On this week’s episode of The Morning Filter, Dave Sekera and Susan Dziubinski discuss how big the Federal Reserve’s interest cut this week might be and what to listen for in Fed Chair Jerome Powell’s comments. Recent stock pick Lennar LEN reports earnings in the next few days, and Dave explains why he’s watching for results from FedEx FDX and Darden Restaurants DRI this week, too.
Oracle’s ORCL shockingly strong forecast drove investors wild last week but left Dave feeling very late-1990s; tune in to find out exactly what that means. They also unpack earnings results from Adobe ADBE, Chewy CHWY, and several companies viewers and listeners have been asking about.
Small-cap stocks remain an undervalued pocket in a fairly valued market. Special guest Bryan Armour, Morningstar director of ETF and passive strategies research, argues why stock investors would be wise to invest in smaller companies via an ETF and shares several of his picks. And Dave’s stock picks this week are undervalued small-cap stocks to buy before they rally.
Episode Highlights
- Is Oracle Stock Worth the Hype?
- Lightening Round: Earnings Season Recap
- Undervalued Small-Cap ETFs to Consider
- Stocks to Buy Before They Rally
Got a question for Dave? Send it to themorningfilter@morningstar.com.
Transcript
Susan Dziubinski: Hello. Welcome to The Morning Filter. I’m Susan Dziubinski with Morningstar. Every Monday before market open, Morningstar Chief US Market Strategist Dave Sekera and I sit down to talk about what investors should have on their radars for the week, some new Morningstar research, and a few stock ideas.
Well, good morning, Dave. The Federal Reserve’s September meeting is on radar this week. Now we had some mixed inflation figures come out last week. The PPI was a bit lower than expected. CPI was a bit higher. So given all that, what’s the Fed going to do this week, Dave?
David Sekera: Hey, good morning Susan. Just noting that it is Fed week. We’ll see. There might be some volatility later this week depending on what Federal Reserve Powell has to say. But for today, Monday morning coffee mug, just me chilling with Bob Ross this morning. Markets look a little bit in the green, but hopefully today will be a pretty chill day. Now as far as what the Fed’s going to do this week, they’re going to cut by 25 basis points. Market’s got that fully priced in right now. And in fact if they don’t cut out by 25 basis points, I’d say put on your hard hat and get under your desk and look out below because things will be falling pretty hard if they don’t.
Looking forward, Fed CME FedWatch tool, 85% of a cut of a probability in October, another 80% probability of a cut here in December. So unless there’s just a major spike in inflation over the next couple months, the market right now is essentially forcing the Fed to have to cut three times before the end of this year.
Dziubinski: Now, there might be some who could argue that a 50-basis-point cut could be in order at this week’s meeting. Walk us through that argument and whether or not you buy that.
Sekera: Yeah, I mean I’ve heard that in a couple of different places. Now in my own opinion, I highly doubt that they cut by 50 basis points. But having said that, back in September 2024, I was shocked when they cut 50 basis points at that point in time. And I went back and I kind of looked at what the numbers were back then versus now.
So back then the economy was actually running at a stronger rate than it is now. Inflation was at a higher level than it is now, depending on how you look at it, anyways. Payroll growth was stronger. Unemployment was pretty much the same rate. The stock market at that point in time was either at or near its historical highs as well. The 10-year US Treasury, the yield was at 3.00% and 3.25%, so lower than where it is now. M2 money supply was all growing at a pretty steady rate. So if they could decide to cut 50 basis points back then, there’s no reason why they couldn’t do it again now. But I just don’t see that being in the cards here.
Dziubinski: So then what would you expect Chair Powell to address in his comments this week?
Sekera: Yeah, and I think that is a little bit of the wild card here.= in the short term—what will be his focus? Is it going to be employment or is it going to be inflation? And really whether or not he intimates to the markets any further cuts and the pace of what those cuts are going to be.
Now, considering how much payrolls had been revised down for the last couple of months, essentially eliminating about like half of the jobs that it had reported since the middle of last year, I think his focus has to be on the labor market. But if he talks a little bit too much about inflation and maybe people think he’s a little bit more hawkish than dovish, that could send some volatility into the markets as well if people are concerned about those additional rate cuts coming before the end of the year.
Dziubinski: So let’s pivot a little bit. Any earnings reports you’re going to be watching for this week and why?
