4 Stocks to Buy After Earnings

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, on your radar this week, Dave, are a few earnings stragglers. Who’s on tap that you’ll be watching for?

Dave Sekera: Good morning, Susan. It’s interesting. Last week the focus was really on the industrial sector, and the week before that was on the technology sector. The focus this week is really all going to be about the U.S. consumer. We do have both Walmart WMT and Target TGT reporting this week. Now, between those two, I think they provide us really the broadest view of the U.S. consumer. And I know there’s three things that our analytical team is going to be listening for, and that’s really going to give some indication on consumer strength. The first one is, are consumers still shifting their spending into grocery and away from goods? Are they also still trading down to private-label brands as opposed to the premium-branded goods? And how many items are they buying per trip? We’ve definitely seen a shift of people buying fewer items per trip to the store.

So, if the answer to these is yes, I think that indicates that the consumer is still under pressure. Some of the other retailers that are out this week is Home Depot HD. I think that’s going to give us some indications on what’s going on in the housing market. And I know there they’re going to keep a close eye on the number of transactions as well as the average sales per transaction. I know what we’ve been seeing at Home Depot for a while is a trend toward smaller projects, less big-ticket items, and that home projects have actually become much more nondiscretionary as opposed to remodeling. I would caution investors here it is a 2-star-rated stock. It trades at a 27% premium to our fair value.

As far as upper-end consumers, I know we’re going to be looking at Estee Lauder EL. I think that’ll provide us some insights there. Now Estee Lauder’s stock has been on a downward trend for a while, but we do think that it sold off too much. It’s a 5-star-rated stock, trades at a 34% discount to our fair value. In fact, it was actually recently added to our Best Ideas list. And our analyst there, she’s noted that the challenges are really cyclical, not structural. She’s also highlighted for long-term investors that there’s really very good growth prospects here in the emerging markets. I think that’s about one third of their overall sales.

And then lastly, for the value-conscious consumers, we’ll be looking at TJX TJX, and of course they’re a value proposition for off-priced retail, and that should continue to perform well in this economic environment. However, I think that’s already reflected in the stock. That one’s a 2-star-rated stock. It trades at a 22% premium to our fair value.

Dziubinski: Earnings season is starting to wind down. What percentage of companies have reported so far, and how did things look? Did most companies meet those forecasts?

Sekera: I think right now we’re probably pretty close to 90%. Maybe slightly over 90% of the S&P 500 have reported. And as you and I have discussed here in the past with the economy being stronger than expected in the second quarter, management having provided pretty conservative guidance coming into this quarter, there’s been a higher-than-average number of companies that have reported earnings well above their consensus.

Dziubinski: What are some of your key takeaways then from this earnings season?

Sekera: Well, one of the things that’s really stood out to me this earnings season is the bifurcation we’ve seen between the virtual or online world versus the real world or the in-person world. In the virtual world, things are still going very well. We’re still seeing very strong earnings growth, good top-line growth, good outlooks; stocks like Alphabet GOOG, Microsoft MSFT, Amazon AMZN, Meta META, all doing very well. Whereas in the real world, I think things are much more mixed. And we started talking about this after last quarter, and we’re still seeing those short-cycle industrials continuing to show economic weakness, that began last quarter. Companies such as Honeywell HON and JCI JCI; I think our analytical team has called out that short-cycle weakness there.

Now the long-cycle industrials, I talked to Josh [Morningstar senior analyst Joshua Aguilar] the other day, he actually kind of laughed and said, “Recession, what recession?” I mean not only are the long-cycle industrials not being impacted, but he’s seeing even stronger backlogs. He also noted that anything tied to infrastructure spending was just in great shape. Eaton ETN was one company that he highlighted there. And I also noted, too, that engineering and construction companies do have a good tailwind behind them as well.

And then lastly, among the consumer-related industrials, there have definitely been some disappointments. The top line has been weaker than expected. A lot of them are struggling to put through the price increases that they need in order to cover their own inflationary cost increases. 3M MMM would be one that we would highlight there. So net-net, I would say that the takeaway here is I do think that what we’ve seen thus far does support our economic outlook: no recession, but a slowing rate of economic growth for the next couple of quarters.

Dziubinski: Early in earnings season stocks did pretty well, but they seem to be retrenching a bit so far in August. Why do you think that’s happening?

