Even as challenges that marred the start of this year are projected to linger in the months ahead, the volatility that rocked global financial markets, damaged equities valuations, and sent investors running for safety has left stocks undervalued.
We predicted that stocks were overvalued at the start of the year, and that four reasons would limit market growth:
- Economic growth is slowing.
- Interest rates are being raised by the Federal Reserve.
- Interest rates are rising.
- Inflation
The Morningstar US Market Index is down 13.86 percent this year through the end of last month.
However, we believe that the current selloff has pushed the overall US share market too low. Following this fall, our market valuation indicator has slid into the undervalued category. The overall U.S. equities market is presently trading at a 12 percent discount to fair value, according to a composite of stocks studied by Morningstar’s equity research analyst team.
Morningstar’s Equity Coverage Price/Fair Value for U.S. Equities
We indicated at the start of the year that value stocks were better positioned than expensive core and growth stocks. The Morningstar US Value Index fell 2.08 percent until the end of April, while the Morningstar US Growth Index fell 25.90 percent and the Morningstar US Core Index fell 12.09 percent. We continue to believe that the value category trades at an 11 percent discount to fair value, and that it has strong economic tailwinds.
Growth stocks, on the other hand, have dropped to the point that they are now trading at a 17 percent discount, making them attractively priced for long-term investors.
We indicated at the start of the year that value stocks were better positioned than expensive core and growth stocks. The Morningstar US Value Index fell 2.08 percent until the end of April, while the Morningstar US Growth Index fell 25.90 percent and the Morningstar US Core Index fell 12.09 percent. We continue to believe that the value category trades at an 11 percent discount to fair value, and that it has strong economic tailwinds.
Growth stocks, on the other hand, have dropped to the point that they are now trading at a 17 percent discount, making them attractively priced for long-term investors.
Small-cap stocks are the most undervalued across market capitalization levels, trading at a 21% discount to our fair value. Both large- and mid-cap stocks are cheap, with discounts of 12 percent and 11 percent, respectively. Large- and small-cap stocks have both dropped by 14.34 percent and 14.27 percent, respectively, since the beginning of April. The mid-cap sector fell 11.96 percent.
Stocks with wide economic moats are currently trading at significant discounts to fair value.
The selloff this year has been largely indiscriminate. Stocks of all types of businesses have fallen, including those with the biggest long-term competitive advantages. The Morningstar US Wide Moat Index, for example, has dropped 15.81 percent. However, value has been an important factor in limiting the downside. This index, on the other hand, includes all of the stocks we recommend. The Morningstar Wide Moat Focus Index is made up of the 40 equities with the lowest price/fair value ratio and a wide economic moat. The Wide Moat Focus Index had only lost 9.11 percent compared to the Wide Moat Index.
Market Price / Fair Value of US Equities Based on Economic Moat Rating
Defensive sectors are overvalued, while growth sectors are undervalued.
Investors raced to defensive sectors as the market fell, but we believe that in most cases, their attempt to protect themselves from risk led them to push up stock prices excessively high across these sectors. The Morningstar Consumer Defensive Index, for example, surged 2.31 percent in April and is up 0.97 percent year to date, making it one of only three sectors with a positive return this year. The Consumer Defensive sector, on the other hand, has a price/fair value of 1.10, which means it trades at a 10% premium. It is now the most overvalued industry we cover.
The Utility sector declined 4.21 percent in April and is close to even this year, having gained 0.08 percent. It is also expensive in our opinion, trading at a 7% premium. Furthermore, we believe that if inflation continues to rise, the Utility sector would be the hardest hit.
Finally, the Energy sector lost 1.66 percent in April but is up 36.17 percent for the year. After starting the year as the market’s most undervalued sector, it is currently trading close to fair value.
Market Price/Fair Value of US Equities by Sector
Where Can You Find Today’s Most Undervalued Opportunities?
Communications is currently the most appealing and, by far, the most undervalued sector. Over half of the index’s market capitalisation is held by Alphabet (GOOGL) and Meta Platforms (FB). Both are severely discounted, skewing the index’s valuation downward. There are also a large number of undervalued companies in the traditional communications and media sectors.
Cyclical Consumption
Consumer Cyclical equities plummeted 11.82 percent in April, the third-worst performing sector, and are down 21.22 percent this year due to high inflation and slowing economic development. We see tremendous potential in this sector, particularly among companies in the services industries, based on our above-consensus forecast for economic growth over the next few years.
Consumers moved their spending from services to commodities during the pandemic. We expect consumer behaviour to stabilise and return to pre-epidemic levels as the pandemic fades. According to our research, we believe there will be a $450 billion change only to go back to pre-pandemic levels.
monetary services
The Financial Services sector did well in the first quarter, but then fell 9.36 percent in April, contributing to a year-to-date decrease of 12.09 percent. While slower economic growth may limit near-term loan growth, rising interest rates, strong economic growth, and moderated inflation should provide a positive tailwind for banks. These characteristics will result in increased interest income, fewer default rates, and lower charge-offs.
Asset managers, who are normally compensated as a percentage of assets under management, have seen their valuations plummet. With the market correction, investors are anxious that earnings may suffer. Long-term investors, on the other hand, can take advantage of this drop to invest in high-quality asset managers with a large margin of safety.
