Morningstar Uncovers Undervalued Stocks

Brandon Rakszawski, Director of Product Management, VanEck

The Morningstar Wide Moat Focus Index systematically targets US companies that Morningstar's equity research team identifies as 1. possessing sustainable competitive advantages or moats and 2. importantly are also trading at attractive valuations. 2024 has been full of market distortions. Growth has outperformed value. We've seen an extreme lack of market breadth—in other words, very narrow leadership among mega cap companies, many from the tech sector.

Both of these distortions are at levels not seen since the dot com bubble of the turn of the century. All of these distortions are offering pockets of opportunities in the US equity market. And Andrew Lane will discuss the equity research that fuels this underlying strategy.

Andrew Lane, Director of Equity Research, Morningstar

In this video today, we're going to be highlighting some of the more undervalued securities in the Morningstar Wide Moat Focus Index. And to do that, we'll be hearing from a number of Morningstar Equity Research Analysts. Morningstar is the largest independent equity research provider globally with roughly 100 equity analysts. And again, we'll be hearing from a number of them today.

The Morningstar Wide Moat Focus Index is a very unique index and to build it each quarter and reconstitute it and maintain it, what we look to do is to really take advantage of wide economic moat rated companies that are trading at a discount to our analyst driven fair value estimate. So there are two parts there, of course. The economic moat rating is a measurement of how durable a competitive advantage will prove to be into the future.

And then our fair value estimate, our take on valuation, is what we think the stock really should be trading at today. And to reach that fair value estimate, our equity research analysts use a three-stage discounted cash flow models. So forecasting free cash flow long to the future and discounting it back to the present day. And so with that in mind, let's hear from some of the Morningstar equity research analysts highlighting some very attractive investment opportunities in the Morningstar Wide Moat Focus Index.

Damien Conover. Director of Equity Research, North America, Morningstar
Covering: Pfizer

We believe Pfizer has a wide economic moat supported by the intangible moat source, really focused on patent protection. When you think about Pfizer, this is a company with a lot of different products, a lot of different drugs, vaccines. And each one of these products and vaccines has a different sort of patent protection. And by using a portfolio approach, it's likely that Pfizer can adapt to patent losses while bringing out the next generation of innovation. And that ability enables Pfizer to have these excess returns or what we consider a wide economic moat. And because the innovation is so strong and the portfolio is so deep, we believe Pfizer has a wide economic moat. So we're very confident in Pfizer's excess returns over the next 20 years.

We also see Pfizer as undervalued. One of the key reasons we think Pfizer's undervalued is the ability to cut costs, which is, I think, a little bit unique to some of the large-cap pharmaceutical firms. In Pfizer's case, they built up a tremendous amount of investment during the COVID time period. And now that COVID has subsided, they're cutting $4 billion out of their cost structure that will likely fall to the bottom line. And we think the market's underappreciated that.

The second reason we really like Pfizer is its ability to innovate. You know, Pfizer has a lot of different shots on goal within its pipeline. One of them is Danuglipron, which is a new obesity drug. And although it won't be first to market like Eli Lilly, we think the obesity market is very, very large. And Pfizer has the ability to enter that market and really explode the growth potential of its pipeline.

And then lastly, there is concern about Pfizer adapting to its patent losses. Now Pfizer does have some patent losses, but they're not of a huge degree. And when Pfizer enters the patent loss time period for itself that really gets high in the 2028 time period, we believe these next generation drugs, both on the obesity side and several different drugs in oncology and immunology will really mitigate that. In totality, we see Pfizer's undervalued with a wide economic moat.

Sean Dunlop, Senior Equity Analyst, Morningstar
Covering: Etsy

Etsy is a really interesting company. It's a global marketplace that connects artisanal craft sellers and buyers around the globe. Today it has 96 million active buyers and 9 million active sellers worldwide. It's far and away the largest craft marketplace.

