Susan Dziubinski: Hello, and welcome to The Morning Filter. I’m Susan Dziubinski with Morningstar. Every Monday morning, I sit down with Morningstar Research Services Chief US Market Strategist Dave Sekera to discuss what’s on his radar this week, some new Morningstar research, and a few stock picks or pans for the week ahead. So good morning, Dave. The first thing on your radar this week is what happens next, after Iran’s air attacks on Israel over the weekend.

What impact could this have on markets this week?

Dave Sekera: Hey, good morning, Susan. Well, really, it just depends on what happens from here on out. So in my view, if Iran is finished with this retaliatory strike and assuming Israel doesn’t then now try and attack Iran, I think the scope here will be really pretty limited for the US markets. In that case, I think people are just going to focus on earnings and outlooks this week, however, if there is any further conflict either from either side and especially if that conflict were then to start widening out, I would look for US Treasury prices to rise, meaning that bond yields would fall. The stock market would sell off as investors look to derisk their portfolios.

Of course, in the oil markets, you’d see a much higher premium for oil prices. And then also I think gold would see a safe-haven bid. Fortunately, this morning it looks like that is not happening. We’re actually seeing a nice bounce here in the equity markets. And things are definitely looking like they’re starting to normalize after Friday’s selloff.

Read: Q2 Stock Market Outlook

Dziubinski: Earnings season you mentioned continues this week. And we have many regional banks reporting. In general, what would you want to hear about from the regional banks?

Sekera: Well first of all is going to be guidance for net interest income. Especially in light of interest rates have been going up this past quarter. I also want to hear about what’s going to happen with the amount of embedded losses that they may have in those securities that they’ve held, and they’re held to maturity accounts. Yeah, I suspect a lot of the regional banks have probably hedged out their interest-rate risk there, especially from the turmoil that we had last year. But if they haven’t hedged out that interest-rate risk, and if we see those embedded losses in those hold to maturity accounts really start increasing as a percent of capital, yeah, I could see those specific regional banks selling off, and in some cases selling off pretty hard. Of course, commercial real estate exposure and outlook is always going to be top of mind here. Are we seeing an increase in loans going into their special mention accounts or an increase in defaults? Or are we still kind of in this steady state of commercial real estate where it’s continuing to weaken but not weaken any faster than what people are currently expecting? And then it’s not as much of a thing to watch anymore, but again, we still need to monitor deposits and see if there’s any further deposit loss.

Dziubinski: Now, we’ve talked about one of the largest regional banks, U.S. Bancorp, ticker

USB , on The Morning Filter several times. What does Morningstar think of that stock heading into earnings?

Sekera: Yeah. So US Bank is interesting in that it is a mixture of being a large bank but not as large as the mega banks, but certainly being larger than the regional banks. So it does have a mixture of both of those characteristics. This is a bank that we’re very comfortable with its balance sheet.

It is a 4-star-rated stock, trades at a 22% discount to our fair value. Has a 4.5% dividend yield. It’s got a wide moat, medium uncertainty. You know one of the few stocks that we do rate with exemplary capital allocation. So U.S. Bank has been and actually still is one of our top banks among the US regional banks. It is the only one we rate with a wide economic moat. And we do have a good comfort level with its ability to mitigate the deposit loss it had had.

Dziubinski: Now, what the regional banks stand out to you today and why?

Sekera: The two probably that stand out the most are going to be Comerica and [KeyCorp]. These are two of the regional banks that our analyst team has noted in the past have probably higher than average earnings risk among the other regionals. So when I look at Comerica, it is the most undervalued of the regional banks.

So 4-star-rated stock. Trades at a 30% discount. Has over a 5% dividend yield. Narrow economic moat but does have a high uncertainty. So what we’ve noted here on Comerica, it does have pretty high commercial real estate exposure. But the exposure it does have in commercial real estate, it’s actually on the low side for the amount of office exposure.

And then KeyCorp is a bank we rate with no economic moat. Also a high uncertainty. Also a 4-star-rated stock at a 23% discount. And then with Key, really the issue here, does have the most exposure to the investment banking business of the regionals. So that will be a benefit when investment banking activity picks up, which, that should happen in a much more normalized environment. But at this point, it’s just still a very especially cloudy outlook for investment banking over the next couple quarters.

Dziubinski: Now we also have Netflix reporting this week. Now, the company put up some outstanding numbers last quarter. And the stock’s having a pretty good year. What’s Morningstar’s take on the stock heading into earnings?

