U.S. Equity Outlook
We're still bullish, even if a recession is under way.
Morningstar's staff of more than 120 equity analysts focus on understanding the competitive strength of individual firms and the structure and development of their industries. In turn, we develop expectations for free cash flow generation and estimate fair values for individual companies. Whilst it is a bottom-up approach, we think it can yield valuable top-down insights.
Indeed, taking our individual calls together, we still believe the U.S Equity market looks cheap. The chart below shows the median ratio of stock price to Morningstar's fair value estimate for our coverage universe since 2001. Lately, we've been at 2001-02 levels--another period that turned out to be a good time to put cash to work by buying stock in risky but productive enterprises.
Economic growth in the States has slowed significantly in the past year, and a recession could well be under way right now. But getting bullish in an economic slowdown can make a lot of sense. The S&P 500 Index is included in the index of leading economic indicators for a good reason. Stock prices tend to drop before recessions start, remain weak in the early stages of a recession, and then go up before recoveries begin. That's why, since World War II, an explicit strategy geared to putting cash in the stock market only at the beginning of recessions would have significantly outperformed putting cash into the market continuously.
There are, however, a few caveats: Although we think the U.S. equity market looks cheap, a turnaround may require patience, and certain factors could affect our fair value estimates as events unfold. For example, the economic slowdown may be longer, deeper, and have a more dramatic impact on our revenue and cash flow assumptions than we currently expect. We've been shaving expectations for revenue and cash flow in 2008 for many of our companies, but our forecasts could still be too high. In turn, persistently higher inflation could mean that our discount rates are too low, and our fair value estimates too high.
But in the cash flow analysis that drives our fair value estimates, longer-term expectations drive much of the value we see in individual enterprises. No method is perfect when estimating fair values for stocks, but our approach can be especially valuable in times of economic slowdown. The market may be too focused on immediate issues, and our fair value estimates are anchored by our longer-term expectations. We've taken a close look at them, and they appear reasonable.
The Market, Sector by Sector
Looking across our coverage universe, each of the 12 main sectors appears undervalued, just as they did last quarter. In other words, we still think there's a lot of value out there, and in a lot of places.
| Sector | Current Median Price/Fair-Value |
Three Months Prior |
Change (%) |
|
|---|---|---|---|---|
| Business Services | 0.93 | 0.88 | 6.2 | |
| Consumer Goods | 0.88 | 0.89 | -1.4 | |
| Consumer Services | 0.83 | 0.78 | 6.6 | |
| Energy | 0.87 | 0.93 | -6.0 | |
| Financial Services | 0.88 | 0.88 | -0.5 | |
| Hardware | 0.91 | 0.85 | 6.7 | |
| Health Care | 0.88 | 0.90 | -2.3 | |
| Industrial Materials | 0.91 | 0.90 | 1.4 | |
| Media | 0.98 | 0.91 | 7.6 | |
| Software | 0.92 | 0.88 | 4.1 | |
| Telecommunications | 0.86 | 0.90 | -4.3 | |
| Utilities | 0.98 | 0.93 | 5.4 | |
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| Data as of 13-06-08 | ||||
Cyclical Sensitivity
Here's another way to start looking for ideas. We cover about 2,000 companies in the 12 main sectors listed above. There are more than 100 identified subsectors, each with its own competitive dynamics as well as sensitivity to economic cycles. Much of the undervaluation we're seeing in the overall market appears to be driven by companies in subsectors that are sensitive to the economic slowdown. The median price/fair-value ratio for 35 subsectors we identified as economically sensitive comes in at 0.85, for example, significantly below the median ratio of 0.91 for companies in the other sectors in our coverage universe.
Looking at the financial data and the projections underlying our fair value estimates, we expect better improvement in revenue growth in the cyclically-sensitive subsectors in the U.S. than in other sectors in the next two years. The cyclically-sensitive sectors also had greater margin erosion in the last two years, and we expect better margin improvement in the cyclically-sensitive sectors than the other subsectors in the next two years. That's not to say that there aren't good investments in areas that are insensitive to the business cycle, but in aggregate, the cyclical sectors may offer more opportunity.
Here's a look at all of these subsectors and the median price/fair-value ratio for each of them.
