DAVID SEKERA | From Morningstar
DAVID SEKERA | From Morningstar
Inflation, recession, high interest rates, mortgage stress and cost-of-living pressures, just some of the cheery headlines that we can look forward to in 2023. Or is the future looking more benign? This is the first fresh episode of the year and my guest is Dave Sekera chief U.S. market strategist for Morningstar. Dave is the author of Morningstar’s Stock Market Outlook for 2023 which is the basis for this interview. Following are the key points covered:
- Stocks are trading at a deep discount to our fair value estimate.
- Volatility will remain high over the first half of 2023, but market should begin sustained recovery in second half.
- Headwinds identified at beginning of 2022 are forecast to turn into tailwinds in second half of 2023.
- High-quality companies with wide economic moats especially attractive.
"So 2023 I think is interesting in that it's shaping up to be a tail of two halves. You know, the first half versus the second half. So the four different headwinds we identified at the beginning of last year war, you know, the slowing rate of economic growth in the US that we expected the Fed to start tightening monetary policy. You know, we noted that inflation was gonna be running hot and that we had expected long-term interest rates to rise. So as we're looking at those headwinds now, you know, two of those four we think are starting to abate. So inflation is still high here in the US but it's moderating, you know, we think it's already peaked and should slow further now, not only this year but actually even going into 2024."
We also spoke about how analysts at Morningstar calculate fair value, what is a risk premium, and the mindset required to for investors to be successful.
"You also will have these periods of volatility where you can see the equity markets, you know, fall of 15, 20 plus percent in a year. And so for investors, I just wanna make sure they have, you know, the right risk appetite to be able to take those kind of losses and you want to be able to hold, you know, through those down periods and not be selling stocks out when they're at the bottom and have to take those losses because we do believe that over the long term, time in the market is actually gonna be one of the largest factors for investors to be successful."
TRANSCRIPT FOLLOWS AFTER THIS BRIEF MESSAGE
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Stocks for beginners.
The markets will swing based on a combination of both, you know, fundamental and what we call technical factors. And as analysts, you know, I consider our job to see through the noise and really think about, you know, what is a company worth? What do we consider to be the intrinsic value of that company based on how much cash flow we think that company is gonna be able to generate, you know, over the course of its entire lifetime. And the technical side. And we don't really spend a lot of time focused on that, but you know, you can see what they call like risk on risk off sentiment. You know, you can see a lot of momentum. But as long-term investors, you know, we're really looking for where we see a difference in the long-term view of that company versus what's currently being priced into the markets.
Hi, and welcome back to Stocks for Beginners. I'm Phil Muscatello, inflation, recession, high interest rates, mortgage stress and cost of living pressures. Just some of the cheery headlines. Oh, and I should not forget War as well. These are some of the cheery headlines that we can look forward to in 2023. Or is the future looking a bit more benign to discuss in the first fresh episode of the year is Dave Sekera, who is the chief US Market strategist for Morningstar. Hello Dave.
Dave (1m 17s):
Phil (1m 18s):
Thanks very much for joining me today. Now Dave is the author of Morningstar's Stock Market Outlook for 2023, which I'll link to in the blog post and the show notes. And I just wanted to note before we started that we're recording today on the 12th of January and the latest inflation figures have just come out, which does have a lot of bearing in what we're going to be discussing today. But first off, let's back look back to 2022. How was it in the markets from yours and Morningstar's point of view?
Dave (1m 46s):
Well, it was definitely a tough year in the US markets and one of the few years that you see in which both equities and fixed income suffered, you know, relatively large losses. So when we look at the broad US market, we used the Morningstar US market index and is down almost 20%. And then looking at a broad fixed income market, you know, that was also down 13%. Now having said that, I do think that you kind of need to also put that into a bit of a historical context over the past couple of years. And so we had noted, you know, you had some relatively large gains in 2020 and 2021. And in fact, by the end of 2021, you know, we had noted that we thought that many of the mega cap stocks were really rising out too far too fast, and that the broad market itself had become overvalued.
Dave (2m 31s):
So to some degree the losses last year, I think the beginning part of the year that was really just coming back down to more normalized valuations. But by the end of 2022, you know, I think the pendulum has actually now swung too far to the downside and that the markets are actually undervalued in the us.
