3 Overvalued Stocks to Sell and 3 Undervalued Stocks to Buy Instead

Susan Dziubinski: Hello and welcome to The Morning Filter. I’m Susan Dziubinski with Morningstar. Every Monday morning I talk with Morningstar Research Services chief US market strategist Dave Sekera about what investors should have on their radars this week, some new Morningstar research, and a few stock picks or pans for the week ahead. So good morning, Dave. Looking ahead this week, you’ll be keeping an eye on inflation. So what’s the market expecting in terms of the CPI report, and what’s Morningstar’s outlook for inflation ahead?

David Sekera: Hey, good morning, Susan. Yes, we’ve got CPI coming out this week. Now the headline CPI consensus is looking for a 0.2% increase on a month-over-month basis and looking for a 2.6% increase on a year-over-year basis. Now, of course, CPI is the much more important number of the two. That one also on a month-over-month basis, consensus is looking for 0.2%, and that should put that at about a 3.2% year-over-year number.

Now, 3.2% year over year. I mean, that would be flat from last month. But when I look at the longer-term trend here, it still stays on that long-term gradual decline that we’ve been seeing for quite a while now, since it peaked out in September of 2022. Now, longer term, I know our US economics team is looking for inflation to continue to keep moderating over the course of this year and well into next year.

In fact, we do have a bit of an out-of-consensus view that we’re looking for inflation to fall below the Fed’s 2% target in 2025 before it starts floating back up in 2026. Back to their target.

Dziubinski: But even with inflation coming down, we’re still seeing signs that the consumer is feeling pressure. So talk a little bit about that and what that could mean for the economy.

Sekera: Exactly. So it’s not necessarily inflation right now that’s pressuring the consumer. It’s really about two years now worth of just high inflation and the compound impact there, that’s really pressuring the consumers. Of course, we first saw it really start to hit low-income consumers. And to some degree it’s really still hurting them pretty badly when we look at a lot of the examples out there.

For example, both Dollar Tree and Dollar General recently reported, and in their reports, they noted that consumer spending among their demographics still is increasingly shifting their spending to food items and other essentials and away from discretionary items. Both stocks sold off pretty hard after those reports. And really what’s going on here is that their margins are getting squeezed because discretionary products have much higher margins than food products.

But it’s not just the low-income consumers that are under pressure. And I think we’ve talked about this for the past two quarters now. We’re seeing a lot of middle-income consumers also shifting their spending habits. A couple of examples that we’ve highlighted in the past is Walmart. They’ve been reporting that they’re seeing an increase in new consumers coming into their stores.

But even there the spending is more focused on food and essentials and away from discretionary. And even within that discretionary category, items that are more extravagant certainly are getting hit the hardest. And the example there is Starbucks. I think we highlighted this the past couple quarters as well. In the first quarter, their same-store sales declined, and that’s because traffic fell by 7%.

And then they reported another 2% decline in same-store sales in the second quarter. McDonald’s is just another example out there where we’re seeing consumers pull back especially where they’re not seeing the value proposition. Really, from an economic perspective this shift in spending, both how it’s being spent as well as the decline in the rate of growth of spending, is why our US economics team is modeling in a slowdown in economic growth, not only this quarter but going into the fourth quarter. And that slowdown’s really not stopping until the first quarter before slowly starting to come back over the remainder of next year.

However, you see a lot of media headlines out there, claiming the end of consumer spending and so forth. And yeah, I really just want to highlight it’s not like consumer spending is falling off a cliff. Unemployment still remains relatively low. We’re seeing wage growth still on a positive trend.

The hours working is still increasing. So from my point of view, what I’m watching for both on individual stocks as well as the market is that unemployment rate. Now, if that unemployment rate stays the same I think that’s really going to work into our view for the slowdown in the economy, but not for a recession.

But if unemployment were to ratchet up quickly, then I think we would become much more concerned about the rate of growth and potentially a recession.

Dziubinski: All right. Let’s pivot over to earnings. You have a couple of companies you’re watching this week: Oracle and Adobe. Why are you interested in these two companies in particular and how are their stocks looking heading into earnings?

