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Every week, Kyle Caldwell and guests take a look at how the biggest stories and emerging trends could affect your investments, with practical tips and ideas to help you navigate your way through. Join the conversation, tell us what you want us to talk about or send us a question to OTM@ii.co.uk. Visit www.ii.co.uk for more investment insight and ideas.
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, what has played out year to date is that from mid February to early April, those seven companies along with the technology sector and also the wider market suffered from US tariff uncertainty.
Kyle Caldwell:We now know with the benefits of hindsight that a stock market recovery started taking place from the April 8 onwards, and as a result, the markets recovered. Magnificent Seven and the broader technology sector have also recovered their poise. Now while the jury is out on whether valuations that are 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 much cheaper entry points elsewhere. And joining me to discuss three sector specific opportunities is Michael Fields, chief equity market strategist at Morningstar. So Michael, you're gonna run through why healthcare, luxury, and industrials all present compelling undervalued opportunities, and you're gonna name some stock examples within those three sectors.
Kyle Caldwell:Before we go free sector, could you give an overview of Morningstar's methodology? So those three sectors combined account for nearly half of Morningstar's four or five star ratings for the European coverage. Customers of Interact 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:Yep. Absolutely, Kyle. So the star rating system, ultimately, it starts with the analysts, right, on a bottom up basis. That the analysts do a valuation of a stock, and then they tell you this is 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.
Michael Field: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. And anything over one then is bad to simplify it because the price that it's trading at is more than what we actually think it's worth. So that's the the simple starting point. And 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.
Michael Field:They can say, look, there's only 2% upside to this utility company, but it's our top pick. Because they kinda have to say, look. This we 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.
Michael Field:And 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 I think on, the simplified basis, a three star rating means the stock is fairly valued. It's where it should be.
Michael Field:If you buy it now, you basically get the returns that you should every year, but you're not gonna experience huge upside as the stock corrects. Four stars is good. Five stars is even better. Five stars is gonna back up the truck, essentially. And then on this the opposite scale of that, two star is overvalued, and one star is very overvalued.
Michael Field:And as you correctly pointed out then, 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 by energy and four star stocks in every single sector. You're right in saying that they are concentrated in some sectors more than others.
Kyle Caldwell:And in terms of the number of companies that are a a one, two, three, or a five star, is there a certain percentage that goes into each, or does it just depends on the fundamentals? It's you know, depends on the value of the company that could be at one time quite a lot of four or five stars, for example.
Michael Field:So this is kind of what makes my job interesting and what I like about it that 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 we can actually it's out of our hands, ultimately, the the star ratings. So we can say, like, right now, 40% or more of stocks are four and five star, and that we don't see that very often is what we can kinda say. Or in the inverse of that, you can say, look, the market's mostly fairly valued.
Michael Field:There's actually very few opportunities at the moment. And then you can kind of, earnestly say that to investors then, and that kind of builds the trust, I think, as well that they say, look, you know, last year, you came to us and said there wasn't much opportunities, and now you're saying there's loads, so maybe we should listen to you now.
Kyle Caldwell:And how frequently are the star ratings changed?
Michael Field:So it's dynamic. It's it 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 up the system every day, it can give me a new star rating based on if a a share price jumped or something. I was looking at Kay for instance this morning.
Michael Field:I saw H and M was up 8%, as kind of those retail stocks can be quite volatile, and then that's currently a three star rating stock at the moment 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, look, it's fairly valued. There's no 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. So the first one you're gonna cover is health care. Could you explain why health care is looking attractive at the moment in terms of its valuations?
Michael Field:Yep. So I think I I put this up on LinkedIn recently as well. If anyone wants to follow me on that, we can we can send through the link. But I I asked the question, like, what do you think is the cheapest sector in Europe at the moment? And would you have guessed that the answer is health care?
Michael Field:And I personally, if I hadn't seen that number, would not have guessed that because, you know, we're in kind of volatile times at the moment. Right? We've been through tariffs this year, trade agreements, and still things aren't fully resolved yet as we've seen. Right? Every day we open the newspaper and we see this.
Michael Field:And yet, healthcare traditionally is a very defensive sector. It's where people go to when times are volatile and they just want stable returns and companies that are kind of doing innovative things in the background and just, you know, products that people have to buy regardless of how bad things or good things are in the economy. Right? And yet health care is the cheapest sector in Europe at the moment. It's maybe kind of 12 to 14% discount to our fair value estimate at the moment.
Michael Field:So, you know, I mentioned there's opportunities in every single sector. Even the sectors, and we'll we'll talk about this in a minute, that are actually overvalued at the moment, you can still find opportunities. But if you 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 health care. And to your question about, you know, what's wrong with health care that people are worried about, it's it's kind of a handful of things. It's like the perfect storm of events for health care.
Michael Field:So first of all, you have companies like GSK and Astra AstraZeneca, I'm taking these because maybe they're companies, you know, UK listed companies that are close to people's minds and hearts, but two big kind of global health care companies. And one of the reasons know, 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, obviously, you know, the obvious answer there is, well, the pandemic's over. Right? Why are they still selling vaccine drugs?