Phil (2m 49s):
So you, you mentioned and referred to the fixed income markets there. Now that's, that's basically bonds, isn't it? And we always hear about the 60 40 portfolio as being one of the, the cornerstones of any portfolio, and some of that's in fixed income and some of that's in inequities or the, the majority inequities. What, what are the factors behind the fixed income side of the portfolio doing so poorly? Because historically that's never really happened too much. Well,
Dave (3m 16s):
It's similar to the equity market where a fixed income just became, you know, too overvalued. So when you look at the US you know, like the 10-year US treasury rates, you know, coming into the year in 2022, you know, I think the 10-year was yielding about one point a half percent. And of course that was, you know, significantly below, you know, the rate of inflation at the beginning of the year. And inflation in the US did continue to keep, you know, taking up throughout most of the year.
Phil (3m 40s):
Yeah, I'm, I'm fascinated by the fixed income market because coming in as a newbie into this, this area, I just didn't realize how much influence and how large that particular sector is. And I might bore listeners a little bit by going on a bit too much about this sector, but really the interest rates, is it to do with the interest rates prevailing in the economy at the time that has made this sector out underperform?
Dave (4m 7s):
Yeah, and really, you know, when you think about bonds, I mean the real big differentiating factor with bonds is that you have, you know, a fixed coupon on there and you have a set maturity date. And so when you think about bonds, you know, the best thing that can ever really happen as a bond investor when you buy a bond, you know, at par, which is a hundred cents on the dollar, is, you know, you get your coupon every six months and then at the end at maturity, you know, you get that principle payment back. So what happens is that as interest rates are going up, you know, the value of those coupon payments that you're getting as an investor essentially become worth less because the new bonds that are out there now have those higher interest rates. So of course people won't be willing to pay as high a price, you know, for the existing bonds.
Dave (4m 50s):
And so that's why you see as yields go up, you know, existing bond prices will come down. Okay.
Phil (4m 55s):
Well let's get back to the equity markets. And it's a story of different sectors. Now. The equity markets are chopped up into different sectors according to the industries that companies work in. What, what is the, the, your broad overview of the sectors and how each performed last year?
Dave (5m 13s):
Sure. And there's really two ways that I think about the equity market. So the Morningstar uses what we call the nine box style box. And so we break it into, you know, three different categories. We have growth stocks, core stocks, and value stocks, you know, growth stocks being those companies that you expect over time will have, you know, much faster earnings growth. And so those stocks are you gonna be, you know, valued more highly in different types of valuation matrices. Whereas value stocks are gonna be more, you know, tried and true stocks companies that have been around a long time, you know, that are not gonna see as much earnings growth, but they're usually less volatile, less risky kind of stocks. And core stocks are really a blend.
Dave (5m 53s):
They usually have some attributes of both growth and some attributes of value, but don't fit neatly into, you know, one of those categories or the other. So one of the things that I really noticed this year is how big of a differentiation there was between growth and value stocks. So while the overall market fell about 20%, really the preponderance of that decrease came in the growth category. So growth stocks were down, you know, almost 37% for the year. And then those value stocks, they were almost on change. They're only down a little bit under 1%. And then core stocks kind of came in in the middle of that. So a lot of people then might be asking, well, you know, why was there such that huge differentiation? And so when you think about growth stocks and you think about what sectors are in there, you know, that's gonna be heavily weighted towards, you know, things like the technology sector, communication sector, consumer cyclical sectors, you know, those that had the highest evaluations coming into the year.
Dave (6m 49s):
And of course those then were the ones that sold off the most, whereas the value stocks, you know, those are gonna be more defensive in nature. So defensive companies, you know, think some of the, the food companies, supermarket companies, you know, things like that. And so they really ended up holding, you know, pretty well to the downside.
Phil (7m 7s):
And mega caps played a big role in the this downturn as well in value what's, you talked about a list of nine of which four were on the overvalued list last year.
Dave (7m 19s):
So tell us about those. Yeah, so first of all, there really is no, you know, streetwide definition of what exactly a mega cap stock is.
Phil (7m 27s):
So yeah, it's an, it's an interesting usage that you've got there. Yeah, yeah, yeah.
Dave (7m 30s):
So in this case, you know, I look at those companies that have, you know, market capitalizations of over 250 billion us. So the largest of the large, you know, out there, the Apples, the Microsofts Alphabets, you know, and so forth. And so at the end of 2021, you know, we noted that a lot of those really had become significantly overvalued. So last year in our 2022 Outlook we highlighted 15 that we rated, you know, one or two stars. So essentially those that we thought were, you know, the most overvalued, you know, based on the underlying fundamentals of the companies now of that list, you know, nine of those 15 underperformed the markets, you know, in many cases, you know, very significantly on a couple kind of came in, you know, in line with the market.
