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Susan Dziubinski: Hello, and welcome to a special episode of The Morning Filter. I’m Susan Dziubinski with Morningstar. Like every Monday morning, I’m here with Morningstar Research Services' chief US market strategist Dave Sekera. But this week on The Morning Filter, we’re doing something a little different. We’re answering questions from the viewers and listeners of our show. So, thank you to everyone who sent in questions the past few weeks, and as we always do, we’ll end today’s episode with a few of Dave’s stock picks. All right, Dave, are you ready?
David Sekera: All right, let’s get it going.
Dziubinski: Let’s kick things off with some broader questions. Aaron points out that you often suggest investors build positions in stocks starting with a half position and working up to a full position. But Aaron wants to know how does an investor know what a half or a full position is, and should you always start with a half position? Is there ever a time to take that full position out of the gate?
Sekera: Of course, that’s just my own personal investment style. I think every investor probably is going to have their own style, but I do prefer being able to scale into a position, so that way if a stock is trading down, you’ve got the room within your portfolio to add more, assuming of course that you’re still on the same investment thesis as when you invested in it originally. And, of course, then as a stock moves up, you can scale out and take profit to the upside. But unfortunately, there’s really no way for me to specifically answer that viewer question. It’s, of course, going to just depend on everyone’s individual personal investment situation, what their goals are, what their risk tolerances are. So again, I would think for most investors, you probably start off with a pretty balanced portfolio of diversified investments, using mutual funds and ETFs and so forth.
But then within that allocation, I think you can have a suballocation dedicated to individual stock selection. And of course that’s going to depend on each individual investor, how many individual stocks do they think that they can adequately follow on an ongoing basis? Then it’s going to depend on how risky that individual stock is. And I think that will help you determine how much a full position should be as a percentage of your overall investment portfolio. And I think the last thing, too, is you also kind of have to take it in the context with the attributes of your overall portfolio. So, again, depending on your allocations between style, i.e. value versus growth, by capitalization, large, mid-, and small cap. And then if you want to have any sector concentrations, if we think sectors are trading at undervalued levels.
Dziubinski: You’ve said before on the show that small-cap stocks pretty much remain significantly undervalued relative to large-cap stocks this year. Richard wonders if it might be a good idea to buy an ETF or a mutual fund that tracks a small-cap index and then maybe buy just a couple of small-cap stocks outright rather than just exclusively buying small-cap stocks outright. What do you think of Richard’s idea?
Sekera: For most investors, I think that’s probably a really good idea. That way you get good broad diversification. And, in fact, for most investors, I think that’s a good idea for much of your investment portfolio overall as well. But again, this way you can then focus on those individual stocks that you have a particular interest in, whether it’s just because they’re significantly undervalued or if it’s just something that you enjoy following the sector or the company or maybe a specific technology. And then that way you have those handful of companies you can continue following them over time, helps you to determine if your investment thesis is working out as you expected or not.
And then it gives you the ability to manage sizes to be able to add to or scale out of those stocks depending on how much they move up or down as compared to their intrinsic valuation. So again, I always am a big believer in taking profit if a stock is moving up too far too fast, but then also if that stock is selling off, and we think that our investment thesis holds for the long term, being able to scale back into it as that stock goes down.
Dziubinski: Richard was also asking if we have any ideas as far as some mutual funds or ETFs that could work in this role. So, Richard, I’ll give you a couple of low-fee ETFs. They earn high ratings from Morningstar and they track small-cap indices. First would be Vanguard Small-Cap ETF, which is ticker VB. And the second is a SPDR Portfolio S&P 600 Small-Cap ETF, that’s ticker SPSM. And you can find more of the best small-cap ETFs and funds on Morningstar.com.
Mike wants to know what it would mean for REITs if the 10-year Treasury yield stayed high, say in that 4.5% to 5.0% range for the long term.
