Should You Buy 3-Star Stocks?

3-star stocks are not all equal, and avoiding them would rule out most of the FTSE's biggest names

James Gard 10 August, 2021 | 9:34AM
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At Morningstar.co.uk we often discuss which shares are overvalued and undervalued, but what about shares which are fairly valued? What does a 3-star rating mean for owners and potential owners of a stock, and does it mean you should buy, hold or sell?

With many global stock markets still highly valued after last year’s bounce, finding cheap stocks is getting harder. Currently Morningstar rates 1,724 stocks globally and the 3-star cohort is by far the most populus, with 728 of our rated stocks falling into this category. 

Morningstar’s director of equity research, Alex Morozov, says a 3-star stock could still be a good investment, but may not be attractively priced at this point in time: “We're not saying that an investor should not look at those securities. What we are saying, however, is that the stock is probably going to return somewhere in line with what the market should return over time.” He says a 3-star rating could be considered closer to a "hold" recommendation than a "buy" or a "sell".

Some Key Things to Consider:

  • Just because a stock has a 3-star rating, that doesn’t mean it’s perfectly fairly valued. For example, 3-star Tesla (TSLA) has just been upgraded by Mornings analysts, to $570 per share, but that is still below the current share price of $643 . “At current prices, we view Tesla shares as slightly overvalued, with the very high uncertainty stock trading in 3-star territory, but over 15% above our fair value estimate,” says analyst Seth Goldstein.
  • The star rating needs to be considered in conjunction with a firm’s economic moat and its uncertainty rating. Screening out 3-star stocks would exclude some of the UK’s most popular stocks such as AstraZeneca (wide moat, medium uncertainty) and Unilever (wide moat, low uncertainty.
  • The Morningstar star rating is updated at the close of business every day so a 3-star stock can quickly become a 2-star or 4-star stock. Even the share prices of the least volatile companies can gyrate over short time periods, pushing the stock into undervalued and overvalued territory.

Our table shows that many of the FTSE stocks rated 3 stars by Morningstar are household names. Looking at the price to fair value ratio tells us a bit more. This measure gives investors an idea of just how under- or overvalued a company is. For example, a P/FV of 1 suggests a stock is perfectly fairly valued, whereas one with a 0.50 is 50% undervalued. The price to fair value ratios of our 3-star cohort range from 0.87 for mining stock Glencore (GLEN) to 1.24 for fellow miner Anglo America (AAL). Ocado comes closest to trading at perfect value on the day we ran our data, with a P/FV of 0.99.

table of UK 3-star stocks

Supermarkets, which were lockdown winners, are now in focus again as WM Morrison (MRW) is in the midst focus of a takeover battle which has pushed its shares up nearly 50% this year. Ocado (OCDO) is also on the list, and at a price to fair value of 0.99, its share price is (for the time being) very close to its fair value. Does this mean investors should shun the online food delivery firm? Not necessarily. According to Morningstar analysts, while it doesn’t have an economic moat, its moat trend is positive, meaning it could be upgraded to moat status in the near future.

The company’s shares have also been the best performing in the UK market since the 2016 Brexit vote, rising just under 600%, though they have slipped back this year. “From its humble beginnings as one of the first niche online grocers to its current status as a technology powerhouse and online retail disrupter, Ocado Group offers unique exposure in one of retail's largest and most dynamic segments: global online food retailing,” says analyst Ioannis Pontikis. While Morrisons and Ocado are both in the food retail sector and are rated 3 stars, the market rates Ocado’s prospects much higher than Morrisons, as measured by their price/earnings ratios (67 versus around 140).

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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James Gard  is content editor for Morningstar.co.uk