Sekera: Oracle, not only is it rated 1-star, meaning it’s one of the stocks that we think is very overvalued. But when I look at our coverage, it’s actually one of the more overvalued stocks in total under our coverage. It trades at a 45% premium to fair value.

Right now, I think the market is treating it as an AI play. And to some degree, the company will benefit from the growth in artificial intelligence. But in our model, we think the market is just pricing too much of a benefit than what we’re seeing. The other thing about that name, too, is I think over time, our analyst is concerned that they will probably lose market share to new competition as well as potentially new database types.

Adobe is an interesting one, just taking a look at the chart and the performance of that stock. It had a pretty tough start at the beginning of the year. It tumbled pretty hard until it bottomed out in early June. So just as a reminder we had highlighted after that first quarter earnings call, we thought the company had made a mistake.

The guidance that they gave to the market was just really what we considered to be especially convoluted. The market took that as a negative and just sold first and asked questions later. Now, that stock dropped pretty far into 4-star territory at that point in time, but we had held our fair value unchanged. We just didn’t see anything that would have caused us to change our longer-term projections at that point.

Since then, the stock has recovered pretty well. Still trades at about a 12% discount. That’s puts it, I think, in the lower part of the 3-star range.

Dziubinski: Well, let’s catch up on some new research from Morningstar. And we have a good deal of ground to cover here given that we didn’t have a show last week. So first, let’s talk Nvidia earnings. The stock’s down about 18% since reporting, and Morningstar maintained its fair value estimate on the stock after earnings of $105. So what did Morningstar think about Nvidia’s report and how does the stock look today after this pullback?

Is there an opportunity here?

Sekera: You know, there is a confluence of factors that caused the stock to pull back. More of a more technical in my mind and not necessarily fundamental. I think what happened here is that the amount that Nvidia had beat earnings was less than the amount it had beat earnings in the past. And then when we look at the guidance that it provided this quarter, I would say that guidance was in line with what the market was expecting, whereas in the prior quarters that guidance was coming out above expectations.

So really from a sentiment point of view, I think that took the wind out of that stock’s sales here in the short term. But from our point of view, from a fundamental basis, there’s just really no change. We maintained our $105 per share fair value, puts that stock at a 3-star level.

In fact, I think the stock’s almost trading right on top of our fair value. Having said all of that, from a fundamental point of view, we still expect to see heightened growth for at least probably the next four quarters. The company is still supply constrained. They just can’t make enough of these AI GPUs to meet demand, and demand is just going to remain exceptionally high.

In fact, when you go back to some of these, their customers’ earnings calls like Alphabet, I mean, they made a specific comment saying that the risk in AI right now isn’t spending too much, but not spending enough. And if you look at the capex spending programs from Microsoft, Meta, Amazon, and so forth, they’re all pointing to higher capex spending over the next 12 months or so.

But it is a stock that is pretty fully valued when you look at our valuations, our earnings estimates for this year for fiscal 2025 is $280 a share. Now that is growing very quickly, going up to $456 a share by fiscal 2027. That stock is trading at a forward P/E today of 45 times.

Of course, that comes down to 28 times based on our 2027 earnings estimates. So again, a very richly priced stock, but one that is still growing very quickly for the next couple of years.

Dziubinski: Well, let’s talk about Salesforce now. Morningstar inched up its fair value estimate on the stock by $5 after earnings, which brought it up to $290 per share. So what did Morningstar think of the report, and how does the stock look today from a valuation perspective?

Sekera: Well, from a valuation perspective, it trades at about a 16% discount from fair value. That does put it in 3-star territory, although you are much closer toward 4-star than it is to anything else. So again, undervalued but within that fair value range. I think the takeaway here is that, from our point of view, second-quarter results were good.

Full-year revenue guidance was maintained, their profitability was raised slightly. And overall, I know our analytical team still considers Salesforce to be one of the better opportunities for investing in software over the long term. Really what’s going on here is just a good balance between growth, margin appreciation potential, as well as a strong balance sheet.

Dziubinski: Now, we had tech giant Broadcom reporting last week, and AI seems to be driving the company’s growth this year. Morningstar held its fair value estimate on the stock at $155 after earnings. So what’s the outlook for the company? And is the stock a buy today?