It sits in really interesting niche focusing on non-commoditized, non-branded long tail products. So think about wedding gifts, birthday gifts, special occasions, stationery, home goods, decor, apparel—very discretionary, but very interesting and unique items. We believe that Etsy has carved out a wide economic moat, and we believe that it has done so around network effects and intangible assets. So it's a particularly interesting company because it pales in comparison to eBay and Amazon in terms of scale. Etsy transacted just $13 billion globally last year against about $74 billion eBay and $900 billion-ish at Amazon. They don't obviously disclose that, but we still believe that it's carved out a really durable competitive position within its niche. It doesn't compete on the basis of price. It doesn't compete on the basis of fulfillment speed but all of its sellers sell really unique products and 87 percent of buyers agree that Etsy sells products you can't find anywhere else. So even as the firm only has a $6 or $8 billion market cap, we believe that its competitive position is all but impregnable. It has somewhere between 15% and 20% penetration of the population in each of its key countries: the US, the UK, Germany, Canada, France and Australia.

Its biggest struggle has been getting buyers to transact frequently on the platform. The average buyer only spends about $130 today, but it certainly has been able to generate a broad reach, broad traction, and its sellers really don't sell anywhere else. About half of Etsy sellers only sell on Etsy. And the second largest sales channel for those people is actually offline craft shows and events. If you take the sales of Shopify, eBay and Amazon in the category combined, it's less than those sellers generate in craft fairs and events offline. So Etsy really is in a category of one here. We believe that it's also carved out a moat around intangible assets. And that's basically the ability to take these hundred million listings on its site at any given time and map these attributes that non-professional sellers give them onto buyer search intent.

And it's a really challenging problem. So if you think about looking for men's cocktail party attire, you might be wanting to turn up a blue navy blazer or a pocket square. And obviously, none of the search terms correspond with what you're looking for there. And they've been able to solve that problem quite well. At this point, 95% of Etsy's sales come from the first page of results, so definitely a durable competitive edge there. We think that we have a fair value estimate of $100 for the company per share.

Right now it trades in the ballpark of $55 or $60 per share. And we think that the big difference is the market underestimates Etsy's long-term market growth potential and the really strong contribution margin that it generates on incremental sales. Said otherwise, we think that as the firm returns to growth, it should see really strong margin expansion and continue to generate returns on invested capital comfortably ahead of its weighted average cost of capital.

More concretely, we mentioned that buyers spend about $130 every year on the platform today. We think that that can gap up to about $240 over time, driven predominantly by frequency. As the firm improves its search algorithm, it starts to generate a little bit better off-site traffic with programs like its Google off-site ads, as it improves its search proficiencies, as it rolls out its nascent loyalty program.

Etsy basically has no cost of sales. It pays about 15% for payment processing and 15% for cloud hosting, which means that generally it generates about 70% margin on each incremental sale. So over time, we expect it to achieve really attractive returns for investors. We think that's something that the market misses today.

Nicolas Owens, Equity Analyst, Morningstar
Covering: Boeing

Boeing re-entered the wide moat index earlier this year because it has a wide moat, a durable competitive advantage, and it was trading below our fair value estimate at the time.

The main reason we assigned Boeing a wide moat is that making hundreds of big commercial jets is extremely technically challenging, and it's one of only two companies on earth that can do it. We call those intangible assets and switching costs, and that leads us to expect Boeing to out-earn its cost of capital for at least 20 more years.

Airlines are always competing with each other to have the most efficient planes. They order new jets years in advance. And once they commit to a given model, they usually stick with it and order more of them. And that's really good for Boeing's repeat business. Now, Boeing's shares are cheap because there have been an awful lot of bad news coming out of the company for the last several years. And they're going through some very serious problems. A lot of the trouble Boeing has been having stems from decisions made 15 to 20 years ago, which is in its own way evidence of how slow moving things like customer decisions and market share are in the aerospace industry, which is another reason why we assign it a wide moat. The most important value driver for Boeing is that there's a huge global demand for jets, a backlog going out decades, not just of airlines reordering newer and more efficient planes, but actually net new demand as markets around the world become more prosperous. Middle-class consumers demand air travel. And so there's new airlines being formed, airports being expanded. And so that's going to add to the order book for planes, especially narrow-body jets like the 737 and the Airbus A320.