The Four Strong Winds Investor Sentiment and Valuation Pressure
As investors grapple with how to account for—and protect themselves from—the four headwinds we outlined at the start of the year, volatility remains high. We expect volatility to continue high in the next months, as these difficulties do not appear to be resolved until the second half of the year
Economic Growth Rate Is Declining
We reported in our 2022 outlook that the United States’ economic growth rate was dropping from last year’s blistering speed as the economy recovered from the pandemic-induced freefall. However, economic growth is dropping significantly more than we anticipated. Preston Caldwell, Morningstar’s chief economist, cut his projection for US real gross domestic product in early April.
In 2023 and 2024, however, we forecast pretty strong economic growth. Due to our positive views on the supply side of the economy, particularly labour force expansion, our real GDP growth projections remain approximately 2% above Wall Street consensus through 2025.
Monetary Policy Tightening by the Federal Reserve
The market now expects the Federal Reserve to tighten monetary policy more aggressively this year, which is the most significant change in economic data in the last month. By the end of 2022, the federal funds rate is predicted to hit 3%, and by mid-2023, it will be over 3.5 percent. This should help to combat inflation, but it will slow economic development in the short run. In addition, the Fed is projected to start letting its balance sheet assets mature. We expect the Fed to start slowly but eventually enable the rolloff to reach a $95 billion per month run rate, decreasing market liquidity by over $1 trillion annually.
Interest Rates are Increasing
In April, interest rates continued to rise. The yield on the 2-year Treasury jumped 42 basis points to 2.70 percent at the short end of the curve, 49 basis points to 2.91 percent in the middle, and 57 basis points to 2.89 percent at the long end. Interest rates are expected to rise this year, according to our forecast. The five-year breakeven inflation rate is currently 3.21 percent, while the five-year forward inflation expectation rate is 2.41 percent. We anticipate the 10-year Treasury yield to be higher than the average of these market estimated inflation rates.
Takeaways from FAANG+MT’s First Quarter Earnings
Few stocks attract as much investor interest as the FAANG stocks (Meta Platforms, Apple (AAPL), Amazon (AMZN), Netflix (NFLX), and Alphabet), which also include Microsoft (MSFT) and Tesla (TSLA) (TSLA).
Platforms for Metadata
We modestly reduced our predictions and lowered our fair value estimate by 4% to $384, based on lower-than-expected first-quarter sales and Meta Platforms’ (parent of Facebook) revenue expectations for the current quarter. We like this wide-moat brand because it’s now selling at around half of our fair value estimate.
Meta reported mixed first-quarter statistics, but the increase in monthly and daily active users stood out, demonstrating that the company’s powerful network effect is still in place. Meta’s continued strategy to monetize Reels, which currently has lower ad prices, contributed to the revenue shortfall by driving user monetization down somewhat from the previous year. We are optimistic, though, that Meta will boost Reels monetization over time by attracting more advertisers thanks to its enormous user base, which is spending more time watching content on the platform.
Apple
Following earnings, we maintained our $130 fair value on Apple stock. Despite supply chain difficulties and an ongoing chip shortage, Apple’s fiscal second-quarter earnings beat our expectations, as demand for the company’s latest iPhone 13 and MacBook Pro fueled record iPhone and Mac revenue in the March quarter. However, we expect that if COVID-19-related Mac and iPad demand fades, the recent streak of strong revenue growth will be difficult to maintain.
Amazon
Following earnings, we cut our fair value estimate by 6% to $3,850 per share, down from $4,100 before. We modestly cut our growth and profitability expectations, particularly in the short term, to account for guidance and increased uncertainty.
Operating margin was a problem, as inflation, labour and capacity excesses ate into profit, which was slightly above the low end of forecast and far below our expectations. Meanwhile, second-quarter guidance falls far short of our expectations, as we expect profitability issues to persist for several quarters, maybe into next year. The strength in Amazon Web Service, which is benefiting from the continued movement of enterprise workloads to the cloud, was the highlight of the results.
Netflix
Due to substantially weaker subscriber growth in 2022 and slower profit expansion, we reduced our fair value by 8% to $280 from $305. Following earnings, the stock dropped and is now trading at a low enough margin of safety below our fair value that the stock rating has been lowered.
Alphabet
had a mixed first-quarter performance. While revenue was slightly lower than expected, operating margin and profitability exceeded expectations. Following profits, we kept our $3,600 fair value. Strong growth in search advertising and cloud was offset in part by a faster-than-expected slowdown at YouTube. The similar trend of robust growth in search advertising is expected to be countered by a faster-than-expected downturn at YouTube in the current quarter, according to management.
Although YouTube’s ad revenue growth was disappointing, we believe the platform is still well positioned to monetize content and viewers in the face of growing competition. We anticipate growth to pick up in the fourth quarter.
Microsoft
Our fair value estimate of $352 remained unchanged following earnings. Despite some existing and new difficulties, Microsoft had solid results overall, with revenue and earnings per share coming in somewhat higher than projected. We believe that digital transformation projects will continue to drive overall demand, and Azure’s strength gives us hope. Microsoft’s ability to deliver both growth and profits at scale remains amazing, and we believe there is more to come on both fronts.
Tesla
We raised our fair value estimate to $750 from $700 following Tesla’s report. The quarter validated our long-term thesis that Tesla can raise prices, lower unit production costs, and reduce overhead expenditures, all of which will result in larger profits.
The stock has recently been under pressure as a result of Elon Musk’s agreement to buy Twitter, as investors fear Musk will spend less time running Tesla. However, we don’t believe Musk needs to be involved in day-to-day operations because the company has demonstrated its capacity to increase output and profitability through operating leverage. As Tesla continues to boost vehicle deliveries, cut unit production costs, and develop autonomous driving software, we believe Musk’s direct reports should be able to oversee the many areas of the company.