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Four undervalued stocks in an overpriced market

In an ocean of stretched equity valuations there are islands of opportunities to be found in Morningstar's vast coverage universe.

Vikram Barhat 9 August, 2017 | 5:00PM
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When the Dow Jones index broke above 22,000 earlier this month, it reinforced the euphoric belief that the markets are going to continue to climb -- despite the occasional spike in volatility -- as they have over the last several years. On the other hand, the record high valuations are making things that much more difficult for those looking for an entry point or to rebalance their portfolio. Both the Dow and the S&P 500 had clocked year-to-date gains of nearly 12%, as of Aug. 2, 2017.

Indeed, valuations matter. However, despite the current market frothiness and a fragile global economy, it may not be prudent for investors to stay in cash and wait for the bull market to abate.

Interestingly, in an ocean of stretched equity valuations there are islands of opportunities to be found in Morningstar's vast coverage universe, which includes more than 99% of the firms in the S&P 500.

Some of the high-quality names in this coverage are still significantly undervalued. In other words, their market price is considerably lower than their fair value estimated by Morningstar equity analysts. These stocks offer some margin of safety, represent durable businesses, and while there's no saying how equity markets will behave in the short term, Morningstar analysts have good reason to believe these picks have some room to run over the long haul.

Stericycle Inc.
Ticker: SRCL
Current yield: -
Forward P/E: 16.2
Price: US$77.06
Fair value: US$110
Data as of Aug. 8, 2017

 Stericycle (SRCL) is the largest U.S. provider of regulated medical waste management to hospitals and pharmaceutical companies, and medical and dental offices. The company's international operations include Latin America, Europe, South Korea, Ireland and Japan, which combined represent nearly 20% of total revenue. The company also provides risk management platforms, such as returns and recalls management, as well as compliance training and secure document destruction.

Stericycle has been evolving from a pure-play medical waste company into a comprehensive provider of secondary services built around compliance and risk management. "Close to 50% of Stericycle's consolidated sales now come from document destruction and non-medical hazardous waste management," says a Morningstar report. "Adding these services expanded Stericycle's addressable market far beyond healthcare into the industrial, retail, legal and financial landscapes."

The firm has ample opportunity to expand both the top and bottom lines by upselling secondary services and increasing revenue and customer stickiness, says Morningstar equity analyst, Barbara Noverini, who appraises the stock's worth at US$110. "As healthcare services delivery shifts from hospitals to ambulatory care clinics, Stericycle has the potential to skew its customer mix from lower to higher margin, both domestically and internationally," she adds.

Stericycle's robust competitive advantage springs from an unmatched scale in medical waste collection, treatment and disposal assets. They combine to create a cost advantage and customer switching costs.

Noverini projects the firm to rake in US$4.5 billion in revenues by 2021, at a five-year organic compound annual growth rate of 3.7%, and a midcycle operating margin of 20%.

Allergan PLC
Ticker: AGN
Current yield: 0.58%
Forward P/E: 13.3
Price: US$239.74
Fair value: US$300
Data as of Aug. 8, 2017

A leading specialty pharmaceutical company,  Allergan (AGN) specializes in aesthetics, ophthalmology, women's health, gastrointestinal and central nervous system products.

The firm has made strategic acquisitions to become a dominant pharmaceutical player, and continues to deleverage its balance sheet and use cash for more acquisitions, says a Morningstar report. "Allergan's diverse portfolio of defensible products, broad pipeline and future potential acquisitions will sustain healthy earnings growth," says the report.

Allergan's acquisitions of Warner Chilcott and Forest Labs helped bolster its branded drug portfolio with a significant presence in the primary care markets of women's health, gastrointestinal, urology and central nervous system therapeutics. Further, the firm's "considerable scale in niche markets of ophthalmology and aesthetics offers a long runway for growth thanks to defensible products (especially Botox) and an attractive pipeline," says Morningstar equity analyst Michael Waterhouse, who puts the stock's fair value at US$300.