Sekera: I think this really gets back to kind of the two parts to the earnings season. The first part of the earnings season in July, that was all about the virtual world. Many of those stocks we thought were actually still undervalued coming into earnings. A lot of those companies beat their numbers. So, we did see those stocks surge after earnings. And then here in August, the second part of earnings season being more focused on the real world has had mixed results. We’ve seen a number of companies that have missed expectations or gave downward guidance, those stocks sold off pretty hard.

From a broad market perspective, we are seeing that consolidated analyst expectations, consensus earning projections are essentially unchanged. Typically, I would expect during earnings season to see those numbers start coming up. And I’d also note that a higher percentage than normal of companies have given slightly negative guidance. It’s not that much more negative, but definitely some negative guidance. And I think the market is just generally kind of disappointed in that. I think the market was hoping for better.

Dziubinski: What might this all mean for the market for the remainder of the year, Dave?

Sekera: From a valuation perspective, following this little bit of a pullback we’ve had here at the beginning of August, the market right now is trading at a couple percent discount to our fair value. Now, long-term investors that maintain their allocations through this should expect to earn cost of equity over time, like an 8% to 9% area. So again, for long-term investors that have the wherewithal to hold through any kind of market volatility in the short term, I still think you’re in pretty good position. But I do think this is a good time to take another look at your portfolio, look for those stocks that have become overvalued, overextended. Sell those, lock in your gains, and reinvest in those stocks that are undervalued and have lagged behind the rest of the market.

Now from a trading perspective, I am a little more concerned that I do think there is some downside risk over the next couple of months. Specifically, we do forecast a third-quarter GDP, will probably only come in about 1%. So definitely a slowing economic rate of growth. And if we are correct, I do think the risk here is to the downside in the short term. However, for most investors, time in the market is more important than trying to time the market. On the other hand, sounding like an economist here, so while it’s not our base case, the economy could once again hold up better than expected in the third quarter, kind of like what we saw in the second quarter. For example, again, it’s still very early in the third quarter, but the Atlanta Fed GDPNow, which is a metric based on economic metrics as they come out, that’s still 4.1%. If the economy were to hold up this well in this quarter, there is still room for the upside.

Dziubinski: Let’s pivot and talk about some new research from Morningstar, some updates from our analysts on stocks that they have differentiated opinions about that reported last week. And I think the biggie here is probably International Flavors & Fragrances IFF. It’s a stock we’ve talked about before on the show. But earnings disappointed, the stock plunged, and Morningstar even cut its fair value estimate on the stock. Let’s walk through what happened and what we think of the stock today.

Sekera: And there’s no way to sugarcoat this one. I mean it was definitely a disappointing quarter. But I do think for long-term investors, you need to dig deeper into the specifics of the results. So I did look through our analytical research here, and one thing that Seth Goldstein noted was that there’s a significant difference in the company’s performance between its specialty ingredients versus its commodity-oriented ingredients. On the specialty side, I think that’s about three quarters of their sales, actually did OK. I mean they even saw an improvement in the margin. They were able to put through some price increases faster than inflation.

So that part of their business worked out pretty well. However, the commodity ingredients, I mean the volume there fell 20% and really pushed down the margins in that side of the business. I know he did update his model. He did reduce his forecast for the commodity ingredients, pulled that down by 20% for this year, and then he’s only looking for modest growth thereafter. The other part was the projections for the specialty business, and based on this quarter, he left his outlook there unchanged. We do forecast that if IFF will be able to continue to raise their prices enough in order to be able to recover that cost inflation that they’ve given up the past couple quarters and get back to historical norms, the company overall still looks good from a long-term perspective.

Now, as you noted, we did cut our fair value by 7%. However, the stock fell about 20% in the market. And I think the stock market movement here is an indication not just of concern about the near-term fundamentals, but I think this is a case where investors do seem to be losing their confidence in management. The company’s now reduced guidance three times over the past three quarters. So, at this point, it is a 5-star-rated stock, trades at about half of our fair value. And then just as a takeaway here to give you an indication of where it’s trading in the market, it looks like it’s trading at about 18 times our 2023 earnings estimate. But when you look at earnings for 2024, it’s a much more modest 14 times.

Dziubinski: Another stock that Morningstar has liked but disappointed last week was Tyson Foods TSN. Here, however, we stuck by our $85 fair value estimate.

