The UK stock market enjoyed a strong performance in the first half of the year as the country geared up for an election that led to a new Labour government. However, the recent Budget sent stocks lower over fears of inflation and lower growth. Combined with a Trump win and stronger dollar, this has continued to drive down UK share prices.
While some investors see a lower stock price as a buying opportunity, it is important to separate a low-quality stock from one that is higher quality but just trading below its fair value. There are a few ways Morningstar looks at valuations to identify opportunities. Does the stock have a competitive advantage versus rivals? Does it know how to best manage its cashflows? How much is the share price likely to fluctuate around this valuation estimate?
We have identified 16 stocks that that fit these criteria. Out of a total of 16 stocks, eight are currently undervalued. These are the stocks we’ve highlighted in this article:
• GSK GSK
• Rentokil Initial RTO
• Spirax SPX
• Melrose Industries MRO
• British American Tobacco BATS
• Reckitt Benckiser Group RKT
• AstraZeneca AZN
• BAE Systems BA.
• Diageo DGE
GSK GSK
• Fair Value Per Share: £22.00
• Morningstar Rating: ★★★★★
• Morningstar Uncertainty Rating: Medium
• Capital Allocation Rating: Standard
The most undervalued stock in this list according to Morningstar metrics is GSK GSK, one of the largest pharmaceutical companies in the world. Its new products and expansive list of patent-protected drugs are key reasons for GSK’s wide economic moat rating.
One of GSK’s strengths is its focus on innovation, particularly within oncology and the immune system by using genetic data – treatments that hold stronger pricing power and which could improve approval rates.
Following the U.S. election, Morningstar strategist Karen Andersen noted that the biopharma industry can expect mergers and acquisitions to become easier, and a potential repeal of parts of Medicare could lessen pricing pressure on the industry. However, approval decisions on drugs, particularly vaccines, could become less predictable.
The stock is currently trading at £13.10, at a 40% discount to fair value.
Rentokil Initial RTO
• Fair Value Per Share: £6.20
• Morningstar Rating: ★★★★★
• Morningstar Uncertainty Rating: Medium
• Capital Allocation Rating: Exemplary
Pest control and commercial hygiene company Rentokil RTO is currently attempting to turn around its struggling North American pest control business, which, along with the rest of the market, struggles to achieve growth. However, after its third quarter update in October, Morningstar’s senior equity analyst Grant Slade believes shares screen attractively, with investors’ low confidence being an “overly pessimistic perspective”.
Rentokil’s strategy focuses on attaining and maintaining market share leadership through mergers and acquisitions, which continues to be a priority. This strategy yielded a durable cost advantage for Rentokil’s pest-control business, which is the source of its wide economic moat rating.
The stock is currently trading at a 35% discount to fair value, with a share price of £4.04.
Spirax SPX
• Fair Value Per Share: £96.50
• Morningstar Rating: ★★★★★
• Morningstar Uncertainty Rating: Medium
• Capital Allocation Rating: Standard
Spirax SPX, an industrial producer of thermal systems and biopharma tools, has seen a slowdown in performance recently. That said, Matthew Donen, senior equity analyst at Morningstar, believes this is a cyclical downturn confined to a few sectors and China.
Morningstar is confident in the company’s fundamentals, despite a recent management change and recent acquisitions. With consistent capital returns and half of sales derived from recurring maintenance, our analysts have assigned the company’s shares a fair value of £96.50. Spirax has a share price of £65.50, 32% below their fair value.
Melrose Industries MRO
• Fair Value Per Share: £7.40
• Morningstar Rating: ★★★★★
• Morningstar Uncertainty Rating: Medium
• Capital Allocation Rating: Standard
Engine and component supplier Melrose MRO is a long-term partner with “all engine” original equipment manufacturers such as Pratt & Whitney, GE, Safran, and Rolls-Royce. Morningstar believes that the company is strongly positioned to benefit from the post-pandemic civil aerospace recovery, growth in the engine aftermarket sector, and uptrends in civil and defense markets. Last earnings season, both operating profit and margins increased, and Morningstar expects strong defense revenue driven by spending in both Europe and US.
Melrose closed at £5.27 on Nov. 18, trading at a 29% discount.
British American Tobacco BATS
• Fair Value Per Share: £39.00
• Morningstar Rating: ★★★★
• Morningstar Uncertainty Rating: Medium
• Capital Allocation Rating: Standard
Globally, sales of cigarettes are declining about 5% a year, but British American Tobacco BATS is able to maintain its wide economic moat rating due to the addictive nature of their products. Moreover, Morningstar’s analysts believe the US market is attractive and expects BAT to be able to continue increasing prices to offset volume declines and drive robust free cash flow generation.
