Why these three sectors stand out from the crowd

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The focus for this episode is where investors can look for potentially undervalued opportunities. Kyle is joined by Michael Field, chief equity market strategist at Morningstar, who explains why three sectors stand out from the crowd, and outlines share examples. The episode also covers the danger of potential ‘value traps’.

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Kyle Caldwell, funds and investment education editor at interactive investor: Hello, and welcome to On The Money, a weekly show that aims to help you make the most out of your savings and investments.

We’re focusing this episode on where investors can look for potentially undervalued opportunities.

Over the past couple of years, stock market returns globally and for the US market have been dominated by the technology sector, particularly the so-called Magnificent Seven stocks. Heading into this year, there were many commentators warning that valuations have potentially become overheated for the world's biggest companies.

However, from mid-February to early April, those seven companies along with the technology sector and also the wider market suffered from US tariff uncertainty.

We now know with the benefit of hindsight that a stock market recovery started taking place from 8 April onwards, and that markets recovered. The Magnificent Seven and the broader technology sector have also recovered their poise.

Now, while the jury’s out on whether the valuations attached to those seven companies and technology sector in general are a price worth paying for the potential high growth on offer, there are lots of other opportunities for investors to take advantage of, and much cheaper entry points elsewhere.

Joining me to discuss three sector-specific opportunities is Michael Field, chief equity market strategist at Morningstar.

So, Michael, you’re going to run through why healthcare, luxury, and industrials all present compelling undervalued opportunities, and you’re going to name some stock examples within those three sectors.

So, those three sectors combined account for nearly half of Morningstar’s four or five-star ratings for the European coverage.

Customers of interactive investor have access to Morningstar’s star rating system when they’re researching companies.

So, could you talk us through how the star rating system works?

Michael Field, chief equity market strategist at Morningstar: Yep. Absolutely, Kyle. So, the star rating system, ultimately, it starts with the analysts on a bottom-up basis. The analysts do a valuation of a stock, and they tell you the fair value of the stock. And then from there, we compare that to the price of the stock, and that gives you a price to fair value estimate.

So, anything under one is good because the value that we’re saying is higher than the actual share price currently, so there’s upside. Anything over one is bad, to simplify it, because the price that it’s trading at is more than what we think it’s worth.

So, that’s the simple starting point. Then from there, we derive the star rating system. And the difference between us and brokers and sell-side shops out there is that it’s more subjective for them.

They can say, look, there’s only 2% upside to this utility company, but it’s our top pick. Because they kind of have to say, look, you have to buy something, so here you should buy this one, this is our top pick.

Whereas for us, once the analysts basically come up with a value for the stock, it’s out of their hands. Then there’s an automated system which takes into account how volatile the stock is, maybe how uncertain the returns are, and then it builds that into the star rating system. So, that’s the complicated part.

The easy part around that is to explain the star rating. So, on a simplified basis, a three-star rating means the stock is fairly valued. It’s where it should be.

If you buy it now, you basically get the returns that you should every year, but you’re not going to experience huge upside as the stock corrects. Four stars is good, five stars is even better. Five stars is going to back up the truck, essentially. And then on the opposite scale of that, two star is overvalued, and one star is very overvalued.

And as you correctly pointed out, the four and five-star ratings, while you can get them across the board, we do have five-star stocks in every single sector now bar energy, and four-star stocks in every single sector. You’re right in saying that they are concentrated in some sectors more than others.

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Kyle Caldwell: In terms of the number of companies that are a one, two, three, or a five star, is there a certain percentage that goes into each, or does it just depend on the fundamentals? So, does it depend on the value of the company, so there could be at one time quite a lot of four or five stars, for example?

Michael Field: So, this is what makes my job interesting and what I like about it is that there’s no agenda, like I mentioned that you sometimes have with brokers, etcetera, where they’re always plugging something. They always want you to buy something.

Whereas it’s out of our hands, ultimately, the star ratings. So, we can say, right now, 40% or more of stocks are four and five star and we don’t see that very often. Or the inverse of that is that you can say the market’s mostly fairly valued, and there’s actually very few opportunities at the moment.

You can earnestly say that to investors, and that builds the trust, I think. As well as that, you can say, look, last year, you came to us and said there wasn’t much opportunity, and now you’re saying there’s loads, so maybe we should listen to you now.

Kyle Caldwell: How frequently are the star ratings changed?