Sekera: Yeah Netflix is one of these stocks, I mean, it often trades well into the territory that we consider to be overvalued. When I look at the chart here, back in late 2021, it was a 1-star-rated stock. It’s dropped pretty precipitously in 2022. Fell all the way down into 4-star territory. And as you mentioned, it’s now having a really strong year after that fourth quarter. But it’s now shooting into that overvalued territory. So it is a 2-star-rated stock at a 47% premium. It did have very strong subscriber growth last quarter, but we think the market’s pricing in too much subscriber growth for too long. Our analyst specifically noted that he thought that those catalysts that led to those outside gains last year are starting to subside here in 2024. So this is a stock that I would be very concerned that, if they missed market expectations, you could see a pretty good selloff here.

Dziubinski: Now we also have healthcare giant Johnson and Johnson reporting this week. J&J was in the news earlier this month when it announced plans to acquire Shockwave Medical, which will expand its medical-devices segment. The stock’s been a pretty sluggish performer. What does Morningstar think of it today?

Sekera: So it’s currently rated 4 stars, trades at a 10% discount to fair value and slightly over a 3% dividend yield. And this is a stock I would note that historically not very often does it trade into the 4-star territory. In my view, I think this is a core holding type of stock. It is a company we rate with a wide economic moat and a low uncertainty. As far as the Shockwave acquisition goes, according to our analyst team, it looks like a pretty solid tuck-in, should bolster growth in their medical-devices division. But it was not necessarily large enough in and of itself to move the needle on the valuation.

Dziubinski: Now what other companies that we’ve talked about before on the show are reporting this week that you’re keeping an eye on?

Sekera: Well, first of all, I have to point out P&G. Procter & Gamble. Again it would be another core holding type of stock, but unfortunately we think it’s overvalued. Wide moat, low uncertainty. They just bumped up their dividend yield. So it is a company that I would keep you on your watchlist here. But currently 2 stars. 10% premium.

And then Crown Castle is the other one I’m watching. So our analyst team just added this to our quarter’s top picks this past quarter. For those of you that don’t know Crown Castle, it’s a REIT that owns cellphone towers. My opinion, I think that’s probably a pretty defensive real estate play right now. It’s a 4-star-rated stock with a narrow moat and a 6.1% dividend yield.

Dziubinski: And also this week we have several Federal Reserve presidents making speeches. Why is their talk something that you have on your radar this week?

Sekera: Yeah. In fact, when you look at the 12 voting members, I think seven of them are out giving public commentary this week. And really, what it does is it provides them with the opportunity to be able to provide to the market their own views as to inflation and monetary policy. So I think the market’s going to be listening to their commentary.

They’re going to try and ascertain what these individual governors, specifically the voting members, are watching most closely and try and listen for clues as how they might vote at future fed meetings, depending on how inflation and economic metrics pan out over the next couple of months.

Dziubinski: Well, that’s a good segue into the new Morningstar research portion of our show, Dave. Let’s talk about Morningstar’s reaction to that higher than expected CPI number that came out last week and sent the market reeling. First, what did Morningstar think of the number? Was it as bad as the market thought?

Sekera: Well, I think first of all, we just have to admit inflation has been stickier than what we’ve been projecting otherwise. But yeah, according to our economics team, it’s just not yet time to panic. So the real test if going to be later this month. We’ve got the personal consumption expenditures coming out. And of course, PCE is the Fed’s preferred measure. Now we’ve noted a couple of times and Preston always highlights, the PCE does use some different weightings, a couple of different calculations, different data sources than CPI and PPI. So based on some of the CPI data, based on some of the PPI data, he’s still forecasting core PCE of 0.2% a month-over-month basis. And if it comes in at that 0.2%, I think the market’s going to breathe a sigh of relief at that point.

Dziubinski: Now back to the CPI number. We also see that housing is a substantial contributor to that stickiness of inflation, right?

Sekera: Yeah. So shelter’s definitely been one of the areas that has been stickier or higher than what we have expected. Now in this case, Preston is watching some real-time indicators for rent prices, and he notes that, over the past couple months, that has been slowing. So that should begin to show up in the inflation metrics sometime over the next couple months. It’s just hard to exactly pinpoint when that flows through.

Dziubinski: So were there any silver linings in that report?

Sekera: So we saw a goods deflation. So core goods ex food prices actually averaged a negative 1.4% on an annualized basis, so for the past three months ending in March. And we are seeing disinflation there. So according to Preston yeah he still thinks that there has a lot more room to run as far as durables deflation goes as we get back toward more prepandemic type of trends.