Dave (8m 14s):
But of those, you know, only two actually generated a positive return. So now I'm actually looking at it, you know, from the opposite perspective and looking at, you know, those mega cap stocks that we think have actually fallen too much this year. So there's now nine of these mega cap stocks and of those mega cap stocks that we think that are undervalued, you know, four of those were actually on that overvalued list last year. So for example, Tesla, Nvidia, bank, America, and Broadcom. So I think, you know, like Tesla is an example where, you know, the market had just become, you know, too far overextended on that name. You know, we thought it was overvalued. I think the stock fell like 70% this year and now the pendulum has swung, you know, too far to the downside.
Dave (8m 58s):
We think the market is, you know, overly pessimistic on that name. And so now is actually the time that we would recommend investors, you know, to be taking a look at that one. And you know, if that's something that's right for your portfolio, I think now is a good opportunity to buy at a relatively low valuation based on its growth prospects.
Phil (9m 14s):
And the energy sector was an area that outperformed last year as well, wasn't it?
Dave (9m 19s):
It was. So actually energy was the sector that we had noted coming into 2022 was the most undervalued of all the different sectors that we covered and it really just skyrocketed last year it was up, you know, over 60%. But I would caution investors at this point with as much as it has gone up as quickly as it's gone up, we actually think it's now overvalued and in fact that's the sector under our coverage that we would say is the most overvalued out of all 11 sectors.
Phil (9m 51s):
So your report that you authored mentions that the headwinds identified at the beginning of 2022 a forecast to turn into tailwinds in the second half of 2023. What are those headwinds and how can they become tailwinds?
Dave (10m 4s):
So 2023 I think is interesting in that it's shaping up to be a tail of two halves. You know, the first half versus the second half. So the four different headwinds we identified at the beginning of last year war, you know, the slowing rate of economic growth in the US that we expected the Fed to start tightening monetary policy. You know, we noted that inflation was gonna be running hot and that we had expected long-term interest rates to rise. So as we're looking at those headwinds now, you know, two of those four we think are starting to abate. So inflation is still high here in the US but it's moderating, you know, we think it's already peaked and should slow further now, not only this year but actually even going into 2024.
Dave (10m 44s):
And then as far as you know, long-term interest rates, you know, we think the preponderance of those increases are behind us and in fact, I would expect long-term interest rates to even start coming down and the second half of the year. So that leaves us with the economy and with the Fed. So at this point it does look like the Fed will continue to tighten monetary policy with at least one or two more, you know, interest rate hikes and then we'll pause to see exactly, you know, how much that really takes out of the economy in the first half of this year. Now we do think that the rate of economic growth will be slowing here in the US we see that the first half is going to be stagnant to even potentially recessionary before it can really start to accelerate in the second half of next year. So really, you know, the takeaway is that, you know, based on a combination of slowing economic growth and then the moderating inflation, I think that's gonna allow the federal reserve in the US to shift its focus back to its dual mandate, which not only includes, you know, making sure that they keep inflation down, but also fostering an economy that can maximize sustainable employment.
Phil (11m 43s):
So the house for then is recession is, if it does come, is only going to be slight. And I'll just preface this by saying it seems to be everyone seems to be talking about an A recession on the horizon and it's the most widely forecast recession we've ever seen. But the house view there is that it's not really, if it is going to be there coming, it's not going to be that bad,
Dave (12m 7s):
Short and shallow is how our US economics team is quantifying it at this point. So we'd be looking for, you know, about like an eight tenths percent decrease in G D P in the first quarter and then a .4% decrease of G D P in the second quarter then starting to accelerate in the second half of the year. So our full year G D P expectation for the US right now is just under 1% at eight tenths of a percent. But we do think that momentum will then continue and carry into 2024
Phil (12m 36s):
I, it's just that I have seen some commentators say that the Fed won't stop raising interest rates until unemployment goes up. And at the moment the labor market seems to be very, very strong.
Dave (12m 49s):
The labor market has definitely been holding in there relatively well, but it's not necessarily just the number of jobs that they're watching, but I think they're also gonna be watching, you know, for wage growth and wage growth has been lagging the amount of inflation that we've seen. So that's gonna keep that price wage growth, you know, spiral from occurring. And so that's why I think that when the economy is gonna be relatively soft with inflation still continuing to calm down, you know, that's when they'll be able to kind of get away from that focus that they have Right now I think that they just kind of were surprised last year with how much inflation, you know, was not transitory how much and how hot it really got. So to some degree I still think they're playing a little bit of catch up, but based at this point I do think that rates are pretty close to as high they're gonna get.