Sekera: Yeah, there’s three I’ve got on my calendar that I’ll be watching. The first one is Lennar LEN, that’s currently rated 3 stars. It’s still trading at a 13% discount. That was a recent recommendation of ours. But that stock has been on an upward trend over the past couple months as the market is pricing in those rate cuts. For those of you that don’t know the company, it is the second-largest homebuilder. They have a pretty good mixture of entry-level homes as well as move-up homes. So lower interest rates should spur new-home demand. So I just want to hear their own outlook as far as the probability of increases in home demand in existing sales in the short term and medium term.
Also up will be FedEx FDX, another 3-star-rated stock. That one’s trading almost right on top of our fair value, so really nothing to do there from a perspective of the stock. However, I find FedEx to be as close to a real-time economic bellwether as you can find out there. They always provide a lot of good color on what they’re seeing out there, whether it’s business to consumer or business to business. I especially listen for any kind of commentary they have on less-than-truckload trucking. That’s a good indicator for what’s going on with small businesses. And they’ll give a pretty good description of what they’re seeing both internationally as well as domestically.
And then last will be Darden DRI. Now that is a 1-star-rated stock. Trades at a 36% premium. In my mind, I think that’s a good real-time indicator of consumer sentiment. Now there’s a lot of consumer sentiment surveys out there. Personally, I don’t pay attention to any of those numbers at all. I haven’t for years and years. What I’ve always found is there’s always a difference between what consumers say they’re going to do versus what they actually do. As an old consumer analyst, I just had learned long ago, never underestimate the American consumer’s propensity to spend. For those of you that don’t know the company, Darden is the largest full-service restaurant operating in the US. 11 different restaurant brands, anywhere from Olive Garden to The Capital Grille. So that helps get a sense as far as what’s going on anywhere from kind of the middle-class consumer all the way up to the high-end consumer. Eating out, of course, is just a highly discretionary activity. So any contraction or expansion there really shows what consumers are doing versus what they’re saying.
Dziubinski: All right, well, let’s talk about some new company-specific research from Morningstar, and we’ll start with Oracle, ticker ORCL. The stock was up 36% after earnings. So explain why investors were so excited.
Sekera: Yeah, I mean, just a crazy ramp up after their numbers came out. Now interestingly, they missed expectations on both the top and the bottom line, but to be honest, no one really cares what’s going on with the legacy business at this point in time. All the attention was on the guidance that they provided for their cloud infrastructure business. So just to put this into perspective, as far as what’s going on there, that portion of their business did $10 billion in revenue last year. They’re forecasting to increase 77% this year. So that would take it up to 18 billion. But really what the market was looking at was the forecast. By 2030, they expect that business to do $144 billion in revenue. That’s 14 times growth in just six years.
Dziubinski: So after Oracle reported and the stock shot up, Dave sent me a message saying, “I’m getting late 1990s’ vibes.” So Dave, I want you to explain to me and to our audience what that means.
Sekera: I think for those of us that lived through the tech bubble in the late ’90s, I think we’re all going to have kind of these late ’90s vibes with what’s going on in the markets today. And really just trying to understand what the total addressable market is in the future for artificial intelligence. Now, when I look at the market performance this year, especially this past earnings season, it’s all been about artificial intelligence. When I look at real economy stocks, I’d say for the most part, pretty stagnant at best. Yeah, maybe a couple popped here and there. Definitely a couple that were a lot worse than what expectations were. But AI stocks is where all the action has been.
So if you look at this past earnings season, if you look at like four of the biggest AI stocks, Nvidia NVDA, Microsoft MSFT, Meta META, Taiwan Semi TSM, we increased our market valuations on those four stocks alone by about $2 trillion. Now to put that into context, that’s like adding 20 $100 billion companies’ worth of valuation to the market index. And to put that further into perspective, there’s only 140 companies about that, that have over $100 billion in market revenue. So again, kind of those late ’90s’ vibes, you’ve got this combination of this new technology that’s out there. Everyone realizes it’s going to revolutionize business and the economy.
Overall, expectations here just continue to keep getting ratcheted upwards. We have huge increases in stock valuations for those companies. Most leverage to it. Honestly, I think over the course of my career, since the early ’90s, I’ve only seen this growth really a couple of times. Just reminds me that a lot of the projections that we saw for Internet stocks back in the 1990s, just trying to wrap my mind around where all this anticipated growth is going to come from and how everyone’s going to pay for it.
So when you think about this business at Oracle right now, their revenue is someone else’s expense. So their clients are going to need to be able to generate enough revenue, in fact enough revenue with some margin on top of it, to be able to pay for all of that. And they’re going to have to get enough productivity growth to offset all of that additional spending.
