3 Undervalued, High Quality Cyclical Stocks
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Amid ongoing worries about the possibility of a recession cyclical stocks—those most closely tied to the economy’s ups and downs—have had a rough year.
But as a result, many cyclical stocks have fallen into undervalued territory. For long-term investors looking beyond the potential for a recession in 2023 and considering buying cyclical stocks, that means there are opportunities.
To find those undervalued names, we turned to the 574 stocks in the Morningstar US Cyclical Super Sector Index and looked for undervalued names. The Morningstar US Cyclical Super Sector Index measures the performance of stocks from the cyclical sectors, which are basic materials, consumer cyclical, financial services, and real estate.
In 2022, the index lost 17.9% for the trailing 12-months while the broader market fell 15.8%, as measured by the Morningstar US Market Index.
With cyclical stocks having suffered broad-based declines, there’s a long list that are in undervalued territory with a Morningstar Rating of 4 or 5 stars. Out of the 217 stocks in the US Cyclical Super Sector Index covered by Morningstar analysts, 120 were undervalued as of Dec. 31. There were 223 stocks covered as of Dec. 31, 2021, with 167 being undervalued.
To trim the list down, we next screened for only the most undervalued stocks that carry a 5-star rating. Then we looked for the stocks that have earned a Morningstar Economic Moat rating of wide to find companies with the strongest durable competitive advantages.
While we focused on stocks with only wide moat rating—meaning their competitive advantages are expected to last more than 20 years into the future—there are even more attractively priced companies within the index that have narrow moats (meaning their competitive advantage will likely endure for the next 10 to 20 years). The full list of undervalued wide-moat stocks can be found at the end of this article.
What Is a Cyclical Stock?
Cyclical stocks are those that follow the overall economy, rising and falling alongside macroeconomic trends. That’s largely because many of the industries within the super sector are dependent on discretionary spending. These industries include basic materials, consumer cyclical, financial services, and real estate. JPMorgan Chase JPM, Tesla TSLA, and McDonald’s MCD are among the largest companies in the cyclical super sector index.
Cyclical Stocks to Buy Now
These were the three most undervalued, wide-moat stocks in the Morningstar US Cyclical Super Sector Index as of Jan. 17:
Amazon was the most undervalued cyclical stock, trading at a 45% discount to the fair value estimate set by Morningstar analysts.
Amazon
- Fair Value Estimate: $150
- Economic Moat Rating: Wide
“Our fair value estimate for Amazon is $150 per share, which implies a 2022 enterprise value to sales multiple of 3 times and a 0.5% free cash flow yield. We think multiples are a little less meaningful for Amazon given the ongoing heavy investment and rapid scaling that depresses financial performance. However, we expect the company to significantly grow its free cash flow as it matures.
“Over the long term, we expect e-commerce to continue to take share from brick-and-mortar retailers. We further expect Amazon to gain share online. We believe that over the medium term, COVID-19 pulled forward some demand by changing consumer behavior and better penetrating some retail categories, such as groceries, pharmacy, and luxury goods, that previously had not gained as much traction online. We think Prime subscriptions and the accompanying benefits, combined with selection, price, and convenience continue to drive the retail story. We also see international as being a longer-term opportunity within retail. We model total retail-related revenue growing at a 7% compound annual growth rate, or CAGR, over the next five years.”
“Amazon dominates its served markets, notably e-commerce and cloud services. It benefits from numerous competitive advantages and has emerged as the clear e-commerce leader thanks to its size and scale, which yield an unmatched selection of low-priced goods for consumers.”
— Dan Romanoff, senior equity analyst
Polaris
- Fair Value Estimate: $175
- Economic Moat Rating: Wide
“Polaris is one of the longest-operating brands in powersports. We believe that its brands, innovative products, and lean manufacturing yield the firm a wide economic moat and that it stands to capitalize on its research and development, solid quality, operational excellence, and acquisition strategy. However, Polaris’ brands do not benefit from switching costs, and with peers innovating more quickly than in the past, it could jeopardize the firm’s ability to take price and share consistently, particularly in periods of inflated recalls or aggressive industry discounting.”
“We believe Polaris has established a wide economic moat, delivering healthy adjusted returns on invested capital (averaging 21%, including goodwill, during the past five years). We believe innovative product offerings and growth of adjacent categories through acquisitions (and organically) have positioned the business to continue to capture increasing volume and profits as it reaches new end users.”
“We are maintaining our $175 per share fair value estimate for Polaris after incorporating third-quarter results, which were affected by depressed retail sales (down 8%), resulting in market share declines across its ORV and marine segments. We believe this stems from a dysfunctional supply chain and expect market share losses to reverse as parts availability improves over the next six months, supporting our hypothesis that Polaris will continue to carry a topnotch brand intangible asset.”
— Jaime M. Katz, senior equity analyst
Ecolab
- Fair Value Estimate: $210
- Economic Moat Rating: Wide
“As the global leader in the cleaning and sanitation industry, Ecolab provides products that help its hospitality, food-service, and healthcare customers do laundry, wash dishes, and maintain regulatory compliance. With unmatched scale and a solid razor-and-blade business model, Ecolab’s competitive advantages are firmly in place. The company’s cleaning and sanitation scale dwarfs the competition. Ecolab generates over 3 times the revenue of its largest rival. Its industries are fragmented, with many markets made up of regional and local competitors. Ecolab controls roughly 8% of the $152 billion global market. With its unrivaled scale and breadth of product offerings, the company is an attractive partner to global hospitality, food-service, and manufacturing firms. We think it will continue to grow from market share gains and expansion into new markets.”
“Ecolab’s installed base and consumables model, commonly known as the razor-and-blade model, is the most important driver of high switching costs. The company leases proprietary cleaning equipment and devices to its clients and then sells a steady stream of the consumables required to keep the machines running. In addition to the cost savings that its products’ customers appreciate, Ecolab minimizes downtime for key pieces of its customers’ machinery, allowing its business processes to proceed without costly interruptions. Customers are motivated to avoid the costs associated with swapping to new equipment and retraining staff.”
“Our fair value estimate is $210 per share … [which] includes a continued recovery from the COVID-19 slowdown and higher input costs weighing on 2022 results. The company should resume growth in 2023 as cost inflation begins to subside and the company’s recent price increases allow it to recover profits. However, we expect an economic slowdown will reduce the growth rate. Over the medium term, we expect volumes to fully recover and Ecolab to benefit from price increases in excess of higher costs, driving margin expansion.”
— Seth Goldstein, strategist
Read More: 3 Undervalued, High Quality Cyclical Stocks