Phil (13m 34s):
Mm. Because in the past when central banks have tried to keep inflation under control, it's been really like jacking up, well we, we have had very large interest rates increases compared to other tightening cycles, but it's still, they always seem to overshoot badly causing a recession, which then resets everything in the economy. But I don't know, you seem to feel like it's going to be more benign than that.
Dave (14m 0s):
Well it's interesting, as you mentioned, when you look at past tightening cycles, you know, at least since the beginning of my career in 1991, this is, you know, the steepest and the most that they've raised.
Phil (14m 10s):
It's very fast, isn't it, that they've been doing it. It is,
Dave (14m 12s):
Yeah. Yeah. But I also think you take a little bit more of a historical perspective and start looking at, you know, what happened in the 1970s and 1980s. And so if you look at, you know, what the monetary tightening policy has been now, while it's certainly been, you know, a lot more than what we've seen the past couple of cycles, it's actually a lot less than what we saw in the 1970s and 1980s. Now of course inflation then, you know, did get well into, you know, the double digits here in the US you know, at this point I think we only peaked out at slightly over 9%. So I think it actually makes a lot of sense when you look at how much they've risen rates at this point where it's been more than what we've had, you know, the past couple of decades. Cuz inflation really had never gotten this hot really since, you know, the 1970s and 1980s.
Dave (14m 55s):
But with inflation not being as high as it had gotten back then, you know, they don't need to try and fight it as much as the seventies and eighties
Phil (15m 2s):
Stocks are trading at a deep discount. You believe, or the house viewers that stocks are trading at a deep, deep discount as you've referred to prior in the interview. How can the pendulum swing so wildly? Yeah,
Dave (15m 15s):
Well and that is the nature of stocks and stock markets and and human behavior and you know, markets will,
Phil (15m 21s):
Is that where the psychology's coming into it?
Dave (15m 23s):
It is. So, you know, the markets will swing based on a combination of both, you know, fundamental and what we call technical factors. And as analysts, you know, I consider our job to see through the noise and really think about, you know, what is a company worth? What do we consider to be the intrinsic value of that company based on how much cash flow we think that company is gonna be able to generate, you know, over the course of its entire lifetime. And so, and the technical side, and we don't really spend a lot of time focused on that, I really think that's more the realm of traders and not investors. But you know, you can see what they call like risk on risk off sentiment. You know, you can see a lot of momentums, you know, when things are going up, people are buying it cuz it's going up and when it's going down they're selling it just cuz it's going down and you know, fun flows, options, positioning, you know, a lot of things that can move the market, you know, here in the short-term.
Dave (16m 15s):
But as long-term investors, you know, we're really looking for where we see a difference in the long-term view of that company versus what's currently being priced into the markets. And so we're looking at, you know, a lot of those factors, you know, what's driving revenue, how much revenue growth are we expecting, you know, over the long term we're gonna model out, you know, the company's costs, you know, what the operating margins were going to look like and then be able to come up with, you know, our view of earnings and then discount those earnings to today. So even though, you know, maybe a company reports earnings and you can see the stock move, you know, a pretty good amount because maybe they beat those earning expectations or miss those earning expectations, you know, from my point of view that's trading, it's really not investing.
Dave (16m 60s):
What I wanna do is say, okay, well if they missed or they beat, well why did they miss? Why did they beat? And then take a look at the assumptions that we have in our financial models and determine whether that ends up changing our long-term view of the company. So when we look at those earnings beat and misses, yeah maybe they can, you know, cause us to move our stock valuations, you know, maybe three to 5% in the short term. But it's really those paradigm changes, you know, those big catalysts where there's a change in the underlying business or the underlying fundamentals that end up, you know, changing, you know, the valuations, you know, well into the double digits in some cases.
Phil (17m 34s):
Yeah, I'm interested to, in your comment that it's your job as an analyst to see through the noise and that's something, it's a valuable lesson for new investors as well because they're confronted with so much noise in financial media and traditional media every day, aren't they?
