The bargain hunters' guide to undervalued stocks in the coming quarter

At the same time as speculation of a likely recession continues, we are looking at a rotation back into Growth stocks. Technology in particular has staged an extraordinary comeback off the back of trends towards artificial intelligence, along with better fundamentals post cost-cutting in late 2022. But does that mean Value is out? The answer is not quite – but quality matters.

Each quarter, Morningstar’s team of equity analysts releases an outlook for markets, including those companies they identify as being undervalued. Are there bargains to be had on the ASX? You’ll need to decide for yourself, but either way in this wire, I’ll explore their top picks by sector and where they see markets heading, and take a closer look at their top pick for the most undervalued sector and two value picks in growth stocks.

The state of the nation

In short, we haven’t seen the end of interest rate hikes or persistent inflation.

Peter Warnes, Morningstar's head of equities research ANZ, anticipates unemployment numbers to hit 5% by the end of 2024, a negative read on household consumption and a technical recession by mid-2024. If there’s any positive to be had, it’s perhaps the view that the fall in house prices from higher interest rates is done and dusted.

Real estate as a whole is benefitting from migration numbers, continuing return to the office and low supply which Morningstar doesn’t anticipate will ease until at least 2025.

From the perspective of tougher times, it shouldn’t come as a surprise that the consumer cyclical sector is the best hunting ground for bargain hunters.

There has been a shift towards paying for services over goods, while consumer staples like supermarkets and liquor stores are benefiting from that increasing tightening of belts. It’s a good time for supermarkets, with an abundance of cheap generic brands. It's a considerably less positive time for premium fashion brands.

It’s also getting harder for the banks. This is despite years of strong profits. There’s slow credit growth, high refinance activity, and the maturing of fixed-rate loans to deal with.

Energy markets continue to benefit from demand and supply dynamics, with natural gas to be strong. Morningstar expects to see upstream oil and gas company earnings to half though compared to 2022 numbers.

Where the value lies

“The consumer cyclical (consumer discretionary) sector is now one of the most undervalued given growing headwinds to consumer spending. 

"Value has also improved in the healthcare sector, while many other sectors have become more expensive. Nonetheless, we see plenty of opportunities across real estate, technology, financials, energy, and communications,” says Morningstar analyst Adrian Atkins

Top-rated picks per sector

We’ve narrowed down the picks from Morningstar to the top star ratings in each sector, then by the lowest price to fair value rating. Morningstar’s rankings are based on data as at 26 June 2023. 12 July prices are sourced from Market Index.

A closer look at the most undervalued sector and stock – consumer discretionary

Kogan.com (ASX: KGN)

E-commerce company Kogan.com has a portfolio of businesses offering products from leading brands across consumer electronics, appliances, homewares, hardware, toys and more. It also operates and owns a suite of private-label brands.

Kogan 1-year performance. Source: Market Index, 12 July 2023

Morningstar analysts Angus Hewitt CFA and Johannes Faul CFA argue that Kogan's prices have been impacted by the unwinding of the COVID-19 online retail boom which has caused a decline in sales and earnings. They believe that as consumer spending will return online and Kogan's revenues will benefit.

“There are early signs of improvement with a return to an adjusted EBITDA profit in March quarter 2023. We also expect Kogan First to underpin customer loyalty and generate a valuable recurring revenue stream. More rational online competition is also likely to reduce some operating cost pressures,” they said.

Mark Gardner from MPC Markets referenced the company as a sell for him in March this year. He noted the increasing dominance of and competition from Amazon in Australia.

“With expectations that the Australian economy will slow in 2023, we believe KGN could report further decreases in sales and hence KGN represents a sell for us," he said.

Market Index’s market consensus tool currently positions Kogan.com as a Strong Sell, with 5 brokers listing it as a hold and 8 as a sell as a 1 July 2023.

And turning to value in 2 growth sectors and stocks

Megaport (ASX: MP1)

The global technology sector is once again surging and local companies are no exception.

Megaport offers Network as a Service (NaaS) solutions for companies on cloud connections.

Megaport 1 year performance. Source: Market Index, 12 July 2023

Megaport has been unfairly penalised for the market downturn and management uncertainty according to analysts Roy van Keulen and Shaun Ler. They note sales growth remains high and there is a continuing trend of significant margin expansion.

“Megaport should benefit from increasing global reliance on data traffic. We expect sales growth to remain high and for EBITDA profitability from 2023. More importantly, we expect further profit growth and positive free cash flow by 2024,” they said.

Megaport was discussed in a recent edition of Buy Hold Sell with Shane Fitzgerald from Monash Investors and Sam Koch from Wilson Asset Management.

Fitzgerald viewed it as a hold. He wants to see recent cost-cutting initiatives result in growth coming through. By contrast, it was a buy for Koch.

“From our perspective, it’s a turnaround story. It will take 12 to 18 months to play out, not a couple of quarters. And it’s trading towards the bottom end of its EV/EBITDA valuation range. The catalyst is a re-acceleration of revenue growth and successfully hitting those earnings targets,” he said.

Market Index’s market consensus tool currently positions Megaport as a Buy, with 10 brokers listing it as a buy, 6 as a hold and 1 as a sell as a 1 July 2023.

Nufarm (ASX: NUF)

Falling under the Basic Materials sector, Nufarm is a global crop protection and seed technology company that helps growers fight diseases, weeds and pests. It has manufacturing and marketing operations in Australia, New Zealand, Asia, the US and Europe.  

Morningstar analyst Jon Mills points out that Nufarm’s earnings are sharply seasonally skewed to the first half of the year, with cash flow appearing in the second half. Nufarm’s top 22 crop protection projects have passed proof of concept and have an addressable market of around US$6.6bn. Revenue from its Omega-3 canola seed technology is also growing fast.

“We project a five-year EPS CAGR of just over 16% to AUD 0.71, for an attractive prospective P/E of less than 10 by fiscal 2027 based on the current share price,” says Mills.

Nufarm was a top pick for Tribeca Investment Partners’ Todd Warren in a March episode of Signal or Noise.

“Some of the Australian producers have had a multi-year earnings tailwind for some time now. But Nufarm is not one of those companies where its earnings may have peaked, thanks to its offshore operations primarily,” he said.

Market Index’s broker consensus tool positions Nufarm as a Buy with 9 brokers ranking it as a buy and 5 as a hold as at 1 July 2023.

This article was first published for Livewire Markets on Thursday, 13 July 2023.