Dziubinski: So then a day after those CPI figures came out last week, we had PPI numbers released that were more in line with what the market was expecting. So given that, what’s Morningstar’s takeaway today on inflation?

Sekera: Yeah, I mean, again, we have to admit inflation has not come down as fast as we originally had forecast. But based on the underlying fundamentals, we still forecast inflation will continue to keep moderating over the course of the year.

Dziubinski: So we had three of the big banks reporting last week. And we’d want to hear your take on what you heard. Let’s really start with J.P. Morgan. The bank reported better than expected first-quarter revenue and profits. But the stock fell hard on Friday after J.P. Morgan gave disappointing guidance on 2024 interest income. Was Morningstar’s surprised by this guidance?

Sekera: Well, I’d say no. We weren’t necessarily surprised. In fact, prior to earnings, our rating on J.P. Morgan was 2 stars. The stock was trading at a 16% premium. It did gap down 6.5%. The market was looking for an improvement in guidance in that net interest income, which certainly didn’t happen. And I think that was really the catalyst to push the stock down.

Dziubinski: So why is net interest income a driving force for the bank’s earnings over the shorter term? And what should investors expect on the earnings front going forward?

Sekera: Specifically, part of the reason that we did view J.P. Morgan stock as overvalued is that we currently think it’s already outearning its normalized level of net interest income. Their balance sheet is materially more asset-sensitive than a lot of the other large banks. So we do think it will experience the most pressure going forward on their interest income line when interest rates decline.

Dziubinski: So did Morningstar make any changes to its fair value estimate after earnings? And what do we think of this stock after the pullback?

Sekera: We held our fair value pretty steady here. It’s still a 2-star-rated stock, and it trades at a 9% premium to fair value.

Dziubinski: Now we also had Wells Fargo and Citi report earnings on Friday. So fill us in on what Wells Fargo’s earnings and forecasts looked like. Any surprises and any changes to our fair value?

Sekera: Again, no surprises at Wells. Management guidance for the year was unchanged. Our $58 fair value was unchanged as well. Yeah, I would note Wells Fargo was one of our top stock picks for most of 2023. But at this point, it’s up 45% from its October lows. So it’s currently trading in that range that we consider to be fair value at 3 stars.

Dziubinski: And what about Citi? Good news there, right?

Sekera: I don’t know if I would necessarily characterize it as good news. But we look at Citibank is really being a value play because it trades below its tangible book value. So in this case, all we really needed to have was just not bad news. I’d note, Citibank is still in that transitional period as it’s looking to cut expenses. But we do think that they should have some better margins in the second half of this year as their cost base starts to decline.

Dziubinski: So any changes here to the fair value estimate after earnings, and how’s the stock look? Still undervalued?

Sekera: No change to the fair value. It is the most undervalued of the mega banks. Trades at a discount to tangible book value. So it’s a 4-star-rated stock at a 12% discount. But I would caution, it is a company that we rate with no economic moat. So again trading at a good margin of safety from fair value. But once it moves up, this might be a stock where at that point you take some gains off the table and move into more core type holdings that do have economic moats.

Dziubinski: So now, in nonbank earnings news last week, Constellation Brands reported earnings, and the stock popped. What did Morningstar think about earnings, and what do we think of the stock today?

Sekera: Again no change to our fair value estimate. Our analyst team noted that the results and the management outlook both came in within our forecast. For this year, we’re looking for 6.4% sales growth. We’re looking for earnings of $13.70 per share. So it does trade at a slight discount of 5% to our fair value. But that does put it still in that range of 3 stars. It is a company with a wide economic moat and medium uncertainty. So I would still keep this one on your watchlist for a pullback and be able to look to either start or build positions if it does trade at a decent margin of safety, if we do see any kind of market selloff.

Dziubinski: Let’s move on to the picks portion of this week’s program. Today you’ve brought viewers six stock swaps to make in a couple of overvalued sectors. The idea here is Morningstar thinks these sectors are overvalued. So if you want to maintain your exposure to this given sector, you can reduce your price risk by selling overvalued stocks in the sector and buying undervalued ones.

So the first expensive sector is industrials. So Dave, first tell us what three overpriced stocks in that sector are the sells?

