Three Canadian stocks with upside potential

Morningstar Investment Management's Rob Miehm looks at a bank, an energy firm and a utilities company where there is room for improvement given their current valuations

Robert Miehm 12 December, 2018 | 1:00PM

 

 

Robert Miehm: As we near the end of the year, let’s take a look at a few stocks where we feel there is some longer-term room for improvement given their current valuations.

Keep in mind, these ideas are only a starting point. You should always have your own individual investment process, that should take into consideration your investment goals, time horizon, risk tolerance and income needs.

To pick the stocks, I use the Morningstar Star Rating as the basis for my opinion. A stock’s star rating takes into account the firms’ moat, the stock’s fair value, our uncertainty around that fair value and the current market price. Five-star stocks sell at the largest risk adjusted discount relative to their fair value and one-star stocks sell at the largest risk adjusted premium relative to their fair value. For more details on the star rating, click on the link below.

The first of three stocks I’d like to consider is  Cenovus Energy Inc (CVE). Cenovus Energy has a 5-star rating, with no moat, a fair value of $21 per share, and a very high uncertainty rating.

The company’s fair value is driven by detailed projections of the company’s future cash flows based on the Morningstar analyst’s research. Its current valuation is appealing, but without a moat, profits in this company would be more susceptible to competition from its peers. We generally expect returns of companies with no moat to fade more quickly than those firms with a narrow or wide moat.

The uncertainty rating, which in this case is very high, indicates that the range of potential intrinsic values is high due to risks of oil price variability, competition, environmental regulation and the general state of the economy.

A second stock you could consider is  Fortis (FTS), which is a 4-star rated stock with a narrow moat, a fair value of $48 per share and a low uncertainty rating.

Fortis has a narrow moat, based on its exposure to regulated gas and electric assets and one of its latest acquisitions, ITC Holdings, a wide moat large electricity transmission company in the U.S.

The regulatory environment, where revenue and returns are capped, is one of the main reasons for the narrow moat vs a wide moat for Fortis. The fair value uncertainty for Fortis is low indicating that the forecast of fair value can be more tightly estimated because of the regulated nature of the industry in which Fortis operates.

A final stock to consider is  Royal Bank (RY), which just reported last week, and is a 4-star rated stock with a wide moat, a fair value of $111 per share, and a medium uncertainty rating.

Wide moat companies are the small group of companies where we have high confidence that excess returns may remain for over 10 years. Royal Bank of Canada has a wide moat because barriers to entry into the Canadian banking industry are very high. It is one of the large Canadian banks that controls most of the Canadian market, it has strong operating efficiency, and it has a vast distribution network covering many different regions for its diverse product offering.

 

The fair value uncertainty on this stock is assigned a medium grade. Macroeconomic risks exist for the company related to the credit and debt cycle… Interest rates have been low, but as the Bank of Canada continues to increase rates, more strain will be put on households as they cope with their mortgage and consumer debt.

For Morningstar Investment Management, I’m Rob Miehm

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Robert Miehm

Robert Miehm  Robert Miehm is a senior investment analyst with Morningstar Investment Management.