Dave (17m 51s):
They are. You know, and I think a lot of that is just based on traders, you know, kind of whipping around, you know, the, the PE multiples or whipping around, you know, the stock in the short term. And so as a fundamental long-term investor, you know, it's always incumbent, you know, to really decide, you know, what has really changed here? Is there something that's changing my view, you know, this company, this sector, which really I should then now, you know, be looking to sell out of the stock because what I expected wasn't going to be something you know is gonna happen going forward or conversely and you know, someone with one of the hardest things in finances to figure out, well, okay, you know, I bought this stock, I thought it was fairly valued or undervalued at this price, this has now happened, the stock is down, you know, whatever amount, you know, some people say, you know, your, your best loss is your first loss, but if the stock is going down and you really have confidence in your fundamental view, that oftentimes is, you know, a very good time to be able to, you know, invest more in that company and be able to buy more of that stock at an even lower price.
Phil (18m 54s):
I wanted to talk to you about risk premium. What is risk premium and how do you use that in the way that you analyze stocks?
Dave (19m 2s):
Whereas a couple of different ways to think about risk premium. So you know, when we're looking at the stocks and we model out how much cash we think this company is gonna generate, you know, each year over the course of its lifetime, we'll then use a weighted average cost of capital to discount that, to come up with what we think the intrinsic value of that company is worth today. And then based on the number of shares, you can divide that into the intrinsic and that essentially gives us, you know, what we think the stock price should be worth in the markets. So that weighted average cost of capital, you know, that's gonna be based on your risk free rate, which in most cases is just going to be equivalent to like a long term US treasury rate. But then a cost of debt and a cost of equity.
Dave (19m 42s):
So your cost of debt, that goes back to the corporate credit spreads that a company is gonna have to pay in order to be able to fund itself in the debt markets. And then the cost of equity. Now when we think about the cost of equity, you know, we tie that to what we call our uncertainty rating. So the lower uncertainty in a company, we think that the cost of equity is also going to be lower. So a company like, you know, maybe a soda company like Coca-Cola is gonna be a very steady company year end, year out. I mean there'll be some changes, you know, in its earnings over time, but it's gonna be, you know, pretty steady. And we think that we're gonna be able to model that company out over the long term pretty accurately.
Dave (20m 23s):
So that's gonna have a low cost of equity in the marketplace. Now a company that's very volatile, maybe something in the commodity sector where those earnings can swing, you know, quite dramatically based on maybe the price of oil or the price of copper, you know, those companies are gonna require a much higher cost of equity because it's much more difficult to really accurately be able to price those companies and forecast them out into the future. So you might have a, a cost of equity of maybe 10% on those companies as opposed to maybe seven or 8% on the less risky companies.
Phil (20m 55s):
Because I think that's one of the real bases of investing is understanding, and this again we're talking to beginner investors here, is that the capital that you are deploying into a company when you buy a stock, you've actually gotta think about the difference between the risk that you are taking on compared to risk free. Just putting it into, you know, a a, a bank deposit or something like that, that's just paying a fixed rate of interest. Isn't that one of the basics?
Dave (21m 20s):
It is and you know, you always kind of think about it from a individual investor point of view. I always think that you should start off, you know, with investing in, you know, the less risky investments and you know, as you're able to start building up your portfolio you can start taking additional risk. So you might start off with, you know, having you know enough money in the bank to be able to suffice to, you know, pay expenses in case you were laid off for a couple of months. And then from there you might layer into, you know, some longer fixed income securities where you're getting a higher yield on those securities. And then once you have that base, then you can start moving into the equity market. Cause of course, you know, as you've seen, well equities certainly can provide, you know, much bigger gains over the long term.
Dave (22m 3s):
You know, you also will have these periods of volatility where you can see the equity markets, you know, fall of 15, 20 plus percent, you know, in a year. And so for investors, I just wanna make sure they have, you know, the right risk appetite to be able to take those kind of losses and you want to be able to hold, you know, through those down periods, you know, and not be selling stocks out when they're at the bottom, you know, and have to take those losses because we do believe that over the long term, you know, time in the market is actually gonna be, you know, one of the largest factors for investors to be successful.
Phil (22m 35s):
So slow and steady then.
Dave (22m 37s):
Phil (22m 38s):
Okay, so another metric that you use is price to faire value ratio. How do you calculate that or how does Morningstar calculate that?
Dave (22m 48s):
Well, we use a discounted cash flow model and it's, you know, really
Phil (22m 52s):
Remember keep it simple. Keep it simple here.
