Four undervalued sustainable stocks with potential for growth

Morningstar index constituents score high on ESG parameters.

Vikram Barhat 13 September, 2017 | 6:00PM
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Investors are increasingly warming up to the idea of sustainable investing, an approach where environmental and social consciousness and monetary gains go hand in hand.

In its early days, sustainable investing comprised a set of approaches that incorporated environmental, social and governance (ESG) issues into financial analysis and investment decisions to help investors meet their capital and conscience needs. However, investor attitudes are shifting as the investment strategy gains momentum and overcomes barriers of cynicism and a lack of understanding.

"It's true that originally, socially responsible investing was more about investors trying to align their investments with their values by excluding companies from investment mandates," says Jon Hale, head of sustainability research for Morningstar. "But sustainable investing now is more about considering relevant non-financial factors in the search for alpha."

Thus, irrespective of whether ESG factors align with your ideas of social responsibility, there are reasons to believe that some stocks score highly on sustainable metrics -- such as corporate governance, customer privacy and efforts to reduce environmental impact while reducing costs -- and are well positioned for growth. The following four stocks, all of which are constituents of the Morningstar US Sustainability Index,  score high on ESG parameters. Moreover, these companies have competitive advantages that will allow them to ward off competition and remain profitable for at least a decade, and they are currently trading at a considerable discount to their fair value, according to Morningstar research.

Ticker: WSM
Current yield: 3.31%
Forward P/E: 12
Price: US$46.17
Fair value: US$65
Data as of August 31, 2017

 Williams-Sonoma WSM is a leader in the US$109-billion home-furnishings market. Its namesake Williams-Sonoma brand offers high-end cooking essentials (234 stores), while another brand, Pottery Barn (204 stores), sells home accessories. The Pottery Barn division also provides products for kids and teens through brand extensions including Pottery Barn Kids (85 stores) and PBteen (23 stores).

"Relative to its peer group, Williams-Sonoma is in good position to outperform its competitors and hold its share," says a Morningstar report. "The firm still has access to some of the best analytics in retail."

Williams-Sonoma's e-commerce business (52% of total sales) helps build the brand cost-effectively and leverage costs, driving improvements in operating margins. The firm's growing footprint could help improve sourcing and distribution costs over the longer term, further improving margins.

"Global expansion allows access to a wider profile of consumer preferences, lending to better local merchandising and marketing, which could facilitate higher unit sales," says Morningstar equity analyst Jaime Katz. 

The company already operates stores in the U.S. Australia, Canada and the U.K., and has unaffiliated franchisees in Mexico, the Middle East, Philippines and South Korea. Williams-Sonoma is expected to generate solid performance as U.S. housing market prices and turnover remain strong, says Katz, who has set the stock's fair value at US$65, nearly 50% higher than its current price.  

Morningstar projects operating margins to rise to about 10% over the next decade from an estimated 9.4% in 2017, while total sales are forecasted to grow at a 3.6% average clip over the next five years.

L Brands
Ticker: LB
Current yield: 6.66%
Forward P/E: 9.3
Price: US$36.47
Fair value: US$69
Data as of August 31, 2017

Popularly known by its lingerie brands Victoria's Secret and La Senza,  L Brands LB retails women's intimate, personal care, and beauty products, and also owns the Pink, Bath & Body Works, and Henri Bendel brands. The company operates more than 3,000 stores and generates almost all of its business in North America, with only 3% of sales coming from international markets. 

"In the near term, we see multiple catalysts for an inflection point in sales and margin performance with discontinued categories being comped, bralette penetration stabilizing, Victoria's Secret Beauty improving, and new structured bra introductions," says a Morningstar equity report. "Further, the company has a healthy long-run growth opportunity in China."

Victoria's Secret and Bath & Body Works account for more than 90% of total sales. Competitively differentiated intangible assets, the two brands are a big part of the firm's wide economic moat, or sustainable competitive advantage, and enjoy high levels of consumer loyalty.

