Should You Invest in Growth Stocks or Value Stocks Now?

Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. Every Monday morning I sit down with Morningstar’s 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.

Dave, the big thing on your radar this week is bank earnings with Citi C and JPMorgan Chase JPM reporting later this week. What will you be listening for from the banks during earning season, given the solvency issues some of the regionals faced in March?

Dave Sekera: Susan, good morning. I think the biggest thing that’s going to be on everyone’s minds is deposits. Who gained deposits, who lost deposits, and by how much? But even more importantly than the big banks are two regional banks that are reporting, PNC PNC and First Republic FRC. I think those could be indicators of just how much deposit flight we’ve seen out of the regional banks and how those regional banks are going to be financing themselves following any potential deposit losses.

Now, on First Republic, I would note on that one, we did lower our fair value all the way down to $3 a share on that stock after there was reports out there it lost, I think, 40% of its deposit base. And at that level, we just don’t think that First Republic is really going to be able to remain profitable and we’re also concerned it could breach some of its capital requirements by the end of the year. Plus, in just looking at other than the change of deposits, I think some of the other things we are going to be listening for with the Big Banks: Any guidance on net interest margins, with money market funds being over 4%, I want to hear if banks are going to have to start offering higher rates on their deposits in order to be able to keep those accounts.

And then, lastly, just any guidance they may have on the economic outlook. How much of a downturn are they expecting ahead of us? From their perspective, what are they preparing for? For example, I’ll be looking for how much of an increase in loan-loss reserves they’ll be taking. So it’d be interesting to see, from their point of view, how much weaker do they think the economy may be getting later this year.

Dziubinski: At this point, Dave, does Morningstar see any opportunities among bank stocks?

Sekera: We do see quite a number of opportunities, although it’s certainly cloudy going into earnings of this quarter. But Eric Compton, our bank analyst, did publish an article relatively recently, and he did highlight three bank stocks that he thinks are undervalued but also pretty well situated even with everything that’s going on in the banking sector. Those three banks would be Citibank, Comerica CMA, and U.S. Bank USB.

Dziubinski: Speaking of Morningstar research, let’s pivot over to a new piece of research from you on Morningstar.com, and that’s your second-quarter market outlook. Now, in that outlook, you say that investors should expect continued volatility ahead. Walk us through your rationale on that.

Sekera: Sure. And there’s been a lot of movement in the market just over the past couple of weeks. Right now, according to a composite of about those 700 stocks that we trade on U.S. exchanges, we think the market’s trading at about a 10% discount. Some of the reason that we think there’s going to be a rough road ahead of us over the next couple quarters is that while the U.S. economy has been more resilient than we originally expected to tightening monetary policy, we do think tightening monetary policy will take its toll over the latter half of the year.

Our estimate for first-quarter GDP is 2.6%, but for the second quarter we expect that to fall to zero, to be flat in the second quarter, and then actually decline slightly, a small contraction in the economy of 0.8% in the third quarter, before we start to reaccelerate and see some more growth back in the fourth quarter. So, of course, a slowing economy will reduce earnings growth, and I think that could pressure stocks in the short run.

I think what the market’s going to be looking for later this year is really for a rebound in leading economic indicators, and that, I think, could be then the sign to really start seeing the market start taking off and start moving back up to where we see long-term intrinsic value.

Dziubinski: Given that outlook, Dave, what do you think specifically of growth stocks today? Now, they had a great run in the first quarter. Can that rally persist?

Sekera: Growth stocks really did outperform, and they outperformed really very significantly compared to both growth and value. In fact, they’re pretty much responsible for all the market growth that we’ve seen thus far this year. So, for the first quarter, the market itself was up 7.4%, but growth was up 14.8%. Core was only up 3.4% and value was essentially unchanged.

I think a good part of the rally for growth is that it had a really good setup coming into 2023. Of the different categories, we thought growth was the most undervalued, plus it also had a large, what I would consider to be a technical overhang. At the end of last year, we did see investors sell a lot of those growth stocks, which had declined over the course of last year in order to harvest tax losses.

