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- According to Dave Sekera, investors should favor value stocks right now.
- Utilities are one industry with stocks trading at steep discounts.
- The stocks listed below are high-quality names with high dividend yields.
Stocks have fallen in the second half of the year, wiping out some of the gains made by the magnificent seven, or mega-cap technology companies.
According to Dave Sekera, Morningstar’s chief US market strategist, the tailwinds from the seven stocks had run their course by July. He added that the majority of those stocks now have three or four stars out of five.
According to him, the best opportunities today are in value stocks, which trade at a 22% discount to fair value. That outperforms stocks with a mix of value and growth, which are only trading at an 8% discount to fair market value, he adds. Morningstar calculates fair value based on its forecast of a company’s future cash flows and their predictability.
Investors turned to dividend-paying stocks as a fixed-income substitute when interest rates were much lower, he said. However, as interest rates rose, many investors dumped them in favor of the risk-free returns offered by Treasuries, causing a sell-off in dividend payers.
He cited utilities as an example of a sector that suffered in August and September as interest rates rose. In fact, many utilities stocks have fallen more than long-term bonds year to date. Utilities stocks stabilized in October, and their underlying fundamentals remain strong, according to Sekera.
The great thing about utilities stocks is that they are very stable because electricity demand is inelastic. And, of course, the sector pays higher dividends, he added. Unlike bonds, which have a fixed interest rate for the duration of the bond, stocks in this sector are expected to increase their dividends over time, he added.
Utility stock prices are expected to rise at a rate of about 7% per year, give or take, depending on the company, according to Sekera. According to an October 16 note by Morningstar’s energy and utilities strategist Travis Miller, they are trading at a median 15% discount to fair-value estimates. The sector’s price-to-earnings ratio of 16 is the lowest since the 2008-2009 recession, according to the note.
Morningstar’s picks for utilities
Entergy (ETR) is the first stock in this sector with the best combination of growth, valuation, and yield. It is a five-star stock that trades at a 23% discount to fair value and pays a 4.58% dividend yield.
NextEra Energy (NEE) is another five-star stock with a 3.14% dividend yield. According to Sekera, it is the most undervalued utility stock at a 30% discount to fair value.
Duke Energy (DUK) is trading at a 15% discount and yields 4.56%.
NiSource (NI) is trading at a 23% discount with a dividend yield of 3.94%.
Finally, American Electric Power (AEP) is trading at a 21% discount with a 4.44% dividend yield.