Sekera: And in fact even within industrials I would note it’s really that transportation sector that’s the most overvalued. And in fact for whatever reason it actually has some of the most overvalued stocks under our coverage today. Now in this case it’s not a case of bad companies or poor fundamentals, but just the fact that valuations, in our opinion, have gotten too far ahead of themselves.

So the first one is going to be Southwest Airlines. 2-star-rated stock at a 45% premium to fair value. They have been able to benefit over the past couple years from that pent-up demand for travel during the pandemic. But that’s unlikely to last. We think a lot of that pent-up demand at this point is now satisfied.

So we really look for them to have to pick up additional market share in order to be able to justify their valuations. But, in this kind of low-cost environment for airlines, for the low-cost competitors, I think that’s going to be increasingly hard really for them to be able to generate at this point.

And the other thing, too, is I would note, according to our analyst team, we don’t think the revenue is going to keep up with their expense growth. So one that definitely has some headwinds ahead of it. The second one is going to be XPO Logistics. Growth fundamentals here have been great. XPO gained a lot of market share, a lot of new business, after competitor Yellow Freight filed bankruptcy last year. However, this is really just going to be a one-time pickup in growth. We don’t think that that’s going to be sustainable. Trades at a 57% premium to our fair value, 1-star-rated stock with no economic moat.

And then lastly, Caterpillar, again, it’s another one of these ones—I think it’s a really good company. We rate them with a wide economic moat. Good fundamental outlook. I mean, the company’s really going to be poised to benefit from infrastructure spending, construction spending, here in the short term. But when I look at, over the more medium term, we do think that infrastructure spending will start to probably slow down and normalize in 2025 and thereafter. A lot of that, just because the government stimulus programs that’s keeping that infrastructure spending high today will end up beginning to fade as they roll off. So 1-star-rated stock and trades at a 58% premium to fair value.

Dziubinski: So Dave, let’s go through the three undervalued stocks in the industrial sector to buy instead. The first one on your list is 3M, which is one we’ve talked about a bit on the show before. Remind viewers why you like that one.

Sekera: You know it’s interesting. So between the legal liabilities they have and some relatively weak results they’ve had in China in the short term, 3M has actually had a rough couple of years. When I look at this stock chart, I’d note that it’s fallen almost 50% from its high in May 2021. But they’ve actually been undergoing a number of different corporate actions over the past year in order to really right the ship here.

They’ve done things like spin off businesses. They brought in some new management. So in this case, I like it because the valuation here really isn’t based on necessarily a big material improvement in the near term. But looking at just the stock having fallen too far. So for example the stock currently trades at only like 14 times our 2024 adjusted EPS. So I think pretty conservative valuation and again looking for improvement in the business but not any kind of necessarily big ramp up in the short term. It’s a 3-star-rated stock. So it does trade at a 12% discount and a 6.5% dividend yield, and is a company we rate with a narrow economic moat.

Dziubinski: Now your second undervalued stock to buy in the industrial sector is RTX. Now this one isn’t really a screaming buy, but it is undervalued. Why do you like it?

Sekera: Yeah, it does trade at a 11% discount. Just puts it into that 4-star territory. Company with a wide economic moat. So what I’d note here is that, as far as like the defense companies go, Raytheon is actually split probably about halfway between its commercial business and its defense business. And according to Nic Owens, who is the analyst that covers it, he thinks that there’s actually a lot of negative sentiment among the defense companies right now, specifically due to uncertainty surrounding the federal budget for 2025 and exactly how the priorities within the defense budget are going to shift.

So I think a lot of negative sentiment there has really pushed down the stock overall. Now, on the commercial side, you know, Collins is one of the largest aircraft component suppliers. You know, it’s Pratt and Whitney division we think is really at the early stages of a long ramp up for delivering thousands of jet engines over the next couple of years.

And in the defense side, Raytheon provides missiles, missile defense, secure communications, which, you know, unfortunately, this past weekend really shows the benefit that they have. So again, that’s just a company that we think is poised to do well over the next couple of years.

Dziubinski: And then your last undervalued industrial stock pick is Chart Industries. This one’s pretty deeply undervalued, at least relative to its sector. Tell us about it.

Sekera: Yeah probably underfollowed and pretty unknown company. The company does provide cryogenic equipment and distribution for industrial gases as well as liquefied natural gases. Small-cap stocks are definitely one you need to do your homework on. But trades at a 23% discount, puts that well into 4-star territory. For dividend investors, I would note they do not pay a dividend, so if that’s something you’re concerned about, I just wanted to highlight that. It is a company that we rate with a narrow economic moat. And what I really like here is, according to Steven Ellis, who’s our analyst that covers this name, he thinks that the consensus estimates on the street are just too low. So we are looking at this company at having a good combination of fundamental underlying growth here in the near term, as well as a tailwind that as the street catches up to management guidance and brings their numbers up, we think that’s going to help that stock as well.