Sekera: I reached out to Kevin Brown, he’s our equity analyst who covers a lot of the REITs under our coverage. And in his response he noted that if rates were to stay at elevated levels, we’d probably need to raise our cost of debt within our weighted average cost to capital by, call it, 50 to 100 basis points. And so when you break that down into REITs, now assuming a REIT, which might be a capitalized 75% equity, 25% debt, and if we use that in our weighted average cost of capital calculation, that increase of 50 to 100 basis points would probably reduce fair value estimates on average, call it 3% to 7%. So, not necessarily a huge decrease. However, when you look a REIT coverage right now, a lot of them are even well below that 3% to 7% discount. So, if we were to cut our fair values by that much, I still think over time you would still get upward movement toward our fair values in a lot of that REIT coverage that we have today.
Dziubinski: Let’s pivot over to some company-specific questions that have come in from our audience. Now, one of our viewers on YouTube wants to know what you think about Western Union, which is ticker WU.
Sekera: The company right now, or the stock anyway, is rated 5 stars. That’s our highest rating, meaning most undervalued, and it provides an extremely high dividend yield of 8.8%. Now we currently rate the company with a narrow economic moat. That economic moat is based on scale-based cost advantages, and we rate the stock with a Medium Uncertainty. I read through our coverage over the past couple of days and it appears that the company is undergoing some business changes. I reached out to Brett Horn, he’s the analyst who covers the stock for us. And, by the way, he’s a very experienced analyst. Looks like he’s been with Morningstar for over 18 years at this point. But what he noted is that the current CEO took over at the end of 2021, and the new CEO really has been charting a different course for the company, specifically taking aggressive pricing actions in order to be able to restore the company’s market position, especially in digital transfers.
In his view, the prior management team probably spent most of the past decade on defense trying to maintain their pricing and their near-term margins. And unfortunately the result was that they ended up losing a lot of market share and some of its competitive advantage over time in that digital-transfer space. Looking forward, the company has been quite clear in communicating to investors that they expect essentially all of their long-term growth to come from the digital-transfer space. I pulled up our model here, and we’re really not expecting much on the top line. We’re only looking for growth of 1.2% as a compound annual growth rate over the next five years.
We are looking for $1.80 worth of earnings this year but really not modeling much in the way of earnings growth over the next five years. And I think that’s just a big reason why it’s only trading at 6 times earnings today. And of course the other big question I think on investor minds is its dividend whether or not that is sustainable. And in Brett’s view, he expects that they’re going to be able to maintain that dividend yield over the long term.
Dziubinski: Another YouTube viewer wonders what you think of Comcast, which is ticker CMCSA, after earnings. He doesn’t understand why the stock sold off as it did, because he thought the numbers looked pretty good for the quarter.
Sekera: Currently, Comcast is rated 4 stars. So again, it is undervalued in our model. Trades with a 3.75% dividend yield, so relatively attractive. It’s a company we rate with a narrow economic moat, and we rate the stock with a Medium Uncertainty. I did reach out to Mike Hodel, he’s the analyst who covers Comcast for us. And in his view, he thinks the market is just being overly focused on near-term growth concerns. Specifically, there’s been a lot of new competition from fixed wireless providers and from fiber network buildouts, and both of those have hurt growth here in the short term. But overall, Mike thinks Comcast remains pretty well positioned in the broadband market overall. And so as fixed wireless network capacity gets absorbed and those fiber buildouts mature, he thinks the broadband business will return over time to that steady albeit modest growth for the long term.
The downside here that Mike did point out was the media side of Comcast. He doesn’t think that that’s very well-positioned today. He noted that traditional TV networks continue to lose viewers. Peacock, its streaming business, is struggling to try and keep up with other streaming platforms as well. I think the market is probably also very focused on the restructuring that’s going on there. However, as that business is restructuring, we think that will probably lead to industry consolidation. Mike thinks that over time that actually could be a positive catalyst for the stock. So, in the meantime, while that’s all working its way through, Comcast does generate very solid free cash flow, has a very solid balance sheet, and the company’s also repurchasing shares relatively aggressively. And as they repurchase those shares at a level that is below our fair value estimate, that should add to the economic value of the company as well. And, in the meantime, you’re getting what I consider to be a pretty attractive dividend in today’s marketplace.
