Market outlook: Lofty valuations call for careful stock-picking

Given general valuation levels, careful individual stock selection is more important now.

Elizabeth Collins 30 March, 2017 | 5:00PM
  • The Morningstar Global Markets Index has returned more than 6% year to date and 16% over the past year.
  • The market-cap-weighted price/fair value estimate ratio for our equity analysts' coverage universe is 1.06.
  • Healthcare is the most undervalued sector, with a price/fair value estimate ratio of 0.98. Basic materials is the most overvalued sector, with a price/fair value estimate ratio of 1.44.

 

Healthcare is top of mind as one of our most undervalued sectors -- if only on a relative basis -- and the one facing the most immediate possible changes under the Trump administration and Republican-controlled Congress in the United States. Both are looking to fulfill the long-standing promise of repealing the Affordable Care Act.

The road to repeal is rough, as the proposed reform ideas could lead to eliminating coverage for millions of Americans, and Republicans hold only a narrow majority in the Senate. The House vote on the American Health Care Act scheduled for Friday, March 24, was called off for lack of support, making the ultimate outcome even more uncertain, given opposition from both very conservative and moderate members within the Republican party. Most Republican proposals would lead to fewer insured Americans, weaker coverage and higher out-of-pocket costs. Our analysts view the drug industry as best positioned for potential changes, with  Roche (RHHBY) and  Allergan (AGN) trading at attractive valuations.

Consumer cyclical is another sector where we see a decent amount of value in a generally overvalued market. Consumer confidence has remained high since the U.S. presidential election, but as consumers become increasingly comfortable making purchases online, companies relying on foot traffic in brick-and-mortar locations have continued to come under pressure.

Still, we think companies such as  Hanesbrands (HBI) and  Williams-Sonoma (WSM) are positioned well to be profitable in the long term. Hanesbrands is distribution-channel-agnostic, and thanks to strong brand recognition and consistency, consumers should feel comfortable purchasing items online. Meanwhile, Williams-Sonoma has strong brands that command some loyalty and pricing power.

On the other side of the valuation spectrum, metals and mining stocks look especially expensive. Commodity prices have rallied since early 2016 thanks to China's stimulus, but mines previously shut down are now coming back on line, and greater production has already started from high-cost producers of bulk commodities.

We view both the stimulus and the production curtailments as unsustainable, and see significant downside risk in stock prices. China optimism is also unduly propping up U.S. steel producer valuations, in our view, and these stocks are also baking in expectations for a material increase in infrastructure spending that could prove hard to deliver in reality.

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
Allergan PLC166.47 USD0.45
Hanesbrands Inc14.33 USD-1.10
Roche Holding AG ADR35.71 0.20
Williams-Sonoma Inc65.11 USD0.06

About Author

Elizabeth Collins

Elizabeth Collins  Elizabeth Collins, CFA, is global head of equity research for Morningstar Research Services LLC, a wholly owned subsidiary of Morningstar, Inc. In this role, she leads the global equity research team, which focuses on providing in-depth, fundamental equity research based on sustainable competitive advantages and long-term valuation analysis. Before assuming her current role in 2018, Collins was director of North American equity research. She joined Morningstar in 2005. She holds an MBA from DePaul University and is coauthor of Why Moats Matter: The Morningstar Approach to Stock Investing, published by John Wiley & Sons in 2014.