Michael Field:And they've got a broad portfolio of vaccine drugs. It's not just COVID nineteen, but they sold a load of COVID nineteen drugs, obviously, in 2021, 2022. And what's been happening since is when we compare the results every year, like, how is your 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, you know, they're not impressed by it. So that's number one.
Michael Field:There's still an effect of they sold 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 the health care department, he's an anti vaxxer, and he's anti big pharma person. So there's big concerns around The US where, you know, 70% of the world's drugs are sold, basically.
Michael Field:Right? 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 everything has a 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.
Michael Field:And people are always concerned about the pipelines, but investors seem more concerned than ever about those pipelines, whether they're strong enough to kind of withstand the pressures and whether they're good enough to actually keep up that sales growth in future as well. And then finally, the other reason, and it harks back to politics as well, is around tariffs. So, you know, we've seen 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.
Michael Field:And the last point on that then is that what are these companies doing about that? Well, the if you've been reading the news lately, GSK announced just last week and AstraZeneca a few weeks before them, and Sanofi, you know, a month before them, that they're building new plants in The US and investing loads of money in The US as a result. And some of this is a bit cynical. They were gonna do this anyway for new drugs, and it's all in the future. But a part of this is, you know, appeasing the president and telling them that, yes, we're following your what your advice, and we're gonna move more to The US, so please don't impose any more tariffs on us.
Michael Field:So there's this whole kind of barrage of factors at the moment. I think that's that's more than enough to put investors off that sector.
Kyle Caldwell:And how does the weight loss trends fit in within the sector? Obviously, the two main beneficiaries of that are Eli Lilly and Novo. Are those two companies standing out in terms of valuations?
Michael Field:Yep. So that's this is a great point as well. And one of the things that we commented on last year about the sector as a whole is that one of the reasons why it's cheap is that investors automatically float to the sexiest areas of health care, and then they completely ignore other areas of health care. So you've had stocks that have got exposures to areas like oncology, cancer treatments, vaccines, and many other areas that people just really had no interest in whatsoever. And all the attention and the focus went to the weight loss drugs, as you mentioned.
Michael Field:And then there's just 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. And 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. And if they can have that 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.
Michael Field:So to answer your question about valuations, we don't see much value in 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 that 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, actually, it's overvalued at the moment, which makes it even more interesting in my view.
Kyle Caldwell:We're next gonna move on to luxury goods. Could you firstly explain what types of businesses fit into that sector?
Michael Field:The luxury goods itself is a subsector of consumer. Right? And consumer consumer I spoke about how health care 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, that basically no one wants anything to do with the consumer generally. And you could speak about almost every facet of consumer, and it's all looking bad at the moment, that basically people have less money in their pockets. Inflation was high for a long time.
Michael Field:It's coming down, but it's still, you know, 3.8% in the in The UK. Right? And people are feeling that on the street that it's 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 is no different. Hopefully, that will change relatively soon, but it might take some time.
Michael Field:And then luxury goods slides into that segment. And I think 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, well, luxury goods is a very clever place to invest because the consumers of luxury goods, generally speaking, are less price sensitive than they are for regular retailers and clothing manufacturers, etcetera. So while Primark and Zara and companies like this are fighting it out with each other and having sales and promotions, you know, Burberry and Gucci and companies like this 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, etcetera. And that's the thesis.
Michael Field:That's the idea. But that has coincided with basically 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. And it's you know, the fear initially was 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're we've hit the bottom of that and we're on the way up again, and despite fears about it being a structural issue that people are saying, look, people are just not gonna buy luxury goods anymore. They've moved away from them.
Michael Field:She's 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 gonna be they're gonna 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 that there's been a slowdown, which which has been a headwind for that sector?
Michael Field:Yep. And this is the difference between kind of theory and reality. Right? We spoke about we've touched on a couple now, but, like, health care, 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 it's done badly for mainly other factors.
Michael Field:And then consumer as a whole as well, you know, one of the things we were saying before about is you buy companies with strong brands, multi brands, as we would say. Right? So companies like Nestle and Danone and companies like this, that we've said, look, these are the companies that can increase prices even if inflation's high and people will still buy them. And 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 kind of breaks apart that, yes, for a year or maybe a year and a half or two years, they can increase prices and consumers will just pay up.
Michael Field:But eventually, you get to a point that the consumer is basically just tapped out. So that that explains most consumer goods. I would say 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 then the more lower to mid tier brands. So I think for a while, what happened was luxury goods companies were trying to sell to everyone, and they ended up bringing in this whole group of people that maybe wouldn't normally buy luxury goods, but they're aspiring. They're kind of aspiring to be affluent, right, the aspirational class of people.
Michael Field:And sales to those people fell off because they're more price sensitive than, you know, 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 like this while they were cooped up at home, and that set the bar really high. And 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 and luxury goods just fell out of favor. So I think to some degree, like, I'm gonna 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 wanna spend their money currently.
Michael Field:But, again, our analysts feel this thing is cyclical, and we're slowly moving out of that. I think the caveat here is what she's saying is that, look, this isn't the case that every luxury stock is gonna recover, and you can buy whatever you want, and it's gonna be great. But what she's saying is if you buy certain brands, like Caring, for instance, who own Gucci, she's saying, like, that's got a lot of upside. That's a really strong brand. Whereas on the converse of that, she's saying, like, Burberry.
