These 5-star-rated stocks are substantially undervalued

It's getting hard to find quality stocks at a bargain; these four names may fit the bill.

Vikram Barhat 23 August, 2016 | 5:00PM

Investors are spooked by the current market frothiness and a fragile global economy. Many are opting to stay in cash while waiting for the market uncertainty to abate. In fact, investors are currently holding the biggest cash pile since 2001, according to a Bank of America Merrill Lynch survey of fund managers in June.

Things aren't getting any easier for bargain hunters with the S&P 500 and the S&P/TSX Composite Index clocking year-to-date gains of 15.1% and 8.3% respectively, as of August 17, 2016.

Valuations matter. Luckily, little islands of opportunities still exist in a sea of stretched equity valuations. A close look at the vast coverage universe of Morningstar, which includes more than 90% of the firms in the S&P 500, reveals a small number of high-quality names that are still significantly undervalued.

There are three key factors that determine the star rating of a stock: its current price, Morningstar's estimate of its fair value, and the uncertainty rating of that fair value. Stocks that have the biggest discounts are rated the highest and provide a better investment opportunity than those rated the lowest. As of Aug. 17, only 10 stocks traded at enough of a discount relative to Morningstar analysts' estimates of their fair value to qualify for our top rating of 5-stars.

Hanesbrands Inc.
Ticker HBI
Current yield 1.54%
Forward P/E 12.4
Price US$27.90
Fair value US$39
Data as of Aug. 19, 2016

 Hanesbrands (HBI) manufactures innerwear and activewear apparel under brand names Hanes, Champion and Maidenform. Almost 50% of sales come from mass merchants in the United States and the rest from national chains, department stores and international and specialty retailers.

Given advantages that are difficult for rivals to replicate, Hanes' competitiveness remains solid in a highly commodified marketplace. Some of these advantages include "the firm's large owned and controlled supply chain, core product positioning in a space where brand is more important than price, and economies of scale achieved through a growing portfolio of synergistic brands," said a Morningstar report.

Pricing premiums, leverage of the global supply chain, and additional acquisitions synergistic to core products could propel earnings per share to almost double in the next five years, the report noted.

Hanes' portfolio of brands, found in 80% American households, hold the number-one or -two market shares in each of the core apparel categories in which it competes, said Morningstar equity analyst Bridget Weishaar, who put the stock's fair value at US$39.

The strength of its brand equity and manufacturing capabilities, she added, will allow the company to achieve 32% returns on invested capital annually for the next five years.

"[The firm's] earnings growth will be driven by innovations in innerwear, which will drive price per unit and margins up, as well as through supply chain leverage, scale, efficiency innovations, and capacity additions," said Weishaar, who forecasted 8% revenue growth and 10% operating profit in 2016.

HollyFrontier Corp.
Ticker HFC
Current yield 4.87%
Forward P/E 10.9
Price US$27.10
Fair value US$47
Data as of Aug. 19, 2016

 HollyFrontier (HFC) is an independent petroleum refiner that owns and operates five refineries with a total crude oil throughput capacity of 443,000 barrels per day. It also has a 39% ownership stake in Holly Energy Partners, which owns and operates petroleum product pipelines and terminals mainly in the Southwestern United States.

Despite weak second-quarter earnings data, its currently undervalued stock remains "one of the most attractive names in the energy sector," said Morningstar strategist Allen Good in a report.

The firm has benefited, more than any other refiner, from the recent wide difference in price between West Texas Intermediate (WTI) and Brent crude, Good said. "With access to abundant supplies of WTI, HollyFrontier's refineries have enjoyed the additional margin that this spread offered," he said.

While he doesn't expect a return to the spread of a few years ago, Good asserted "HollyFrontier should continue to benefit" from the differentials which are set "to remain well above historical levels."

Ongoing projects, such as expansion of its Woods Cross refinery, "will nearly double the capacity of the refinery," forecasted Good, who puts the stock's fair value estimate at US$47, implying a forward enterprise multiple of 6.9 times.

The stock's attractiveness also lies in a consistent and generous return of cash to shareholders. "Flush with cash, HollyFrontier has substantially increased shareholder returns via repurchases and dividends, which have far outweighed similar efforts by peers," said Good.

Roche Holding AG ADR
Ticker RHHBY
Current yield 3.21%
Forward P/E 15.6
Price US$31.75
Fair value US$42
Data as of Aug. 19, 2016

Swiss biopharmaceutical and diagnostic behemoth  Roche (RHHBY) sells a variety of oncology therapies (60% of its pharmaceutical sales), while professional diagnostics make up more than half of diagnostic-related sales.

Roche's drug portfolio and industry-leading diagnostics create strong competitive advantages. "Roche's wide moat arises from its status as the leader in oncology therapeutics (30% market share) as well as in-vitro diagnostics (20% share)," said a Morningstar report. "The firm has a promising strategy of combining its expertise in both areas to generate a growing personalized medicine pipeline, making use of companion diagnostics."

The pharmaceutical division boasts blockbuster cancer biologics that are rapidly gaining market share in approved treatments while garnering widened approval in new treatments and emerging markets, pointed out Morningstar strategist Karen Andersen, who assessed the stock's fair value to be US$42 per American Depository Receipt.

Three-fourths of Roche's top pharmaceutical sales are from biologics, which not only makes the firm the biggest biotech in the world, but also provides a buffer against traditional generic competition. The Swiss pharma giant is forecasted to generate a 6% top-line compound annual growth rate through 2020, which Anderson attributed to the company's "biologics focus and innovative pipeline."

Roche's diagnostics business is also strong. "With a 20% share of the global in-vitro diagnostics market, Roche holds the number-one rank in this industry over competitors," said Anderson.

Williams-Sonoma Inc.
Ticker WSM
Current yield 2.74%
Forward P/E 13.4
Price US$52.58
Fair value US$76
Data as of Aug. 19, 2016

A leader in the US$104-billion home furnishings category,  Williams-Sonoma (WSM) offers high-end cooking essentials under Williams-Sonoma (239 stores) and casual home accessories under Pottery Barn (197 stores) brands. It also offers products for kids and teens through brand extensions including Pottery Barn Kids (89 stores) and PBteen (21 stores).

"Relative to its peer group, Williams-Sonoma is in a strong position to continue outperforming its competitors and capturing share," said a Morningstar report. "The firm still has access to some of the best analytics in retail that can be captured."

Morningstar equity analyst Jaime Katz expects the firm to remain a leader in the teen and kids category, which has few sizable competing brands. WSM's international expansion may further boost sales and improve cost efficiencies. "The firm's expanding global footprint could help improve sourcing and distribution costs in the longer term, improving operating margins," said Katz, noting that markets in different geographies allow access to a wider profile of consumer preferences, better local merchandising and marketing, which could boost sales.

The firm has already opened stores in Australia and Mexico, and is expected to generate solid performance as U.S. housing market prices and turnover tick higher. Katz, who has set the stock's value at US$76 -- about 50% higher than its current price -- projected total sales to grow at a 6% to 7% clip over the medium term, and operating margins to rise from 10% in 2015 to nearly 13% over the next decade.

Complete access to Morningstar's research on equities, mutual funds and exchange-traded funds is available to subscribers to Morningstar Canada Premium.

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
Hanesbrands Inc14.87 USD0.27
HollyFrontier Corp53.05 USD0.02
Roche Holding AG ADR35.29 USD0.31
Williams-Sonoma Inc65.28 USD-2.84

About Author

Vikram Barhat

Vikram Barhat  Vikram Barhat is a freelance writer.