Shares trading at £28.82, leaving them 26% discounted.
Reckitt Benckiser Group RKT
• Fair Value Per Share: £65.00
• Morningstar Rating: ★★★★
• Morningstar Uncertainty Rating: Medium
• Capital Allocation Rating: Standard
Reckitt Benckiser RKT is a leader in a categories across consumer hygiene, health, and infant nutrition products. It has however struggled with changing leadership changes and litigation around its premature infant formula products, leaving it out of favor with investors. That said, shares jumped 10% at the start of November following a win in its litigation process. Morningstar equity analyst Diana Radu argues that the litigation win goes a long way to restore confidence, while the overall majority of Reckitt’s portfolio is well positioned to benefit from secular growth drivers.
Reckitt is trading at a 26% discount to fair value with a share price of £47.83.
AstraZeneca AZN
• Fair Value Per Share: £124.00
• Morningstar Rating: ★★★★
• Morningstar Uncertainty Rating: Medium
• Capital Allocation Rating: Exemplary
AstraZeneca AZN is the second-largest company by market capitalization in the FTSE 100. Its patent-protected drugs and developing pipeline-one of the strongest in the industry, according to Morningstar’s analysts-adds up to a wide moat rating. Our analysts also see Astra as a company with a sound balance sheet, a strong track record of investments, and largely fair shareholder distributions.
AstraZeneca’s current share price of £99.15 is 20% below fair value.
BAE Systems BA.
• Fair Value Per Share: £14.90
• Morningstar Rating: ★★★★
• Morningstar Uncertainty Rating: Medium
• Capital Allocation Rating: Standard
Wide-moat BAE Systems BA. has seen strong performance since the war in Ukraine broke out, with a three-year annualized return of 34%. The defense industry is characterized by technological knowledge, patents and strict laws, making it harder for new players to enter the market. Escalating global security concerns are driving structurally higher growth in the defense market. Morningstar anticipates global security concerns will continue to drive uninterrupted growth for at least several years. BAE Systems is strategically positioned to benefit, given its significant stakes in a broad array of major international defense projects.
The stock is 13% undervalued with a share price of £12.96.
Diageo DGE
• Fair Value Per Share: £31.00
• Morningstar Rating: ★★★★
• Morningstar Uncertainty Rating: Low
• Capital Allocation Rating: Standard
Morningstar recently lowered its fair value estimate for Diageo DGE, the owner of over 200 alcoholic beverage brands, due to the post-covid demand reset. Morningstar believes in the company’s premiumization strategy, capitalizing on the consumer trend of “drinking less but better”. With brands like Johnnie Walker, Diageo has scope for some of the core brands in the portfolio. However, the cyclical nature of the industry means garnering returns on premium investments might not be a straight journey.
The company is trading at a 9% discount to fair value with a share price of £23.61.
By Margaret Giles
One of the keys to finding the best long-term investments is buying companies that can stay one step ahead of the competition. Legendary investor Warren Buffett originally coined the term “economic moat” to refer to a company’s ability to keep competitors at bay over time. Morningstar builds on this idea to rate companies based on their “moat”, or the strength and sustainability of their competitive edge.
We’ve compiled a list of the best companies our analysts cover that are available on the London Stock Exchange. These companies have successfully carved out wide moats between them and their industry competitors, and we’re confident that they will produce returns that outweigh their costs for the next 20 years or more. In other words, these companies will reliably be able to produce returns for investors over a long period even as they invest in their growth.
The companies that make our list also have predictable cash flows, the money going into and out of a company, so our analysts can more accurately estimate how much the businesses are worth. These companies also make smart decisions about how they manage and invest their money.
We aren’t advocating that you buy shares of every company on this list today. Even the greatest company can be a bad investment if you overpay. The share prices of many companies on this list overestimate their real value, so it may not be the right time to buy. Still, we believe these companies could be worth adding to a stock investor’s watchlist.
We’ve grouped the companies on this list according to the overall sectors of the economy in which they compete.
Readers of Morningstar.co.uk can use Morningstar’s unique suite of tools to create “pick lists” of companies for their own portfolios. This allows you to cross-reference your own ideas against Morningstar’s own extensive research database.
To find out more about how to deploy Morningstar data to enhance your own equity, fund, and portfolio selection process, visit this article.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.