Now, in addition to Oracle, we already have Amazon’s AWS, Microsoft Azure, Google Cloud. I believe even Alibaba has their own cloud business out there for hosting AI. So when I pulled up the models on those companies, currently we project $335 billion in revenue for those four companies this year. According to our projections, those four grow to $700 billion in revenue by 2030. So now we add Oracle on top of that. So that means that’s a total of $845 billion in spending. That increase in Oracle just increased that total spending we’re already projecting by 20%. So when I put that growing into perspective here, for Oracle to grow that business line a multiple of factor 14 over the next six years, that’s similar to the growth pattern that we saw from Nvidia from 2021 to 2026. So again, just some eye-popping numbers as far as what we’re projecting today and kind of what you need to believe to get to today’s fair values.
Dziubinski: Well, and speaking of fair value, Morningstar raised its fair value estimate pretty significantly on Oracle’s stack. So walk through that change and then tell us whether there’s any opportunity with Oracle today.
Sekera: Yeah, so once we included that new guidance into our model, I mean just getting down to the brass tacks here, revenue this year we’re projecting at $66 billion, so we’re forecasting that to grow to $196 billion by 2030. We’re looking at earnings per share this year of $6.07 but growing all the way up to almost $20 per share in 2030. So our projection right now is $19.86 per share. So when I look at that on like a multiple basis—and of course we’ve talked about this multiple times over the years, we’re not a PE shop, we don’t use multiples for valuation—but to put kind of the growth pattern into perspective compared to earnings, that would be 48 times this year’s earnings. We’re looking at 39 times next year’s earnings. But by 2030 we’re only seeing the stock trading at 15 times those 2030 earnings estimates. So even following our 60% increase in the fair value on that stock, it’s currently a 3-star-rated stock. So it’s trading within that range that we consider to be fairly valued today.
Dziubinski: All right, well let’s talk about Chewy, ticker CHWY. Now before earnings, this stock was trading about 28% above Morningstar’s fair value estimate. And then after earnings, the stock was down almost 17%. So what did Morningstar think of the results, and is there any opportunity here after the pullback?
Sekera: Well, if you remember last week we talked about this company pre-earnings as we talked about back then, I actually have a pretty favorable view on this company fundamentally. In fact, this stock was a pick a couple of years ago, but we noted the stock just rallied too far to the upside. It was well within 2-star territory. But overall, I mean, it looked like a really strong quarter to me. Sales growth, 8.6%, was ahead of their 7% to 8% guidance. Adjusted EBITDA margin expanded by 80 basis points to 5.9%. Increase in active customer accounts. Plus, they even raised their 2025 sales guidance. So that’s now 12.5 to 12.6 billion. That’s an increase from 12.3 to 12.4 billion. But even all of that wasn’t enough. As you mentioned, the stock dropped. At this point, there’s still nothing to do. Even with the stock having retreated as much as it has, that was just enough of a pullback for it to fall into 3-star stock territory. So nothing to do in our mind today.
Dziubinski: All right. Adobe, ticker ADBE, also reported earnings last week. The stock rallied after-hours, but then it pulled back. So what did Morningstar think of Adobe’s report?
Sekera: Yeah, I read through our stock analyst note here. I mean, it all just looks pretty solid to me. Revenue up 10% year over year. They have a very high operating margin, 46.3%. Both of those numbers topped what guidance were. Fourth-quarter guidance, slightly ahead of expectations on both the top and the bottom line. Overall, we maintained our fair value of $560 a share. And as you mentioned, the stock performance really kind of surprised me. At the end of the day, it was essentially unched.
Now when I look back at how this stock has moved after the prior four earnings reports and how much it fell after each one of those reports, I thought that it was going to go one way or the other this quarter. I thought that if results didn’t meet what expectations were or missed, I thought a lot of people just might throw in the towel and just dump this stock. So you could have had a lot of volatility to the downside or, conversely, there’s so much negative stock already on. No, I’m sorry. So much negative sentiment on the stock today. I thought that if they meet or beat expectations, you could see a big jump to the upside. So like I said, I was just kind of surprised that it was just so lackluster in the markets.
Dziubinski: Now, Adobe stock has been a pick of yours in the past. So do you still like it?
Sekera: Yeah, I mean, it’s still a 4-tar-rated stock. Trades at a 38% discount. Company we rate with a wide economic moat. And as our long-term investment thesis here, our analyst still thinks Adobe ultimately will be a long-term beneficiary of incorporating artificial intelligence into their products to be able to help generate economic value for their clients to be able to generate both revenue and even higher margins over time. So yeah, from our perspective, we still think it looks attractive here.
