5 Financial Stocks to Buy After Earnings

Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. Every Monday morning I sit down with Morningstar Research Services Chief U.S. Market Strategist, Dave Sekera, to discuss one thing that’s on his radar this week, one new piece of Morningstar research, and a few stock picks or pans for the week ahead. So you have a couple things on your radar this week, Dave. The first is, of course, earnings season. Several of the magnificent seven companies that have driven so much of this year’s market return will be reporting this week, and that’s Microsoft MSFT, Alphabet GOOGL, Meta META, and Amazon AMZN. So what are a couple of questions investors will be looking for answers to from each of these companies?

Dave Sekera: Hey, good morning, Susan. It’s going to be interesting. Now, considering how much these stocks have risen thus far this year, I think it’s going to be pretty interesting to see how well they perform. It’s almost, I think there’s a little bit more risk here to the downside that I think they’re going to need to be able to keep up with the earnings expectations here. Otherwise, I do think there is a chance we could see some selloffs. Each of these stocks at the beginning of the year was rated either 4 or 5 stars, but only Alphabet now is still rated a 4-star stock. Others are now 3 stars based on how much they’ve moved up.

But let’s just run through the list here. It’s going to be a big week, as you noted. First up is going to be Microsoft. So I think the focus here really is going to be on Azure, that’s its cloud business. Now with Azure, the growth rate has been slowing there, so I think the market’s going to be looking at that growth rate just to see not only how much more it might be slowing here in the short term, but really whether that path is still going to be for slower growth going forward, or if it’s starting to stabilize. Now for all of these companies, there’s always going to be a lot of focus right now on artificial intelligence, so specifically for Microsoft, it’s going to be on OpenAI and specifically its co-pilot Powered Solutions. And then lastly with Microsoft, just based on their size and scale and global business, I really want to hear what their macroeconomic outlook is.

Moving next to Alphabet. So I think the focus there is going to be on their advertising revenue growth—now specifically whether or not they see the economy slowing in the second half of the year, and if so, whether or not that will then pressure their advertising revenue. Getting back to artificial intelligence, people are going to want to hear more about Bard, which is their generative AI product, and how they plan on monetizing it. And then the other thing is they’re going to want to hear about Google, or Alphabet’s cloud business, the focus on profitability, demand, and the potential impact from AI. And really for all of these companies, AI, it’s going to be interesting that we do think it can drive future growth, but it also could require higher CAPEX spending here in the short term. So we’ll see what these companies have to say on that.

Next up is going to be Meta. Now that stock, I think, has more than doubled this year based on expectations that the cost-cutting they’ve been doing will be bolstering that company’s profitability. So I think we’re going to want to hear, is that cost consciousness going to stay, or are they really going to start ramping up spending on AI? Now they had that Threads product that they recently introduced, so I think people are going to want to get some updates here on the user count, the engagement, the potential for monetization. But also really hear what are their future plans for trying to really build that platform, as it does appear that maybe it’s not off to the start that they would’ve liked it to have been off. And of course then we’re getting back to artificial intelligence again. What is their long-term strategy and specifically, how does that really converge and go with their Metaverse strategy over the long term?

And then lastly, and I know this has been a long discussion, but there’s a lot to talk about here is Amazon. So again, first with Amazon, what are the e-commerce trends? What’s the outlook for consumer spending? I’m going to want to hear about Amazon Web Services, AWS, that’s their cloud hosting business, of course, like some of these others, that has been a key growth driver, but that growth has been decelerating. So we’ll get the outlook there. But then the other key growth driver for them will be their advertising. Has that been holding up? We do think that one, in the short term, has been holding up actually better than Alphabet and Facebook or Meta. So we’ll want to see if that’s still continuing or not. And then lastly, their profitability, especially given all the substantial layoffs they’ve had over the past couple of quarters and the strong results, and whether or not we’re going to see that same level of profitability going forward.

Susan Dziubinski: Got it. So then we also have Verizon VZ and AT&T T reporting in this week, and both stocks were really hammered last week after news surfaced regarding a lead issue in their cable sheathing. So what’s Morningstar’s take on that and what do we think of the stocks today?

Dave Sekera: Both stocks are now five-star rated stocks and they trade at about a 40% discount to our fair value, and with as much as they’ve fallen, but yet still holding their dividend payments, that dividend yield now is up to, I think, about 7% or even slightly over 7%. Now, I would note both of these stocks have been in a long-term decline, even before that Wall Street Journal article came out about potential liability from their lead cable sheathing.

Our equity research team, I mean they’ve looked into that issue and based on their analysis, they don’t expect any real substantial liability regarding that lead. And in fact, I think AT&T it looks like just recently released some data. We’ve got an article out on that and that gives a little bit better idea of the scope of how much lead sheathing cable exists out there. And I think the real takeaway there is that it’s really going to be a lot of this cable is old enough that they were going to have to replace it anyways. And so I think all this is going to do is accelerate that replacement of those lines.