The Boeing 737 is its most important product. It accounts for at least half the franchise value of the company. And it's been going through a lot of really thorny problems for the last handful of years—so combining the software design problem, the crashes, regulatory problems, and the pandemic, which caused huge disruption to their staffing and supply chain. They're still unwinding those problems, and we do think that it'll take another year or two for the company to increase its jet production and get the 737 and other commercial jet assembly lines back in ship shape. But we're fairly confident that they can do it and will. And when they do, their revenues, profits, and cash flows will increase dramatically. And that results in our $218 fair value estimate for the shares.

Erin Lash, Consumer Sector Director, Morningstar
Covering: Campbell Soup

The ingredients for a moat in the packaged food landscape consists of a strong brand portfolio, an entrenched position with leading retailers and/or cost advantage, and wide moat Campbell Soup boasts all three. The firm's namesake soup offering has long been the leader in U.S. shelf stable soup with more than 60% share and it's been building a growing presence in snacking with brands including Pepperidge Farm, Goldfish, and Snyders of Hanover. This affords insights into evolving consumer trends that aid its relationship with its retail partners and its vast U.S. manufacturing and distribution network unlock scale advantages that smaller competitors have been unable to attain. But shares traded a 15% discount to our $61 fair value estimate.

So why aren't investors serving up a helping of shares? From where we sit, much consternation centers on the potential for increased competitive intensity amid a weak consumer spending backdrop and the impact that could have on Campbell's volumes and ultimately its market share position. But we believe that Campbell is astutely focused on investing in consumer valued innovation and marketing to ensure its products align with consumer trends.

This underpins our forecast for Campbell to continue to grow in line with the broader market, boasting about 2% organic sales growth longer term, while generating high teens operating margins. In contrast, we think the stock market price implies that Campbell stands to lose share with growth 50 to 100 basis points below the market's pace and mid-teens operating margins neither of which strikes us as reasonable, and thus we think shares look undervalued.

Seth Goldstein, Equity Strategist, Morningstar
Covering: International Flavors and Fragrances

International Flavors and Fragrances is a global leader in flavors, fragrances, enzymes, and cultures used in food, beverages, nutrition, fragrances, and personal care products. We award IFF a wide moat rating due to the combination of intangible assets and switching costs. Intangible assets come from its market-leading portfolio of differentiated specialty ingredients.

These unique formulations are used by IFF's consumer packaged goods companies when they're developing a new product. Oftentimes, a flavor or a fragrance is the key ingredient and the main reason why a food or perfume is successful with consumers. As a result, once IFF's ingredients are in a product, switching costs come into play, as its consumer packaged goods customers rarely switch key ingredients for fear of turning away consumers and losing sales.

This combination of intangible assets and switching costs drive strong pricing power for IFF. At current prices, we view IFF shares as undervalued. In 2023, customer inventory de-stocking caused sales volumes and profits to decline. While IFF will likely see a rebound in 2024, the market questions the company's growth outlook following several years of stagnant sales.

Despite recent results, IFF maintains its market leadership in flavors, fragrances, cultures, and enzymes. In the coming years, we forecast solid revenue growth and a full profit margin rebound as IFF's strong product portfolio will win business and drive volume growth. In turn, this will generate revenue and profits higher in our above consensus outlook for the company, which forms the basis of our undervalued stock call.

Dan Su, Equity Analyst, Morningstar
Covering: Estee Lauder

Estee Lauder is the leading global beauty product maker with decades of expertise across skincare, color cosmetics, and fragrances. The company has earned a wide economic moat rating from us, as we believe Estee Lauder has built a durable competitive position in the structurally attractive beauty industry by leveraging its portfolio of top-selling premium brands, entrenched relationship with major channel partners in the U.S. and internationally, and a scale-based cost advantage. As such, we expect the firm to deliver investment returns above its weighted average cost of capital for more than 20 years.

