4 New Stocks to Buy With Catalysts for Future Gains

Susan Dziubinski: Hello, and welcome to the Morning Filter. I’m Susan Dziubinski with Morningstar. Every Monday morning, I sit down with Morningstar Research Services chief US strategist Dave Sekera to discuss what’s on his radar this week, some new Morningstar research, and a few stock picks or pans for the week ahead. So, hi, Dave. Let’s start with the CPI and PPI numbers, both of which are on your radar this week. What’s the market expecting?

David Sekera: Hey, good morning, Susan. Hope you had a great 4th of July. Yeah, so let’s take a look here. For CPI, the consensus forecast for headline on a month-over-month basis is up, it looks like one tenth of a percent, and that’d be compared to flat last month. But on a year-over-year basis it looks like it’s coming down slightly, down to 3.1%. That was 3.3% last month. But of course, more importantly, we’ll be watching the core CPI. The consensus there, on a month-over-month basis, is actually similar month-over-month and year-over-year. So up two tenths of a percent, that’d be equal to last month of two tenths of a percent. And on that year-over-year basis, up 3.4%, equal to last month at 3.4%. Really, inflation’s not getting worse but, essentially, also not getting any better on that core basis.

Now specifically, I did talk to Preston [Caldwell], our US economist. I know he’s really going to be watching housing inflation very carefully. That’s probably one of the areas that I think we have some of the biggest differences from consensus, as far as expecting that to moderate, and of course, bringing overall inflation levels down toward the Fed’s 2% target. And then lastly, we have PPI as well. The headline there, the forecast is up one tenth of a percent, that’s actually after declining two tenths of a percent last month.

Dziubinski: In late June, we saw the latest PCE number come in as expected. Given that, how might the market react this week if either or both the PPI and CPI numbers come in hotter than expected?

Sekera: If I had to rank the risks that I see to the market, I would say inflation is probably one of the higher risks to the market right now. If inflation were coming in hotter than expected, that would push back when the Fed can start lowering the federal-funds rate. Right now, our base case is that they’ll start to cut rates here in the September meeting.

Overall, I would say our base case is that we expect economic growth to slow sequentially over the second half of the year, and then it really won’t start to reaccelerate and pick back up again until the second half of 2025. The reason is that we do expect the Fed to start cutting rates in September. Of course, it takes time after they start cutting rates for those lower rates to actually start impacting the real economy. Depending on the economist, and what’s going on with the economy, it could take anywhere from six to 12 months after they start cutting rates to start impacting the wider economy. If the Fed can’t start cutting rates within the next couple months, the economy would be at risk of weakening even further in the short term, and that would also push back when we would expect the economy to start to reaccelerate. I do think that if that inflation were to kick back up, that certainly would be a big negative for the market overall.

Dziubinski: We also have earnings season kicking off this week, it’s a busy week, with big banks starting to report on Friday. So what’s Morningstar think of the big banks in general, as we head into earnings season?

Sekera: There’s a couple of different things that I’m going to be listening for. First is really just their outlook for their net interest margin; that, of course, is really one of the largest drivers of their earnings. But I also want to hear commentary from them on their delinquency rates. There’s been a lot of talk about increasing delinquencies in cards, auto loans, mortgages, and so forth. But of course, you have to remember, delinquencies were very low during the pandemic. Consumers had reduced the amount of spending overall. They had their stimulus checks, so that kept delinquencies low, but delinquencies are now of course starting to increase. Now we do model them to increase further from here, but really only to get back toward what we consider historical average rates, not any higher than that essentially. Because while we do expect the economy to slow, we’re not looking for a recession. And then lastly, I just want to hear any commentary and see where they’re building loan-loss reserves. Are they building them any higher in anticipation of a weakening economy, or is it just going to be steady as she goes?

Dziubinski: The stocks of the big banks are all having a pretty great 2024 so far. Let’s talk about, with viewers, what Morningstar thinks of each of these stocks heading into earnings, starting with J.P. Morgan?

Sekera: J.P. Morgan is really just kind of the go-to stock for investors that want exposure to the larger US banks. But at this point, I would say it is overvalued. It’s a 2-star rated stock, it trades at a 22% premium to our fair value. It is a wide-moat business with a medium uncertainty. Fundamentally, there’s really nothing wrong here, it’s just probably it’s just getting overvalued at this point.

