We think stockpicking--rather than macro guessing--is the way to excess returns.
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By Lauren Adams, CFA | 09-25-13 | 06:00 AM | Email Article
  • With the S&P 500 up nearly 6% since our last market outlook, our coverage universe has closed the valuation gap from its previous 94% of fair value and now looks slightly on the overvalued side at 102%.
  • With interest rate prognosticating top of mind in today's market, we continue to think uncovering undervalued, competitively-advantaged businesses--rather than guessing at macro trends--is the best way to earn excess returns over the long run. However, the market doesn't always follow fundamentals, and we wouldn't be surprised to see the market become overvalued before undervalued (especially given the Fed's recent decision to prolong its bond purchases).
  • Social media names have had a banner quarter, but we think tech valuations overall are now getting ahead of themselves. Energy, basic materials, communication services, and utilities sectors are trading at the largest discount to fair value estimates, and we think Europe remains the cheapest region under our coverage.

Lauren Adams is the Director of Cross-Sector Equity Research at Morningstar.

This month marks the five-year anniversary of the financial market collapse, and we have certainly come a long way since September 2008 (140% off March 2009 lows at the time of this writing, to be precise). With the S&P 500 and the Dow once again eclipsing all-time highs and interest rates staying low for the longest stretch in 50 years, most investors have already seen quite a lot of benefit from the fount of cheap money. As our Bond Strategist, David Sekera, CFA noted, "Whether the Fed begins to reduce its asset-purchase program in the near term or medium term, we expect rates will continue to rise back toward the average real return over inflation." This is Sekera's long-term view, and as you can see in this quarter's bond market outlook, we don't think the market is in any hurry to rush toward that long-term view as the Fed has now clearly signaled it will keep the flow of cheap money coming.

All of this debate around the macro picture and interest rates makes us happy to stick to our approach of using fundamental research to identify great companies trading at a discount. As Morningstar Stock Investor Editor Matthew Coffina, CFA put it, "I remain focused on a singular goal: seeking out companies with strong and growing competitive advantages trading at reasonable prices. I'll leave it to others to play guessing games with the Fed."

In a market that is leaning toward the expensive side, it takes even more effort to uncover pockets of hidden value, and discounts available might not be as steep as we would typically prefer. Looking at our analyst coverage universe, the Energy sector is currently trading at the steepest discount to intrinsic value of around 91% of fair value, followed by Basic Materials and Communication Services both at 94% of fair value, and Utilities at 95% of fair value.

Technology remains one of our most overvalued sectors, with an average price trading at 114% of fair value. However, as director of technology research Peter Wahlstrom, CFA notes in our Technology Outlook, there are still pockets of value to be found, including 4-star-rated  Apple  and  Oracle . The social media and mobile advertising industry was once again set abuzz by news of an upcoming Twitter IPO. This group has been on a tear in recent months, led by an 85% gain in Facebook and a nearly 40% pop in LinkedIn . We think valuations of these companies may be getting ahead of themselves, and nearly all of our online media coverage carries a one or two-star rating. Industrials and consumer cyclical sectors--each trading at 107% of fair value--also continue to look on the expensive side in aggregate, thanks in part to a recent rally for large-cap growth stocks over the last three months.

On a global scale, Europe remains the most undervalued region with Australia/New Zealand, Asia-Pacific, and North America trading closer to fair value.

Thirty-five of the firms that have the strongest competitive advantages in our universe--and thus earn a wide moat rating--carry our 4-star rating right now, including firms such as  Berkshire Hathaway , Coca-Cola , eBay , Exelon , McDonald's , and Sanofi . We think these firms will earn excess returns for longer periods of time than their no-moat counterparts, and while they are not quite cheap enough to garner a 5-star rating, they are still undervalued today.

Please see our detailed take on each sector in the reports that follow. 

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Lauren Adams, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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