So really, it gets back to really thinking about the long-term investment thesis here. And our view is that following consolidation within the wireless business, we think this industry is going to really compete much more like an oligopoly going forward, such that they’re not going to compete nearly as much on price and that should lead to higher operating margins, and that really is the genesis of why we think these stocks have gotten as undervalued as they have.

Susan Dziubinski: Got it. So let’s talk about a couple of companies that reported last week. We saw Tesla TSLA and Netflix NFLX both report and both stocks immediately did take a hit after they reported. What do we think about both of those stocks today?

Dave Sekera: With Tesla, reading our analyst note, I mean there’s really nothing in the earnings that I think was all that different from our expectations. Now, Tesla’s stock, that did surge thus far this year. It was a 4-star stock at the beginning of the year, it’s now, I believe, a 2-star-rated stock, it’s a 22% premium to our fair value. So I think that one’s really just much more of a case of an overvalued stock that’s now giving back some of those recent gains.

It’s almost a similar story for Netflix, that stock did sell off, but not necessarily from an earnings disappointment. In our view, the earnings were solid, I think it’s just more a matter that the Netflix stock got caught up with that large tech growth kind of rally that we saw over the past couple months. That stock is still at a 33% premium to our fair value and it’s rated 2 stars.

Susan Dziubinski: Got it. So now last week, several regional banks also reported. So how did those numbers look? Are we out of the woods?

Dave Sekera: Well, I think it depends on what you mean by out of the woods. So from the perspective of, are there going to be widespread regional bank failures? Yes, I’d say we do think that we’re out of the woods as far as that goes. Now as far as earnings for these individual banks, we do still see higher funding costs from lower deposit bases going forward that will lower earnings sequentially through the end of this year, well into the beginning of next year before we really see that start to rebound.

Now looking specifically at deposit losses, I talked to Eric, our analyst at the end of last week, and generally I think those deposit losses were mostly within his expectations. So looking forward, it does appear that deposits are stabilizing for most of these banks. Now, some may still experience some deposit loss, but it’s going to be at a much slower rate than what we’ve seen this past quarter. And he actually noted a few of these other banks do think they’re now in a position where they could start rebuilding that deposit base.

So just from an investor top-down perspective, we still see a lot of undervalued opportunities among these regional banks now, even incorporating that earnings pressure in the short term, we think that the market just pushed a lot of these stocks down way too far compared to their long-term intrinsic value. And yeah, I still think the takeaway is here, yes, the sector is under pressure, but it’s not broken.

Susan Dziubinski: Got it. So in non-earnings news on your radar this week, we have the Fed meeting. What’s the market expecting in terms of whether we’re going to see a rate hike?

Dave Sekera: I think just looking at the screens here, the market’s definitely pricing in that 25-basis-point hike. And I would say, according to the probabilities, I mean the market’s just pricing that in as a done deal. I mean if they weren’t to hike, now that actually, in my mind, would be a shock to the marketplace. So looking forward, the market is pricing in no hike here in September, but the market’s not yet entirely convinced that the Fed is done. There’s another about 30% probability of another hike at the November meeting. I know our base case here talking to Preston, the head of our US economics team, he thinks we’re one and done. And in fact the next action by the Fed, in his view, would be sometime early next year, even possibly as soon as February, the Fed will reverse course, start to ease monetary policy, and start bringing interest rates back down.

Susan Dziubinski: Got it. So let’s move on to some new research from Morningstar that’s somewhat related to this topic and that’s your bond market outlook for the rest of the year, which we just published on morningstar.com. So first give viewers a quick recap of how bonds performed during the first half of 2023.

Dave Sekera: You have to remember, we’re also coming off the worst year ever for bonds in 2022. So I would say fixed income generally has normalized, and I think it’s performed pretty well, relatively a solid performance for the first half of the year. When I look at our screens here, the Morningstar Core Bond Index, now that’s our broadest proxy for the overall fixed-income market. I think that’s up just under 3% year to date. So a nice run rate for thus far this year.

And it’s really due to a couple of things. I think the combination of just the underlying yield carry that we’ve generated, a slight decline in long-term interest rates has helped bolster long-term bond prices, and a little bit of tightening and credit spreads has all come together in order to help build that performance for the year. And then when I look even deeper into our indices here, I’d note that bonds that trade with a credit spread, such as corporate bonds, have done even better thus far this year. So the Morningstar US Corporate Bond Index, that’s our proxy for the investment-grade corporate bond market, that’s up almost 4% year to date and the high-yield bond index, that’s up almost 7%.

Susan Dziubinski: Wow. So what’s your expectations for the back half of the year, Dave?

