This interview was a part of Morningstar's Investing Insights podcast. You can watch the entire episode here.
Ruth Saldanha: Halloween is coming, and Morningstar has uncovered five stocks that investors should be afraid to invest in right now. These specters can be found across sectors—from education to telecom, from tech to logistics. Dave Sekera, the chief U.S. market strategist for Morningstar Research Services, is here to tell us more. Dave, thanks so much for being here today.
Dave Sekera: Of course. Good to see you, Ruth.
What Makes These Stocks So Scary?
Saldanha: Before we get into what the stocks actually are, tell us why you picked these stocks. What makes them so scary?
Sekera: It’s a combination of different factors that I looked for these stocks, and so I used a couple of different Morningstar tools in order to sort for the following characteristics. First I looked for those stocks that we rate with either 1 or 2 stars, meaning that we think that those stocks are trading significantly above their intrinsic value. Then I also look for those companies that we rate with not having an economic moat, so companies that we don’t think have long-term durable competitive advantages. And then lastly, I look for those stocks that we rate with either a High or a Very High Uncertainty Rating. Then once I had that, I did a little bit of a qualitative overview. I looked for those situations that I think have poor risk/reward scenarios, specifically instances where I think there’s a potential that these stocks could gap down very quickly upon certain catalysts.
What To Do If You Own Scary Stocks
Saldanha: So, now we know what investors should do to avoid these stocks, but what should investors do if they already own the stocks?
Sekera: It always depends on your own personal investment portfolio strategy, but considering that all of these are going to be rated 1 or 2 stars, I do think investors should consider selling some of these stocks or at least begin to pare down their exposure. Now, depending on your portfolio construction and your investment strategy, I would then think that you can go and look to reinvest those proceeds and look for a couple of different characteristics. First, you can look for stocks of companies in the same or similar sectors. You can keep your portfolio weightings the same. Then I’d also look for stocks that are undervalued, those that we rate either 4 or 5 stars, look for companies with a wide or narrow economic moat. And then lastly, those companies that we rate with either a Low or Medium Uncertainty.
2023: The Year of Tech - But Tech Stocks are Scary
Saldanha: Let’s get into some of the stocks themselves. 2023 has arguably been the year of tech, and tech firm Dell DELL has made your list. Tell us about that.
Sekera: So right now Dell is rated 2 stars, trades at over a 40% premium to our fair value. We do rate the company no-moat, and it is a High Uncertainty stock as well. I think most people know Dell. I mean they sell PCs, displays, servers, and external storage, but that stock has risen over 60% thus far this year. In our opinion, we think the rally has outpaced the fundamentals. And I spoke to our analyst here and he suspects that this rally’s really due to an overexuberance on artificial intelligence here as well as the market’s expectations over the near term that we might see a rebound in the PC market.
But longer term, when I look at our forecast, we’re only projecting modest top-line growth in the medium to long term. And we see little opportunity here for material durable margin expansions. So for investors that are still looking for that exposure in the technology sector, one stock I would highlight is Advanced Micro Devices AMD. That’s currently a 4-star-rated stock, and it trades at over a 20% discount to our fair value. And it’s not only just a play on the recovery in the PC market, but we also do think it has some long-term potential to be the number-two player behind Nvidia NVDA, which is the number-one player in manufacturing those chips for artificial intelligence.
Supply Chain and XPO Stock
Saldanha: Another sector that we cover a fair bit is the supply chain, And freight and logistics company XPO XPO makes your list. Tell us a little bit more about that.
Sekera: Of course. XPO stock is currently rated 2 stars, and it trades at a 50% premium to our fair value. We also rate that company no-moat, and it has a High Uncertainty as well. For those of you who aren’t familiar, XPO provides trucking services and they really focus on what’s known as the less-than-truckload shipping sector. That stock is up 115% year to date. The reason there is that the market expects that XPO is going to benefit from the bankruptcy of its competitor Yellow Trucking, which filed earlier this year. And we agree it will certainly benefit from that. It will pick up some of that business. But I did speak with Matt Young, he’s the equity analyst who covers transportation and in this case XPO. Now, he thinks that investors right now are just over-extrapolating the benefits from the bankruptcy of Yellow, and he thinks they’re overestimating the long-term growth and profitability here. And considering how much and how quickly the stock has risen, if this company doesn’t meet these short-term expectations, I could easily see this stock gap down if this company misses.
And secondarily, I’m also just concerned that the trucking sector could be under pressure the next couple of quarters as the U.S. economy slows. Our economics team does think that the rate of economic growth is going to slow for the next three sequential quarters. I do think that’s a concern here as well. For investors looking for a swap idea in the transportation sector, I’d highlight Norfolk Southern NSC. That’s a 4-star-rated stock, trades at a 16% discount, and it currently yields 2.4%. That’s a company we do rate with a wide economic moat and a Medium Uncertainty Rating. And the wide moat here is going to be based on efficient scale and cost advantages. And lastly, the thing I would note here with Norfolk Southern is rarely do railroads ever trade much of a discount to our fair value. So, this is a rare opportunity today.
Advertising and Content Tech
Saldanha: Another tech name made the list and that’s Trade Desk TTD. Why did this advertising and content tech firm make the cut?
