Morningstar: Quality stocks undervalued but further downside risk in market

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Equity research firm Morningstar says many quality stocks in New Zealand and Australia are trading at a big discount to their underlying values, but warns of further downside risk.

Morningstar Australia head of equities Peter Warnes said quality stocks had retained their value amid market volatility, high inflation and interest rates, but strong underlying values should not be seen as a recommendation to buy.

“That doesn’t necessarily mean that the stocks are good buying at these levels. It just means that they’re undervalued as far as we’re concerned, but there could be more downside risk in the market. . . And I’d be very, very cautious about buying into the equity markets at this point in time,” he said.

Low interest rates unlikely to return

“I mean, the bond market is telling you that uncertainty is going to be your companion for quite a while.”

He said bond yields were likely to remain at current levels for a long time, with interest rates likely to remain between 4 and 6 percent, which was a normal range going back six decades.

“I think the period, following the GFC (global financial crisis) and then through the pandemic and into 2020, was abnormal and unprecedented – where you had bond yields, basically at zero. That is not going to recur,” he said.

“People who think interest rates are going to come down to those levels again are fooling themselves.”

Global debt to weigh on markets

Warnes said higher interest rates and record global debt levels would weigh on equity markets for years to come.

“The last three years, we’ve had fiscal policy and monetary policy working overtime, and the governments and the central banks took insurance policies out to ensure that the economies didn’t just go diving into oblivion.

“And now you’ve got government debt at levels you have never seen before.

“The government debt in the US is $33 trillion and by 2028. It will cost them to service that debt $1 trillion per year.

“That is going to send reverberations through financial markets. And that is why you have got to be very, very careful at this point in time.”

Conditions favour cash

Warnes said current market settings favoured cash, as deposit rates continued to rise.

“I have seen a lot of people go into markets when they’ve fallen, but not realising that there’s a bigger fall to come,” he said.

“If you’re going fishing, fish close to the shore and in calm waters. Do not venture outside into rougher water.

“Look for companies that have well managed and have got good financials and make sure that you understand the risk that you are taking as an investor in a risk asset.”

Corporate profits expected to

The report says the outlook for 2024 was for moderating growth in corporate profitability with higher interest rates and operating costs putting pressure on margins.

Morningstar’s fourth quarter report indicates companies exposed to discretionary spending would continue to see a deterioration in revenue while consumer staples should generally ride out the storm, though margins would likely contract with easing sales volumes and increasing competition.

However, it also sees opportunity for New Zealand and Australian equities, which were trading at a 9 percent discount to fair value on average as of 22 September, compared with the long-term average of a 5 percent premium over the past 10 years.

Warnes said the real estate sector was significantly undervalued with further downside risk.

“But we see plenty of opportunities for investment in high-quality names with more favourable outlooks. We also see opportunities across technology, healthcare, energy, and communications.”

New Zealand stocks

Morningstar singled out a few New Zealand stocks in its report, including casino operator SkyCity, which was the subject of ongoing regulatory investigations on both sides of the Tasman.

“A short-term suspension of the New Zealand casino license is likely, the Adelaide casino license is under review, and there is significant uncertainty around the Austrac civil penalty against SkyCity Adelaide – we expect about $50 million,” the report said.

“But we think pessimism is overblown. SkyCity’s properties are enjoying significant revenue and earnings growth with pandemic restrictions over, capital spending is set to ease as $1 billion in major projects across Auckland and Adelaide complete, and the long-dated and exclusive license in Auckland means it should benefit from the continued recovery in New Zealand tourism.”

Morningstar said the outlook for Australian and New Zealand utilities was solid, with the outlook for New Zealand power producers even better.

“They too benefit from high wholesale electricity prices but instead of aging coal- and gas-fired power stations, they primarily own irreplaceable hydroelectric schemes.

“These long-life assets produce cheap electricity, have flexible output, and are environmentally friendly.”

However, it said the positive outlook was already priced into most New Zealand utilities, which it saw as overvalued. It said Manawa Energy was offering one of the best values.

Morningstar also liked speciality milk company, A2 Milk, with growth in its Chinese-language-labeled infant formula supporting its outlook.

“We forecast 9 percent annual revenue gains to fiscal 2028 as channel inventory levels normalise and market share increases, alongside improved sales of higher-margin English-label product and operating leverage from higher revenue.”

“I think you’ve got to be very cautious and very prudent and keep a lot of cash because you are now getting paid for holding cash,” Warnes said.

“So I’d be I’d be making sure that I had a good arsenal of cash to be able to open the guns and start firing when these markets finally bottom and I think that’s a little while away.”

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