What the heck, Dave?

Sekera: All right. Well, first, Susan, I think we do need to recognize that Estee Lauder stock was overvalued, and it was rated 2 stars at the beginning of 2022. And I think what we’ve seen over the past couple years—a combination of two things. That one, it was overvalued, so I think it’s just natural for that stock price to come down over time to what we think is the long-term intrinsic valuation. But the company’s performance has also been a much weaker than expected over the past couple years. In fact, we actually just recently cut our fair value estimate as well.

Now, when I look at the company’s top line, I would note that their sales to the Americas, Europe, and Asia each account for about a third of their company’s revenue. And the company’s been struggling in both Europe and Asia. Both of their economies have been stagnant or possibly recessionary in the case of Germany. And China’s economy’s also been much weaker than I think anybody expected over the past two years.

So with that top line being under a lot of pressure, the operating margins have contracted—and contracted actually quite substantially. When I look at the margins, they averaged about 15% over the past five years but dropped to as low as 10% last year. To the upside, when the company was doing well, it was as high as 20%.

So I think the story here to some degree is we are looking for margin expansion as that top line then starts to stabilize. We’re looking for an average margin of 13.4% on average over the next five years, looking for top line growth of 4.6% over the next couple of years. But between that top line growth and then throwing that margin expansion, we’re looking for earnings growth to average 16% over the next five years.

When I’m thinking about what’s going on globally—Europe’s Central Bank is also easing its monetary policy; China just recently announced a number of different stimulus measures there—so between the two of those, we are looking for that longer-term improvement in the global economies and that should be a catalyst for this stock.

Dziubinski: So then what are the key metrics on this one, Dave?

Sekera: It’s currently rated at 5 stars, trades at a 45% discount from our current intrinsic valuation, has a 2.75% yield. It is a company we rate with a wide economic moat. That moat is really going to be based on not only its strong brand equity, but the relationships it has with its retailers. And we also think it benefits from cost advantages based on its size, and it’s a company we rate with a Medium uncertainty.

Dziubinski: Well, thanks for your time this morning, Dave. Viewers who’d like more information about any of the stocks that Dave talked about today can visit morningstar.com for more details. We hope you’ll join us for The Morning Filter 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.