Sekera: Well taking a look at results for the third quarter and looking at their guidance for the fourth quarter, our analyst noted that both were in line with his expectations. Now, interestingly, the stock was trading right at fair value prior to earnings. It dropped pretty hard after that earnings report. And I think what’s going on here is what we’re seeing in a lot of these AI plays.

It seems like the market was pricing in better-than-expected results. And when that didn’t materialize, I think we’re seeing a lot of short-term traders just punting their positions and getting out. So from our perspective, our long-term growth thesis is still intact, we held our fair value unchanged. So it leaves that stock trading at fair value in that 3-star territory.

Dziubinski: Let’s talk a little retail, Dave. Let’s start with Dick’s Sporting Goods. The stock’s up 43% this year, and that’s after being down a bit after earnings. That’s kind of notable considering how sluggishly the specialty retail group overall has performed this year. So what’s going on here?

Sekera: Well, fundamentally, Dick’s is actually still performing quite well. I mean, they posted an increase of 4.5% in same-store sales this past quarter, margins actually came in a little bit better than what we were forecasting. But as you alluded to, I think what happened here is the market just ran up too far, too fast, and now we’re giving back some of those gains.

Plus, we think that stock is just way overvalued at this point. Our fair value, I think, is $114 a share, but it’s now trading at an 80% premium to fair value. Puts it well into that 1-star territory. Fundamentally, we don’t see this company as having an economic moat. It is rated as a no-moat company.

Granted, they are the largest independent sporting chain in the United States, but there’s just too much competition out there from a lot of different channels, whether it’s e-commerce, mass market, outlets, other specialty stores, and all of that is going to limit its ability over the long term to be able to outearn its cost of capital. And it’s also one where, if we do have the slowdown in consumer spending ongoing, I wouldn’t be surprised to see the stock remain on that downward trend as consumer spending does soften over the next couple of quarters as the rate of economic growth slows.

Dziubinski: Sticking with retailers, Chewy stock was up double digits after earnings. And this was a name that you first recommended back in November of last year and then again in June of this year. So what did Morningstar think of earnings, and is the stock still a buy today?

Sekera: Its second-quarter results were solid, good combination of strong margin performance, modest sequential growth, increase in active customers. So we still like the long-term story here. And this is one that we talked about in depth in a couple of those other calls. So really the synopsis here, the example of how the pandemic skewed growth trajectories for a lot of different companies, this one in particular.

If you remember, following the emergence of the pandemic, people were going into lockdowns. We had social distancing. We saw a big increase in the number of households with new pets. So growth at Chewy initially soared that first year or two during the pandemic. Pet owners turned to Chewy not only to feed their pets, but buy a lot of the high-margin items. You have crates, toys, other accessories, and so forth.

But then, of course, that sales growth just naturally started to slow down. Now, we think that a couple of years past that slowdown we’re getting to the point where that growth rate for households with pets should begin to increase and get back toward historical normalized levels. And we expect Chewy to start to see some sales growth reaccelerate in 2025.

The stock is up 15% since the June recommendation, up 43% since that November recommendation. Right now it trades at about a 13% discount, but that does put that in the 3-star range, meaning we think it’s within the range we consider to be fairly valued at this point.

Dziubinski: Another one of your picks back in that November 2023 show that was a specialty retailer was Bath & Body Works. Now, the company reported earnings in late August, and the stock took quite a tumble. So what happened? And do you still like the stock today?

Sekera: It’s really unfortunate. The stock has really round-tripped all the way back to where it was when we first started talking about it last November. Last November, I think it was somewhere in that three handle range of $30 or so, you know, moved all the way up to $50 as the story was playing out.

But now, as you mention, it’s all the way back to $30 again. So it is a 5-star rated stock at this point, trades at, I think, slightly over a 50% discount to fair value. And to some degree, I think the market right now is just throwing the stock out along with all the other discretionary product retailers.

But we just don’t see it that way. We don’t think the current trends are going to be indicative of the long-term fundamentals here. Talking to Jamie Katz, who covers the stock, she looks at their products really as being more an affordable luxury and that should hold up, even in a time period where we’re looking for consumer spending to slow down. We’re going to be coming into the holiday sales period here relatively shortly.