Dziubinski: So those are the swaps to make in the overpriced industrials sector. Now we’re moving on to another overpriced sector. And that’s technology. That also looks overpriced relative to our metrics. Which highly overpriced stocks in the tech sector should investors consider selling to take some price risk off the table?

Sekera: It’s interesting: All three of these stocks are stocks that we have a different opinion than the market. I think the market is looking at these as being plays on artificial intelligence, which for these specific companies, we’re just not seeing. So if I look at Dell: That’s a 1-star-rated stock. It’s over double our fair value. That stock’s up 54% year to date. Again the market’s pricing it like an AI play, but we just don’t necessarily see it.

IBM: 2-star-rated stock, 31% premium to fair value. We’ve talked about this one a number of times. When I look at how this company’s done over the past 10 years, looking at the decline in their revenue, it’s really kind of been a melting ice cube here. But yet that stock has surged over the past six months. But looking at the numbers here, we’re only looking for like 2% to 3% top-line growth. Only 5% to 6% earnings growth. So we’re just not necessarily seeing why the market’s applying as high of a valuation as they are.

And then Western Digital: another 1-star-rated stock. Trades at a 70% premium. That stock also up 38% year to date. But when we look at the data storage business, overall we think it’s just a commodity business and that they’re not going to necessarily get the kind of earnings growth that I think the market it’s currently assigning to it.

Dziubinski: So now let’s talk about the undervalued stocks in the tech sector that investors can buy to maintain that tech exposure. Your first pick here is Zoom Video Communications. Now of course this stock price peaked during the pandemic and then has then plummeted shortly thereafter and really hasn’t done much over the past year. Why do you like it today?

Sekera: Yeah, as you mentioned, I mean that stocks just skyrocketed in 2020. This business really surged those first couple months and even first year following the pandemic. I mean not only did they go up into that 1-star territory, but I think the stock price was trading at multiple times what our fair value was at that point in time.

But yet when you see kind of with those highfliers, once growth began to slow, that stock cratered. Yeah, I think it’s fallen a total of 90% since its peak in November 2020. But now the pendulum has swung too far the other way. And I think our forecasts here look relatively conservative. We’re only forecasting a 4% five-year compound annual growth. We’re even forecasting the margin to contract over the next couple of years. But yet, even with those forecasts, it’s trading at a 30% discount and puts it in that 4-star territory.

Dziubinski: Now another undervalued tech stack you like is Cognizant Technology Solutions. Tell us about it.

Sekera: And this is one that we actually look at as being kind of a second derivative play on artificial intelligence. So the thesis here is that most small-cap, most mid-cap companies aren’t going to have the expertise or the financial wherewithal to be able to develop, build, train, and then roll out their own artificial intelligence programs. And in order to do that, they’re going to need to hire outside consultants to help them do that. So this stock trades at a 26% discount. It’s a 4-star-rated stock. And that is a company we rate with a narrow economic moat. So we do think that does have some good tailwinds behind it to be able to generate revenue growth based on that AI.

Dziubinski: And your last pick this week is Teradyne. Really attractive discount for a wide-moat tech stock. What’s the market missing here?

Sekera: Well, the market’s just so hyperfocused on anything that they can attach the artificial intelligence label to that I think Teradyne has really just slipped through the cracks here. I mean, the company provides testing equipment for semiconductors. In fact, our analyst team notes that they’re only one of two companies that produces that testing equipment that’s needed for the most cutting-edge semiconductors today.

We’ve noted the company does have a very strong relationship with both Apple as well as Taiwan Semiconductor. It’s a company with a wide economic moat, trades at a 22% discount, which puts it in that 4-star territory. So again, for people looking for some large-cap, wide-moat exposure in the tech sector, this is probably one of the better picks.

Dziubinski: Thanks for your time this morning, Dave. Viewers interested in researching any of the stocks that Dave talked about today can visit Morningstar.com for more analysis. We hope you’ll join us for The Morning Filter again next Monday at 9 a.m. Eastern, 8 a.m. Central. In the meantime, please like this video and subscribe to Morningstar’s channel.

Have a great week!