Dave (22m 56s):
Well that really gets back to, you know, trying to figure out and think about, you know, how much is this company going to earn? And again, we're forecasting a how much company cash is gonna get generated over its lifetime. So think about like the income statement. So we're gonna break down how does this company make money? What is its basis for its revenues? How fast can they grow revenue over time? Do they have certain products that we think will grow, you know, extremely fast? Or is this company where their products are gonna grow, you know, in line with, you know, maybe the economy or with G D P? And then we'll kind of have to figure out, well what kind of cost does it take in order to be able to sell these products and come up with like our cost of goods sold, how much does it take to be able to manufacture these products?
Dave (23m 41s):
And then we can figure out, you know, how much we think the operating earnings of that company is going to be. You'll run that through the model and come up with that cash flow stream. Now the one thing that is different that we do here that I think a lot of other places may not do is we incorporate what we consider an economic moat analysis. So it's really a very, what I consider to be Warren Buffet type of analysis. So we're looking to see does a company have specific long-term durable competitive advantages that will allow that company to be able to generate excess returns over the long-term. So here we're looking at specifically, you know, returns on invested capital and we're comparing that to the company's cost of capital.
Dave (24m 23s):
And so the longer that they can generate those excess returns, the more valuable we think that company is going to be. So a company that we think can generate those excess returns for at least the next 10 years, we're gonna consider that company having a narrow economic moat. Those companies that can generate excess returns for 20 years or longer, that's gonna be a company that can, that we're gonna rate with a wide economic moat.
Phil (24m 46s):
What are some examples of companies with wide economic moats?
Dave (24m 49s):
Well, let's go back to the consumer products sector for example. And so when you think about like Coca-Cola and Pepsi, you know, those are companies that you know, have very strong international brands and people will gravitate to buying, you know, a Coke or buying a Pepsi over brands that they have never heard of before. And so when you have people who are willing to pay a high price for that brand over the long term, you know, that is a, a moat where it's a very difficult for new entrants to be able to break into that market.
Phil (25m 19s):
So let's dig into that economic moat. You talk about the five sources of working out the economic moat.
Dave (25m 27s):
Yeah, so the first one is, you know those that are the low cost provider within their industry and it really is just as simple as it sounds, you know, who can be able to provide, you know, the product at the lowest cost. And so, you know, as people are competing, even if other people are, you know, trying to grab additional market share and lowering their prices, that low cost provider will always be able to match that price or even go lower because they'll be able to still make money when others can't. So one example of that might be like in the basic materials area. So if you think about, you know, certain mining companies, you know, based on the geology of the areas that they might be mining will be able to get at those, you know, different products at a price that other mining companies might not be able to get at.
Dave (26m 13s):
Efficient scale would be the next one that I would mention. And again, it's, you know, a company that is large enough and has, you know, enough fixed costs that they can make that product, you know, more efficiently than any other new competitors that could come into that market. So the third source that we look at are intangible assets, you know, those branded assets that people are willing to pay extra for, for those brands. But you can also think about other things too, like in the pharmaceutical industry, you know, the patents that people have on different drugs where they can generate, you know, excess returns on selling those drugs as long as those patents are outstanding. The network effect, I think that one is really interesting.
Dave (26m 54s):
So the network effect is that the more clients or more consumers that use your product, the more valuable that product ends up becoming. And so meta platforms, you know, the parent of Facebook is one that we always point to for that network effect, that the more people that get onto Facebook, the more people that attracts to get onto Facebook. And of course then, you know, they can use all the digital advertising in order to be able to monetize the number of people that are coming onto that platform. And then lastly, switching costs. So switching costs just means that, you know, once someone starts using your product, and this is, you see this a lot in the technology sector that it just becomes cost-prohibitive for a company to be able to move away from that product and switch to a competitor.
Dave (27m 41s):
Phil (27m 42s):
Yeah, that network work effect is an interesting side of it, isn't it? And because we always hear about newcomers coming into, especially the digital space that are going to be competitors to meta, but as you say, it's a very difficult thing for users to change. I mean, if you are used to exchanging pictures and stories with your own family, moving to another platform really constrains your ability to do so.
Dave (28m 9s):
Exactly. You know, another example might be with Apple. So Apple, you know, does have its own ecosystem of its own technology. And so once people move onto, you know, the Apple iPhone and then they start using some of the other Apple products and then they interact with other people using those products and then they use, you know, some of the different apps out there, you know, it really becomes difficult for people to move off of the Apple network and back onto some of the competitor networks. And so that's why we award or we rate Apple with a narrow economic mode.
