Spotlight on SMID-Caps: Morningstar’s Undervalued Picks

Brandon Rakszawski, Director of Product Management

The Morningstar US Small-Mid Cap Moat Focus Index offers investors exposure to US SMID-cap companies that Morningstar’s equity research team believes possess durable competitive advantages and trade at attractive valuations.

SMID-cap companies have traded at decades low valuations relative to their large-cap peers. Many investors have considered allocating to smaller companies weighing the risk and reward.

This strategy leverages Morningstar's extensive equity research process. And Andrew Lane is going to walk us through that equity research and how it fuels this underlying strategy.

Andrew Lane, Director of Equity Research, Morningstar

Thanks, Brandon. So in this video, we'll be hearing from a number of Morningstar equity research analysts, and they'll be highlighting some of the most undervalued investment opportunities in the Morningstar US Small-Mid Cap Moat Focus Index. Morningstar is actually the largest independent equity research provider globally, with roughly 100 analysts in the group. And again, we'll be hearing from a number of those analysts today, highlighting these attractive investment opportunities.

When it comes to building the Morningstar US Small-Mid Cap Moat Focus Index, what we're really trying to do at Morningstar is take advantage of the most undervalued companies with narrow and wide economic moats in the small and mid-cap space. Of course, when it comes to economic moats, what we're looking for are companies with durable competitive advantages, high returns on capital that should last long into the future.

From a valuation perspective, we're going to hear about fair value estimates from these analysts. And that's what we think these stocks should be trading at today. Fair value estimates really are the present value of all cash flows our analysts are forecasting for these companies for many years into the future. So let's hear from some of our analysts about some of these attractive investment opportunities in the Morningstar US Small-Mid Cap Moat Focus Index.

Karen Andersen, Equity Strategist, Morningstar
Covering: Ionis Pharmaceuticals

Ionis Pharmaceuticals has built a narrow moat with its innovative technology that targets a genetic material known as RNA. These therapies can help patients either make more of helpful proteins or stop making harmful ones. The company was founded several years ago in 1989, but it's actually been improving its technology ever since to make safer and more targeted therapies, which we think is culminating in a very strong portfolio and pipeline.

So in terms of its moat, we think Ionis has strong intangible assets surrounding its latest generation technology. And this technology has actually led to several partnerships and the firm's first blockbuster is actually a rare disease drug called Spinraza marketed by partner Biogen. So far, Ionis generates most of its revenue from these kinds of partnerships. Right now it has a new amyloidosis drug. It's launching that with partner AstraZeneca.

Although both Spinraza and this new drug face strong competition, I think the market right now is short-sighted, and it's overly focused on the competitive landscape for these first programs to emerge from the Ionis pipeline. We see solid potential for new partnered programs like a Novartis-partnered cardiology program and a Biogen-partnered Alzheimer's drug. Both of these could be multi-billion dollar blockbusters.

Partnering the drug candidates that also require the most expensive clinical trials makes a lot of strategic sense to us. It helps protect the firm from major value destruction if several programs fail to reach the market. And in contrast to that, Ionis has also chosen to keep rights to specialty drugs that have smaller clinical trials. And as a smaller company, it can commercialize those on its own. So these programs, I think, are more important to Ionis's growth and profitability. And the first programs are really rapidly approaching the market here. There's cardiology drug, triglyceride-lowering drug, Olazarsin, and a rare disease drug, Angelman syndrome drug, Ion 582. Both of those look extremely promising. So overall, we think Ionis's technology has proven its safety and efficacy, and we like the diversity and size of its pipeline.

We think Ionis has a critical mass of new drugs right now that will lead to sustainable profitability by 2027. And we also see shares trading at about a 30% discount to their fair value estimate.

David Whiston, Equity Strategist, Morningstar
Covering: CarMax

Lots of things about CarMax's narrow moat are replicable in theory, but we see them as difficult to copy well. The cost advantage moat source in our framework comes from the firm's size enabling scale on things such as overhead, buying advertising, and health insurance. While the intangible asset moat source has several dimensions to it stemming from strong brand equity and the firm's cache of auto pricing and lending data that goes back through 1993. This data cannot be purchased by a competitor.

