What are we looking for?
Undervalued stocks in the TSX 60 index.
The screen
On a year-to-date basis, the 60 large companies that make up the S&P/TSX 60 Total Return Index have produced roughly a 5.4-per-cent return, mirroring the 15-year annualized return of the same index (roughly 5.8 per cent annualized). This return to the black may provide investors with some relief, given that the same blue-chip index lost 6.3 per cent over the 2022 calendar year. Today, I seek to find companies within the index that have potential to grow further, based on how the stocks are trading relative to Morningstar’s estimate of fair value.
Recall that most Street analysts will value a company based on a projection of future cash flows or earnings, then will discount those cash flows back to present value to arrive at a fair value for the stock. This analysis is aptly named a discounted cash-flow model and is the basis of Morningstar’s own valuation methodology for stocks. The nuances of the model, namely the projected growth rate and the discount rate, influence the outcome greatly.
This is where Morningstar’s equity analysts’ expertise comes into play, particularly because they focus on a firm’s ability to keep competitors at bay – its economic moat, a term attributed to Warren Buffett. Morningstar identifies five sources of such a moat: (1) switching costs, those obstacles that keep customers from changing from one product to another; (2) the network effect, which occurs when the value of a good or service increases for both new and existing users as more people use that good or service; (3) intangible assets – patents, government licences, brand identity; (4) cost advantage, which allows a company to undercut its competitors or achieve higher profitability; and (5) efficient scale, which benefits companies operating in a market that only supports one or a few competitors, limiting rivalry.
Companies with wide moats are predicted by Morningstar to maintain competitive advantages for more than 20 years, while those with narrow moats are predicted to maintain advantages for 10 years. The concept of stock valuation and economic moat make a formidable combination, allowing investors to find competitive companies that may also look undervalued.
Today we screen the constituents of Canada’s blue-chip index to find companies that remain undervalued despite the recent positive performance of the index. To do so, we look for companies that have a Morningstar rating for stocks of four stars or better. Recall that Morningstar’s stock rating is a comparison between the stock’s current price and Morningstar’s fair-value estimate. Five-star stocks are considered undervalued, while one-star stocks are considered overvalued.
What we found
The stocks that met the above screen are listed in the accompanying table, alongside the Morningstar rating, an assessment of moats, dividend yield, price-to-earnings ratio, return on equity and trailing returns. Canada’s oligopolistic structure is evident in this screen – note the appearance of our large telecom providers and Schedule I banks at the top of the list.
This article does not constitute financial advice. Investors are encouraged to conduct their own independent research before purchasing any of the investments listed here.
Ian Tam, CFA, is the director of investment research for Morningstar Canada.
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Ian Tam, CFA