4 Stocks to Buy in Q3 2023

Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. Every Monday morning, I sit down with Morningstar Research Services’ Chief U.S. Market Strategist, Dave Sekera, to discuss one thing that’s on his radar this week, one new piece of Morningstar research, and a few stock picks or pans for the week ahead.

So, let’s talk about what’s on your radar this holiday-shortened weekday besides some barbecue and homemade margaritas. We have the Purchasing Managers Index, the PMI, and the Institute of Supply Management, ISM, numbers coming out this week. What do each of these numbers tell investors, and do you think the numbers will move markets?

David Sekera: Hey, good morning, Susan. Those two numbers are business surveys, and they try and gauge whether the economy is expanding or contracting. They’re also known as what’s called a diffusion index. So, depending on what those readings are, a reading above 50 indicates expansion, and then a reading below 50 would indicate contraction. There’s really two things that I’m going to watch for in these numbers. One is just the amount above or below 50, as that indicates the amount or the potential strength or contraction, and then also just whether or not there could be any change in direction or trend for either of those numbers.

We are starting the week here with the manufacturing component. Now the readings there for both of those have been on somewhat of a long-term downward trend, and the consensus is expecting to show further contraction in both of those numbers. And then, at the end of the week, we’re going to see the services, or the nonmanufacturing, components for these two numbers. Now those have actually been on a somewhat steady upswing, and we do expect that those will show further expansion. And I think that this is just indicative of the ongoing shift, and we’ve talked about this a couple of times in consumer spending—in that spending is going away from goods and into services.

Now, from a trading perspective, if the readings are substantially different than what’s expected, you could have some short-term impact in the markets. But for long-term investors, this typically are not readings that I really think change the course of the markets. I watch the numbers when they come out, but usually, it’s not something that’s really going to change my mind as far as our outlook for the economy.

Dziubinski: Now, Dave, nonfarm payroll numbers come on Friday, too, right?

Sekera: Yeah. Now that’s the opposite. That is a number that I’m going to watch very closely, and that’s a number that really is going to have a bearing on the Fed’s next move at their meeting at the end of July. Depending on the reading there, I think this one also could maybe portend potential what the Fed could be thinking about doing in September as well. Now the consensus is looking for a reduction in the number of new job hiring. However, they do look for the unemployment rate to stay steady at this point. Now a higher payrolls number and/or lower unemployment rate—that may indicate the economy is staying stronger than expected. And of course, then the Fed may decide it may need to raise rates even higher. Whereas a lower-than-expected payrolls number or higher unemployment might indicate that tight monetary policy is finally beginning to start slowing the economy. And then, the Fed may not necessarily need to tighten the monetary policy even further.

Dziubinski: Got it. So, now, let’s pivot over to some new research from Morningstar and that’s your new stock market outlook for the third quarter and viewers can find that on Morningstar.com. Before we look ahead, how about a quick recap of the second quarter? How did the market do for the quarter and for the first half of 2023?

Sekera: It is a very strong quarter here in the second quarter, and it’s been a pretty strong year year-to-date. So, in the second quarter, the Morningstar US Market Index, and that of course is our broadest measure of the U.S. stock market, is up almost 8.5%. And year-to-date, the Morningstar US Market Index is now up 16.5%. I think the returns here have surprised a lot of people since the beginning of the year. Although I’d note at the beginning of the year in our 2023 market outlook that we published, we did note back then that the market was trading at a 16% discount to a composite of our fair valuations, which at that point in time had put the market into pretty undervalued territory.

Dziubinski: Now, it really has been, though, the story of a few select stocks really driving that market performance, right?

Sekera: Yeah, returns have been especially concentrated, almost unusually concentrated thus far this year. There are seven stocks right now. I think a lot of people in the market are calling them the Magnificent Seven, and they account for about three quarters of the market return year-to-date. And it’s a combination of two things: One, just how much these stocks have risen thus far this year—they’ve all significantly outperformed the market, but also the size of their market capitalization. They are some of the largest stocks by market cap out there. Now, at this point, I would caution investors that, according to our valuations, we think the excess returns from these seven stocks have pretty much run their course at this point. Now, at the beginning of the year, six of those seven were significantly undervalued. We had rated them 4 or 5 stars. At this point, only one is still undervalued; four have moved into 3-star territory, meaning we think they’re pretty close to fairly valued; and two actually have gone too far, and we think that they’re actually overvalued and now trade with 2 stars.

Dziubinski: Let’s move on to your outlook for the coming quarter. How do stocks overall look heading into the third quarter—overvalued, undervalued, fairly valued?

