Five Star Stocks on Deep Discount

Indexes have been jumping to all-time highs as weaker-than-expected inflation data allayed fears of the Fed taking away the punchbowl too soon. However, high equity valuations and slow economic growth make for slim picking for value investors.

The S&P 500 and the NASDAQ Composite indexes have notched nearly 14% and 20% gains for the year to date, respectively, as of June 28, 2021. Against this backdrop, investors must dig a little deeper and work harder to find little islands of opportunities in a sea of frothy markets.

Valuations are of the essence. Luckily, there are some value gems to be found in Morningstar’s extensive equity research coverage universe, which includes nearly 99% of the firms in the S&P 500 index. The following stocks are trading at a significant discount to their fair values, indicating a sizeable margin of safety and upside potential.

British American Tobacco (BTI) is the largest listed global tobacco company by net revenue. The company’s brands include Dunhill, Kent, Pall Mall, Lucky Strike, and Rothmans, as well as e-cigarettes sold under Vype and Glo brands. The company holds 31% of the leading Indian cigarette-maker ITC Limited.

With the consumer less brand-loyal and more health-conscious than before, Big Tobacco manufacturers are betting on the new categories that are most likely to win a share of smokers moving away from conventional tobacco.

“To date, British American Tobacco probably has the most hedged position across the emerging categories,” says a Morningstar equity report, pointing out that the company lags its main rival Philip Morris International in the major new categories.

More recently, BAT has doubled its push into new categories with a target of GBP 5 billion in revenue to be generated from next-generation products (NGPs) by 2025. 

The company has also doubled down on the combustible business with its acquisition of Reynolds American. “We see Reynolds as an incredibly strong asset in a market with plenty of remaining potential for raising prices, and we view the deal positively from a strategic standpoint,” says Morningstar sector director, Philip Gorham, who puts the stock’s fair value at US$56 per ADR.

Wide moat BAT’s sustainable competitive advantage stems from strong franchise, cost advantage and tight government regulations keeping out new entrants, he adds. 

The firm reported revenue of US$35.87 billion in 2020, a 3.3% annual growth, leading management to raise its revenue guidance to above 5% for 2021.

A leading railway operator in southern China, Guangshen Railway (GSHHY) provides passenger and freight transportation and high-speed rail operation services. Its parent company China Railway, a state-owned enterprise, controls 37.12% of Guangshen.

The operator is one of the key railway companies in Southern China's prosperous Guangdong province. The company’s operations connect southern China's three largest population centers - Guangzhou, Shenzhen, and Hong Kong - through both passenger and freight services. “Its favourable geographic location and high-quality railway assets are key strengths,” says a Morningstar equity report, adding that while rising competition from high-speed rail could dent Guangshen's profitability and competitiveness, ongoing railway sector reform could help neutralize some of that negative impact.

Passenger transportation is Guangshen's most critical business segment, with the Guangzhou-Shenzhen intercity express railway its crown jewel. “Historical volume growth has been strong, and despite challenges from various economic vicissitudes, the Guangshen intercity express railway has consistently delivered strong volume growth,” says Morningstar equity analyst Jennifer Song, who puts the stock’s fair value at US$23.50 per American depositary share (ADS).

The operator is a potential beneficiary of China’s ongoing railway reform including tariff hikes and increasing pricing autonomy. As a result, “we expect (Guangshen’s) profitability to continue chugging ahead, which bodes favourably for its long-run competitive positioning,” says Song.

Growing competition from high-speed rail, stagnant industrial activity and cost inflation conspired to squeeze Guangshen’s operating margins from 17.6% in 2011 to 5.2% before the outbreak of COVID-19. While these headwinds are likely to continue over the next five years, Song forecasts the company’s operating margin to improve gradually to 8% in 2025.

Ionis Pharmaceuticals (IONS) is the leading developer of antisense technology to discover and develop novel drugs. The drugmaker’s products target a wide variety of diseases, including cardiovascular, metabolic, neurological, and rare diseases.

A leader in RNA-based therapies Ionis’ spinal muscular atrophy drug Spinraza is the first RNA-based therapy to achieve blockbuster status. While the firm faces strong competition from RNA interference technology and gene therapy pipelines emerging at multiple firms, “Ionis has built a massive pipeline of promising new drugs that are rapidly moving toward the market, securing a narrow moat,” says a Morningstar equity report.

By altering the production of a given protein in the body, Ionis' therapies can tackle diseases that are difficult to treat. “Ionis has a broad pipeline and strong collaboration partners to help usher to market drugs for large indications, requiring large clinical trials and salesforces,” says Morningstar sector strategist Karen Andersen, who recently lowered the stock’s fair value from US$66 to US$62, after factoring in the halt of a phase 3 study for Huntington's disease drug candidate.

On a brighter note, Anderson’s forecasts the drugmaker’s revenue growing to US$3.1 billion by 2030, and operating margins approaching 50% by 2030, “as several of the most advanced programs at Ionis are partnered and are likely to translate into higher-margin cash flows from milestones and royalty-based payments.”

The stock’s recent weakness can be attributed to a less-than-rosy 2021 earnings report showing adjusted loss per share of 32 cents compared with a loss of 7 cents per share the year before. The company reported total revenue of US$112 million, down 15.8% year-over-year due to lower R&D revenues and royalties for the quarter.