The company boasts a sustainable competitive advantage built on Botox and "an industry-leading portfolio in the specialty markets of ophthalmology and aesthetics, which enjoy much higher barriers to entry and lower risk of generic competition than most pharmaceutical products," says Waterhouse.

Allergan's product innovation supports pricing and helps keep market share healthy, supplemented by acquisitions and partnerships to enhance the portfolio. With more than US$20 billion in cash, "acquisitions should eventually improve growth opportunities and increase product diversification, which helps minimize patent cliff concerns," says Waterhouse, who forecasts high-single-digit growth over the next few years, a free-cash-flow margin near 35% and about 45% EBITDA margin.

Express Scripts Holding Co
Ticker: ESRX
Current yield: -
Forward P/E: 8.1
Price: US$62.24
Fair value: US$89
Data as of Aug. 8, 2017

The largest pharmacy benefit manager in the U.S.,  Express Scripts (ESRX) holds a dominant and critical place in the U.S. pharmaceutical industry. Through its mail-order pharmacy and network of retail pharmacies, the company processes approximately 1.4 billion prescriptions annually for its payer clients.

"The firm's core cost saving and efficiency services along with its colossal size gives it a wide economic moat [or sustainable competitive advantage]," says a Morningstar report. "This position will remain steady for years to come as demand for its PBM (pharmacy benefit managers that assist clients with the fulfilment of member prescriptions) services grows."

Express Scripts is one of three major PBMs (CVS and UnitedHealth being the other two) that control nearly 80% of all prescription volume in the U.S. "This dynamic allows these firms to directly negotiate discounted drug pricing with manufacturers, distributors and retail chains," says the report.

More critically, however, "the colossal claim volume processed by Express Scripts allows it to scale its centralized costs and leverage its asset-light capital structure into solid economic profits," says Morningstar equity analyst Vishnu Lekraj, who pegs the stock's fair value at US$89.

Further, the firm has some of the lowest selling, general, and administrative costs and highest operating profit per claim. "These metrics have translated into significant economic profits," says Lekraj, who forecasts "client growth, increasing claim volume per client and expanding centralized cost scale” leading to an overall 2.1% revenue growth and 5.5% operating margins over the next five years.

Walt Disney Co
Ticker: DIS
Current yield: 1.47%
Forward P/E: 15.2
Price: US$106.98
Fair value: US$134
Data as of Aug. 8, 2017

A media behemoth,  Walt Disney (DIS) makes films under such popular banners as Pixar, Marvel and Lucasfilm. Walt Disney owns the rights to some of the most globally recognized characters including Mickey Mouse, Buzz Lightyear, Thor and Luke Skywalker. The media conglomerate also owns and operates media networks (ESPN, ABC and Disney Channel), television production studios, theme parks and resorts, among other assets.

While ESPN -- the crown jewel of Disney's media networks segment -- remains the leading revenue generator, the firm has successfully exploited its Disney brand, popular with children and parents. "Over the past decade, Disney has demonstrated its ability to monetize its characters and franchises across multiple platforms -- movies, home video, merchandising, theme parks and even musicals," says a Morningstar report.

The ESPN network dominates the U.S. sports entertainment space with exclusive rights for the NFL and college football. "It profits from the highest affiliate fees per subscriber of any cable channel, and generates revenue from advertisers interested in reaching adult males ages 18 to 49, a key advertising demographic," says Morningstar equity analyst Neil Macker, whose US$134 fair value of the stock points to considerable upside potential.

On the film production side, Disney's franchises will continue to grow as more popular movies get released by the animated studio and Pixar that produced blockbusters such as Toy Story, Cars and Frozen, says Macker, who projects operating margin to improve from 25.8% in 2016 to 26.8% in 2021.

Morningstar forecasts 3% annual sales growth for the media networks, 6% for parks and resorts and 3% for the film segment.

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About Author

Vikram Barhat

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

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