3 Undervalued Growth Stocks to Buy

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, there are story stocks reporting this week on which our analysts have differentiated opinions from the market. Let’s talk about a few of them. The first on the list is International Flavors & Fragrances IFF. Now the stock’s having a tough 2023 after having a tough 2022, but we think there’s opportunity here.

Dave Sekera: Good morning, Susan. IFF has been having a tough year thus far this year. Now IFF is in the specialty chemical sector, and as its name implies they make different types of products for food and beverage, healthcare, and consumer products. And these products are used to be able to create specific types of taste, smell, or mouth feel for consumer and those types of applications based on the specifications that those consumer product companies want for those different types of products. Now, it is a little bit more defensive than what you’re going to see as compared to most specialty chemical companies, but it does still have some cyclicality to its business. Earlier this year, volumes were slightly lower than expected due to macroeconomic weakness. Plus, the company did have some excess inventory that built up over 2022 that it needed to reduce. That did lead management to reduce their guidance earlier this year, and the stock sold off pretty hard after that.

Now, in our financial model, we’d actually already incorporated a little bit of slowness earlier this year, but we do expect that that slowdown will be contained in the first half of the year and that things should start to normalize in the second half of the year. So, the company’s stock is rated 5 stars, trades at a 43% discount to our fair value, and the company’s also rated with a wide economic moat.

Dziubinski: The next company reporting this week that you’re watching is Tyson Foods TSN. Tyson is actually among our analysts’ lists of undervalued stocks they like most for this third quarter, but it too has struggled during the past couple of years.

Sekera: It has. So Tyson is currently rated 5 stars, and it trades at a 34% discount to our fair value. Now, we have seen some very challenging dynamics in the meat markets. Now, similar to IFF, it is a company that does have some cyclicality in its business. And when I look at our notes here, really it’s been hard to push through a lot of the cost increases as fast as inflation has been ratcheting up. And then that’s been combined with lower demand. So, with this inflationary environment, we’ve seen consumers switch to cheaper forms of protein. And so between the two, we’ve really seen operating margins under a lot of pressure. This one is a bit of a story in that it’s a play to normalization over time, which is going to be typical of a commodity-oriented company.

Dziubinski: Got it. Jacobs Solutions J is also among our analysts’ top ideas for the third quarter, and at two reports this week. Now this is perhaps a less familiar name for viewers. Tell us about it and how our take differs from that of the market.

Sekera: Jacobs is an engineering and construction company. It’s currently rated 4 stars, and it trades at an 18% discount to our fair value. Now, I think this one actually should have a pretty good growth trajectory over the next couple of years. Specifically, I think that they’re going to be due to benefit from all the infrastructure spending that we’re going to see coming from the Inflation Reduction Act, which is really just starting to roll out.

Dziubinski: And next, Celanese CE also reports this week the stock’s having a pretty good year, but we still think it has room to run, right?

Sekera: We do. We still think it’s undervalued at this point as it’s tied to a couple of different long-term secular trends. So, the stock itself trades at a 23% discount to our fair value. It is another specialty chemical manufacturer, but its products are really tied to electric vehicles. So, if you remember, we’ve talked about in the past how electric vehicles are going to be two thirds of new global auto production by 2030, and it takes anywhere between 2.5 to 3.0 times as many specialty chemicals to be able to make one electrified car as compared to an internal combustion engine. I would note for investors that are interested in learning more about the specialty chemical sector, I did publish an article on Feb. 24, “6 Cheap Stocks to Play Long-term Growth Trends.” And so in that, we reviewed why we think the specialty chemical companies do stand to benefit from a number of different structural growth themes that we see.

Dziubinski: We also have some inflation numbers coming out this week, Dave. What are you expecting, and what might the impact be on the market?

Sekera: We have two coming out. First up we have the Consumer Price Index, or CPI, on Thursday, and then on Friday, we have the Producer Price Index, also known as PPI. Now of these two, I’m probably going to focus more on the CPI number. And right now it looks like the market is expecting, on a year-over-year basis, that headline CPI may actually increase a little bit up to 3.3%. We did note that there were some temporary factors that had brought it down last month, but when we look at these and really delve into the specifics, we do think core inflation should still be steady or even better than what we saw last month. So, as long as the readings are in line with what the market consensus is, then I don’t really think there’s going to be much of a market impact. However, if these were to indicate that inflation is starting to head upward, then we could see a market selloff as people would be concerned about the Fed having more tight monetary policy yet to come.

Dziubinski: Let’s pivot over to some new research from Morningstar, and that’s your new stock market outlook, which published on morningstar.com last week. Now at the start of 2023, the market looked about 16% undervalued, according to Morningstar’s metrics. So, given the market rally that we’ve experienced this year, is the market overvalued now?

Sekera: At this point, no, it’s not overvalued yet. And I think this would also be a good time to explain how we look at the market valuation differently than I think what you’re going to hear from a lot of other market strategists. We cover over 700 stocks that trade on U.S. exchanges, and we take the intrinsic value as determined by all of our equity analysts on those stocks. We put together a composite where if every single one of those stocks were to trade to what we think that stock would be worth, and then compare that to where the market is actually trading. So, it’s really that bottom-up focus, whereas a lot of other strategists use a lot of more top-down estimates to come up with where they think the market should be trading. At this point based on that composite, we’re looking at a market that’s trading almost exactly in line with those intrinsic valuations on average.

Dziubinski: Then from a practical standpoint, Dave, when we have a market such as this one where we think it’s fairly valued, what does that really mean? Does that mean we don’t necessarily think there’s any upside left in the market?