Michael Field: So, it’s dynamic. Again, it’s just the system. It’s just doing the basic calculations in the background based on the last change in the share price. So, when I open the system every day, it can give me a new star rating based on if a share price jumped or something. I was looking this morning for instance.

I saw Hennes & Mauritz AB Class B (OMX:HM B) was up 8%, as those retail stocks can be quite volatile. That’s currently a three-star rating stock because it’s very close to our fair value estimate. So, even though it’s jumped 8% today, taking that into account, we’re still saying it’s fairly valued, there’s no huge point in buying this. If you have it already, you can hold on to it. It’s not overvalued yet, but if you’re looking for new ideas, there’s better ideas out there.

Kyle Caldwell: Let’s now move on to three of the sectors that are standing out on the star rating system. The first one you’re going to cover is healthcare. Could you explain why healthcare is looking attractive at the moment in terms of its valuations?

Michael Field: Yep. So, I think I put this up on LinkedIn recently as well. If anyone wants to follow me on that, we can send through the link. But I asked the question, what do you think is the cheapest sector in Europe at the moment? And would you have guessed that the answer is healthcare?

Personally, if I hadn’t seen that number, I would not have guessed that because we’re in volatile times at the moment. We’ve been through tariffs this year, trade agreements, and still things aren’t fully resolved yet, as we’ve seen. Every day we open the newspaper and we see this.

And yet, healthcare traditionally is a very defensive sector. It’s where people go when times are volatile and they just want stable returns and companies that are doing innovative things in the background, and products that people have to buy regardless of how bad or good things are in the economy, right? And yet healthcare is the cheapest sector in Europe at the moment. It’s maybe 12% to 14% discount to our fair value estimate at the moment.

So, I mentioned there’s opportunities in every single sector. Even in the sectors - and we’ll talk about this in a minute - that are actually overvalued at the moment, you can still find opportunities.

But if your starting point is a sector that’s trading on a big discount, you can be sure to find lots of opportunities within the sector, and that’s the case with healthcare. To your question about, what’s wrong with healthcare that people are worried about, it’s a handful of things. It’s the perfect storm of events for healthcare.

First, you have companies such as GSK (LSE:GSK) and AstraZeneca (LSE:AZN), I’m taking these because maybe they’re UK-listed companies that are close to people’s minds and hearts, but two, they are also big, global healthcare companies. One of the reasons they’re not performing brilliantly at the moment, or why their valuations are looking somewhat attractive, is that they’ve got exposure to vaccine drugs. And the obvious answer there is, well, the pandemic’s over. Why are they still selling vaccine drugs?

And they’ve got a broad portfolio of vaccine drugs. It’s not just Covid-19, but they sold a load of Covid-19 drugs, obviously, in 2021, 2022. What’s been happening since is that when we compare the results every year, and [consider] the sales growth versus last year, the results aren’t looking good because they’re selling fewer and fewer of these drugs. So, when people look at the sales growth of these companies, they’re not impressed by it. So, that’s number one. There’s still an effect [from them selling] way more of these drugs a few years ago, and they’re not selling much now. That’s one negative.

The second negative then is around, politics. So, if you look at, Robert F. Kennedy in the US, so the head of the healthcare department, he’s an anti-vaxxer, and he’s an anti-big pharma person. So, there’s big concerns around the US, where 70% of the world’s drugs are sold. So, these investors are concerned about those companies from that angle.

Also, the third factor is around the pipeline. So, these companies are only as good as what they have in the pipeline. So, yes, they’re selling this today, but some drugs are on a patent, and those patents eventually fall off a cliff after a number of years, and they have to continually find new drugs to replace the old ones to continue that sales momentum.

And people are always concerned about the pipelines, but investors seem more concerned than ever about those pipelines, whether they’re strong enough to withstand the pressures and whether they’re good enough to keep up that sales growth in future as well.

Finally, the other reason, and it harks back to politics as well, is around tariffs. So, we’ve seen that there’s an agreement between the US and the UK now in which the UK have pretty advantageous rates relative to the rest of the world. Still not great, still paying 10% tariffs, but it’s not as bad as it could be at all.

But it’s not over yet, and Donald Trump has said that pharmaceutical companies, because they’re selling so much into the US, should be producing more in the US, and he’s still threatening to increase the tariffs on pharmaceutical companies specifically, and he’s threatening upwards of 250% tariffs, which obviously would be devastating for pharmaceutical companies that are producing things outside the US.