Dziubinski: What about Wells Fargo?

Sekera: Wells is interesting. That was actually a 4-star rated stock at the beginning of the year. It’s performed pretty well—I think it’s up about 20%, so that now puts it into that 3-star range. Again, it’s another stock with a wide moat, medium uncertainty. I think the thing I’m going to be looking for here is just ongoing or continued progress to move past the regulatory issues that they have had in the past.

Dziubinski: Citi has really been a story stock, more so than some of the other big banks, right?

Sekera: It is. Actually, I think Citi was a pick of ours on the May 15 show last year, and we had recommended the stock as a deep-value play. It was trading at a very large discount to its tangible book value at that point in time. Taking a look at the charts here, this was actually a 5-star stock still, as recently as last November. It’s now up 60% off its lows, which puts it in 3-star territory as well. The only thing I would caution investors here is that when you’re looking at the large, mega US banks, it’s really the only one of those four that we rate with no economic moat, whereas the other three are all wide-moat stocks.

Dziubinski: Any other companies reporting this week that you’re keeping an eye on?

Sekera: There’s really three that I’m going to be watching. And I’m really watching these three specifically to try and gauge consumer spending, how that’s trending. We’ve, of course, talked about the retrenchment that we’re seeing in a number of different areas. The first one is going to be Delta Air Lines. Last quarter, in their conference call, they mentioned that they expect another record summer travel season this year. That supports what our equity research team is seeing. Travel has been holding up pretty well in the face of consumer spending, retrenchment elsewhere. To some degree, in my opinion, it just might be that people already bought their tickets, already made their hotel reservations earlier this year. So I want to get a sense from them how long this travel spending is going to stay at these kind of elevated levels. I know when I look at our models, over the long term, we’re looking for more historically average type of travel, more historically average margins over time. So right now, when we look at Delta, we think the market’s pricing in too much growth for too long. It’s a 2-star rated stock at an 18% premium.

And then taking a look at Pepsi, that’s also a 2-star rated stock. Pepsi, of course, is a pretty defensive stock overall, but a large portion of their business is going to be in the snacks business, so I’m going to be listening to commentary there. Are consumers pulling back on snacks, are they considered an affordable indulgence, or is this an area that consumers are looking at pulling back their spending there in the face of inflation as well?

And then lastly, it’s going to be ConAgra. ConAgra is a 4-star rated stock, trades at a 15% discount. It’s a company we rate with no economic moat. In fact, when I look at all the food stocks, in my opinion, I think I do see better value among some of those stocks than ConAgra. Short story here, last quarter, their grocery and snacks business showed pretty decent strength, but it was the refrigerated and frozen segments that were challenged. I suspect what’s going on is I think refrigerated and frozen has a lot more higher-cost prepared meals. I think that might show that consumers are pulling back on those higher-cost items themselves. So the question here is, are we still seeing more of that trend? And then lastly, with ConAgra, last quarter, management did provide full-year organic sales guidance for a decline of 1% to 2%, and I want to see if that’s still holding true. The reason I bring that up is just to put that in perspective, General Mills last quarter reported a 6% decline in their sales. Again, just trying to understand if we’re seeing a big shift in consumer spending in the food market overall.

Dziubinski: Well, let’s turn to some new research from Morningstar. We’re going to start with Morningstar’s take on Constellation Brands’ earnings report. You said on last week’s episode of the Morning Filter that this was a company you were interested in hearing from. So what did you hear, and how’d the numbers look?

Sekera: I think the numbers looked OK. The stock did dip a few percent after earnings on Wednesday, but then we saw it rebound a pretty good amount on Friday. Still a 3-star rated stock, our fair value of $280 a share is unchanged. To put that in perspective, that equates to about 20 times our fiscal year 2025 earnings estimates. Overall, I’d say just not a lot to report here, really no new news. When I look at the fundamentals, their beer was doing pretty well, that business is still strong. The wine and spirits business is a little on the soft side. But overall, there was really nothing that changed our long-term forecast. So in my mind, I’m still keeping this one on my shortlist of stocks to watch. If we were to see some sort of selloff in the stock, that’d be a good time to sharpen your pencil, and maybe take a position in this one.