Dziubinski: Now given how busy earnings season is, Dave and I don’t always get to talk about all of the company results we’d like to right after they happen. So we’re trying something new this quarter. We’re calling it an “earnings season lightning round” where we’ll talk briefly about some company earnings that we didn’t get a chance to discuss after they reported but that viewers have asked us about. So first up is Salesforce, ticker CRM. Salesforce reported in early September. The stock pulled back after earnings. So what was Morningstar’s take, Dave, and do you think Salesforce is attractive today?
Sekera: This is another one. I thought the reaction of the stock in the market was confusing to me. After earnings came out, results top both a high end of guidance, revenue growth of 9%, operating margin at 34.3%, guidance largely in line with consensus. And when you look at some of the fundamentals for their AI business here, their annual recurring revenue—1.2 billion—was up 120% year over year. So getting that AI revenue growth that we’re looking for there, it all came in line with what we were expecting. We maintained our fair value at 325 a share. It’s a 4-star-rated stock at a 25% discount. We still think it’ll be a beneficiary of AI over the long term. So we still like it.
Dziubinski: Gilead stock, ticker GILD, this one shot up after reporting earnings in August, but it’s kind of since pulled back a bit. So what did Morningstar make of Gilead’s report, and is the stock attractive today?
Sekera: Another one that was a pick of ours back on the June 26, 2023, episode of The Morning Filter. And in fact we reiterated that call, it looks like in May of 2024, after the stock had slid following the original recommendation. Stock at this point up 48% since that original recommendation. It’s actually up 69% from when we reiterated that call. Right now, the story, though, is really nothing to do about earnings as they are today. Our analysts noted that the FDA approved, and I’m not sure about the pronunciation of this, Yeztugo maybe for HIV prevention that came through in June. So we did bump up our fair value 6% to 115 per share. Looks like the stock is trading right at that fair value. So it rated 3 stars. Nothing that you necessarily need to be selling today if you had bought it back then, but at the same point in time, no longer trading at that margin of safety that we typically look for.
Dziubinski: Becton Dickinson, ticker BDX, also reported in August. Stock was up about 8% after earnings, but again has since given back most of those gains. So what’s Morningstar’s take on Becton Dickinson, and is the stock a buy now?
Sekera: Yeah, so just a brief update here. This was one of our viewer questions in May. That’s when the stock just got crushed following a relatively poor earnings report. The investment thesis back then was that, over time, we would expect the company to get back toward more-normalized growth and margins. Really looking for the life sciences and diagnostics market to start stabilizing over the next couple of quarters. The takeaway was that we just thought that the company was going to need to be able to generate top line growth a couple of quarters just to be able to recapture that investor confidence that it lost this spring. This quarter looks like revenue growth came in at 3%. Not much, but enough to be able to beat consensus. Management raised their guidance to 14.30-14.45 in earnings per share.
So when you look at the midpoint, it’s trading at 13 times earnings. Overall, nothing to change our fair value here. So we maintain that at 270 a share. In our view, market still looks pretty skeptical that the company will be able to achieve that long-term mid-single-digit growth as the environment for their products normalizes, which is what we’re modeling in. Stock’s at a 30% discounts. Rated 4 stars. So we still think it looks attractive here.
Dziubinski: Insulet, which is ticker PODD, reported in August. The stock is up more than 12% since then. Now Morningstar raised its fair value quite a bit on this one, too. So, Dave, walk us through what led to the fair value increase in Insulet and whether there’s an opportunity with the stock today.
Sekera: Yeah, and this is a stock we probably should have been talking a lot more about over the past year and a half. This was one of our picks on the March 25, 2024, episode of The Morning Filter when we highlighted a number of different small-cap companies. Stock value has doubled since then. When I look at results, very strong. Second-quarter revenue up 31%. Operating margin expanded by 670 basis points.
So overall, I mean, these strong results just tell us the company’s gaining ground at the expense of its main rival. We raised our fair value by 20% to 314 per share. Right now it looks like the stock is maybe trading a bit above that fair value, but enough that it’s still within that 3-star range. So, maybe at this point, with as much as that stock has moved, if you’re involved, good time to maybe take some profits off the table. But at that 3-star territory, you certainly don’t need to dump it all.
Dziubinski: Now, Workday stock, which is ticker WDAY, is about flat since reporting earnings in late August. And this stock was a reasonably recent pick of yours. So what do you think of it after earnings? Is it still pick?