Dziubinski: John observes that you seem to have changed your preference to Devon Energy, which is ticker DVN, from APA, which is ticker APA. So, John’s question is, are you no longer a fan of APA?
Sekera: Well, unfortunately, our equity research team does review their coverage on a pretty consistent basis. And in this case they did drop coverage of APA. Of course once we dropped that coverage, I’m just no longer in a position to be able to make any kind of valuation commentary on that stock.
Dziubinski: That ties into some other emails that we received from viewers asking about stocks that honestly, Morningstar analysts just don’t cover, so we can’t comment on them in the show. Give us a little bit of a background, Dave, on how does Morningstar determine which stocks its analysts will cover and how large is that pool.
Sekera: We just try and cover those stocks that we think are going to be most meaningful to investors. That starts with the pool of those stocks that are largest from a market capital position and also those that have relatively liquid trading. We’re not going to follow a lot of those small-cap stocks that only trade by appointment only. We also try and focus on those companies that we think have economic moats. And then within a sector, we’ll also cover those companies that we think we need to cover just to make sure that the analyst understands the competitive dynamics within that sector. Right now our total coverage globally is over 1,600 stocks, of which over 700 of those trade on US exchanges. We have about 120 equity analysts globally, of which about 60 are located here in our Chicago office.
Dziubinski: Tom wants to know what you think of a stock that he already owns and that’s Illinois Tool Works, ticker ITW.
Sekera: It’s just one of these situations. Looks like a very good company, but unfortunately an expensive stock, it’s a 2-star-rated stock. Trades at a premium to our fair value, has a 2.4% dividend yield. But again, strong company, we rate it with a wide economic moat based on switching costs and intangible assets. The stock’s rated with only a Medium Uncertainty. Took a quick look at our financial model over the weekend, our five-year compound annual growth rate for revenue is about 4%. We’re looking for some margin expansion from 26.8% up to 27.8% by 2029. Between those two, that just equates to 6.6% net income growth over the next five years on a compound-annual-growth-rate basis. So when we look at the valuation for the company, for example, at $10.74, that’s our earnings estimate for this year. The company’s trading at 24 times earnings, whereas our model would put the fair value closer to 21 times earnings. So, we do think that the stock is a bit overvalued at this point.
Dziubinski: Mike would like a comparison of US Bancorp, which is ticker USB and Truist Financial, which is ticker TFC. Which one is more attractive today and why?
Sekera: USB is rated 4 stars and provides a 4.75% yield today, whereas Truist is a 3-star-rated stock, trades much closer to our fair value, albeit at a slight discount, but does have a higher dividend yield at 5.1%. But we rate that company with a narrow economic moat and a High Uncertainty. I reached out to our banking team in order to get the comparison on a couple of different things. So first, the moat sources for both banks are based on their cost advantages and their switching costs. But the reason that we rate US Bank with the wide moat as opposed to the narrow is it does have a stronger and larger deposit base with a lower deposit beta. Also US Bank has a much larger corporate trust business that helps them generate a lot more noninterest income. And then we also think that US Bank exhibits greater switching costs.
The bank does have more comprehensive set of products and services, so that’s really the differential from the economic moat perspective. Taking a look at the differential and the Uncertainty Ratings, we think Truist has a lot more moving parts, and that’s really caused by a couple of different things. They have much more M&A on a historical basis as well as some recent or more-recent mergers that they’ve made. So, more moving parts there. Plus, Truist is much more reliant on net interest income than fee income as compared to US Bank. So, again, that’s going to be a little bit more volatile just with how interest rates move versus fee income, which is going to be more steady.
Then lastly, just taking a look at the differential in the profitability. In our model, in our weighted average cost to capital, we use a 9% cost of equity for both. But when we forecast US Bank, we think its return on tangible common equity is probably closer to a 17% to 20% range over an entire business cycle, whereas we forecast Truist to only earn 13% to 15% over that same business cycle. So, the final takeaway here, taking a look at Truist, it’s trading at a 9.7 times forward PE ratio, whereas US Bank is trading a little bit below that at 9.4 times. At the end of the day, it’s just a matter of US Bank and our view is a higher quality business that’s trading at a more attractive valuation.