Dziubinski: Adobe, which is a pick of yours that you’ve talked about quite a few times so far this year, that stock moved into 3-star range last week, which means that Morningstar thinks the stock is now fairly valued. In practical terms, Dave, what does that mean? Is it time to sell?

Sekera: No. And actually, not time to sell on this stock just yet. Of course, as you know, that 3-star rating really means that it’s trading within the range that we consider to be fairly valued. So essentially, for long-term investors that either buy or own that stock here, we expect that they would earn the company’s cost of equity over the long term.

Of course, that range is determined by our uncertainty rating. In this case, we do have a high uncertainty rating assigned, and I think that this is a pretty wide range for this stock. The stock closed last Friday at $578 per share. Our fair value is still much higher at $635. Overall, I think the story is working out as we thought after the stock fell, following their first quarter earnings report earlier this year. We, of course, held our fair value estimate unchanged at that point in time. Overall, it looks like the stock has some pretty good momentum here, so I think this one probably still has further to run to the upside. Plus, when I look at our large-cap tech names, this is really still one of the few ones that’s trading at a pretty decent discount below its fair value.

Dziubinski: All right, sounds like a keeper for now. Let’s talk a little bit about your midyear US market outlook. But before we do, I’d like to invite viewers to attend Dave’s Comprehensive Midyear US Market Outlook webinar, which takes place this Thursday, July 11, at 11 a.m. Central Time. It’s free to attend, and viewers can register for the webinar via a link beneath this video. Dave, you suggest in your outlook that the AI trade is over, unpack what that means for viewers.

Sekera: In the short term, just because a stock is already fully valued or overvalued, doesn’t mean that it can’t become even further overvalued. And to some degree, that might be the situation that we’re in right now with the market. But when I look at our valuations, according to where we are right now, just the huge gains that we’ve had for the past year and a half, the outperformance specifically of the AI stocks, we think that’s probably largely behind us. Just to put it in perspective, since the end of 2022, there’s only seven stocks that equate to over half of the market return since then. But looking at our valuations, they’ve run their course. Just running down the numbers here, when we look at Meta Platforms, that was a 5-star rated stock at the end of 2022. People hated that name—you couldn’t even give that stock away. I think it traded at below half of our fair value at that point in time.

It’s now run up so much, it’s actually a 2-star rated stock, putting it in overvalued territory. Other names like Amazon and Alphabet were both 5-star rated stocks back then, they’re now 3-star rated stocks. Nvidia, of course, we all know the story there. That was a 4-star rated stock at the end of 2022, it’s now a 3-star stock. Even within that 3-star range, I think it’s toward the top of that range. Microsoft and Broadcom, similar stories, both 4-star stocks, now at 3-stars. And then Apple, that was a 3-star rated stock back then. It’s moved up a pretty good amount since the developers conference over the past couple of weeks. We don’t really necessarily understand what the market sees differently now than prior to that conference. That’s now a 2-star rated stock, so in overvalued territory in our mind as well.

Dziubinski: Dave, if the AI trade is in fact over, what would you suggest investors be doing in the third quarter instead?

Sekera: I think right now, you really need to start shifting your mindset away from thematic investing, really get away from what’s worked over the past one and a half years, to thinking more like an individual stock-picker, really looking for more idiosyncratic type of situations. I think the second half of this year is really setting up to be much more of a stock-picker’s market. What that really means is I think outperformance from here is going to be driven more by company-specific situations. I think investors should look for those stocks where they have specific catalysts that could cause those stocks to start moving upward. That could be anything like a soft catalyst, where you see ongoing industry normalization following the pandemic, looking for situations where we expect a turnaround in earnings. One example there would be IFF, that’s a stock we’ve talked about a couple of times on our show. In fact, I think it was one of our picks on our Sept. 18 show last year.

Or stocks with what I consider to be hard catalysts, specific events which could provide significant upside evaluations. An example there is going to be APA, that was a stock pick back on our Jan. 18 show. And I think also, you just need to look where to take profits in your portfolio, areas to steer away from, or at least not put new money into. For example, the tech sector we think is about 10% overvalued—not the most overvalued tech has ever gotten in the past but certainly getting up well above its fair valuations. And then look for those other sectors that are still out of favor and been left behind in this rally. Three areas that I would look at are going to be real estate, energy, and basic materials. There’s three sectors that are all still trading at pretty attractive discounts to their fair value.