CarMax uses the data to arm its buyers with the best information on vehicle auction pricing and appraisal value. The data is also used to develop a national pricing algorithm, which helps CarMax retail over 99% of the vehicles offered through its stores. CarMax’s data advantage and its large cap to finance arm results in stronger profitability compared with competitors. We believe its data edge has helped the firm maintain its remarkably consistent gross profit per retail unit in the low $2,000 a unit range despite significant volatility in average selling and procurement prices caused by the chip shortage. The brand doesn't just help CarMax sell vehicles though. It also helps them best source the vehicles. In recent years, it has bought well over 1 million vehicles with about half of those vehicles purchased online. Something we don't think a one or two store dealer can do without massive IT investment or a brand as powerful as CarMax's name. That matters because vehicles bought from consumers are more profitable than those bought at auction. The company's size and large store base give an advantage over smaller competitors. Plus CarMax can offer a hybrid or what's called an omni-channel shopping experience. So customers have the most flexibility in how they shop. About one third of volume also comes from customers who don't want to shop online. So that's several hundred thousand vehicles CarMax can sell that a digital-only player like Carvana cannot. This is a very high-quality growth name and because of that it's rarely cheap, but the chip shortage hurt all used vehicle retailers due to it causing less supply and much higher pricing for used vehicles. So we think that presents an excellent buying opportunity for the long-term investor.

We might all depress EBIT margins for fiscal 2025 and 2026, and then in my view recovery is highly likely because it's just used vehicles supply and demand math coming back into balance, which will eventually cause higher same-store comps, higher margins, and likely a large upward price movement on the earnings release day that all finally happens.

Jaime Katz, Senior Equity Analyst, Morningstar
Covering: Norwegian

The cruise lines are really unique in how the industry is set up. The top four companies represent more than 80% of the global capacity. And that means there's a really consolidated sector. We think the large operators like Norwegian have a narrow economic moat and that's based on three different sources.

First, the brand intangible asset. Consumer loyalty is really pervasive by brand in the consumer industry. Consumers really crave a certain experience, and they prefer consistency. So this loyalty along with strategic marketing efforts really generates best in class pricing at Norwegian and that signals brand resonance to us.

Next, we think there's a cost advantage given the scale of the business relative to small competitors. For Norwegian, the size of the fleet allows them to negotiate well with vendors, procure goods at a competitive price, and these companies also have low cost financing access, so they're able to get financing for their ships at really competitive prices improving the payback period.

Lastly, we think there is an efficient scale mode source. There's a very high fixed cost to the business. There's been limited shipbuilding capacity and limited entry in the last few decades. And to us, that signals really an interesting barrier to entry.

Firm wide, specifically for Norwegian, we think they remain very attractive from a valuation perspective for a few reasons. To start, the fundamentals of the business are better than ever. Customer deposits and pricing are well above pre-pandemic levels, and that shows us the consumer still has an appetite for cruising. Additionally, the booking visibility has been really terrific. We're looking at the majority of bookings already into 2025 at this point, and that leaves really little risk for 2024 projections. And we think that investors may be discounting the importance of this insight.

Lastly, we think the firm's rhetoric around financial discipline has really changed in the last year. They've hard-coded financial goals for 2026 targets, implying basically mid 20% EPS growth in 2025 and 2026. But in our model, that would only require 3% yield or price growth and 2% cost growth on average, because there is some capacity boosting that top line growth. In our opinion, if the consumer continues to prefer experiences over things, we think the firm could really surprise to the upside and maybe meet its goals faster than anticipated.

Dan Romanoff, Senior Equity Analyst, Morningstar
Covering: Zoom

We rate Zoom as having a narrow moat based on switching costs, which is the primary mode source within software, I think more broadly. We see about 30% upside still to shares, so we think it's attractively priced now.

Five to 10 years ago, the core Zoom video call solution was a pretty dramatic improvement in terms of quality and reliability and user experience simplicity. That product was seeing viral adoption leading up to COVID and then COVID hit and that was basically, the product went nuclear and everyone used it sort of on a daily basis and it just became its own thing.

Investors still seem to think of Zoom as that company with just one product and that's not really appropriate. In reality, they've introduced a number of products. They have a complete UCaaS product at this point, so that's voice, video, chat. They have introduced Zoom phone. They have millions of Zoom phone seats. That product is several years old already. It's more than 10% of revenues. And more recently, they've introduced the Zoom Contact Center. And that is something that I think investors are pretty excited about. It's certainly gaining a lot of traction right now.

At the same time, there's a mismatch, I think, between the expectations that the street has versus what the company is delivering. And so Zoom is kind of plodding along at sort of 3% growth right now and gone are the days of those 50% growth quarters. And so that is the issue right now. We have growth in our model decelerating currently, and it'll start accelerating within the next quarter or so over the next year. And so we're going to get into maybe as high as the mid-single digits. And we also have margins actually declining a little bit. There's this pretty pedestrian set of expectations, for whatever reason, the street is really bearish. And I think the underlying cause of that is Microsoft Teams. Everyone expects that Microsoft Teams will just sort of come to dominate the market. There really aren't many markets where there's just one product that completely dominates. So, I think there's plenty of room for multiple winners and Zoom is well positioned to be one of those winners, especially after it proved itself during those COVID lockdowns.

