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Falling Oil Prices Leave ‘Pocket of Opportunity’ in Pricey Market: Morningstar

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While the stock market seems “fully valued” at the end of its sixth consecutive year of positive returns, recent extreme volatility creates “pockets of opportunity” — particularly in the hard-hit energy sector — according to Morningstar, which released its quarter-end insights Monday.

Yes, the S&P 500 is trading near all-time highs, says Morningstar analyst Matthew Coffina.

But the collapse in oil prices — Brent crude is under $60 a barrel from $115 a barrel back in June — has precipitated a nearly 25% plunge in energy stocks in the past quarter.

That downward pressure on energy companies has led to a surge in the number of stocks earning all five of Morningstar’s coveted stars.

The Chicago-based investment firm — generally better known for its fund ratings — has been fairly stingy in its stock ratings in recent years.

In the quarter ending just three months ago, the firm gave five stars to just 10 companies across the entire universe of stocks its 100-plus analysts cover. To earn that rating, a company must have both sustainable competitive advantages and be cheap. That last criterion is especially hard to achieve in an aged bull market.

But the sell-off in energy and other areas of the market (such as basic materials) has swollen the list of five-star companies from 10 to 64, more than half of which, 37, are in energy.

The reason for this “pocket of opportunity” in a fairly priced market is the view of Morningstar’s stock analysts that oil’s retreat is just temporary. The firm calculates stock prices’ fair value based on long-term (i.e., beyond three years) expectations, and Morningstar’s “long-run oil price forecast remains $100/barrel for Brent and $90/barrel for West Texas Intermediate.”

Coffina attributes the current plunge to a basic supply and demand imbalance in the volatile commodity.

On the supply side, North American production has surged, accompanied by unexpectedly high production in the Middle East and North Africa, despite regional turmoil. At the same time, energy demand has ebbed because China’s growth is decelerating while other major economies — Europe, Japan and Brazil among them — are flirting with recession.

The result of all this will be to temporarily shut down production of high-cost energy from deep water and oil sands, for example, causing such resources to “lose their relevance to setting oil prices,” Coffina writes. Low-cost producers capable of exploiting lower costs of services such as rigs, equipment and labor can offer the margin of safety investors require at a time of low near-term prices.

“Such margins of safety are now widely available in energy” — a sector whose median stock is trading 27% of Morningstar’s estimate of fair value, Coffina continues.

An updated list of five-star stocks that Morningstar has provided to ThinkAdvisor includes well known energy and production names such as Chesapeake Energy, Range Resources and Apache Corp., as well as smaller firms like SandRidge Energy and California Resources Corp.

Morningstar’s senior research analyst Annette Larson cautions, however, that market changes since mid-December, when the quarter-end insight was produced, have pared down the list of five-star stocks to 24, though a majority of those companies are energy-related.

The fourth-quarter analysis accentuates the risk side of the equation (more than the opportunity side) in discussing basic materials — after energy, the second most undervalued sector, trading 11% below the firm’s fair value estimates as of mid-December.

The big problem there is slowing growth in China, which accounts for “about half of all global steel demand and two-thirds of the seaborne iron ore market,” for example. With consumption of these and other materials in what appears to be a steady decline, prices are declining and investors, like in the case of energy, must look for “low-cost miners with sustainable competitive advantages.”

ArcelorMittal, BHP Billiton, Barrick Gold and Yamana Gold alone make that cut among basic materials companies meriting five stars from Morningstar.

The Q4 analysis finds the overall market trading a mere percentage point below fair value, but that aggregate figure derives from undervalued energy, basic materials and other cyclical stocks “offsetting modest overvaluation in more defensive sectors” like consumer staples, health care, utilities and real estate. Technology and industrials are also trading at premiums to the firm’s fair value estimates.

While broad market gauges such as Shiller P/E and price to trailing peak operating earnings reveal that stocks are pricier than they have been in 62% to 63% of readings since 1989, Coffina offers the hope that today’s historically low interest rates — if sustained — “could justify substantially higher P/E ratios than we’re used to.”

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