Dziubinski: Let’s talk a little bit more specifically about those sectors, Dave, about why they look attractive, especially today.

Sekera: The first one’s going to be real estate. It trades at about an 11% discount to a composite of our fair values. There’s nothing that’s hated more by Wall Street right now than commercial real estate, but I think that’s also why you see the opportunity there. There’s a lot of concern in the marketplace regarding valuations for commercial real estate, specifically urban office space, and I think rightly so. But that’s really brought down the entire real estate sector, so those real estate plays that have more defensive characteristics have been brought down with urban office space, so we see a lot of value specifically in those types of plays.

The other sector I really like right now is going to be energy. It trades at a 7% discount, but what I like is that we actually have a pretty negative, bearish-type view on the long-term price for oil. We look for oil over the midcycle to be $55 a barrel when we look at West Texas Intermediate. Of course oil, I think, is still above $80 now. If oil were to stay here or move up, I think there’s a lot of upside leverage in a number of these different stocks. Conversely, if oil does subside, if it falls down to our forecast over the next four or five years, you’re still buying a lot of these stocks at a discount to their intrinsic valuation. Plus I think the energy sector, the oil companies specifically, provide a pretty good natural hedge in your portfolio against if inflation were to stay higher for longer, or any kind of increase in geopolitical conflict.

Dziubinski: All right, it’s time to move on to the picks portion of our program. This week’s picks are all new names to Morningstar’s quarterly list of analyst picks. And viewers can find a link to the complete list of analyst picks for the third quarter beneath this video. Today, you’re focusing on four of what we call story stocks from that list that are undervalued and that have catalysts that could drive outperformance. Your first pick this week is Nutrien; tell viewers about it.

Sekera: Even before I get into Nutrien, I just want to caution investors, as you mentioned, these are what I consider to be story stocks. I do think there are some catalysts that’ll help these stocks over the longer term, but I highly recommend go to Morningstar.com, read through the analysts’ writeups on these names, make sure that you really understand the story and that you’re comfortable with it here. Largely because with story stocks, there might be some additional volatility in the shorter term, and I just want to make sure that investors understand what that story is, has that comfort level, so that way if there is some short-term volatility, they can either use that to build into even larger positions over time or at least be able to hold these stocks through that short-term volatility.

Nutrien itself is a 4-star rated stock, trades at almost a 30% discount to fair value. I think its dividend yield is about 4.3%. It is a company that we rate with a narrow economic moat, however, it does have a high uncertainty rating. But of course, as a commodity-oriented company, being in a more cyclical industry, that high uncertainty rating makes a lot of sense here. The company did have their investor day in June, and there’s a couple of different key takeaways here that our analyst wrote about.

Specifically, he talked about their disciplined capital allocation strategy, specifically geared toward maintaining the company’s low-cost position in potash and nitrogen. We’re not looking for any new major capital-intensive projects here. We’re really looking for the company to maintain their position in the bottom quartile of the cost curves for potash and nitrogen. And really, that’s what underpins our narrow economic moat rating here. In fact, when I look at the commodity companies under our coverage, there’s very few that we rate with an economic moat, and when we do rate it with a moat, it’s almost always based on being a low-cost provider here.

Longer-term, in the investor presentation, I believe management did provide their outlook for potash demand. It’s in line with our long-term forecast as well. Currently, we forecast potash demand in 2030 to be about 82 million metric tons. The company’s forecast is a range of 80 million to 85 million metric tons. Potash is one of the largest business segments for the company, I think it accounts for nearly 40% of their adjusted EBITDA. In my mind, what’s the catalyst here? Right now, looking at our forecast and our model, we do project that demand is growing faster than supply. That should send prices up about 10% over our 2024 average, toward our long-term forecast of $325 per metric ton. And that in turn will then drive profit growth in 2025 and thereafter.

Dziubinski: Your second pick this week is Huntington Ingalls Industries. This is a midsize wide-moat company, and the stock’s in the red this year. What’s the story and the catalyst here?