Dan Wasiolek, Senior Equity Analyst, Morningstar
Covering: Wynn Resorts

Many are probably familiar with Wynn's Las Vegas resorts, but we think its moat is derived from its gaming license in Macau, which some refer to as the Las Vegas of Asia. The Macau gaming industry has attractive supply and demand characteristics that generate healthy economic profits and support Wynn's narrow moat.

On the supply side, Wynn is one of just six that have a gaming license in Macau. On the demand side, only 1% to 2% of China's 1.4 billion population visited Macau last year versus over 10% of the US's 330 million having gone to Las Vegas. Given this positive supply and demand characteristics, we think it's reasonable to expect Macau to continue to see visitation and revenue growth for the foreseeable future.

But despite this positive and constructive intermediate term view, shares have underperformed, which we think is due to investors focusing on near-term issues that should prove transitory, such as China's slowing economic growth and Wynn's levered balance sheet. But we think Wynn's debt-to-adjusted EBITDA ratio will drop towards four times in 2025 from over six times in 2023, as Macau's gaming demand continues to recover.

To this point, in recent months, Macau's gaming revenue has reached a high 70% level of 2019s, which is up from the low 60% mark in 2023. And we think the market can fully recover by 2026. And then in the following years after that, that Wynn Resorts Macau division can continue to post around 6% average revenue growth for the next several years. Overall, we think Wynn Resorts can post a return on investment capital averaging around 16% over the next five years. We see shares as attractive, trading at a meaningful discount to our $117 per share fair value estimate.

Julie Utterback, Senior Equity Analyst, Morningstar
Covering: Baxter International

Baxter is one of our best ideas. Baxter is a narrow economic moat company in our opinion. And like many of the other med-tech companies that we cover, it has a moat based on intangible assets on its proprietary products and some customer switching costs. For example, its infusion pumps have a traditional razor/razor blade type business model. Also, it has some businesses where it has multi-year contractual arrangements that are often renewed frequently. And that comes in the form of group purchasing organization contracts. And those group purchasing organization, or GPO, contracts have some nice pros and keep a lot of new entrants at bay in some of its target markets.

They also have some cons, too. And we've seen that in recent Baxter earnings reports, specifically since 2022, when there was some inflationary pressure in its supply chain. Baxter was having a mismatch between the prices that it was able to charge customers and the costs that were coming in through its supply chain. So that has really hurt them in recent years. The good news is those contracts are being renewed as we speak, and two of the three major GPO contracts are going to be repriced as of January 1, 2025. And according to Baxter, the indexing dynamics of those contracts should be much more appropriate and prevent some of those mismatch between prices and costs going forward. So that could be positive for Baxter's earnings.

Also, the company has had some challenges in its former Hillrom assets that were acquired a few years back, those are typically capital equipment businesses and those purchases can be delayed by customers. And frankly, in early 2024, during the change network outage, some of Baxter's clients had some liquidity problems, and they delayed some of those orders. And so the market's really been focusing on that. However, order activity in the second quarter picked up. And we think that will translate into better revenues and profits going forward, particularly in late 2024 and early 2025.

For investors though, shares haven't fully reflected those potential positive catalysts. Specifically, we think the shares are trading at nearly a 40% discount to fair value. And as it moves through some of these recent challenges and gets to the more positive end of those potential catalysts in terms of earnings growth, et cetera, we think that shares have room to run and they should rise going forward.

Seth Goldstein, Equity Strategist, Morningstar
Covering: Scotts MiracleGro

Scotts Miracle-Gro is the market leader in the U.S. gardening industry. We award Scotts a narrow-moat rating due to its strong branded tangible assets. Scotch sells grass seeds, fertilizer, mulch, and lawn defense products that fight weeds and insects under well-known U.S. brands. These include Scotts, Miracle-Gro, Roundup, Ortho and Tomcat. Due to Scott's strong marketing efforts, the company has crafted a high -quality brand image which allows it to charge a premium price versus private label competitors.

At current prices, we view shares as undervalued as the company is recovering from the post pandemic bust. Scotts Miracle Gro was one of the rare companies to benefit from the pandemic, as many consumers stayed at home and turned to gardening as an activity. This led to sales and profits hitting an all-time high in 2021.

However, the boom turned to bust. As consumers began to resume normal activities away from the home, Scotts sales began to fall. At the same time, Scott's incurred strong cost inflation and by 2023, profits fell to below pre-pandemic normal levels. While sales and profits will grow in 2024, margins are still well below historical normals and the market questions that Scott's profitability was permanently impaired.

