RBS Dropped from Best Stock Ideas List

Morningstar equity analysts have dropped Royal Bank of Scotland from their global list of best investment ideas due to concerns around Brexit

Michael Holt, CFA 3 May, 2016 | 9:44AM
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Morningstar equity analysts are removing Royal Bank of Scotland (RBS) from the Best Ideas list of undervalued high-quality stocks. While our thesis that the bank will build up to £20 billion of capital to return to patient shareholders remains intact and we think the shares are attractively priced, we think recent political events in the United Kingdom may mean that the road to get there will be rockier than we anticipated.

We're particularly concerned about the impact of uncertainty about Brexit, which we think has already had a negative impact on economic growth and RBS' ability to sell noncore assets. We think the negative impact is likely to linger on through 2016, even if a no vote prevails as we expect. We prefer to steer investors toward banks with more near-term upside, such as Citigroup, trading at a 29% discount to our fair value estimate.

Which UK Stocks are on the Best Ideas List?

Diageo (DGE)

Sentiment is low on Diageo following three years of underperformance, several strategic and execution errors, acquisitions that have failed to create value, and most recently, a Securities and Exchange Commission inquiry into its shipment practices. We think Diageo's wide moat is due to the breadth and strength of its brand portfolio and the scale of its production, which allows it to produce at a lower average cost than smaller competitors. These competitive advantages should drive sustained excess returns on capital.

The catalyst for the stock, however, remains a turnaround in volume. In an environment of low real wage growth, we like Diageo's self-help options for delivering that turnaround. First, management should right size channel inventory as a matter of priority, in order for medium-term growth to match depletions.

Second, Diageo should plug holes in its portfolio, particularly in brown spirits, without stretching its brands too thinly in noncore consumer segments. Third, it could unlock the value in its beer portfolio in Africa either by selling it or integrating the route to market of its beer and spirits portfolios. In addition to these self-help measures, Diageo's volume is likely to benefit from any macroeconomic upswing, as premiumisation is sensitive to the economic cycle in developed markets.

Kingfisher (KGF)

We think do-it-yourself retailers possess structural advantages against the encroachment of online competition in some categories, given the big-ticket nature of room remodeling, the inefficiency of shipping heavy items, and the emergency nature of some DIY purchases. We think these give Kingfisher a narrow economic moat. For most of 2015, the business underperformed our expectations for its normalised growth algorithm, but catalysts in its two core markets in the form of lower stamp duty in the United Kingdom and capital gain tax relief in France should boost housing transactions and prices in 2016, two of the critical drivers of home-improvement industry sales.

What is a Best Idea?

Morningstar believes that a company’s intrinsic worth results from the future cash flows it can generate. The Morningstar Rating for stocks identifies stocks trading at a discount or premium to their intrinsic worth, or fair value estimate, in Morningstar terminology. Five-star stocks sell for the biggest risk-adjusted discount to their fair values, whereas one-star stocks trade at premiums to their intrinsic worth.

Four key components drive the Morningstar rating: our assessment of the firm’s economic moat, our estimate of the stock’s fair value, our uncertainty around that fair value estimate and the current market price. This process ultimately culminates in our single-point star rating. Underlying this rating is a fundamentally focused methodology and a robust, standardised set of procedures and core valuation tools used by Morningstar’s equity analysts.

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.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Rating
Diageo PLC2,422.50 GBX-0.25Rating
Kingfisher PLC253.80 GBX-0.35Rating
NatWest Group PLC413.90 GBX0.34Rating

About Author

Michael Holt, CFA  Michael Holt, CFA, is a senior stock analyst with Morningstar.

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