Four quality U.S. stocks that have lagged

Discounts to fair value are likely to narrow, Morningstar analysts say.

Vikram Barhat 28 September, 2016 | 5:00PM
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Low interest rates on both sides of the Canada-U.S. border have raised concerns about stretched valuations in the equity markets. Softness in economic data has led the U.S. Federal Reserve to take a dovish tone, leaving the federal funds rate unchanged at 0.5% on Sept. 21. Faced with continued meagre yields in the fixed-income markets, investors have been pushing up the prices of equities.

With fundamentals such as price-earnings ratios having become more expensive, the search for stocks with attractive valuations has become increasingly challenging. According to the Morningstar Market Fair Value chart, the average stock in its coverage universe is about 3% overvalued (at 1.03), a touch below the 52-week high of 1.04, as of Sept. 14.

But there are some stocks that aren't as pricey. Well off their 52-week highs, a few of them have lost 11% to 40% of their value since the beginning of this year. These are well known companies with strong fundamentals and sound growth prospects, but have been laggards during the market's current bull run.

Given their long-term market potential, pricing power, expanding footprint and competitive position, it's only a matter of time before these stocks reverse course and move closer to being fairly valued, Morningstar analysts conclude. This may be a good time to consider whether these four undervalued companies might be a good addition to your long-term holdings.

Walt Disney Co.
Ticker DIS
Current yield 1.54%
Forward P/E 14.9
Price US$91.96
Fair value US$134
Data as of Sep. 26, 2016

A leading media conglomerate,  Walt Disney Co. (DIS) makes films under such popular labels as Pixar, Marvel and Lucasfilm. It also produces TV shows and music, and owns other assets including media networks (ESPN, ABC and Disney Channel), production studios, and theme parks and resorts.

While ESPN remains the leading revenue generator, the "firm's parks and resorts segment has rebounded strongly from the recession and the opening of Disneyland Shanghai should provide additional momentum," says a Morningstar report.

"ESPN 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 Neil Macker, equity analyst at Morningstar, in a report. Disney's sustainable competitive advantage, he adds, is built on the unique ESPN content and a rich library of lucrative feature films and animated characters.

"The stable of animated franchises will continue to grow as more popular movies get released by the animated studio and Pixar, which has already generated hits such as Toy Story, Cars and Frozen," says Macker. He puts the stock's fair value at US$134, significantly above its current price of US$92.82, as of Sept. 20. The firm's annual sales growth from the media networks over the five years is projected by Morningstar to be 3.9%, 7% for parks and resorts, and 4.4% for the filmed entertainment segment, boosted primarily by the addition of the Star Wars movies.

Valero Energy Corp.
Ticker VLO
Current yield 4.24%
Forward P/E 13.1
Price US$54.29
Fair value US$68
Data as of Sep. 26, 2016

The largest independent oil refiner in the U.S.,  Valero Energy Corp. (VLO) operates 14 refineries in the U.S., Canada and the U.K. The refiner also owns a 69% interest in Valero Energy Partners LP.

"Given its complex assets and concentration in the Gulf Coast, Valero retains the access and capability to process light or heavy crude, depending on which offers the greatest discount or optimal economics," says a Morningstar report, noting that "Valero is well positioned to thrive in almost any market environment, thanks to its high- quality refining assets and their location."

Many of its investments in processing capacity, yield improvement, and infrastructure can be quickly monetized through its master limited partnership (MLP), Valero Logistics Partners, says Morningstar sector strategist Allen Good. The cash generated, he adds, can be used to fund reinvestment or shareholder returns.

Valero's feedstock advantage has historically resulted from the capabilities of its refineries, which enable Valero "to purchase cheaper, lower-quality crude as feedstock, increasing realized margins," says Good, who estimates the stock's worth to be US$68.

In the coming years, U.S. refiners will continue to benefit from ongoing domestic light-crude discounts to international prices of several dollars a barrel, says Good. He cautions that "narrowing or reversal of those discounts would result in weaker than anticipated performance."

Good praises management's tactical moves over the last few years including "divesting underperforming assets and adding strategic assets cheaply to high-grade the overall portfolio, which should lead to higher returns."

Norwegian Cruise Line Holdings Ltd.
Ticker NCLH
Current yield -
Forward P/E 9.3
Price US$36.72
Fair value US$61
Data as of Sep. 26, 2016

The world's third-largest cruise company,  Norwegian Cruise Line Holdings Ltd. (NCLH), operates 24 cruise ships sailing to more than 510 destinations worldwide. The operator is adding four more vessels through 2020 to expand capacity and geographic presence.

The company reported a 9% jump in revenue (US$1.2 billion), and adjusted EPS growth of 20% for the first half of the year, attributed to improved pricing and addition of two new ships to the fleet.

"As Norwegian is relatively smaller than its North American cruise peers, it has significant global-capacity growth potential over the next five years," says Morningstar equity analyst Jaime Katz, noting that its freestyle cruising caters to older travellers as well as Millennials.

Norwegian's acquisition of the more upscale Prestige brands provides the company a cushion against economic volatility. Katz says that consumers of the company's luxury lifestyle products "tend to be less affected by economic cycles and changes to the pricing strategy."

To capitalize on the growth of middle-class consumers and changing lifestyles in emerging markets, Norwegian is expanding its presence in the Asia-Pacific with new itineraries sailing out of Singapore, Hong Kong, Australia and New Zealand. "Norwegian may be able to support better yield growth ahead, as it replaces lower-yielding itineraries with new, higher-yielding itineraries," says Katz, whose assessment of the stock's fair value of US$61 puts the current price at a whopping 42% discount, as of Sept. 20. The stock is nearly 40% down on a year-to-date basis.

Cognizant Technology Solutions Corp. A
Ticker CTSH
Current yield -
Forward P/E 14.3
Price US$54.15
Fair value US$69
Data as of Sep. 2, 2016

U.S-based IT service provider  Cognizant Technology Solutions Corp. (CTSH) provides technology consulting, application outsourcing, systems integration, business-process services and cloud services. The company generates more than three-quarters of its revenue from North America. Its second-quarter financial report revealed revenue growth of 9.2% year over year to US$3.37 billion, validating analysts' optimism.

"Within the IT services industry, Cognizant is our most favoured vendor because of its high-quality industry position and undervalued nature," says Morningstar equity analyst Andrew Lange. "Cognizant's deeply entrenched position with the largest health-care payers is a mid- to long-term boon." Moreover, the company is expected to be one of the biggest beneficiaries when discretionary spending returns to more normal levels.

Based on a range of opportunities, "the firm can significantly outperform the overall global IT services industry," says Lange. He recently raised his estimate of the stock's fair value from US$64 to US$69, nearly 25% above its current price, as of Sept. 20.

These opportunities include a focus on emerging social, mobile, analytics and cloud (SMAC) technologies, and geographic expansion to underserved markets, says Lange. He emphasizes that "developing depth in existing industries and expanding into new industries such as the public sector will provide additional growth avenues."

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
Cognizant Technology Solutions Corp Class A74.33 USD-2.16Rating
Norwegian Cruise Line Holdings Ltd19.66 USD0.10Rating
The Walt Disney Co95.74 USD-1.08Rating
Valero Energy Corp148.33 USD0.37Rating

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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