Dave Sekera: Looking forward, I still think that fixed income will continue to perform well, maybe not quite as well on a run-rate basis as the first half of the year, but I’m just looking at some of the market dynamics here. So after the Fed this week, we do think that will be the last hike of this monetary tightening policy cycle, and looking at long-term interest rates, generally we do think they’re at or at least near their peak and those should decline going forward.

Susan Dziubinski: Got it. So given this outlook, how should investors be thinking about that bond portion of their portfolio today?

Dave Sekera: I think now is a pretty good time to start lengthening the duration into the longer end of the curve, from the middle or short end of the curve at the beginning of the year that we had noted in our original 2023 fixed-income market outlook. So I mean short-term rates, they are high for now, but we do think that they’ll start to subside early next year. Once the Fed starts cutting the federal-funds rate, those short-term rates will come down as well.

So the thing is, with those long-term rates, we do expect long-term rates to start coming down as well, but when you start moving into those longer-duration bonds, you get the benefit of those rising bond prices, because of course as interest rates on long-term bonds goes down, that does push their bond prices up. And I’d also say I still think sticking with corporate bonds is a good place to be. Now corporate bonds aren’t as attractive as when we highlighted them at the beginning of the year, but I do think credit spreads still remain adequate enough to compensate for future downgrade and default risk based on our economic outlook.

Susan Dziubinski: Got it. So we’ve reached the picks portion of this week’s program and this week, Dave, you’ve brought us five stocks from the financial services sector that you like after earnings. Now your first four picks this week are all regional banks. What are they?

Dave Sekera: All right. Well first up is US Bank USB. I just wanted to highlight this one because this one has been one of our best picks in the regional bank sector for quite a while now. Now, the earnings results in our view were just average, but you know what? With expectations and valuations so low, average is all it needed to see that stock trade up after earnings. So that’s a 4-star-rated stock, still trades at a 28% discount to fair value, and it’s a company that we do rate with a wide economic moat.

After US bank was PNC PNC. Now that’s also a 4-star-rated stock, trades at a 23% discount, and has a narrow economic moat. Again, earnings results, I think they were in line with our expectations, as expected, net interest income was under pressure from deposit loss. But really the takeaway here, reading through our earnings note, is that despite the recent banking turmoil, we do still expect net interest income and revenue will grow over the course of this year. And looking at our financial model here, it’s still interesting though, PNC is still able to produce returns on tangible equity well into the mid-teens.

Now to the downside a little bit, or at least downside from performance goes, KeyBank KEY. So KeyBank did suffer some of the worst pressure on net interest income across our coverage. And our equity analyst did note that, based on those earnings, when he updates his model, he may actually reduce our fair value somewhere in the mid-to-high single-digit percentages following those earnings. Yet taking a look at that stock, it was up about 12% in the days following those earnings. And I think that just shows how undervalued that stock had become as compared to its intrinsic value. So it’s a [5-star]-rated stock, trades at about half of our fair value. Now, I would note, this one does not have an economic moat and as you know, we typically prefer companies with an economic moat, but in this case, with the valuation so low, I think that added margin of safety really makes up for the fact that we don’t believe it has long-term durable competitive advantages.

And then rounding up the banks here is going to be Zions ZION. So the earnings there, we consider that to be a bit of a mixed bag. Now that did have more pressure on net interest income than we’ve seen with some of the other regional banks, but reading through our earnings note here, which is available on morningstar.com, yeah, I’d note that it’s still set to earn pretty solid adjusted returns on tangible equity. We project those to be between 9% and 11%, and the bank is still building capital as well. So again, this one also is a no economic moat, but it’s a 4-star-rated stock, trading at a substantial discount of about 35%.

Susan Dziubinski: Got it. And then your last pick this week, Dave, is Goldman Sachs GS. Why?

Dave Sekera: So, I mean the stock’s done very well since its earnings announcement. I think it’s up about 8% since then. It’s a 4-star-rated stock. Trades at about a 14% discount and we do rate Goldman as having a narrow economic moat. And I’d say this is one that’s going to be a little bit less risky. We do rate the stock with a medium uncertainty, so that’s going to be better than a number of these regional banks, many of which do have a high uncertainty.

Now, when I look at the stock performance over the past year in the charts here, it doesn’t look like the stock has really done that much overall. And a lot of that reason is because investment banking activity this year has been relatively low. Now in our view, we do think that the investment banking business might be bottoming out at Goldman and personally, I wouldn’t be surprised to see an uptick in mergers and acquisitions this year, more private equity buyouts, and things like that. And all of that would just provide a pretty good tailwind for Goldman going forward. And then lastly, I would just note here that they did also bump up their dividend by 10%. So that puts the dividend yield there at just slightly over 3%, about 3.2% right now.

Susan Dziubinski: Thanks for your time this morning, Dave. Dave and I will be back next Monday live at 9:15 AM Eastern, 8:15 AM Central. In the meantime, be sure to like this video and subscribe to Morningstar’s channel. Have a great week.