Sekera: First of all, let me mention, we actually just recently launched coverage on Huntington. So I think this is an interesting one that we’ve kind of taken that fresh look at and put out our new fair value estimates. Again, take a read of what we’ve written on Morningstar.com and really make sure you understand the story here. But it’s a 5-star rated stock at a 23% discount and 2.1% dividend yield. It is a company, as you mentioned, that we rate with a wide economic moat. But the benefit of being a government contractor is that we rate it with a low uncertainty rating. The company is the largest independent military shipbuilder in the US. I believe they’re the sole provider of nuclear aircraft carriers and amphibious landing ships. They’re only one of two producers for nuclear submarines for the US Navy. So as such, when you look at their revenue and profitability streams over the long term, you have a lot of visibility here.

However, I think one of the things the market might not necessarily like is that you can have relatively small shifts in timing, but because these programs are so large, that can cause their quarterly revenue and profits really to be kind of lumpy from quarter to quarter. Looking forward, when we look at what’s going on geopolitically, the amount of conflict out there, it has been leading to larger military budgets—in fact, I think larger than what we’ve seen over the past couple of decades. Specifically, our analyst looks at the portion of those defense budgets which are really geared toward Huntington products. He’s currently modeling that they will continue to grow, probably 2.5% to 3% over the next five years.

The long-term risk here is if the military’s needs shift away from those larger products such as the nuclear-powered aircraft carriers. But we think that over time, that would be balanced out by demand for other products in their portfolio, such as submarines, as well as uncrewed sea vessels. Right now, taking a look at the stock, it only trades at just under 13 times our 2024 earnings, and a similar amount for 2025. I think this one is going to be much more of a soft catalyst, looking for investors to really start getting much more comfortable, that earnings really are bottoming out here in the short term, and that we do forecast they will start to grow again in 2025. A lot of that also largely being due to some of those shifts in the timing.

Dziubinski: Your third pick this week is a more familiar name, it’s UPS. Stock’s having a bad year, down more than 10%. What’s the story and the catalyst with this one?

Sekera: It’s actually had a bad couple of years.

Dziubinski: Yeah.

Sekera: When we look at this one over the past five years, this stock ran up in 2020 and 2021. Of course, home deliveries shot up during the pandemic, but it moved up so far back then—I think it was in early 2021, it was all the way up in 1-star territory. Effectively, the market’s just overestimated how long that kind of short-term growth was going to last. That stock’s been giving up those gains ever since then, but we think at this point the stock has fallen too much. I think this is an interesting opportunity, that when you look at our price/fair value over the long term, this stock really rarely has traded at much of a discount to our fair value. So it’s currently rated 4-stars, at a 14% discount, pays a pretty healthy dividend yield at 4.8%. It’s a company with a wide moat and a medium uncertainty.

Now, revenue did peak in 2022 and fell in 2023. But when I look at our model, we do expect that revenue should be bottoming out here and start moving back up, hopefully in the second half of this year. Similarly, earnings have also fallen, but we expect this to be really the trough in earnings, and looking for earnings to start rebounding as well. A couple of different things fundamentally that’s going on here: The company did renegotiate their union contract recently, so I think the company’s working through, looking for different ways to mitigate those wage hikes. But between top-line growth, probably getting some efficiencies from looking at ways that they can mitigate those costs. We do forecast earnings will start to grow again in 2025.

Looking at the stock, it trades at just under 17 times this year’s earnings. But when you look at our forecast earnings for 2025, that takes it down to only 14 times, which I think at that point in time, will look pretty undervalued from the market’s perspective. I think once the market starts to price in those 2025 earnings instead of the 2024 earnings, I think that’s when that stock really is going to start to perform.

Dziubinski: Your final pick this week is what many would consider to be a surprising pick in an undervalued sector, it’s Kilroy, which is a REIT focused on office space. Explain yourself, Dave!

Sekera: As you mentioned, I think this one is going to surprise a lot of viewers, especially because I think I’ve been pretty consistent in warning that urban office space may still have yet further to fall before it can start to move back up. I wouldn’t be surprised to look in the commentary, if a lot of viewers are going to disagree with me on this one. Specifically, I think this stock and this recommendation is really more for investors that are concerned that, yes, maybe there is still some softness in the office space market, but at this point it’s probably already priced in, or maybe even they think it’s overdone, the downside at this point. So the stock is rated 5-stars, trades at about half of our fair value estimate, has a pretty high dividend yield at 6.9%. Of course, like most real estate stocks, we rate it with no economic moat, and of course this one does have a high uncertainty rating.