The last point is, what are these companies doing about that? Well, if you’ve been reading the news lately, GSK announced just last week and AstraZeneca a few weeks before them, and Sanofi SA (EURONEXT:SAN), a month before them, that they’re building new plants in the US and investing loads of money in the US as a result.

Some of this is a bit cynical. They were going to do this anyway for new drugs, and it’s all in the future. But a part of this is appeasing the president and telling [him] that, yes, we’re following your advice, and we’re going to move more to the US, so please don’t impose any more tariffs on us.

So, there’s this whole barrage of factors at the moment. I think that’s more than enough to put investors off that sector.

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Kyle Caldwell: How does the weight-loss trend fit in within the sector? Obviously, the two main beneficiaries of that are Eli Lilly and Co (NYSE:LLY) and Novo Nordisk AS ADR (NYSE:NVO). Are those two companies standing out in terms of valuations?

Michael Field: Yep. So, this is a great point as well. One of the things that we commented on last year about the sector is that one of the reasons why it’s cheap is that investors automatically float to the sexiest areas of healthcare, and then they completely ignore other areas of healthcare.

So, you’ve stocks that have exposure to areas such as oncology, cancer treatments, vaccines, and many other areas that people just really had no interest in whatsoever. All the attention and the focus went to the weight-loss drugs, as you mentioned.

There’s been a kind of tete a tete between Eli Lilly and Novo Nordisk, and it’s like watching two race cars where one slightly pulls ahead of the other, and then the other one slightly pulls ahead again, and it’s very difficult to call a winner on it.

I think Eli Lilly have been stealing a march to some degree, but you’ve seen a bit of a comeback from Novo recently where the latest efficacy on their drugs, the pill for Wegovy, is that it’s almost as good as the injectable that they had been selling recently. If they can have an efficacy rate as good as the injection, then their market could massively expand in terms of the people willing to take it, right? Not everyone wants to use injectables every single day.

So, to answer your question about valuations, we don’t see much value in Lilly. We do see a lot of value in Novo, and why that’s interesting is that if you had asked me this question a year and a half ago, I would have told you that Novo’s massively overvalued and don’t buy it, basically.

But we’ve had a huge sell-off in Novo since, and it’s come back to that point [where] we think it’s interesting again. But in a contrarian way, that if I look at the rest of the street, the brokers out there, they’re all saying, it’s overvalued at the moment, which makes it even more interesting in my view.

Kyle Caldwell: We’re next going to move on to luxury goods. Could you first explain what types of businesses fit into that sector?

Michael Field: Luxury goods itself is a subsector of consumer, right? I spoke about how healthcare was the cheapest sector in Europe, but if I look at consumer discretionary and consumer cyclicals, they’re the next cheapest sectors collectively in Europe. Basically, no one wants anything to do with the consumer generally.

You could speak about almost every facet of consumer, and it’s all looking bad at the moment. People have less money in their pockets. Inflation was high for a long time. It’s coming down, but it’s still 3.8% in the UK. And people are feeling that on the street, that just everything’s expensive, and consumers are spending less as a result.

So, consumer hasn’t been a good place to be the last couple of years, and this year’s no different. Hopefully, that’ll change relatively soon, but it might take some time.

And then luxury goods slides into that segment. Initially, if you had asked a couple of years ago, ‘If I have to invest in consumer, where should I be?’ The answer would have been that luxury goods is a very clever place to invest because the consumers of luxury goods, generally speaking, are less price-sensitive than regular retailers and clothing manufacturers, etcetera.

So, while Primark (owned by Associated British Foods (LSE:ABF)) and Zara (owned by Industria De Diseno Textil SA Share From Split (XMAD:ITX)) and companies like them are fighting it out with each other and having sales and promotions, Burberry Group (LSE:BRBY) and Gucci (owned by Kering SA (EURONEXT:KER)) and companies like them don’t need to compete at the same level because their consumers generally have money anyway, regardless of whether we’re in a recession or whether we have high inflation, etcetera. That’s the thesis.

But that has coincided with a cyclical downturn in consumer, which is what we’ve seen for the last almost two years now, where people have just been buying less luxury goods as well. The fear initially was that it was China, but it’s happening in the US and it’s happening in Europe too.

But the good news is that our analysts now think that we’ve hit the bottom of that and we’re on the way up again, and despite fears about it being a structural issue, with people saying that people are just not going to buy luxury goods anymore and they’ve moved away from them, others are saying, no, this is cyclical.