We view the Estee Lauder stock as undervalued, currently trading at a more than 40% discount to our fair value estimate. While the market remains pessimistic about Estee Lauder's growth outlook given near-term challenges in China and in Asia travel retail that weigh on the top line and profitability, our view is more constructive. We believe that the firm remains well-positioned to ride the beauty premiumization tailwinds over the longer term as its brand appeal among high-end shoppers and alliances with brick and mortar as well as digital retailers remain largely intact. We expect the firm's innovation focus and branding and cost-saving initiatives should combine to drive a steady rebound in sales and profit margins in the coming years.

Ahmed Khan, Equity Analyst, Morningstar
Covering: Alphabet/Google

So when we think about Alphabet, we think that the company merits a wide moat rating. There's a lot of different economic moat sources that contribute to Alphabet's wide moat. We can think about intangible assets and how Alphabet has built up its brand, Google, its proprietary technology, how it surfaces ads to its customers, how it surfaces results to its end-users. So that's intangible assets.

Then you also have switching costs for Google's or Alphabet's cloud business, the public cloud business. You have cost advantages across the business, especially when we think about its core premier offering—that's the search engine—as well as its cloud platform.

And then wrapping all of these things together is Alphabet's network effect—the idea that business actually gets better as more users type in more queries or use its platform more, and then it's able to use that data, leverage that data, and provide better search results.

As we think about Alphabet's valuation, we think there's two key differentiators between our view and what the market currently values Alphabet at. The first one is antitrust. So we think that there is a broad range of outcomes of the antitrust or regulatory concerns that Alphabet is up against. But we think that in the majority of those outcomes, Alphabet will be able to navigate those potential headwinds and actually still maintain its excess returns, maintain its profitable business.

And secondly, it's to do with the second sort of differentiator between our view and the market's view, is this idea or this perception that has been built up in the market that Alphabet or Google, it is a laggard when it comes to generative AI. First of all, we don't agree with that thesis. But secondly, we think that Alphabet's AI strategy or GenAI strategy is around this theory of commodification of complements. By that, mean, a tech company, if they are able to commodify complementary goods to their core offering, they can extract that value over to their own product. So as we think about public cloud vendors like Microsoft or Amazon and Google, we think that this commodification of complements works out really well for them because they're able to commodify a lot of these large language models and accrue that value over to their own public cloud infrastructure.

At the same time, we think Alphabet's offerings with specific regard to GenAI with AI overviews or the LLMs they have put out are competitive. They're certainly up there and you can look at like third party research websites that compare different models. So we think this market perception is it's not entirely warranted.

Michael Miller, Equity Analyst, Morningstar
Covering: MarketAxess Holdings Inc

We see MarketAxess as benefiting from a wide economic moat due to its position as a leading platform for the electronic trading of U.S. corporate bonds, euro bonds, and emerging market debt. Particularly these markets are increasingly transitioning towards more electronic trading.

Specifically the company benefits from very strong network effects due to its large array of clients and dealers already on the platform This is a common feature of really any successful trading system, as you need a large pool of buyers and sellers in order to ensure there's sufficient liquidity for effective trading. This makes it particularly difficult for new firms to get involved, as you kind of need initial volume in order to attract volume in the first place. Additionally, in this particular industry competition is largely about narrowing spreads and cost efficiency of trading, not pricing, so that supports really wide margins for MarketAxess.

Turning more to valuations, MarketAxess had a very severe sell-off early on in 2024 due to a sudden drop in their high-yield market share. This was caused by a lot of their hedge fund and ETF market maker clients pulling back from the marketplace to really focus on new issuance.