So what does Kilroy do? It owns office space in Los Angeles, San Diego, San Francisco, Austin, and Seattle. These are all areas with probably some of the most negative market sentiment out there. But again, that might also be why this is one of the most undervalued REITs under our coverage on that price/fair value basis. In fact, it’s also one of the most undervalued REITs that we currently cover, even if we look at it more on like a market basis on an enterprise value/EBITDA ratio. I took a look at their most recent investor presentation. According to that, they’re 65% office, 25% life sciences, and then 10% mixed-use. One of the things that we find to be a positive here in the office space, they are skewed toward the tech sector.

When we look at employment in the tech sector, that has been growing. When we look at a measurement of job tech postings within their specific market areas, some of the largest tech companies like Apple, Alphabet, Amazon, Meta, they’re all requiring employees to go back into the office, go back to that hybrid work schedule of at least three days a week. So we’re seeing an increase in foot traffic and occupancy within the buildings that they own. Then that other area, that life sciences area, that is an area that we’ve actually been pretty comfortable with, just due to its more defensive characteristics than what you see in a general office space. In that presentation, they also note that the average age of their buildings is only 11 years, and that’s significantly lower than the average for a lot of their peers. In fact, many of their peers are at least double, if not even older.

What happens is that should lead to better occupancy rates than some of their peers. Really, those younger buildings will better position them to be able to attract new tenants, especially when those tenants have leases coming up in other buildings and are looking for more attractive space. Now as far as the credit quality of this company, it is rated BAA to BBB, puts it in the investment-grade category by the rating agencies. Of course, a lot of concern with a number of the different REITs, especially in real estate, is their debt profiles. Taking a look here, it looks like their maturities are pretty well spaced out. They do have a term loan due in 2026. Some people I’ve talked to in the bank debt market don’t think that that’s going to be a problem for them to be able to term that out once they start getting close to that maturity. And then 50% of their tenants are also investment-grade, that’s going to be higher than most of their peers according to their presentation.

I know this is a long story, but I think this is one where it’s worth really digging into if it’s something that you have an interest in. Another attractive characteristic, their average lease term is eight to nine years. When we look at our base-case forecast for occupancy in LA, it’s currently 77% occupancy, that’s only down from 81% last year. In Austin, we’re looking for that to increase up to 75% this year. San Diego, a slight decrease, but still at 84%, coming down from 87%. San Francisco, coming down slightly, from 92% to 90% this year. And then Seattle, being one of the areas that is going to be a little bit harder hit in our view, but again still 81%, not that bad an occupancy level compared to 86% last year.

As far as revenue, we are forecasting that to decrease 5% this year, and then looking forward to be steady next year. The other thing here is that with REITs, the valuation, when you’re looking at it, I really don’t look at P/E ratios. We really look at it based more on a funds from operations to the stock price. We do expect FFO to decrease 10% this year, down to $418 a share, another slight decrease to 3%, down 3% next year to $405, and then starting to grow again thereafter. So as a point of reference, funds from operations was as high as $469 in 2022. I don’t think we’re really making any real aggressive projections here. In fact, our model doesn’t get back to $469 until our 2028 forecast.

So, Dave, what are the catalysts here? In general, I think it’s much more of the softer catalyst as opposed to the harder catalysts. I think in the short term, it’s going to be the soft catalysts, investors looking to get more comfortable with the outlook for urban office space, specifically for the tech sector. Among maybe some of the harder catalysts over the next couple of years, just looking for that rebound in office and office occupancy, looking for rent stabilization. I think once we start to see that in the lease renegotiations over the next couple of years, I think that would help propel this stock up higher as well. Specifically for Kilroy, I think we’re going to see better performance from their portfolio of real estate than what we’ll see from a lot of other areas. Of course, we are looking for their life sciences portfolio to remain relatively steady. Again, a long story, but one that if you are interested in urban office space, this would be the one that I would really highlight to do your due diligence on.

Dziubinski: All right. Well, thank you for your time this morning, Dave. Viewers interested in researching any of the stocks that Dave talked about today, can visit Morningstar.com for more analysis. We hope you’ll join us again for the Morning Filter, next Monday at 9 a.m. Eastern, 8 a.m. Central. In the meantime, please like this video and subscribe to Morningstar’s channel. Have a great week.