3 Undervalued US Stocks

THE VALUE INVESTOR: After five years of steady growth is the US stock market beginning to come off the boil? We identify three companies that are considered undervalued

Karen Kwok 22 January, 2016 | 8:22AM

US small stocks have now entered a bear market; the Russell 2000 index has lost 20% of its value to return to levels last seen in July 2013. And it is not just the small caps which look wobbly. Fourth-quarter earnings for S&P 500 companies are expected to fall more than 5%, versus expectations of a 0.6% decline at the start of the quarter. This would be the first time since 2009 that earnings have contracted for three consecutive quarters. Higher volatility will likely continue.

In a market sell-off it can be difficult to identify which share prices have fallen with reason and which have been dragged down by contagion.

Morningstar’s rating for stocks can help investors uncover stocks that are truly undervalued, cutting through the market noise. The rating is determined by three factors, which are a stock’s current price, Morningstar’s estimates of the stock’s fair value, and the uncertainty rating of the fair value.

Five or four stars mean a stock is undervalued, while a three star rating means it is fairly valued. One and two stars stocks are overvalued. Below we highlight three stocks in the US that Morningstar analysts rate five stars.

Visa (V)

Visa manages payment brands and an ‘open loop’ global payment network, which allows it to provide authorisation, clearing, and settlement of electronic payment transactions.

The firm generates revenue by charging fees to its customers based on the dollar volume of card activity and the number of transactions processed through the network. It connects consumers, businesses, banks and governments in more than 200 countries and territories. The company has a five stars rating, which is an undervalued stock.

Visa is a trusted and popular brand among cardholders and merchants, which dominates the global market for electronic payments. Visa accounts for about half of all credit card transactions and roughly three fourths of debit card transactions in recent years, according to the Nilson Report.

Morningstar analyst Jim Sinegal believes that the company should flourish as the number of digital payment transactions is constantly growing. New regulation covering interchange remains the largest risk to Visa, but few competitors can match the investments in technology, security, and marketing that Visa makes, limiting possible alternatives in the payment space.

Sinegal believes that Visa’s revenue growth will average 11% annually over a five-year forecast period.

Cabot Oil & Gas Corp (COG)

Cabot Oil & Gas Corp is an independent oil and gas company engaged in the development and exploration of oil and gas properties located in North America. Natural gas represents 96% of production and 96% of reserves. Approximately 60% of the company's reserves are categorized as proved developed. The stock is rated five stars by Morningstar analysts.

A sustained and significant drop in oil and natural gas prices would hurt Cabot's profitability and reduce cash flow available for growth. However, as an early mover and sizable operator in the region, Cabot benefits from reasonable royalty rates, fairly blocked-up acreage positions, and established relationships with service providers and midstream partners, Morningstar analyst Mark Hanson says.

Cabot controls more than a decade of highly productive, low-cost drilling inventory targeting the dry gas Marcellus shale, which will account for about 90% of Cabot’s production over the next several years, Hanson estimates.

The company also established the black oil window of the Eagle Ford Shale position in 2010, which today holds at a relatively low cost. It is still early in its development, which should ultimately help diversify the firm's production mix away from natural gas and provide a nice boost to economics, Hanson says.

Gap (GPS)

Gap is a global apparel retail company. It offers apparel, accessories, and personal care products for men, women, children and babies. Distribution channels include more than 3,000 specialty and outlet stores, online, and franchises. About 77% of revenue is generated in the United States, and about 80% of revenue comes from the Gap and Old Navy brands. The stock is rated with five stars by Morningstar analyst.

Morningstar analyst Bridget Weishaar continues to believe in the long-run potential of the company. Operating margin expansion is the main driver of valuation, as Gap has invested heavily in technology and supply chain systems, which increase its exposure to more-productive and higher-growth vehicles including international, factory, and e-commerce. This can narrow the margin gap between Gap and its global fast-fashion competitors. 

Gap continues to face economic risks including unemployment, wage growth, consumer confidence, and debt is compounded by fashion risk, a competitive and overcrowded apparel retail space with no barriers to entry, international expansion, and difficulty in implementing change in a large organization, according to Weishaar.

But the company remained synonymous with all-American casual basics at an affordable price. This has kept customers coming to its stores and willing to pay a price high enough for Gap to grow. Scale also has provided the company with cost advantages, allowing Gap and Old Navy to be relatively price competitive with fast-fashion retailers while also preserving profitability.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Rating
Cabot Oil & Gas Corp Class A23.31 USD-3.36
Gap Inc26.61 USD-0.08

About Author

Karen Kwok

Karen Kwok  is a Reporter for Morningstar.co.uk