Sekera: I mean the quarter came in line with our expectations. Revenue was up 13% year over year. Little bit of operating margin contraction, but we actually had that already incorporated into our model. We noted that the penetration of Workday’s AI products actually came in faster than expected. Overall, our analyst noted that 70% of their core customers are already on their AI suite here. So it’s kind of doing what we expected it to do. Management increased their revenue growth guidance by 20 basis points to 14.2%. Operating margin guidance, they increased that by 50 basis points to 29%. I mean it was in line with what we’re already projecting in. However, it might have been a bit short of what the market wanted. Overall, we maintained our fair value. It’s a 4-star-rated stock at a 26% discount. Still a pick in my mind. It still should be a long-term beneficiary of AI.
Dziubinski: Now, Dollar General stock, which is ticker DG, is up more than 50% from its January lows. So how did the company’s second-quarter report look, and are Dollar General shares still undervalued after that rally?
Sekera: Yeah, very solid quarter as far as I’m concerned. Total sales were up 5%. Same store sales were up a healthy 2.8%. Earnings per share up 9%. It was all enough that management raised their 2025 guidance. So they’re now looking for sales growth of 4.3% to 4.8%. It’s an increase from their prior guidance of 3.7% to 4.7%. New guidance for earnings—$5.80 to $6.30 per share. That’s up from 5.20 to 5.80. Stock trading at about 17 times kind of that midpoint seems pretty reasonable here. Now the stock was a pick on the Oct. 14, 2024, episode of The Morning Filter. It’s up 31% since then. So it’s now a 3-star-rated stock, but I would say keep this one on your radar. It’s given up some of the gains that we’ve seen over the past couple of weeks. So if it keeps this downward trend, it might be enough to fall into 4-star territory again. So one to keep watch of.
Dziubinski: All right, well, that’s it for this quarter’s rapid-fire earnings recap. Viewers and listeners can visit morningstar.com to get caught up on any companies that Dave and I missed that you’re interested in. Well, now it’s time for our question of the week about another of Dave’s picks. Question’s from Robin, who asks, “As an avid watcher of The Morning Filter, I wanted to see your thoughts, what your thoughts are”—excuse me—“about Americold Realty Trust, which is ticker COLD. It was a previous pick, but the price keeps falling. What’s your take now?”
Sekera: All right, so I did sit down with the analyst that covers the stock, and we actually spoke about this one pretty in length last Friday afternoon. So I’m going to try and give a synopsis here. But I’d say this is one that you really need to go to morningstar.com or whichever Morningstar platform you use and really read through the full report and make sure you understand overall what’s going on here. But really the long story short here is that COLD and its main competitor Lineage started building too much cold storage capacity in 2021, and we’re just now starting to see that new capacity build coming to an end as it’s becoming noneconomic at this point.
I think, overall, these two companies really overestimated how much and how long demand for cold storage was increasing. Of course, if you remember in the early years of the pandemic, there was just a huge pickup in demand. But now that demand for cold storage has not only normalized, but it’s actually now under pressure. So what we’re seeing at the grocery stores is that spending on perishables and frozen foods are either under a lot of pressure or in some cases actually getting cut back. So inflation has increased prices here so much that with households being under pressure, households over the past couple of years wage increases have not kept up with inflation, so we’re starting to see, well, actually it’s been the past year to year and a half in the food business, a lot of substitution effect as people are looking for lower-price items and getting away from the perishables and the frozen, which are typically higher-priced items.
Overall within the cold storage industry, I mean, it’s pretty close to being a duopoly. Americold and Lineage have about 70% market share between the two of them in the top 25 markets. But unfortunately with so much excess capacity out there, they’re still competing on price. Hopefully over time they will get to be a little bit more rational. In fact, our estimate here is that it could take four to five years for the market to digest all of this new supply that’s come online. And for that to happen you just need the combination of that slow and steady long-term increase in demand for perishables and frozen food, which we expect over time. But I think you also need to expect the smaller, the uneconomic, players within the industry essentially just getting forced out of business as some of the pricing is no longer in Americold’s, anyways, rational at this point.
Now when we look at COLD stock, Americold stock, it is pricing in all of their current assets below what we think replacement costs are. So from a fundamental perspective, just based on that view, we think the stock is very undervalued here. Now, even with the sector under pressure for the next couple of years, according to our analyst model, the company should still be able to cover and maintain their dividend. I looked up the ratings by the rating agency. So the company still rated investment-grade. It’s Baa3 by Moody’s, BBB by Fitch and DBRS Morningstar. So fundamentally we’re not concerned about the credit quality of the company. Stock’s trading at a huge discount to fair value of 50%. Provides a 6.7% dividend yield. It’s a 5-star-rated stock. I’m just going to caution that as much as it is undervalued, I think this is a story that’s probably going to take multiple years for valuation really to unfold as you see all that excess capacity get used up in the cold storage space.