Now this is a real headwind for the company. High yield trading volume is down double digits this year. But ultimately this really only touches about 10% of the total trading volume for the platform. And at the same time, they've seen very strong growth, particularly in emerging market debt. So, we see at this point we really don't think the valuation really matches the medium- to long-term opportunities they have as really as they have strong momentum in international trading. Even in the United States, we've seen trading conditions improve and this is a moderate beneficiary of lower interest rates. So there is a solid opportunity facing the company that's not really matching the valuation at the moment.

David Swartz, Senior Equity Analyst, Morningstar
Covering: Nike

Our wide moat rating on Nike is based on its brand and tangible asset. Nike is the world's largest athletic apparel and footwear company. It benefits from the popularity of sports and as products are available in nearly every country in the world. At about $50 billion a year in revenue, it is more than double the size of its main competitor, Adidas. The global sportswear market is very competitive, but Nike has dominated since partnering with Michael Jordan 40 years ago.

Nike leads its competitors in terms of visibility, sponsorships, and geographic reach. Its products are used by professional and amateur athletes throughout the world, and its performance athletic shoes command high prices. Given its brand value, we think Nike has a competitive edge that will last for least another 20 years.

Nike has been posting disappointing sales numbers, which is unusual given its long history of growth. There have been many concerns, including rising competition in sportswear and economic conditions. Nike has also made some mistakes, including falling behind in innovation and pulling back too far from its wholesale partners. Despite these issues, we think investors have been too focused on near-term problems rather than Nike's long-term strengths. The company has all the advantages in terms of R&D, product development, marketing sponsorships, and popularity. We think Nike is doing the right things in terms of marketing and has many new products coming out over the next 18 months.

Although economic conditions in key markets like the U.S. and China are out of its control, you also think that long-term growth in sportswear will continue and that the worldwide market is big enough for multiple successful firms. We think investors are overlooking Nike's potential for growth in emerging markets over the next few decades. Nike currently trades at a large discount to $124 per share, fair value estimate. In the past, we have often rated Nike's as overvalued due to premium valuations.

Historically, long-term holders have been rewarded when buying Nike shares during down periods such as the current one.

Jay Lee, Senior Equity Analyst, Morningstar
Covering: Bio-Rad

I'm excited to talk about Bio-Rad today, which is a wide moat life sciences company that we think has an attractive market valuation right now. So first of all, our wide moat is centered on the intangibles and switching costs in its clinical diagnostics business segment and also its non-consolidated holdings of Sartorius, which is another company that we have a wide moat on.

The clinical diagnostic segment sells in-vitro diagnostics equipment and consumables to medical diagnostics labs, who use Bio-Rad's equipment to run various tests for their patients. Bio-Rad holds niche market leadership in immunohematology and diabetes testing, and the segment contributes about two thirds of overall operating profit. Like many life sciences businesses, the diagnostics equipment market generally has a razor and blades business model, whereby once equipment is placed, customers will usually buy consumables and reagents from the original supplier for the lifetime of that equipment, providing a stream of high quality and high margin recurring revenue.

The remainder of Bio-Rad’s consulting business mostly sells various life sciences equipment used by academic and biopharmaceutical research labs.

Now the second major component of the moat comes from its holdings of Sartorius AG, which is primarily a bioprocessing equipment supplier. Now this equipment is used in the manufacturing of biologics drugs, which is a highly, highly regulated space. And we generally think that incumbents like Sartorius have wide moats in this business.

So although this holding is not consolidated by BioRad, it's about 40% of our fair value of BioRad, so we include it in our moat analysis due to its high interiority.

Regarding the current market valuation, we think that the shares are about 25% discount to our fair value estimate. And we think the primary reason is due to a very pessimistic near-term earnings outlook, which has a number of factors. Most importantly is probably the industry-wide de-stocking trends. Also uncertainty in the China region. And you need to invest in an appetite from biotech and biopharma companies to purchase new equipment.

Now these effects are actually seen across the life sciences sector, including Bio-Rad’s peers. But with the exception of the uncertainty of the China region, we think these trends are likely to be temporary and we expect a return to growth in 2025 and beyond.

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