Phil (28m 42s):
So Morningstar published a list of 33 undervalued US stock picks for the first quarter of 2023. What are two or three of you these favorites of yours to talk about?
Dave (28m 52s):
Well, one of the things I always really enjoy about investing is looking for, you know, long term secular trends. And you know, one here that I think is really interesting is a play on the transition to electric vehicles. And when you look at the transition to electric vehicles, in order for that to happen, you know, they all have to have lithium for their batteries. And I know our team has done, you know, a, a pretty deep dive, you know, into the lithium market and based on the number of suppliers out there today, based on new supply that they see coming on in mining over the next couple of years, we think lithium is going to be undersupplied for about the next decade. And of course that's gonna keep lithium prices, you know, very high. So one stock that we do like there would be Lithium Americas, you know, it trades at a very deep discount to our fair value.
Dave (29m 38s):
Now it doesn't have a economic mote yet and I would note that it is a, a higher risk in situation and probably better for, you know, investors who are willing to take that kind of risk. But it does trade at about a 70% discount to our fair value. So I do think that provides a very large, what we call margin of safety from our valuation, you know, for investors.
Phil (29m 59s):
Yep. And that's something for investors to consider as well as that when we're talking about a commodity, the value of a stock is really based on the price of the commodity itself that's being produced, isn't it?
Dave (30m 12s):
It is. And so that's why when we see lithium being, you know, so undersupplied for the next, you know, decade, that gives us, you know, a lot of confidence in our call on that
Phil (30m 21s):
One. And what about alphabet?
Dave (30m 23s):
Alphabet is a, you know, it's a stock that has been under a lot of pressure, you know, lately. And I think this is one where the market is looking at this, you know, short term softer growth, you know, specifically in their digital advertising. This
Phil (30m 36s):
Is Google, isn't it The Google parent companies?
Dave (30m 38s):
It's Exactly, yeah. And you know, advertising rates have been coming down, especially, you know, with the economy now starting to look like it's getting softer here, you know, in the US again and, and globally in fact. But we think the market is, you know, over penalizing that company for this short term weakness. Now this is one of our more differentiated calls out there. We do think the company has a wide economic moat that's gonna be based on a combination of its intangible assets and its network effect. So again, you know, it's certainly, you know, common parlance here in the United States when someone's talking about looking something up, you'd say, ah, just Google it. So again, you know, definitely has, you know, that brand and also the network effect. So again, the more people are using Google, but not only just Google, but you know, a lot of its other platforms, you know, think YouTube, you know, it definitely builds that network effect.
Dave (31m 26s):
So with the different platforms, you know, it's able to build a, a technological expertise and search algorithms and I think machine learning. So I think that's gonna help, you know, be able to build and deliver more value for advertisers over time.
Phil (31m 40s):
Yeah, because that's been one of the themes that's been discussed over the last couple of weeks that artificial intelligence and chat G P T in particular will maybe breach that mode again.
Dave (31m 51s):
Well there's always that possibility, but you know, we do think that generally we're still like the, the early innings of kind of a long term shift and digital advertising and Google I would say, you know, is one of the strongest platforms out there. And we do think that, you know, they will be able to develop new ways over time to be able to focus their advertising onto those target markets. So I do think that that is one where you could still see, you know, some significant upside in the price in that company. You know, right now it's trading at about a 45% discount to our fair value.
Phil (32m 23s):
Yep. And ServiceNow is another company that you've been looking at?
Dave (32m 27s):
It is, it's a, another one with a wide economic moat. And the moat here is really gonna be based on high switching costs.
Phil (32m 33s):
What does ServiceNow do?
Dave (32m 34s):
It provides US service desk software solutions for different corporate functions. And so once a company moves onto it gets all of its employees, you know, onto that network, you know, it's very difficult to be able to move people off of that network within that corporation. Mm. Now I know, you know, the company has performed in line with our expectations for, you know, the past year, but it's earnings growth has been hampered by foreign exchange translation. So this is one where I think now the market is again, over extrapolating too much to the downside. And we do think that, you know, this company's gonna have, you know, relatively rapid and organic growth over the next couple of years. In fact, I know our analytical team is looking for a growth rate of over 24% for the next five years, also generates probably some of the strongest free cash flow margins, you know, within the software space.
Dave (33m 24s):
And then lastly, I do think that it also has one of the better balance sheets out there. So I do think that, you know, even in, you know, any kind of potential economic storm, you know, they're gonna have the liquidity to be able to ride that out.