Dziubinski: All right, so sounds like patience on this one.
Sekera: Exactly.
Dziubinski: So just a reminder to our audience that you can send us your questions via our email address, which is themorningfilter@morningstar.com. Now, Dave has talked several times on The Morning Filter this year about how undervalued small-cap stocks look.
Now Dave has suggested that viewers have exposure to small-cap stocks because when those stocks do bounce back, the rebound can be quick. And Dave’s also suggested getting small-cap exposure through an ETF. So with all of that in mind, I sat down last week With Morningstar Director of ETF and Passive Strategies Bryan Armour to talk about small-cap ETFs, why stock investors might consider them, how to evaluate them, and a few small-cap ETFs Bryan likes best. Take a listen. Now, Bryan, The Morning Filter’s audience is made up primarily of investors who are buying individual stocks. So make the case for why maybe when it comes to small-cap stocks, an individual stock investor might consider an ETF instead of just buying individual small-cap stocks outright.
Bryan Armour: Yeah, so the old saying is “diversification is only free lunch in investing.” So most small-cap stocks aren’t going to probably outperform in the long term. And so if you can hold hundreds or even thousands at once in one portfolio, that gives you access to the ones that do end up winning. And so it’s less about trying to pick the exact winners and just making sure you do hold the winners is the other side of that coin.
Dziubinski: And that you have exposure to that part of that market. Now, when researching a small-cap ETF that maybe an investor would want to buy, what are some of the key things that you think investors need to be paying attention to?
Armour: Yeah, so I would say cost is always a very important one. That comes up in two ways. Number one, fees. You can obviously get access for a cheaper fee for similar strategies. So always good to optimize for that. But also with small-cap stocks, especially with index funds, there’s more trading involved, especially in the lower bounds of the micro-cap stocks, those are more expensive to trade. So you want some sort of buffer or some sort of limitation on how much trading you’re going to actually be doing down there to try to avoid racking up trading costs for little economic purpose.
Dziubinski: Got it. Now, the bulk of ETF assets are held in passive index type products. But we have seen over the past several years quite a number of active ETFs coming to market. When it comes to the small-cap universe, is a small-cap index fund tend to make a little bit more sense, Do you think it makes—I know a lot of the active funds are newer, but does it make sense to consider an active ETF? What’s your take?
Armour: Yeah, so there’s a couple layers to this, and I do the Active/Passive Barometer for Morningstar, and so success rates are higher among passives. It’s typically lower for active in small-cap US stocks, but overall if you have a concentrated strategy, it can become more problematic in an ETF wrapper because unlike a mutual fund, you can’t close down to new investors, and so active ETFs that’ve really settled into the small-cap space and are the most popular tend to be broader portfolios, systematic selection, and tweaking other portfolios like from Dimensional Fund Advisors and Avantis, for example. So I would say index or some of these broad portfolio active.
Dziubinski: Yeah, where it’s not going to be as big of a deal what your flows are necessarily.
Armour: Yeah, you don’t want to worry about the concentration risk.
Dziubinski: When it comes to, say an investor does want to index the small-cap portion of the market, wants a passive strategy, are there certain indexes that are maybe better than others when it comes to that small-cap space?
Armour: I don’t know that I would say better. But there are different. There are a slight variations on trying to achieve the same thing. So there are different ways of doing it. It could either be count, like the S&P 600, which is like 901st to 1,500th biggest stocks in the US that meet the requirements, or Russell 2000, which is 1,001 to 3,000. But there’s also indexes like from CRSP that are percentage-based, so it’s 85th percentile to 98th percentile. So it could end up in different portfolio, like with different portfolios, different areas of the style box, a little bit, all small cap. I wouldn’t say one’s necessarily better than the other. But an issue for the Russell 2000 is the lack of buffers at the bottom of the market cap. And likewise for S&P, something they do a little bit differently is they require companies to be profitable to get into the S&P 1500, which is S&P 500, Mid-Cap 400, and Small-Cap 600. And so yeah there are different ways to approach it. But I think profitability and quality are good features for small-cap stocks.
Dziubinski: I guess the bottom line is first of all, understand the index that the ETF is tracking and second of all, take a good look at that portfolio because two small-cap ETFs could have very different, say, sector exposures or even be in different parts of the style box.
Armour: Absolutely.