Dziubinski: Dan is asking about the dividend stability of one of your recent picks, Dow, which is ticker DOW. Dan notes that the company’s payout ratio is high, and he wonders if Dow is likely to cut its dividend.
Sekera: I reached out to Seth Goldstein, he’s the equity analyst who covers Dow for us, and Seth acknowledged that free cash flow was below the dividend payment last year, but between reducing capital expenditure spending and some proceeds from some recent asset sales, he doesn’t think they’re going to have a problem paying the dividend this year. In fact, he thinks that the combination of that capex reduction in those asset sale proceeds actually will help them cover dividends both for this year in 2025 as well as for 2026. And since I had him on the line, I also just asked him about any thoughts he had about potential impacts from tariffs. In his view, he doesn’t see the company having any direct impacts, but there could be some secondary impacts. Dow sells a lot of chemicals into the auto industry, so if we were to see a decline in auto production generally that similarly would affect them as well.
Dziubinski: Mark would like an update on FMC, which was a pick of yours last year and which is down quite a bit since then.
Sekera: We did provide a pretty thorough update on one of our shows in February, and essentially I kind of walk through the history of the company, how the business was impacted by the pandemic and the shipping bottlenecks and the overstocking of inventory to the current situation today of the company having to reduce inventory. According to Seth, who covers this one as well, at the end of February, the CEO did provide an update as to their ongoing business at a conference. He said the plan to destock inventory was on track. The company is still on track to meet their first-quarter guidance and 2025 guidance. So essentially they’re looking to finish this inventory destocking in the first half of 2025 and then expecting the company to return to growth in the second half of the year. I just think, in this case, the management just needs that time to rebuild their credibility with investors and with the marketplace going forward.
I think the market’s going to want to see evidence of that return to growth in the second half of this year. But one bit of good news here, we just don’t think the FMC is going to be affected by the implementation of tariffs. It looks like the stock may have bottomed out in February after it cut its guidance. So, at this point, it’s a 5-star rated stock, trades close to half of our fair value estimate, provides a nice hefty dividend yield at 5.75%. However, I do have to caution that dividend could be at risk. Using management guidance, it indicates that free cash flow is pretty close to what they pay out in the dividend. So if there were any miss in their guidance, that could lead to a dividend reduction, in this case.
Dziubinski: We had a few questions come in about how you use some of Morningstar’s metrics and framework for stock investing. So, let’s get to those. Jack would like to know if one company’s wide moat can be more attractive than another company’s wide moat, and if he can use Morningstar’s fair value uncertainty to help determine that.
Sekera: It’s a really good question and it’s hard to answer in a very straightforward way. A wide moat, I do think that based on the number of moat sources could be more valuable. So, that way if one moat source does start to erode over time, you do have the other moat sources, which can still help that company generate excess returns over the long term. So, as you read through the moat write-up in our analysis, you can see which moat sources the analyst points to and how many moat sources are there. The other part with the economic moat is it’s kind of a blunt tool. It only indicates that return on invested capital is forecast to stay higher than the weighted average cost of capital over a certain time period. That’s 10 years or more for a narrow moat, 20 years or more for a wide moat.
It doesn’t take into consideration the amount of margin that the company earns over the return on invested capital. So, the more margin or the greater margin over your weighted average cost of capital is going to be worth more in the present value of the company. Also, those returns on invested capital are increasing over time, that also is going to increase the valuation today. So, thinking through the Uncertainty Rating and what that attempts to do is that’s our way of trying to adjust our star ratings on a risk-adjusted basis. That uncertainty rating governs which bands we use to determine whether or not we think a stock is trading at enough margin of safety below its intrinsic valuation to be attractive to get to that 4-star or that 5-star rating. Or conversely, if it’s trading high enough above fair value that we think that the risk-adjusted returns going forward are going to be low in that case, 1-star- and 2-star-rated stocks.