Sekera: Trade Desk is a 2-star-rated stock, and it trades over 50% premium to our fair value. Again, no moat, very high uncertainty. And for people who aren’t familiar, Trade Desk runs a platform that helps advertisers and ad agencies programmatically find and purchase digital ad inventory. So essentially it serves the buy side of digital ads, and it just trades very high multiples that we don’t think are necessarily warranted for this situation. So for example, it trades at 15 times 2024 revenue and 38 times our expectation for 2024 EBITDA. Unfortunately, we do think and expect that its growth rate is beginning to slow down, and we’re also concerned that the company’s take rate will begin to decline from competition. As such, with just these extraordinarily high valuations, any deviation at all from expectations really could send the stock down in a hurry. The swap idea I have here in the technology sector is for a smaller company called Tyler Technologies TYL. It’s a 4-star-rated stock that trades at a 23% discount. We rate the company with a wide economic moat and a Medium Uncertainty.
Education Sector in China
Saldanha: Let’s talk about the fourth stock, which is in education. The education sector in China has seen increased government regulations in the recent past. Chinese education company TAL Education TAL stock made the list. Tell us more about that.
Sekera: TAL right now is trading at a 70% premium to our intrinsic valuation. That puts it well into that 2-star category. And again, another company we don’t think they have an economic moat. And just because of the fundamentals here and the regulatory environment in China, it’s certainly a Very High Uncertainty Rating. And of course, Chinese companies are just going to be subject to the whims of the Chinese government. For example, in early 2021, the Chinese government decided it would not allow TAL to provide afterschool tutoring, which at that point in time was 90% of its business. At this point, the company does a couple of different things. They do enrichment learning, which are nonacademic programs, and they also have a business-oriented and enterprise-grade technology products and solutions for educational institutions.
Now, when we look at our valuation here, our intrinsic value for the company is $3.5 billion, and that’s comprised mostly of the amount of cash on the balance sheet, which is $3.3 billion. But, unfortunately, we project that they’re going to be free cash flow negative over the next three years, and we don’t forecast that they’re going to turn cash flow positive until fiscal 2027. So, that cash that the current valuation is based on will dwindle over the next three years or so before it could potentially turn around. So for investors that are looking for a company in China, one that’s going to be leveraged to the Chinese consumer, I would highlight Yum China YUMC. It’s a 5-star-rated stock, it’s a 39% discount to our fair value, and another company that we do rate with a wide economic moat and a Medium Uncertainty.
The Most Overvalued Stock
Saldanha: Which brings us to the last and scariest stock on the list, United States Cellular USM. Why is this the scariest stock you’d like to highlight today?
Sekera: United States Cellular is the most overvalued stock across our U.S. coverage right now. It’s a 1-star-rated stock, trades at about a 74% premium over our fair value, no economic moat, High Uncertainty. What this company is it’s a regional wireless carrier, and we think that by itself it’s just too small to be able to effectively compete against the giants like AT&T T and Verizon VZ. In fact, I spoke to our equity analyst here and his belief is that every day that this company operates as a standalone, it actually loses economic value. Now, in the past, the company has been unwilling to consider selling itself, but that changed in August when the company did announce that it’s considering strategic options, and the stock has more than doubled since then.
So if the company is able to sell itself, we do see some value in the company’s assets, and there might still be a little bit of a premium left here, but if it ends this process, and through these strategic alternatives either just doesn’t sell itself or maybe it only looks to sell some pieces of the business, I think that investors would be very disappointed and we could see the stock just drop like a rock thereafter.
In this case, I think the upside is probably pretty limited, whereas I think the downside is a long way to go down to where the stock was trading out prior to the announcement that they were looking at strategic alternatives. So, for investors, I think an appropriate swap here would be either for AT&T or Verizon. Both of those stocks are rated 5 stars. They trade at very deep discounts to fair value, and their dividend yields are over 7%.
How Often Investors Should Check on Stocks in Their Portfolios
Saldanha: Well, thanks for sharing those stocks, but now that we know this, how often should an investor look at their portfolio to make sure that their stocks aren’t about to enter the scary territory?
Sekera: Well, as we’ve seen with several of these stocks, stock prices can move very quickly when there is a catalyst, and I think this is a good reason that when you first buy a stock, you should set target prices both to the upside and to the downside. That way when a stock starts moving up, you might have an alert set up and you can take a look at it and then consider whether or not you should be selling some of that stock when it’s moved up, or conversely, when that stock moves down, whether you should be buying more of that stock when it comes down. Of course, when it hits those targets, you also really need to look and see if there’s any changes to your investment thesis in your valuation at that point in time.
You can use several different Morningstar tools. You can set up your individual portfolios of those stocks either you’re already invested in or that you want to watch those going forward. And you can also use our star rating system. Again, that’s going to tell you when we think a stock is starting to get too high above our intrinsic valuation, it starts moving into a 2-star territory or even a 1-star territory. And then to the downside, if that stock is falling and we think that there’s becoming a greater margin of safety and our investment thesis hasn’t changed, then it starts going into those 4- and 5-star-rating territories, which we think are good opportunities for investors then to start putting money to work.
And then lastly, when a stock is trading in that 3-star territory, a lot of people don’t necessarily understand what a 3-star stock is. What that means is that we think that it’s within the range that we consider that stock to be fairly valued. And for 3-star-rated stocks, we expect that long-term investors will end up earning the company’s cost of equity over time.
Saldanha: Great. Thank you so much for joining us today, Dave.
Sekera: Of course. Thank you, Ruth.