Phil (33m 35s):
So could you also talk about some long-term structural growth themes and stocks that are leveraged to that theme? Cuz these, there's again, a, these are tailwinds, aren't they? This is, you know, a following wind.
Dave (33m 47s):
Yeah. So another one is, you know, when you think about what's happened over the past, you know, two years, well three years now since the beginning of the pandemic is that there was a huge shift in consumer spending. So certainly in 2020 and even in 2021, you know, consumer spending shifted away from services and into goods. And now with, you know, the pandemic, at least here in the US really fading into the rear view mirror. We're seeing that consumer behavior normalize and shift back into those services that people hadn't been spending on for the last couple of years. So in like the travel industry, we think all the cruise lines are undervalued. One that I would highlight there is gonna be carnival cruise lines.
Dave (34m 29s):
We also see that the airline space is undervalued. Southwest Airlines has had some negative publicity with some operational difficulties recently, which has pushed that stock price down. But that's one that, that's,
Phil (34m 40s):
That's putting it, that's putting it very nicely.
Dave (34m 43s):
Well, and again, this is a, you know, opportunity where, you know, you can take a differentiated view from the marketplace in that, you know, because it had, you know, some of this negative press because their operational difficulties and the stock gets pushed down. You know, we don't think that that really changes kind of the long term value that they bring in the airline market, especially for kind of their target audience for travel. So we do think that that will recover, you know, over time. Now, another one in the airline industry that, you know, other investors might have an interest in would be Delta Airlines. So we do see that, you know, not only consumer behavior shifting in, normalizing, but expect to see, you know, a return to the business traveler. And so as that occurs, we think Delta Airlines is the one that's best leveraged for the return of the business traveler.
Dave (35m 29s):
Now people are also going out a lot more. So as people are going out, we're seeing a return to in-person shopping. So the, the malls are, are getting a lot more foot traffic. And a Simon Property group would be the one that I would highlight there for investors. And then the last one I would mention is Sam Adams, or even Anheuser-Busch Inpe. A lot of people don't necessarily think about, you know, the beer industry, you know, really being leveraged to that shift. But what we saw during the pandemic was that as people weren't going out, they were consuming alcohol at home, but when they would consume alcohol at home, they weren't buying, you know, the branded products they were buying, you know, the lower margin, you know, non-branded items.
Dave (36m 11s):
But what happens is that when people go out, they are, you know, brand conscious and they will in public, you know, choose, you know, those branded items which have higher margins. So those would be two companies that we actually think will benefit from that shift as well.
Phil (36m 25s):
Okay. So tell us a bit more about Morningstar. What does Morningstar offer and how can listeners find out more?
Dave (36m 31s):
Well, you can always read more of my content on morningstar.com. Morningstar is, you know, one of the largest global providers of financial research and data out there. And really one of the things that I really enjoy about working with a Morningstar is that we are an independent company. You know, we don't have a trading business, we don't have, you know, investment banking business. So the way I think about it is that, you know, the information that we put out there really is directly for our clients. And you know, we always put investors first, you know, as far as the content and the research that we produce.
Phil (37m 5s):
And it's in institutional grade research for ordinary people really, isn't it?
Dave (37m 9s):
Phil (37m 10s):
And we'll also put some links to the documents that we're referring to in this podcast as well, so listeners can find out more there as well. Dave Sekera, thank you very much for joining me today. It's been a real pleasure chatting with you.
Dave (37m 24s):
Well, thank you very much, Phil. Have been a great time.
4 (37m 26s):
If you found this podcast helpful, please tell a friend, especially if it's someone who needs to start thinking about investing for their future, you'll be helping them and helping me to keep their show on the road.
Chloe (37m 37s):
Stocks for beginners is for information and educational purposes only. It isn't financial advice and you shouldn't buy or sell any investments based on what you've heard here. Any opinion or commentary is the view of the Speaker only not stocks for beginners. This podcast doesn't replace professional advice regarding your personal financial needs, circumstances, or current situation.
Phil (37m 56s):
And thank you for listening to my podcast.
Stocks for Beginners is for information and educational purposes only. It isn’t financial advice, and you shouldn’t buy or sell any investments based on what you’ve heard here. Any opinion or commentary is the view of the speaker only not Stocks for Beginners. This podcast doesn’t replace professional advice regarding your personal financial needs, circumstances or current situation.