Michael Field:She's taking the numbers down a lot for Burberry, she's saying, look. I don't think that brand's gonna recover to the same degree as the higher end ones.
Kyle Caldwell:And the third sector you're gonna talk through that stands out in terms of its valuations is industrials. Could you firstly give a brief overview of the sector and then highlight some stock examples that are looking potentially mispriced?
Michael Field:Yep. So I think industrials is a hugely broad category. Right? And 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 to defense stocks is another one as well within that sector, to kind of more industrial conglomerates, electrical companies as well, the ones supplying data centers and things like this at the moment.
Michael Field:So it covers a huge range of areas. Right? And 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 actually overvalued, but if you delve within that, there's more pockets of value. So I mentioned the tick stocks, the testing stocks.
Michael Field:It's kind of a niche area. You have companies like Bureau Veritas in France or SGS in Switzerland or Intertek in The UK, And, basically, what they do is test products and services, etcetera, and then they charge a fee for doing so. So they've kind of 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 that they're looking a little bit cheaper than they had done previously, so that's quite a positive. And then defense is the other one I touched on, right, that we're always kinda dying to talk about, but defense is an area that we've been increasing our numbers all the time on, and so has the rest of the street ultimately.
Michael Field:But despite the run up in those stocks over the last few years, we still see loads of upside. And if I look through our list of def defense stocks, in Europe, it's mainly like, it's mainly four or five stars at the moment. So even the stocks that have had a huge run, so Rheinmetall, the big German munitions and aerospace and defense company, still has huge upside from here, and the same with BAE Systems in The UK as well that we still see lots of upside here. And to kinda give you the very brief synopsis on it, if you're asking, like, why defense stocks are still looking attractive, it's essentially because people underestimate how much in weapons the Europe and NATO members have already given Ukraine, that even if the war stopped tomorrow, you would it would take ten years to restock everything that Germany has given to them. So, automatically, even taking into account the war stopping tomorrow, you should see Ryan Mattel still having a full order book for the next ten years, basically, just supplying this.
Michael Field:So that's not a short term story. It's not a medium term story. It's 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, you know, there's lower hanging fruit elsewhere certainly on a sector basis, but if you delve into the subsectors like defense, for instance, you can find some really, you know, interesting opportunities.
Kyle Caldwell:Because for retail investors, a danger is identifying a theme too late on in the day. And in terms of defense, we've seen some defense ETFs launched over the past year or so. But in your view, despite the fact that the sector's had a good run, there is more upside potential. So what would be the sort of warning signs that that sector has potentially run its course and there might be a pullback?
Michael Field:Yeah. So I think, ultimately, it comes down to when valuations get detached from reality. Right? Which sounds very simple, but maybe in reality, that's more difficult to to establish. And I think it's hard, even for me, like, I've been speaking about defensive conferences and things like this for the last year or so, and wondering the same myself.
Michael Field:Like, 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 too between momentum and actual underlying fundamentals. Right? And I think the difference between, say, AI, for instance, which if I look across AI at the moment in The US or even in in Europe as well, that valuations are getting rich at the moment.
Michael Field:So if I look at, say, the Mag seven, which you mentioned at the very opening, those our thoughts on the Mag seven are very varied. It's not a it's not a you should buy everything. You know, it's a case of maybe Google looks attractive, Apple doesn't, Meta doesn't. So it's a very mixed picture. Right?
Michael Field:NVIDIA doesn't either. So we're saying, like, already kinda 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?
Michael Field:And I think that's the key difference that if I look at defense currently, yes, there's some stocks overvalued, but on the whole, most of those stocks are hugely interesting, still have a lot of upside. So from that perspective, I think, you know, you continue to ride the wave.
Kyle Caldwell:That goes back to your point earlier that you made regarding if a sector is looking overvalued, that doesn't mean the entire sector is. You can you can find potential undervalued stocks within it. And then 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 kinda what you wanna avoid, right, those value traps. And, you know, consumer, for instance, is a really good example of that, that it's cheap. The whole sector's cheap. There's maybe one or two subsectors that are kind of up with events ultimately, but for the most part, you can pull out a million examples of cheap consumer stocks.
Michael Field:But the problem is, you know, when people say, oh, how long would that take to correct? And I'm like, well, I thought it would correct two years ago. So who knows? Who knows if it's ever gonna correct with some stocks. Right?
Michael Field:And that's what you really need to know what you're buying as well. And that's always a danger as well when we come to this point in the cycle. Right? That we're in a we're in the tail end of a bull market, and it gets harder and harder to find really good opportunities in a bull market that all the good stuff gets bought immediately. And the danger, like you said, is that it's the the not so good stuff that's left over at the end.
Michael Field:And that's where really why, again, like you said, you need to look under the bond.
Kyle Caldwell:That's all we have time for today. And 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.
Kyle Caldwell:You can get in touch by emailing otm@ii.co.uk. And 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, and I'll see you next week.