We’ve seen it happen many times before, and these companies that I mentioned that are selling goods at higher price points and to more affluent customers, they’re going to stay around, and those brands are strong.

Kyle Caldwell: It’s been put to me that luxury goods are quite a defensive sector, but as you’ve mentioned, they are very vulnerable to a slowdown in economic activity. Could you explain why over the past couple of years there’s been a slowdown, which has been a headwind for that sector?

Michael Field: Yep, and this is the difference between theory and reality, right? We’ve touched on a couple now, but healthcare, for instance, I mentioned that’s traditionally a defensive sector, and that hasn’t been working out. Over the last couple of years, it’s done badly for mainly other factors.

And then consumer as a whole as well. One of the things we were saying before is about buying companies with strong brands, multi-brands, as we would say. So, companies like Nestle SA (SIX:NESN) and Danone SA (EURONEXT:BN) and companies like this, we've said these are the companies that can increase prices even if inflation’s high and people will still buy them. That worked out for a couple of years, but we’re in a very strange period economically where inflation’s been high for ages, and, eventually, that thesis breaks apart. Yes, for a year or maybe a year and a half or two years, they can increase prices and consumers will just pay up. But eventually, you get to a point where the consumer is basically just tapped out. So, that explains most consumer goods.

With luxury goods, what we’ve seen is a real bifurcation over the last year or two between the really high-end luxury goods brands and the lower- to mid-tier brands. So, for a while, what happened was that luxury goods companies were trying to sell to everyone, and they ended up bringing in this group of people who maybe wouldn’t normally buy luxury goods, but they’re aspiring to be affluent, the aspirational class of people.

Sales to those people fell off because they’re more price-sensitive than the real affluent people. So, that’s number one, but I think also what you had is the start of things where, during the pandemic, people spent loads of money on clothes and things while they were cooped up at home, and that set the bar really high.

Then, after the pandemic, people just started buying less, and then you had issues in China as well with government and gift giving and things like this where luxury goods just fell out of favour. So, to some degree, I’m going to use the word ‘fashion’ here, but it’s just literally out of fashion at the moment. Luxury goods just don’t have that sense of priority in people’s placing of how they want to spend their money currently.

But, again, our analysts feel this thing is cyclical, and that we’re slowly moving out of that. The caveat here is that it isn’t the case that every luxury stock is going to recover, and you can buy whatever you want, and it’s going to be great.

But what [our analyst is] saying is that if you buy certain brands, like Kering, for instance, that own Gucci, that’s got a lot of upside, that’s a really strong brand. Whereas on the converse, she’s taking the numbers down a lot for Burberry, and saying, I don’t think that brand’s going to recover to the same degree as the higher-end ones.

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Kyle Caldwell: The third sector that you’re going to talk through that stands out in terms of its valuations is industrials. Could you first give a brief overview of the sector and then highlight some stock examples that are looking potentially mispriced?

Michael Field: Yep. So, industrials is a hugely broad category. I used to be an analyst on this, covering a couple of sub-sectors, so I know. But it encompasses everything from testing inspection certification stocks and defence stocks, to more industrial conglomerates, electrical companies as well, the ones supplying data centres and things like that.

So, it covers a huge range of areas. If I look at the sectors as a whole, industrials is basically the second-most expensive sector in Europe. We think the sector itself is overvalued, but if you delve within that, there’s more pockets of value.

So, I mentioned the ‘tick’ stocks, the testing stocks. It’s a niche area. You have companies like Bureau Veritas SA (EURONEXT:BVI) in France or SGS in Switzerland or Intertek Group (LSE:ITRK) in the UK, and they test products and services, etcetera, and charge a fee for doing so.

They’ve been - I’m hesitant to use the word recession-proof - but that’s kind of what they’ve been for a while now. So, we see some gaps in the market for those stocks, they’re looking a little bit cheaper than they have done previously, so that's quite a positive.

And then defence is the other one I touched on, that we’re always dying to talk about, but defence is an area that we’ve been increasing our numbers all the time on, and so has the rest of the street, ultimately.

But despite the run-up in those stocks over the last few years, we still see loads of upside. If I look through our list of defence stocks in Europe, it’s mainly four or five stars at the moment. Even the stocks that have had a huge run, so Rheinmetall AG (XETRA:RHM), the big German munitions and aerospace and defence company, still has huge upside from here, and the same with BAE Systems (LSE:BA.) in the UK as well, we still see lots of upside here.