Sekera: No, not at all. When the market or a stock is trading at fair value, what that means is that long-term investors should expect to be able to generate the company’s cost of equity on average over time or for the market, a blended market cost of equity average. So, when we talk about the market valuation, we talk about what we think it actually is worth today and what’s trading at fair value on average. We’d expect the market to increase based on that cost of equity. Now, we do have different costs of equity that we use in our model that we assign to each individual company, in order to really account for the risk that we see for each one of those individual companies. So, on average, we will use a 9% cost of equity for average risk, but that can vary. It goes anywhere from 7.5% for companies that have below-average risk up to 11% for companies with above-average risk. And for specific companies that are very speculative, we go all the way up to 13.5%.

Dziubinski: What would you suggest that investors do in a fairly valued market like the one we’re seeing today?

Sekera: I think after the rally we’ve had thus far this year and seeing how the market has developed, I think now is a really good time, especially here in August as things are starting to quiet down and take a fresh look at your portfolio, look at your holdings, look at your positionings. And I think what you need to do is go through and really start selling, lock in some gains on those positions where stocks have become overvalued and overextended and look to reinvest in those areas that have lagged behind and still remain undervalued.

Dziubinski: Let’s talk about some areas where investors might consider taking profits and redeploying cash, looking through the lens of style and market cap first.

Sekera: At the beginning of the year based on our valuations, we actually had advocated for a barbell-shaped portfolio. And so we were looking to be overweight growth, overweight value, and underweight core. Now, the preponderance of returns thus far this year have really been among growth stocks. Those are up, I believe about 27% year to date. And so in May, as the market was moving up closer and closer to fair value, we moved to a market-weight recommendation for growth stocks. And then in our third-quarter 2023 outlook, as we got at fair value and even slightly above fair value for growth stocks, we actually moved to an underweight position or underweight recommendation at that point in time. So, when we look at the valuations now, I still think the best positioning for investors is going to be overweight value and an underweight in both core and growth stocks. And then looking by market capitalization, I would note that mid-cap still remains undervalued, maybe not as undervalued, and small-cap stocks are still the most undervalued by capitalization.

Dziubinski: Let’s look at the market through the lens of sector. Which sectors look most overvalued today?

Sekera: The technology sector was actually the third-most undervalued sector coming into this year, but it’s now up about 41% year to date. And it’s actually now the most overvalued sector, according to our valuations, trading at about an 11% premium to our fair value. And then I’d also highlight both energy and industrials are in that kind of fairly to maybe even just starting to get overvalued area, both trading at about a 5% premium to our fair value.

Dziubinski: And now let’s flip things, Dave. Which sectors are undervalued?

Sekera: On the undervalued side, even though it’s up 40% year to date, communications still remains the most undervalued sector based on our valuations, trading at a 16% discount to our fair value. Next up is going to be real estate. That’s the second-most undervalued, trading at a 13% discount. Though I still would caution investors to maybe steer away from the urban office space; I still think there’s a lot of risk in that specific subsector for real estate. And then both basic materials and financials trading at about a 7% discount.

Dziubinski: It’s time to move on to the picks portion of our program, and this week we’re focusing on three undervalued growth stocks. Now, as you noted, growth stocks have gone from being about 23% undervalued coming into the year to about 4% overvalued today, but there’s still some growth opportunities. So, let’s talk about some of them. The first growth stock you like this week is DoorDash DASH, why?

Sekera: Yeah, so DoorDash is currently rated 4 stars, and it trades at a very deep discount of 46% to our fair value estimate. And we actually had maintained that fair value estimate at $155 per share after earnings last week. Now, I’ll admit I actually haven’t followed Dash all that closely myself, but it is covered by Ali Mogharabi. And I’d note he is the analyst that also covers Alphabet GOOG and Meta META, which we had talked about last week. So, he noted that growth in orders and gross value per order both increased during the second quarter. And he also noted the company has retained or actually slightly increased its delivery market share in the U.S., and I think that supports our narrow moat rating, which is based on the company’s network effect.

Now, I would caution the company does still remain unprofitable at this point, but Ali did note in his note that based on continuing investments and enhancing the app, adding services, and being able to attract more customers, that in turn is going to be able to allow the additional top-line growth and free cash flow growth we do expect over the longer term.

Dziubinski: Your next undervalued growth stock pick this week is Uber UBER. Why Uber?

Sekera: It’s a 4-star-rated stock, it trades at a 34% discount, and again, we maintained our $68 fair value estimate after earnings last week. And it also has a narrow moat, which is based on its network effect. Part of the story here is just that consumer behavior does continue to keep normalizing. We are seeing more and more people go out into public, and so Uber has been seeing an increase in the number of users, the number of trips. It has been able to generate increased revenue per user and per trip. And so we just see a lot of fundamental improvement over time. The other thing I’d note here is that Uber did report an operating profit for the first time, and we do expect that margins will continue to expand.

Dziubinski: Your last pick this week, Dave, is Boston Beer SAM. Why?

Sekera: This one is also a bit of a play on consumer behavior normalization. It’s a 4-star-rated stock, trades at about a 29% discount to fair value. There are really two parts to the story here. First, as consumers go out in public, what we see is that they tend to choose higher-branded products as opposed to at home when they’re choosing the cheaper alternatives. So, as they start buying those branded products, you do see a margin uplift in those. But second, over the past couple of years, there’s been a big shift in the alcoholic beverage industry in that we’ve seen the alcoholic flavored seltzers really take off and take some market share from beer. There’s been a big flurry of competition in the space over the past year or two, and we’re really now starting to see that competition stabilizing. Just to note, Boston Beer’s two main brands in that space are both Twisted Tea and Truly. So, what we saw in the second quarter results is that sales were still slightly moderating, but margins now are improving as the product refreshment and cost-saving measures are starting to work.

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, go ahead and like this video and subscribe to Morningstar’s channel. Have a super week.