While Scotts gardening business has seen unprecedented volatility related to the pandemic, over the long term, gardening sales and profits tend to be fairly stable and grow with U.S. housing. Given our outlook for U.S. housing growth and lower raw materials for Scott's going forward, we forecast Scotts will generate revenue and profit growth above consensus, leading to our undervalued stock call.

Brett Horn, Senior Equity Analyst, Morningstar
Covering: Global Payments

Global Payments processes electronic payments on both the merchant and the issuer side. We think the company has a narrow moat due to scale-based cost advantages as payment processing is a highly scalable activity. Global Payments processes about $800 billion in annual merchant volume. That's not as large as some of its competitors, but Global Payments focuses on the SMB space where there is lower volume available, but better pricing.

The company is tied to a still growing industry, as consumers continue to shift towards electronic payments and it generates about a quarter of its revenue internationally, which could provide a further leg of growth even if the domestic market starts to mature.

We think the company has a very attractive business model and has limited capital needs, which means free cash flow and relationship to reported earnings is relatively high. However, the market is concerned about disruption. Recently, we saw peer Worldpay run into trouble. FIS acquired Worldpay in 2019 and recently sold off a majority stake. But we think Worldpay's issues are company specific and stem from a focus on cost reductions following the 2019 acquisition and a lack of reinvestment in the business. We don't see this as a relevant issue for Global Payments, as its 2019 merger with TSYS featured relatively modest cost reductions.

Overall, think Global Payments’ model of partnering with business software providers and owning business software in key verticals remains valid and will allow it to hold its market position. Recent volume growth has held steady, which we think supports that.

We think the company can continue to generate mid to high single-digit revenue growth and modest margin expansion over time. With the stock trading at only 9.5 times adjust to 2024 earnings, we think the market is offering a bargain on an attractive narrow moat.

William Kerwin, Equity Analyst, Morningstar
Covering: Sensata Technologies

Sensata Technologies is a producer of small electrical components and sensors for automotive and industrial applications. We believe the firm holds a narrow economic moat on the basis of intangible assets and switching costs.

For intangible assets, we see Sensata as a design partner to its customers, selling customized and differentiated products into complex electrical architectures. We also believe the firm elicits switching costs at its customers, particularly in the automotive market, because it serves mission critical applications and cars have long product cycles for it to sell products into.

Now, we also believe Sensata is significantly undervalued to our $64 fair value estimate, representing over a 40% discount at current market prices.

We see our disconnect with market valuation coming from a couple key areas. For one, over the past couple of years, Sensata has had some execution missteps, including a failed acquisition and some errors on behalf of management. We like the firm's renewed focus on electrification going forward, with a focus on electric vehicles and electrification in the industrial market. And we also view changes to the management team favorably. Additionally, Sensata has earned over $2 billion in design wins, that have not accrued to revenue yet, but are set to accrue to revenue between 2025 and 2027. In our view, the current market price does not give Sensata enough credit for these design wins that we think will fuel strong growth in the future years.

Jaime Katz, Senior Equity Analyst, Morningstar
Covering: Bath and Body Works

Bath and Body Works’ narrow moat stems from the brand intangible asset. We see this surfacing in the leadership position it holds in the categories that it operates within. So when we look at the market share, Bath and Body Works holds the number two spot in the North American mass bath and shower business. In candle air fresheners, it was also in second place with an impressive 32% market share in 2023, according to Euro Monitor. It also displays significant pricing power, so if you look at where Bath & Body Works prices its shower gels at $13.50 or higher relative to Dove clocking in at around $7.50 for 20 ounces and Dial at less than $7 for 16 ounces, we think that even if you do a buy one get one free from a profitability perspective, Bath & Body Works is really coming out ahead of the game here. People are willing to pay for their products.

Additionally, we think they have a really robust distribution network. There's nearly 1,900 locations. There's a shift to higher productivity off mall locations. And there are some productivity enhancements coming by way of store formatting. The shares have really underperformed recently. They've been digesting concern around the second half of 2024 performance. That sentiment that we've heard from a number of other retailers, given how stretched the consumer has been.

However, we think that this near-term pressure will be transitory. I think there are numerous reasons why the company can really restore sales growth in 2025 and beyond.

First, there's significant category expansion in adjacent silos. So you think about men, hair, lip, laundry. There's a new pipeline roadmap there to continue to stimulate sales. There's international location expansion, which offers global promise. There's continued innovation. So management is not sitting still. They're innovating. They're meeting the customer where they need to be. Right now, that's really looking at the value product side of things. And so as that return to growth begins, we think the firm will really be able to leverage costs much better and capitalize on some of the cost savings that it's taken underway and really that should put the firm back on a path to 20% operating margins from the roughly 17% we think they might actually achieve this year.