And from that perspective, we think that they have a good assortment of products at lots of different price levels. Plus, these are gifts that people look at that they think have appeal from a brand point of view to give during the holiday season. So management did guide for the year for their sales to be down 2%-4%.

It’s a little bit more than what we were expecting. Our forecast was for a 2% decrease. The other thing that management did here is they tightened up their EPS guidance for the year. So it’s now $3.06-$3.26 per share. So I’d note that they brought the top end of their guidance down. They actually raised the bottom end of their guidance by pennies.

That actually gives me some comfort here that they’re really very comfortable with the downside in earnings here in the short term. And I have to talk about this, too. Granted, our valuations are not driven by P/E ratios, but sometimes I do like to look at them to see how the market is valuing these stocks.

And, you know, at the midpoint of that current guidance, the stock is only trading at 9 times forward earnings. So pretty undervalued in our view.

Dziubinski: Well, in other new research, I want to ask you about your September stock market outlook, which viewers can access via a link beneath the video. When you published the report at the beginning of September, the stock market looked fully valued. But with a full week of September market activity behind us now—and that wasn’t a great market activity—do stocks still look fairly valued, and how should investors be thinking about their overall equity positions today?

Sekera: Yeah, we came into September, the market was trading a few percent above a composite of our fair values. The market was starting to feel a little bit overextended after the big rally we had after the selloff at the beginning of August. As you mentioned, we had a pretty tough week in the market. Last week, the market retreated, I think, about 4%.

So at this point, we’re now back to fair value, maybe even just slightly below fair value. When I look at our valuations and look at the macro dynamic factors that we’re thinking about over the next couple of quarters, I think investors should be at whatever their targeted equity allocation is as a percentage of their assets in their portfolio.

And looking forward, what we expect to see is inflation continuing to moderate, long-term interest rates on that long-term downward trend, and of course the Fed to start easing monetary policy after they meet next week. So really, I think those tailwinds should be enough to offset the headwinds that we’re seeing from that weakening rate of economic growth over the next couple of quarters.

Having said that, it could be choppy here in September and October.

Dziubinski: Let’s talk a little bit about that because you do make a note of that in your outlook that you really wouldn’t be surprised to see some choppiness this month and in October. Go into that a little bit.

Sekera: Well, it’s really much more from a technical point of view. September historically has been one of the toughest months of the year for equity markets. I think that’s in the back of a lot of people’s minds. And then thinking about October, I expect a lot of traders are going to look to take risk off the table, exit positions probably in the second half of October, once we get closer to the US presidential elections.

But from a fundamental point of view, while I think that there’s no reason for companies to miss their third-quarter earnings, I am still very concerned about what they might be guiding toward in the fourth quarter. The management teams may be seeing the same things we’re seeing with that slowdown in the economy.

So they may look to bring expectations down for earnings for the fourth quarter. By way of what we’re thinking for the economy right now, our US economic team is only projecting a 1.2% real annualized rate of GDP for the fourth quarter. So pretty low, almost kind of stall speed for the economy.

The other thing I’d note, too, is that while spending on AI is still ramping up, what we’ve seen this past quarter is that these AI stocks are no longer outpacing expectations. And in the fourth quarter—I’m sorry, in the third quarter numbers, coming out in the fourth quarter, just meeting expectations might not be good enough, based on where these stocks are currently trading.

So we could see some softness there, too, if they just meet expectations and don’t bring guidance up further.

Dziubinski: You talk quite a bit in your outlook about the rotation that we’ve seen in the market since July. And you said several times on the show during this first and second quarters that, based on valuations, you thought some rotation was likely, but it certainly has been dramatic over the past few weeks.

Sekera: Yeah. If you remember, like in our third quarter outlook we specifically noted that from our point of view, a lot of those AI stocks had run their race, that they got up to valuations that were either fully valued or in many cases getting to be overvalued. But we still highlighted that valuations for value stocks as well as for small-cap stocks remained very attractive and I’d say attractive not only from an absolute point of view, but also from a relative point of view as compared to the rest of the market.

So it looks like July really is marking the beginning of that rotation out of those overvalued, overextended, large-cap AI growth stocks. And what we’ve seen is that money to go into value stocks as well as down and capitalization into mid-cap and small cap. So quarter to date through the end of August, value stocks were up 8.3%.