Dziubinski: Glenn pointed out that when he Googled the term Morningstar stock ratings, AI told him that our rating for stocks is backward-looking when in fact our rating for stocks is forward-looking. What this tells me, Dave, is don’t believe everything that AI tells you, but Dave, take this opportunity to walk through how Morningstar calculates its rating for stocks.
Sekera: At the end of the day, it’s partially just because the star rating process for stocks is different than mutual funds. I’m not an expert in the star ratings on mutual funds, but I will highlight on the stock side that stock rating is our risk-adjusted rating that indicates our estimate of future returns as compared to our fair value. So, when you get into what the definition of these ratings is, 4- and 5-star stocks are those that we believe the amount of appreciation potential is above a risk-adjusted return on a multiyear time frame. And then those that are rated 1 or 2 stars indicates that we think it’s a pretty high probability of an undesirable risk-adjusted return from the current market price over that same multiyear time frame.
Dziubinski: Evan is interested in Morningstar’s Capital Allocation Ratings broadly, and then specifically he’s interested in why Morningstar recently downgraded its Capital Allocation Rating on Taiwan Semiconductor Manufacturing. Start with the latter, Dave, what was the rationale behind that Capital Allocation Rating downgrade?
Sekera: Just to make a quick synopsis here, the downgrade was because the recent investments that they’re making is the signal to our equity analyst that the company’s investments are not necessarily just commercially driven at this point. When he’s looking at the amount of investment that they’re increasing in the US, he noted that construction and manufacturing in the US are both more expensive here than elsewhere. Previously, the company has stated that its preference was to keep research and development and manufacturing close to Taiwan. He thinks there’s a lot of leverage by having the two of them together, where in this case, when you’re moving it overseas and you’re separating it, you may not necessarily get the same kind of efficiencies. Plus, he also just noted that currently the company’s investments in the US do have a lower return on investment than in Taiwan.
Specifically he identified one of their fabs in Washington generates gross margins in that mid-30% area, whereas similar fabs in Taiwan run at gross margins of 60% or more. Just bringing a fab to mass production, it takes four years. And he just noted that by that time there will be another election in the US. Of course, we have no idea what that election may or may not bring, but if we had a different administration in charge at that point in time, that administration may lower or even eliminate tariffs, which of course then could reduce part of the reason that they were trying to build more fabs in the US.
Dziubinski: Then more broadly, Dave, what considerations go into how Morningstar assigns those Capital Allocation Ratings? What does it take for a company to earn that exemplary Capital Allocation Rating, which is our highest rating?
Sekera: Our Capital Allocation Rating represents an assessment of the quality of how management has put that cash or that company’s economic capital to work over time from a shareholder’s perspective. So there are really three areas that we focus on. We look at the balance sheet, the investments the company has made, and their shareholder distributions. To get that Exemplary rating from a balance-sheet perspective, we’re looking for that strong and sustainable financial position, reasonable debt leverage—when needed, prioritizing debt repayment if that leverage is getting too high—and just making sure that they have sufficient cash flow to be able to handle any kind of economic downturn and not get themselves upside down with too much debt leverage if free cash flow were to shrink during a recession.
From the investment perspective, whether it’s organic or acquisitions, we just want to make sure those investments are used to strengthen or enhance their competitive position, help build that economic moat over time and specifically looking for investments that are going to generate returns above the company’s cost of capital. And then lastly, from the perspective of shareholder distributions, we just want to make sure that they’re appropriately returning cash to shareholders, whether that’s through dividends or share buybacks, potential acquisitions, but really just balancing the reinvestment opportunities that they have, but yet at the same point in time, maintaining that balance-sheet strength.
Dziubinski: We’ve arrived at the stock picks portion of the program, and actually the picks tie into Evan’s question. You’ve brought us three undervalued stocks that carry Exemplary Capital Allocation Ratings from Morningstar. Now, before we get to them, we want to let viewers know that we’re taping this show on Monday, March 17, so valuations may have changed, and probably have a bit, by the time you’re watching this. So, please be sure to visit Morningstar.com for the latest ratings on these stocks. So, your first pick is ExxonMobil, Dave. Run through the highlights on this one.