To give you a very brief synopsis on it, if you’re asking why defence stocks are still looking attractive, it’s essentially because people underestimate how much weaponry Europe and NATO members have already given Ukraine. Even if the war stopped tomorrow, it would take 10 years to restock everything that Germany has given to them. So, automatically, even taking into account the war stopping tomorrow, you should see Rheinmetall still having a full order book for the next 10 years, basically, just supplying this.

So, that’s not a short-term story, it’s not a medium-term story, it’s almost a long-term story at this point. So, again, this comes back to maybe why when you see a sector’s overvalued, there’s lower-hanging fruit elsewhere, certainly on a sector basis, but if you delve into the sub-sectors such as defence, for instance, you can find some really interesting opportunities.

Kyle Caldwell: For retail investors, a danger is identifying a theme too late in the day. In terms of defence, we’ve seen some defence exchange-traded funds (ETFs) launch over the past year or so. But, in your view, despite the sector having had a good run, there’s more upside potential. So, what would be the warning signs that that sector has potentially run its course and there might be a pullback?

Michael Field: Ultimately, it comes down to when valuations get detached from reality. Which sounds very simple, but maybe in reality, that’s more difficult to establish. I think it’s hard even for me, and I’ve been speaking about defensive conferences and things like this for the last year or so, and wondering the same myself.

If I’m talking about it at a conference, is it already too late for people to start jumping on the bandwagon? But what I’ve been learning is, when something has momentum behind it, it can go on for quite a while. And there’s a difference between momentum and actual underlying fundamentals, right?

If I look across artificial intelligence (AI) at the moment in the US, or even in Europe as well, valuations are getting rich at the moment.

If I look at, say, the Mag Seven, which you mentioned at the opening, our thoughts on the Mag Seven are very varied. It’s not a ‘you should buy everything’. It’s a case of maybe Google (Alphabet Inc Class A (NASDAQ:GOOGL)) looks attractive, Apple Inc (NASDAQ:AAPL) doesn’t, Meta Platforms Inc Class A (NASDAQ:META) doesn’t. So, it’s a very mixed picture. NVIDIA Corp (NASDAQ:NVDA) doesn’t either. So, we’re saying already that half the Mag Seven are fairly valued or overvalued at this point.

So, yes, you can get excited about AI as a theme, but should you be buying an AI ETF at this point? You should really be looking at the underlying holdings and deciding on an individual basis. Would I really like to hold this stock? Would I really like to hold that stock as a result?

I think that’s the key difference. If I look at defence currently, yes, there’s some stocks that are overvalued, but on the whole, most of those stocks are hugely interesting, and still have a lot of upside. So, from that perspective, you continue to ride the wave.

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Kyle Caldwell: That goes back to the point you made earlier regarding if a sector is looking overvalued, it doesn’t mean the entire sector is. You can find potentially undervalued stocks within it. And vice versa, if it is a cheap sector, you really need to look under the bonnet because some companies in that sector, they’ll be cheap for all the wrong reasons.

Michael Field: Absolutely, and that’s what you want to avoid, those value traps. Consumer, for instance, is a really good example of that. The whole sector’s cheap. There’s maybe one or two sub-sectors that are up with events ultimately, but for the most part, you can pull out a million examples of cheap consumer stocks.

But the problem is when people ask me how long a stock will take to correct. I tell them that I thought it would correct two years ago, so who knows? Who knows if it’s ever going to correct with some stocks.

And that’s what you really need to know what you’re buying as well. It’s always a danger as well when we come to this point in the cycle, that we’re in the tail end of a bull market, and it gets harder to find really good opportunities in a bull market [and] all the good stuff gets bought immediately. The danger, like you said, is that it’s the not-so-good stuff that’s left over at the end. And that’s why, like you said, you need to look under the bonnet.

Kyle Caldwell: That’s all we have time for today. Thanks to Michael, and thank you for listening to this episode of On the Money. If you enjoyed it, please follow the show in your podcast app. And if you get a chance, leave us a review or a rating in your podcast app too. We love to hear from you.

You can get in touch by emailing OTM@ii.co.uk. In the meantime, you can find more information and practical pointers on how to get the most out of your investments on the interactive investor website, ii.co.uk. I’ll see you next week.