Dziubinski: OK, now Morningstar has ETF flows data, and you touched a little bit on flows before. This year, we’ve seen a lot of small-cap ETFs in general being in outflows. If I’m a new investor to the small-cap space, I want to get a new small-cap ETF, but I hear they’re in outflows, what do I make of that? Is that a good or bad thing? Is it maybe a contrarian indicator? Does it mean anything at all if I’m looking to invest?
Armour: Yeah, a tough question. I would say it doesn’t necessarily mean anything, but it does show you where investors are putting their money. And if they’re taking money out of small caps, then it could be a good time to make a contrarian play. And so what we say in factor investing is “no pain, no premium.” So it has to almost go out of style to have the potential to outperform going forward. So yeah, not a bad time to be in small caps according to outflows.
Dziubinski: All right, then it’s time to name names. Tell us some of maybe a couple of Morningstar’s highest rated small-cap ETFs and why we like them.
Armour: All right, so on the market beta side, Vanguard Small-Cap ETF, which is ticker VB, tracks a CRSP small cap index. And so that is a broad portfolio. It’s a good way to capture the small-cap market. All-in-one, single, supercheap 5-basis-point ETF. And then iShares Core S&P Small-Cap ETF IJR that would hold the S&P 600 Small Cap index. And so both of those are great options.
Also if you’re looking for more of a play on our price/fair value metric, which I know is something that on the stock side they talking about a lot, when you aggregate it up to the portfolio level, both of these are going to be undervalued compared to fair value. If you want to dive even deeper into that, then go small value. There’s a small-value version of both strategies as well.
Dziubinski: How about active small-cap ETFs? Any we like there?
Armour: Yeah. So we have two that we like more than the rest—Dimensional US Small Cap ETF, which is ticker DFAS, which receives a Gold rating, Silver-rated Avantis US Small Cap Equity ETF, AVSC. And both of those tilt toward value and profitability characteristics. They avoid asset growth. They take some of the guesswork out of—is this company actually growing, or is it burning their cash and going to be out of business soon? And so these are both very broad. They hold over 1,000 stocks each. Still relatively cheap, more like 25- to 30-basis-point range, but very solid options as well.
Dziubinski: Well, great. Thank you so much for your time.
Armour: Thanks for having me.
Dziubinski: In keeping with the small-cap-stock theme, Dave’s picks this week are four undervalued small-cap stocks. Perhaps investors can, as Dave has mentioned in the past, supplement a position in something like a broad-based small-cap ETF with some of Dave’s picks. All right, so that first pick this week is Campbell’s, ticker CPB. Run through the numbers, Dave.
Sekera: Stock is rated 5 stars, trades at a 45% discount to our fair value. Looks like the dividend yield right now is 4.6%. We rate the stock with a medium uncertainty and rate the company with a wide economic moat.
Dziubinski: Now Campbell’is trading at a really deep discount to Morningstar’s fair value. So what’s Morningstar think the market’s missing here?
Sekera: Well, first of all, when I talked to Erin on the stock, she just made a mention that there shouldn’t be any inordinate impact to the company from the tariff and the trade negotiations. So I think we can take that off the table right away. What we think is going on here is that the market seems to be overextrapolating disappointing results from last quarter too far into the future. In our view, I mean, the company is just doing what needs to be done in the space today. They are spending the money to reinvest in their brands, just keeping pace with evolving consumer trends. They’re doing things like altering price points, they’re adjusting the packaging size to try and appeal to value-focused consumers today.
When I look at our model, I think they’re pretty modest projections here. Company stock is only trading at 13 times our 2025 earnings estimate. And overall, within the food and the consumer package space, there’s a lot going on. So we had Kellanova, that announced last year as being bought out by Mars. WK Kellogg KLG, which had been a prior pick in the small-cap space a while ago, that announced a couple weeks ago that they’re getting bought out. Kraft Heinz KHC, they just announced that they’re breaking up, trying to be able to enhance shareholder value. So I think there’s a lot of increasing recognition in the marketplace that these food companies are very attractive multiples here. And as we see more players come into this market, whether it’s private equity or other strategic buyers, that could be the catalyst for some of these stocks here to start moving up toward our fair values.
Dziubinski: Now, your next pick this week is a new small-cap name we haven’t talked about before. It’s Portland General Electric, ticker POR. Tell us about it.
Sekera: Yeah, well, I mean, as we’ve talked about in the utility space, overall, utilities in our view, overvalued today. It gets harder and harder to find some undervalued opportunities, which leads us to Portland General. It is a 5-star-rated stock, trades at a 23% discount to fair value, has a 4.9% dividend yield. We rate the company with a narrow economic moat, which is pretty similar to all the regulated utilities, as well as a low uncertainty.