Sekera: It’s another one too where I think it’s good to take a look at the market reaction on how that stock traded. Initially it dropped pretty hard at the open, but by the end of the trading day it was down less than 4%. And it’s actually continued to keep recovering a little bit since then. And this is just an indication that I think the market was initially very focused on just continuing weak profitability there and had overlooked some of the sequential improvements that it had quarter to quarter. I noted our Analyst Report, he said that there’s really no structural change here that altered his long-term outlook. Overall, we’re still looking for low-single-digit percent revenue growth and the company return back to kind of that mid- to high-single-digit operating margin range. As such, that puts our fair value at 5 stars, it’s a 35% discount.

Dziubinski: And then lastly, we have Eli Lilly LLY. Lilly reported really strong results with a lot of excitement last week around its weight-loss drug Mounjaro, but we maintained our fair value estimate and we think the stock is pretty significantly overvalued. Talk about that one.

Sekera: I mean that stock popped 15%. That’s really a big move for a pharmaceutical company. I mean, rarely do you see those kind of movements there. And I think this is a case where investors are just paying up too much for the short-term growth. In fact, our equity analyst Damien Conover noted that in our model we already have an above consensus projection for peak sales for the diabetes and the weight-loss drugs here. Yet that stock is now rated 2 stars and trades at a hefty 44% premium to our fair value.

Dziubinski: Now it’s time to move on to the picks portion of our program. And this week, Dave, you’re focusing on four stocks to buy after earnings. Your first pick this week is Jacobs Solutions J. We talked a little bit about this stock last week before earnings. So, how did earnings look, and why do you like the stock after?

Sekera: Earnings overall were in line with our expectations, and management also reiterated their fiscal year ‘23 earnings outlook. And I think we’re going to see some good positive fundamental momentum at this company, and not only carrying into the latter half of this year, but actually over the next couple of years into 2024 and 2025. I do think that they’re going to be a beneficiary of the infrastructure spending coming from the Inflation Reduction Act. And the market definitely liked what it heard this past week, the stock was up 7% on the week, and we still think it’s undervalued. It’s a 4-star-rated stock and it trades at a 13% discount.

Dziubinski: Your next stock of the week is a name that actually spent a good deal of time in overvalued territory, but it’s now quite the opposite. It’s American Tower AMT.

Sekera: For years the cellphone tower REITs all traded kind of in that 2-star, even at that 1-star level. We could never figure out back then why the market was placing such a high valuation on them as they had. Those stocks did start to come down in 2022, that downward momentum has carried into 2023. But to us, it appears the stock has fallen enough that it looks like it’s now starting to bottom out. Now, they did beat consensus both for revenue as well as earnings here for the second quarter. And, in fact, they raised their guidance for both the top and the bottom line. It’s a company that we do assign a narrow economic moat, it’s rated 4 stars, trades at an 18% discount, and pays a 3.3% dividend yield.

Dziubinski: Your next stock of the week is from the tech sector, which we’ve talked about has done quite well this year. In general, that sector is overvalued, but of course there are opportunities within it. The stock is Cognizant Technology CTSH.

Sekera: It’s one of those ones where maybe people aren’t necessarily that familiar. So it’s definitely good to do some research here. Cognizant is a global IT services company. They provide consulting and outsourcing. This past quarter they beat earnings, raised guidance, the stock was up 7%. And this one, I really like the story here and talked to our analyst on this one. And she noted that they’re not just going to be a beneficiary of the long-term digital transformation trends but also a beneficiary from artificial intelligence. So, this is a company that we do have a narrow economic moat that we’ve assigned to it. It’s 4-star rated, trades at a 25% discount, and pays almost a 2% dividend yield.

Dziubinski: And then your last stock pick this week ties to a theme that we’ve talked about before, med tech. The pick is Guardant Health GH.

Sekera: Guardant provides a number of different cancer and blood tests. They are waiting on FDA approval for colorectal cancer detection test. In mid-May, we did publish an article that outlines why we think that liquid biopsies really could usher in a paradigm shift in cancer detection. We do think that that’s an area of the market in med tech specifically that could grow exponentially over time. And Guardant was one of the two stocks that we highlighted in that article. They posted pretty strong second-quarter results. They raised their full-year guidance. We maintained our fair value at $63 a share. I will caution it is a no-economic-moat-rated stock, but at a 42% discount with a 4-star rating, I think you’re getting well paid here for this situation.

Dziubinski: Well, thanks for your time this morning, Dave. Dave and I will be back next Monday live at 9 a.m. Eastern, 8 a.m. Central. In the meantime, like this video and subscribe to Morningstar’s channel. And have a great week.