Growth stocks were only up 2%. And in fact, within the growth category, large-cap growth stocks were actually down 0.6%. By capitalization, small-cap stocks finally had their day in the sun. They were up 6.7%. Mid-caps also doing very well, up 6.4%. And that large-cap category lagging, only being up 3%.

Dziubinski: Now, we’ve seen a revival in defensive stocks during the past several weeks, including the healthcare sector and the consumer defensive sector. So how do valuations look in each of those sectors after their rally?

Sekera: Well, at this point, we think both of those sectors are overvalued. The consumer defensive sector is very expensive. In fact, it’s the most overvalued sector in our view right now—trades at a 15% premium to fair value. A sector you typically don’t see getting up into those kind of ranges. And healthcare’s also slightly overvalued, trading at a 5% premium.

To some degree, I have to note that when I look at these sectors overall and look at the individual stocks, there are some stocks, some large-cap stocks in these sectors that are skewing these sectors. So, for example, in the consumer defensive sector, if you look at Costco, that’s a 1-star rated stock, trades at a 72% premium.

I think it trades at like a 50 times forward P/E ratio. In healthcare, Eli Lilly has just been a phenomenal riser. But again, it’s a 1-star rated stock, trades at a 56% premium. And because the market caps of these companies are very large, especially within the individual sector, you know, their valuations do at this point in time tend to skew the sector valuation higher.

It’s one of these situations where the sector itself is overvalued, but largely because of a couple of individual stocks that have brought those valuations up. Both sectors do still have some individual stocks that we think are quite attractive. So maybe a better time for stock-pickers in the individual sector as opposed to people that just use the ETFs for their sector exposure.

Dziubinski: Now let’s talk utilities. Dave. You know, here’s another sector that’s considered defensive, and they’ve performed really well this year. And as a result of that, your view on the sector has changed. So talk a little bit about that.

Sekera: Well, I mean, even before that, I really just have to call out Travis Miller and our utilities team, they really called this one so well over the past year, really last October, essentially pounding the table talking about how utilities overall had just gotten to be way too undervalued. And in fact, at that point in time, I think they had noted that they were trading at some of the lowest valuation levels compared to our valuations over the past decade.

Since then, utilities have benefited not only because they’re considered defensive, but they really got caught up and are considered that second derivative play on artificial intelligence. AI computing, of course, requires multiple times more electricity than traditional computing. So, of course, we’re going to see long-term growth in electric demand as AI becomes a larger part of the technology sector.

However, year to date, the sector is up now over 22%, now trades at an 8% premium to fair value. That compares to a 15% discount last October. So at this point, I think the utility sector has probably run its race. It’s now a good time to take some profits, maybe underweight that sector.

But certainly, if nothing else, you know, swap out of some of the stocks that have done really well into maybe some of the ones that we still think have further room to run.

Dziubinski: Another sector story in August was the continued revival in real estate stocks. And here, David, seems like you were just saying that real estate was the most unloved sector, but that’s not the case any longer. So tell us what’s been going on there and what valuations look like today.

Sekera: I think this is a really good example of just how once the market starts to correct just how fast it can go and why you want to have an allocation to these undervalued sectors even when it doesn’t look like they’re going to perform anytime soon. Because once they start to move, they can move really fast.

And I really like this case, too, because you were able to collect a pretty high dividend yield while you waited for it to work. As you noted, just as recently as I think it was in May, the real estate sector was trading at a 17% discount to fair value, but you know, is up 7.5% in July, another 5.4% here in August.

So at this point, you know, from a sector perspective, it’s now pretty close to fair value. Having said that, there are still a number of individual stocks that we like that are undervalued and still pay relatively high dividend yields.

Dziubinski: All right. Well, now it’s time for the picks portion of our program. And today, we’re talking stock swaps investors can consider. So you’ve brought us three overvalued stocks to sell and three undervalued stocks to buy instead. So first, you suggest selling Costco and buying Kraft Heinz. Explain this swap for us.