Sekera: Exxon has just been our go-to pick for the energy sector overall. A 4-star-rated stock, trades at a 3.5% dividend yield. We rate the company with a narrow economic moat, although the stock does have a High Uncertainty Rating.
Dziubinski: What has Exxon’s management done that earns it an Exemplary allocation rating?
Sekera: From the balance-sheet perspective, it has relatively low levels of debt. And looking at the investment strategy, our analyst here has just noted a couple of different things. So, Exxon, they trim their spending, and they’ve really kept their spending focused on what we consider to be moat-enhancing, low-cost, high-margin upstream projects. On the downstream side, the projects there we think have been improving refining yields for high-value products, seen an increase in the production in high-value-added chemicals. The acquisitions they’ve made do make strategic sense to us, and we think that were done at pretty fair valuations. And the company has avoided investing in renewable power generation where it lacks the expertise, and we just don’t see the ability to carve out competitive advantages specifically in those areas. And then lastly, just taking a look at their mix of shareholder distributions, between dividends and share repurchases, our analyst team thinks that those are pretty well-balanced and appropriate.
Dziubinski: Your second pick this week is Alphabet. Give us the headline metrics on this one.
Sekera: Another stock that we’ve recommended multiple times over time. Four-star-rated stock, not necessarily one for dividend investors, only pays 0.5% dividend yield, but a very wide economic moat and a stock with a Medium Uncertainty.
Dziubinski: How have Alphabet’s managers been Exemplary capital allocators?
Sekera: I mean, the balance sheet, and again, most technology companies love having a lot of cash on the balance sheet, and this is just a perfect example. Last I looked, they had $96 billion of cash, but that’s only compared to $11 billion worth of debt. And I think a lot of the debt that they’ve issued in the past was just really to be able to repatriate cash from overseas and not have to pay the tax on it when they brought it back into the US. Taking a look at their investments here, we think their investment strategy has also proven to be very value-accretive over the past two decades. Specifically, our analyst has highlighted its M&A, buying things like Android, YouTube, and DoubleClick.
They’ve just very aggressively reinvested in research and development, and that research spending has really kept the company at the forefront in the technology space. As far as shareholder returns, I mean, they pay a very small dividend, but they have a share buyback program that’s been able to reduce its shares outstanding by 9% over the past five years. And from our point of view, as long as you’re buying back stock below our intrinsic valuation, we think that’s value accretive over time as well.
Dziubinski: And then your last pick this week is Amazon. Go through the essentials on this one.
Sekera: Four-star-rated stock. Unfortunately, they don’t pay a dividend at this point, but it is a company we rate with a wide economic moat, and the stock’s rated with a Medium Uncertainty.
Dziubinski: Dave, why the high marks for capital allocation here?
Sekera: In some ways, it’s very similar to Alphabet. From a balance-sheet perspective, the company has a very substantial net cash position, so we’re not concerned about the balance sheet at all. Now taking a look at the investments here, it’s actually interesting to note what our analyst wrote. He specifically talked about how management over time has had a very strong track record of making acquisitions that initially investors were very skeptical of, but ultimately vindicated the management strategy and provided very strong return on invested capital over time. And then lastly, from a shareholder return perspective, we’re just very comfortable that the investments the company makes taking its free cash flow, reinvesting it back into the business both for organic and nonorganic growth, has really been the key driver for the shareholder returns that this company has already generated over time. As long as they’re prioritizing these capital reinvestments back into the company and generating these excess returns, very comfortable with the company continuing to do that and prioritize that over dividends and buybacks.
Dziubinski: Well, thanks for your time this morning, Dave. Now viewers and listeners, continue to send us your questions. You can reach us at themorningfilter@morningstar.com, and we’re trying to answer a viewer question each week. So, join me next week for a new episode of The Morning Filter where I’ll be talking with a special guest about the first quarter in the markets. We’ll stream on Monday at 9 a.m. Eastern, 8 a.m. Central. In the meantime, please like this episode and subscribe. Have a great week.