So, getting back to your original question, can the rally persist? It certainly can in the short run, but I kind of doubt that growth will really outperform that kind of margin that we are seeing over the past quarter going forward into the second half of the year.

Dziubinski: Let’s talk a little bit about valuation for growth stocks in general after that runup. How does valuation look?

Sekera: They are still undervalued, but, of course, to a much lesser degree right now. When you look specifically just at growth stocks, they’re trading at a price/fair value of 0.90, so that represents about a 10% discount to fair value, whereas at the beginning year, growth stock was trading at about a 16% discount to fair value.

Dziubinski: Let’s pivot over to value stocks. You alluded to the fact that value stocks were kind of flat in the first quarter, really underperforming growth. Why is that?

Sekera: It’s always hard to ascribe a reason for short-term movements in the marketplace. And to some degree, I think the movement in this past quarter was really because growth stocks we’re better positioned, both from a fundamental valuation point of view as well as a market technical position as well. But based on the current level of valuation for long-term investors, I still think they’re going to be well positioned in value stocks going forward once the market really begins to recognize their intrinsic values.

Dziubinski: Talk a little bit about valuation of value stocks, Dave. How do they look today?

Sekera: Sure. When we do that exact same analysis for the value category, they do look pretty undervalued to us. They’re trading at a price/fair value of 0.83, and that represents a 17% discount from their intrinsic valuations.

Dziubinski: In your second-quarter outlook article, you suggest that investors consider barbelling growth stocks and value stocks. Why is that?

Sekera: When we take a look at all three categories, I would note that core stocks are much closer to fair value, and that’s why I think those could be underweighted by investors today and then use that in order to overweight both the value and the core categories. As we saw in the first quarter, value and growth stocks, they can perform differently in different types of market situations. However, with the outperformance and growth, I do think, in this case, it may make some sense to lighten up on that overweight in growth, keeping that overweight, but not as much, and use some of that runup and growth to move some of that capital into value, which still remains much more undervalued, in our view.

Dziubinski: We’re going to move on to your stock picks portion of our segment this week, and you’ve brought us three undervalued traditional growth stocks and three undervalued traditional value stocks to consider for that growth and value barbell. So let’s start with growth. Specifically, let’s start with Amazon AMZN. What do you like here?

Sekera: Amazon is a 4-star-rated stock. We rate the company with a wide economic moat, and that stock right now is trading at about a 25% discount to our fair value. Now, Amazon, of course, had been under a lot of pressure throughout most of 2022, but I do think it looks like, based on the charts, it appears that stock has bottomed out and does look like it’s making a comeback.

You have to remember, in its retail business, a huge amount of growth had been pulled forward during the pandemic, so that way on a year-over-year basis in 2022, it looked like the growth rate actually slowed quite a bit. But we think the market’s discounting that short-term slowdown in their growth rate too far into the future, and in 2023, I think they’re going to start lapping easier year-over-year comparisons. So that’ll help make that part of the business start looking better.

Now, in its Amazon Web Services business, growth has slowed there, but I would note that there is just an exceptionally high growth rate in that cloud computing business. So, even with a slower growth rate there, according to our analysis, we still think there’s a really large market for that part of the business and in that tangible and addressable area, we still see a lot of growth up ahead for Amazon.

And then, lastly, we just don’t think the market has given Amazon the valuation that it deserves for its advertising business.

Dziubinski: Your second growth stock pick this week, Dave, is CrowdStrike CRWD. This plays into a growth theme that you and I have talked a little bit about before and that’s cybersecurity.

Sekera: CrowdStrike, in and of itself, we rate that company with a narrow economic moat, and that stock is currently rated 4 stars as it trades at about an 18% discount to our fair value. Now, cybersecurity is just an area that I just think that there’s a lot of attractive dynamics within that area, and I think cybersecurity in and of itself is in an area where we’re going to see a long-term secular growth.