Dziubinski: Now, as you mentioned, there aren’t really many utility stacks trading at discounts these days. So what’s the story here?
Sekera: I think it’s a combination of a couple things. One, it’s just a relatively small utility stock in Portland, so I think it gets overlooked by the market a lot. I think when you look at the story here, too, it’s not going to have those same kind of growth dynamics that we might see in a lot of other utilities as far as the amount of new demand for artificial intelligence. And I also think that the story here is that the market is probably overly concerned about potential liability from wildfires. Now we’re not really as concerned. I mean, the company is mainly based in urban areas and especially wet geographic location.
And I’d also note that to be found liable for wildfire damage, they’d need to be found to be negligent. So it’s not a strict liability state like in California, where you do have the wildfire risk in those utility stocks. Stock’s only trading at about 13 times our earnings forecast. The rest of the sector is at 19 times. And I would say, overall, when you’re thinking about what companies should benefit from the Fed cutting rates, utilities, of course, comes to the forefront of mind. So I think this is a good one, that you should kind of get that benefit over time as people are looking for undervalued utility stocks to benefit from lower long-term interest rates.
Dziubinski: Your next pick this week is a REIT. It’s Macerich, ticker MAC. Give us the rundown.
Sekera: Yeah, I mean the stock’s trading at a 21% discount, has a 3.8% dividend. We currently rate at 4 stars. Now I’d note does not have an economic moat, but that’s pretty similar to most of our real estate coverage. We find it’s very hard to have a long-term economic moat in real estate. And I’d also note that this one does have a high uncertainty rating as well.
Dziubinski: So Dave, what do you like about Macerich besides that valuation of course?
Sekera: Well, first of all, thinking about which sectors should benefit from lower interest rates, real estate also comes to the front of my mind. So that’s going to do a couple of different things for real estate. So one, just lower interest rates as they go ahead and refinance existing debt when it comes due as well as be able to issue cheaper debt to be able to fund their growth. That’s going to lead to lower financing costs. So that’s going to help improve their earnings. And then it also lowers kind of cap rates. So cap rates are those implied interest rates that real estate investors pay for real estate. So those lower-cap rates increases the present value of properties today. This company owns Class A shopping malls.
Overall, we think the death of the shopping mall is pretty greatly exaggerated. What we’re seeing is that these malls are becoming more experiential in order to drive foot traffic. They’re a lot less reliant on in-person shopping these days compared to what they had been in the past. This is a stock, as well as Simon Property Group, that we’ve recommended in the past.
Now Simon Property Group SPG, that’s moved up enough to be a 3-star stock, that one’s much larger, has always gained a lot more investor attention. I think this company is always kind of overlooked by the marketplace because it is a small-cap stock. Looks like the first time we recommended this company was in March of 2023. It’s up over 70% since then, plus the high dividends that you’ve captured. So again I think this one still has some potential upside, and it’s just a matter of probably being overlooked by the marketplace.
Dziubinski: And your last pick this week is another name I don’t think we’ve talked about before. It’s Ring Central, ticker RNG.
Sekera: Yeah, this one really hasn’t hit a lot of my screens in the past because we do rate it with no economic moat, and it has a very high uncertainty. Having said that, it is a 45% discount to fair value and is a 4-star-rated stock.
Dziubinski: So Dave, first clarify what Ring Central does and then explain why you like it.
Sekera: Yeah. The description of the company—unified communications as a service, crossing voice, video, and messaging. Essentially, what this company is doing is helping companies move from legacy on-premise systems to a cloud-based system. Significant portion of their business is helping companies replace office phone lines. And I’d also note here, talking to Dan, who’s our equity analyst, he thinks that there’s just a huge total, addressable marketplace here. I think he’s noted there’s like over 400 million office lines out there, but at this point still only a relatively small percentage have been replaced by, whether it’s Ring, Teams, Zoom, or some of the other competitors in this space. Overall, he thinks his assumptions are pretty conservative. Taking a look at our model here, only a 5% top line compound annual growth rate for revenue. We’re looking for a little bit of fixed cost leverage in order to lead operating margin expansion. Gets us to 8% net income growth rate for the next five years. Yet taking a look at the stock today, it trades at just under 8 times earnings.
Dziubinski: Well, thank you for your time this morning, Dave. Those who would like more information about any of the stocks Dave talked about today can visit morningstar.com for more details. We hope you’ll join us next Monday morning for The Morning Filter at 9 a.m. Eastern, 8 a.m. Central. In the meantime, please like this episode and subscribe. Have a great week.