Sekera: Costco is just an example of a great company but overvalued stock. We rate the company with a wide economic moat, medium uncertainty. Looks great from a fundamental point of view. But the stock right now is rated 1-star, trades at a 72% premium to our fair value. And just as an indication of how overvalued we think that stock is, it currently trades at about a 50 times forward P/E ratio as compared to our earnings for this year.

So again, great company. Personally, anytime we go to Costco, we spend a lot more money in our household than we probably should. But it just can’t justify that kind of multiple on the stock. Kraft Heinz is a different type of example. It’s a company that we think is turning itself around. We’re looking for improving fundamentals.

In fact, we recently upgraded our economic moat rating to narrow from none last June. So historically, a number of years ago, Kraft was bought out by 3G Partners. 3G, when they went in there, they overemphasized short-term profitability over building long-term economic value in our mind.

And initially it worked. And now they’re able to cut costs, they were able to improve margins. But once that ran out of steam and as people started to see some deterioration in the fundamentals, that stock began to slide and slid pretty dramatically thereafter. Over the past five years Kraft has been going back, really revamping its strategy, focusing on building that long-term value, improving efficiencies, reinvesting back into their brands, improving their category management.

So we think this is a company that’s back on the right track. The changes it’s made, we think, will strengthen its intangible brand assets over time. And that was enough to bring our economic moat rating up. And it also looks like they’ve also strengthened their cost structure. And I think that’s really going to help here in the current period that we’re in.

Overall, 5-star rated stock, 37% discount. Nice, healthy, 4.5% dividend yield while you wait for this one to start working.

Dziubinski: Now in healthcare, you suggest swapping out Eli Lilly and picking up Medtronic instead.

Sekera: Lilly, a phenomenal growth story, based on its weight-loss drugs. But again, another one where we think this market’s just gotten way ahead of its long-term earnings potential. Yes, we agree there is a very large total addressable market out there for the weight-loss drugs. But there’s also going to be a lot of competition from competing drugs coming on line.

Not only here in the short term, but in the medium term as well. So when you look at the valuation here, I mean, there’s just no room for any error, especially if there were to be any kind of side effects. If patients aren’t willing to stay on the drug for the long term.

So when I look at this one, the stock has tripled since the FDA first approved Mounjaro. The stock is currently rated at 1-star, trades at a 56% premium to our fair value. So within the healthcare sector, I’m going to highlight Medtronic. We’ve talked about this one for a while, and it really seems like maybe this is a story that seems to be taking a while to work out.

But, you know, we still see a lot of value in Medtronic. It is the largest pure-play medical device maker. We think it’s one of the best healthcare companies positioned for the continued aging of the baby boomer generation. The company makes medical devices for chronic diseases, things like pacemakers, defibrillators, heart valves, stents, insulin pumps.

So overall, we rate the company with a narrow economic moat and medium uncertainty. Taking a look at our model here, we’re looking for a five-year compound annual growth rate of 4.5%, operating margin improvement, earnings growth of 11.3%. The stock is trading at about 16.5 times this year’s earnings estimates, in our view, decreasing that a little bit over 15 times next year.

So overall, trading at a pretty healthy 20% discount to fair value, puts it in 4-star territory. And again, pretty decent dividend yield of 3.1%.

Dziubinski: And then lastly, among utilities, you’d scale back on Southern and buy Evergy, which I think is a new name that we haven’t talked about on the show before.

Sekera: Southern, when I look at that stock, it’s up 26% thus far this year and actually puts it at a 26% premium to our fair value, enough to push it into that 2-star category. Again, another case where we think the market has just gotten ahead of itself and pricing in too much growth. And yes, Evergy is a new name I don’t think we’ve ever talked about before.

Evergy is a regulated electric utility in eastern Kansas and western Missouri, and our utilities team recently highlighted that one, a note just highlighting it is I think one of the cheapest US utilities right now in our point of view. It’s a 4-star rated stock, 8% discount, dividend yield of 4.3%. You know, we think that the fundamentals here are improving enough it could lead management to boost their earnings growth outlook later this year.

And if they do so, that actually could be a really good catalyst to help the stock move up.

Dziubinski: Well, thanks for your time this morning, Dave. Investors who’d like to learn more about any of the securities that Dave talked about today can visit morningstar.com for more details. We hope you’ll join us for the morning filter 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.