"Bath & Body Works has been able to maintain its lead over its nearest competitor, The Body Shop, and we don't see this changing," says Morningstar equity analyst Bridget Weishaarm, who puts the stock's value at US$69. New entrants, she adds, would find it hard to match pricing advantage of Victoria's Secret, the low cost of word-of-mouth marketing, its massive store fleet, and social media strength.

Morningstar forecasts gross margin to remain roughly 40% to 41% over the next five years, and projects 3% average annual revenue growth, 2% average annual operating income growth, and a five-year operating margin of about 16%.

Tractor Supply Co.
Ticker: TSCO
Current yield: 1.71%
Forward P/E: 15.5
Price: US$59.67
Fair value: US$81
Data as of August 31, 2017

The largest operator of retail farm and ranch stores in the United States,  Tractor Supply TSCO caters to recreational farmers and ranchers, with around US$7 billion in annual sales. It has little exposure to commercial and industrial farm operations. The company operates more than 1,600 stores, across 49 states, which are typically located in towns outside of urban areas and in rural communities. Revenue consists primarily of livestock and pet (46%), hardware, tools, and truck (22%), and seasonal gift and toy (19%).

Tractor Supply is fast expanding its footprint across the U.S. Its store base has grown about 50% over the past five years, driving earnings-per-share growth of 12% over the past three years, says a Morningstar report, which forecasts the number of stores to reach 2,800 over the next decade. 

The firm's niche product offerings place it in a unique position, insulated from peers that focus on one segment of the market. "Tractor Supply focuses on an active do-it-yourself rural consumer. Many of its products are higher-end than those found in retailers that focus on a casual consumer," says Katz, who considers the stock to be worth US$81, considerably higher than its current market value. "The business's ability to cater to a more recreational outdoor hobbyist lends the business to higher-income demographics, and less revenue cyclicality."

Hobby-farmer consumers generate US$16 billion annually in revenue for farm- supply stores, according to IBISWorld, and farm supply products represent only a portion of Tractor Supply's merchandise selection, implying room for growth. 

CVS Health
Ticker: CVS
Current yield: 2.52%
Forward P/E: 12.2
Price: US$77.43
Fair value: US$109
Data as of August 31, 2017

A leading U.S. drugstore chain,  CVS Health CVS owns one of the largest retail pharmacy chains and pharmacy-benefits management (PBM) businesses in the country. The company operates more than 10,000 retail pharmacies across the U.S.

"CVS Health has sought to become an all-encompassing healthcare-services company and has positioned itself as a major player within the U.S. healthcare ecosystem," says a Morningstar equity report. 

The company's business model is unique in that it processes claims as an independent PBM and also runs one of the largest retail pharmacy chains. "The firm's 1.3 billion in adjusted claims processed annually gives it significant scale advantages and the ability to leverage the asset-light nature of a PBM into solid economic profits," says Morningstar equity analyst, Vishnu Lekraj, adding that thanks to such large number of claims "the PBM is able to negotiate top-tier drug pricing discounts with suppliers." This enables it to expand its client base and preserve its gross margins. The company, he adds, has some of the lowest selling, general, and administrative costs, and highest operating profit per claim.

CVS Health's robust competitive advantages have generated outsized returns on invested capital and have carved out a wide economic moat. "We anticipate good growth for the pharmaceutical industry over the long term, which should provide CVS with a solid platform for continued success," says Lekraj, whose US$109 estimate for the stock's fair value indicates sizeable upside potential.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
Bath & Body Works Inc45.22 USD-2.16Rating
CVS Health Corp68.64 USD-1.58Rating
Tractor Supply Co244.89 USD-2.12Rating
Williams-Sonoma Inc288.85 USD-1.91Rating

About Author

Vikram Barhat

Vikram Barhat  A Toronto-based financial writer specializing in investing, stock markets, personal finance and other areas of the financial services industry, Vikram also writes for CNBC, BBC, The Globe and Mail, and Toronto Star.

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