Sekera: Even after this rally, we still think the market is undervalued. It’s trading at that 5% discount to that composite of the fair value. And again, we do do things a little bit differently here. A lot of other strategists use that kind of top-down approach, whereas we do the opposite. We look at those over 700 stocks that we cover that trade in the U.S., and we compare a composite of where those are trading versus our intrinsic valuations to come up with whether we think the market is over- or undervalued. Now, the only other thing is I would mention to investors that, with as much as the market has moved this year, there is much less margin of safety than at the beginning of the year or even then compared to the beginning of the second quarter.

Dziubinski: Now, let’s talk a little bit about some sectors that have outperformed, namely, technology, consumer cyclical, and communication services. Let’s look at them from a valuation perspective, and let’s start with technology.

Sekera: Yeah. So, interestingly, technology was the third most undervalued sector coming into the year based on our composites, had a huge year, year-to-date it’s up 42.7%. And that’s a combination of, one, just the amount of undervaluation that we saw in the technology sector at the beginning of the year but also, over the past few months, a lot of excitement about the potential upside from emergence of artificial intelligence has really propped up a lot of those stocks. I know it’s not a popular opinion right now, but in our view, we think the tech sector has likely risen too far too fast at this point. It’s now moved into what we consider to be overvalued territory, trading at about at 7% premium to our fair values. In fact, right now it’s the only sector that’s trading in overvalued territory.

Dziubinski: What about consumer cyclical stocks? Does the sector look overvalued after that strong first half?

Sekera: Consumer cyclicals were the second most undervalued sector coming into the year. They’ve also had a very strong year. They’re up about 30% year-to-date. So, at this point, they’re trading in line with the broad market discount at that 5% discount to fair value. You’re still able to find undervalued opportunities there but certainly harder to find than what they were before. In fact, I would just note that most of those opportunities now are going to be in that mid-cap and the small-cap space, especially in what I consider to be like the deep-value names. So, some of those names are going to be a little bit higher risk than average but certainly trading at some very big discounts when you go down into that part of the risk spectrum.

Dziubinski: And then, how about communication services stocks? There’s a particularly interesting dynamic going on there with Meta and Alphabet driving so much of the gains in that sector. So, how does the sector overall look heading into the third quarter?

Sekera: Communications was actually the most undervalued, and it was the most undervalued by far coming into the year. So, even after up as much as it is today, it’s still undervalued. It trades at about a 21% discount to fair value. So, as you noted, the returns have been skewed by Alphabet. That’s up over 30% year-to-date, and by Meta, and that’s more than doubled year-to-date. And those two do account for over half the market cap of the sector, so, of course, those movements are going to skew that broad market average.

Now, we are still seeing opportunities in communications, but I would just note that most of those opportunities are going to be more in what I consider to be traditional telecom and media names. A lot of names there that we still think have a lot of market negative sentiment there, but we think they’ve been left behind in this rally and do see opportunities for those longer-term investors willing to ride out until the market starts turning around and seeing the same value that we see.

Dziubinski: So, the communications sector overall is attractive. What other sectors stand out as undervalued to you today?

Sekera: It’s a lot of the sectors that did OK thus far this year, but really not that great. So, the best value right now, we think, still remains in the more cyclical sectors. So, that’s going to be basic materials, financials, and real estate.

Dziubinski: Now, let’s talk a little bit about financial-services sector. Of course, that’s undervalued. Do you think the worst is over there?

Sekera: It’s always hard to tell, but it does appear looking at the charts that the regional banks have bottomed out, and really the entire sector does look like it’s bottomed out. Of course, it did sell off pretty hard earlier this year following the failure for Silicon Valley Bank and a couple of other banks. So, it appears to us, I think the market has pushed financials down too far. We do see a lot of undervaluation, especially in those regional banks. And I know talking to our equity analyst there, his main takeaway is, yes, there is a lot of stress specifically within the regional banks, but he doesn’t think that the regional bank business model is broken. So, now, we could see some volatility in those names when they report second-quarter earnings. And a lot of that’s going to just depend on their deposit base, whether or not they had a lot of deposit loss in the second quarter or not. But I would just note that when I look at our earnings estimates there, we already forecast sequential earnings decline in those names from the second quarter through the end of the year, and that earnings growth stream should then bottom out and start building up again in 2024. So, I do think for investors willing to stand some of that volatility in the short term, there are a lot of good long-term opportunities and some really good dividend yields there, too.

Dziubinski: So, then, given where valuations stand across sectors, Dave, how should investors be thinking about their portfolios heading into third quarter?