Now, thinking about corporations in today’s day and age, they need to protect themselves against both geopolitical events as well as ransomware attacks and hacking. So, I do think that there’s going to be a lot of need for cybersecurity over the long term. And the other part that I really like about cybersecurity is that when you look at overall IT budgets, cybersecurity spending in and of itself is actually a relatively small percentage of that larger budget, but the cost for a company of succumbing to some sort of cyber event has huge monetary and reputational costs. So, even if we do have a slowing economy, or even if we do slip into a recession, this is just one area that I just don’t think management would be willing to try and trim any of their costs.

Dziubinski: And then your last growth stock pick this week, Dave, is Salesforce CRM. Why do you like it?

Sekera: Again, another 4-star-rated stock, wide economic moat, and it trades at about a 20% discount to our fair value. And I would just know with Salesforce, according to our analyst, he thinks that Salesforce represents really one of the best long-term growth stories in the software space, and he’s looking for that firm to be able to generate compound annual growth and earnings of over 20% annually for the next few years.

Dziubinski: Let’s pivot over to the value side, and your first pick here actually came up earlier in our conversation today. It’s Citigroup.

Sekera: Citi is rated 5 stars. Now, I would note there is no economic moat there, but it is trading at about a 40% discount to fair value. So I can really put this in that deep-value stock category. Now, typically, we do prefer companies that do have an economic moat, but in this case, with as much of a discount that it’s trading, I do think there’s enough margin of safety here to warrant the added risk.

I would note we don’t really actually foresee much earnings growth at Citibank, but at that 40% discount, it’s trading at just too wide of a margin from its tangible book value, whereas most of its competitors trade at a premium to their book value. We do think that over time that value will accrete up to that tangible book value, and you end up generating a 4.5% dividend yield while you wait for the market to accrete that valuation back up.

Dziubinski: Your second value stock pick is Verizon VZ. And you mentioned dividend yield with Citi. Besides being undervalued, Verizon offers a really attractive dividend yield, too, right?

Sekera: It does. Verizon stock is rated 5 stars. We rate the company with a narrow economic moat and that stock’s trading at a 30% discount to our fair value at this point in time. Now, it’s interesting, I kind of looked at this one the other night, and since the market bottomed last October, the broad market’s up about 11%, and its competitor AT&T T has risen 23% over that same time period, whereas Verizon’s been flat.

I think when we look at some of the fundamentals here, I’d note we do expect Verizon will gradually lose some market share over time, and we do believe that with the merger between Sprint and T-Mobile TMUS, that wireless competition will actually start to rationalize, following the merger between those two companies. That’s going to actually enable more stable pricing and allow them to be able to build the revenue per customer over the coming years.

This one, I do think we have pretty modest assumptions as we’re only really expecting a 2% to 3% average growth in their wireless service revenue business. So, this is one that I think is well into that value category. And as you know, I think it has well over 6% dividend yield right now.

Dziubinski: And then your last pick, Dave, on the value side is 3M MMM. Tell us about it.

Sekera: 3M stock is rated with 4 stars. It’s another company with a wide economic moat, and that stock trades at about a 20% discount. Again, another high-yielding stock. I think it’s about a 5% dividend yield right now. I think the main point on this one is we think the market’s overestimating potential losses that the company could incur from several ongoing lawsuits. But taking a look at the company, fundamentally looking at its economic moat, we do think the company is built on intangible assets and cost advantages, which really drives that economic moat.

The company just has a long-standing history of investing in the research and development, and that’s really enabled them to build just a very broad portfolio of high-quality patents, brands, proprietary technology that we really think is going to be able to help drive excess returns on invested capital over the long term.

Dziubinski: Thanks for your time this morning, Dave. Be sure to join. Dave and I live on YouTube every Monday morning at 9 a.m. Eastern time, 8 a.m. Central, and while you’re at it, subscribe to Morningstar’s channel. Have a great week.