Sekera: A lot of this is really just market sentiment and also a lot of commentary that I’m hearing in the media right now. From the October lows, the stock market is up over 22%. That technically breaches the indicator of a new bull market. From a lot of these market commentators, I’m starting to hear them saying things like, “This is the start of the new bull market and investors should jump into equities to ride this wave.” However, though, you still hear a lot of market commentators arguing, “Oh, this is a bull trap in an ongoing bear market. So, get out of stocks while the getting is good.” But I think that all really misses the real tenets of long-term investing.

In our view, the question isn’t whether or not to raise the sails and ride the tailwind or batten down the hatches in preparation for a near-term storm, but really: How should you be best positioning your portfolio today based on today’s valuations? And I would say in the wake of the first-half rally, we are seeing lots of opportunities for investors to make those reallocations in their portfolios, look to take profits in those areas of the market where it’s now become overvalued and overextended, and then reinvest those gains in those areas that have been left behind and are undervalued.

Dziubinski: Now, we’ve reached the stock picks of the week portion of our program. Today, Dave, you’re going to talk about four of the stocks from our analysts’ 33 top stock picks for the third quarter that you like. And your first pick this week is from the most undervalued sector that we talked about, communication services. The stock is Pinterest. Why do you like it?

Sekera: Pinterest is rated 4 stars. Trades at about a 24% discount to our fair value. Now we do rate the company with a narrow economic moat. Now, I will completely agree this is not the right way to pick stocks, not the right academic way to think about valuations, but sometimes you just got to stick with a winning horse. And in this case, Pinterest is covered by Ali Mogharabi. He is our analyst that also covers Alphabet and Meta. And I would say he really stuck by his analysis and his fair value estimates in 2022. And if you remember, last year, both of those stocks were getting hit pretty hard. A lot of other analysts on the Street were lowering their valuations in order to follow the market to the downside. So, in this case, I do think that with both of those stocks moving up as much as they have thus far this year, I think the market should be looking for undervalued opportunities specifically within the digital-advertising space that have been left behind. And that leaves me with Pinterest.

Dziubinski: Now, the real estate sector is also undervalued. Your pick of the week here is Park Hotels. Why?

Sekera: All right. So, Park Hotels is a 5-star-rated stock, trades at half of our fair value. Now, it doesn’t have an economic moat, but I’d also note we rate very few companies in the real estate sector with an economic moat. So, in this case, that doesn’t necessarily bother me. Now, Park itself is a high-end hotel REIT. We do expect that it will benefit from the resurgence in international travel, especially from China, which has been loosening its pandemic-era travel restrictions. And in the meantime, you’re getting a nice forward dividend yield here of about 5%.

Dziubinski: Now, your next pick of the week is from the financial-services sector, and it’s U.S. Bank.

Sekera: Yeah. So, another 5-star-rated stock, trades at about a 38% discount to fair value, a company that we rate with a wide economic moat. And a lot of these regional banks like this one are now trading with very large dividend yields: 5.9%, in this case. And I’d note it is one of the largest regional banks, and we do expect less deposit flight risk here. Now, with U.S. Bank, only 14% of its loan book is commercial real estate, and that’s really one of the big areas that investors are concerned about with the regional banks at this point. We do fully agree that we do think urban office valuations are at risk. But I note that our analyst estimates that only about 2% of total loan exposure here are for office buildings. And so, in that case, U.S. Bank is less exposed to the office loan space than the average regional banks. And there is plenty of capital cushion here to absorb any losses that they may need to take within that sector. And then, lastly, I’d just note, they also have very good earnings leverage. So, over the long term, we do forecast this bank will earn about 15% returns on tangible common equity to well above their 9% cost of capital. And that actually places it in the higher end of the regional banks.

Dziubinski: Let’s end this week, Dave, on an undervalued stock in an overvalued sector. What is it?

Sekera: Although tech is overvalued from a sector perspective, there are still a number of undervalued stocks there that have been left behind. So, the one I would highlight here is Teradyne. That’s a 4-star-rated stock, trades almost a 30% discount to fair value, and we do rate the company with a wide economic moat. So, what we’ve seen in technology is there’s been this big focus in the semiconductor space, specifically on those companies that make artificial intelligence chips. But I don’t think there’s been enough focus on that second derivative, and that’s the suppliers for artificial intelligence. Teradyne itself makes test equipment for semiconductors. I know our analytical team has specifically called out its focus on cutting-edge semiconductors. And it has customers such as Apple and Taiwan Semi. So, again, another one where it has a great customer base and a very good product portfolio that we do think will thrive over time.

Dziubinski: Thanks for your time this morning, Dave. Dave and I will be back next Monday at 9.15 a.m. Eastern, 8.15 a.m. Central with a special edition of our show. With travel season in full swing, Dave will be talking with a couple of Morningstar analysts about their top picks in the travel industry. In the meantime, subscribe to Morningstar’s channel. Have a happy 4th of July and a great week.