Key Takeaways
- What core stocks are and what qualities they share.
- Should you pay more for core stocks than you’d pay for noncore stocks?
- Why you can’t simply buy and hold core holdings. You need to buy and manage them instead.
- The best core stocks to own, according to Morningstar’s sector directors.
In this new episode of The Morning Filter podcast, co-hosts Dave Sekera and Susan Dziubinski discuss core stocks. These are the types of stocks that should form the foundation that an equity investor can build upon. They unpack the qualities that core stocks share and whether investors should be willing to pay higher valuations for these high-quality stocks.
There’s a better strategy for managing your core stock holdings than buy and hold; tune in to find out what the strategy is. They wrap the episode with a handful of great core stocks to own when you can invest in them at the right price.
Got a question for Dave? Send it to themorningfilter@morningstar.com.
Transcript
Susan Dziubinski: Hello, and welcome to The Morning Filter podcast. I’m Susan Dziubinski with Morningstar.
Every Monday before market open, I sit down with Morningstar Chief US Market Strategist Dave Sekera, to talk about what investors should have on their radars for the week, some new Morningstar research, and a few stock ideas.
But as you can see, we’re doing something different today. Dave and I are taping a special episode dedicated to core stocks, which is a topic we’ve talked about before and that you’ve told us you wanted to hear more about. We’ll cover what qualities core stocks share, when to buy them, and how to manage your core stock positions. And we’ll wrap up with, of course, some core stocks to buy when the price is right. Dave and I are taping this video on June 3.
All right, great to see you in person, Dave.
David Sekera: It’s good to be back in the studio. I enjoy this.
Qualities of Core Stocks
Dziubinski: Let’s start at the beginning. What qualities do core stocks have in common?
Sekera: Well, you have to think about core stocks as really the basis of your portfolio, really that bottom layer that everything else is going to be built upon. These are the ones you’re going to want to own through pretty much any kind of market cycle. You’re going to want to own these no matter how market sentiment may be shifting. And these are the ones you really want to own through any kind of economic cycle, whether we’re in an expansion or a recession.
Now, as far as the attributes, the type of things I’m typically looking for for a core stock, there are going to be those that have a wide economic moat, those that we think have those long-term durable competitive advantages to be able to generate those excess returns over the next 20 years or more. Maybe those with a low or medium uncertainty. So you’re not going to have hopefully nearly as much volatility in those kind of names as you might see elsewhere.
And of course then one of the big things, too, is also looking at how management has run the company, really looking at their capital allocation rating. Ideally certainly looking for one that has an exemplary rating.
When to Buy Core Stocks
Dziubinski: Now would you recommend, considering we’re talking about core stocks, which again are those foundations for a portfolio, how important is valuation with core stocks? Normally, we talk on The Morning Filter about buying stocks at a discount to our fair value.
Can you fudge a little bit with core stocks and buy them maybe when they’re a little overvalued? What’s your take?
Sekera: Personally, I’d still probably steer clear if they’re overvalued. And again, in that case, if it’s a 2-star or a 1-star, that just tells you that you wouldn’t expect to get those risk-adjusted type of returns that you could get elsewhere. So if they’re a 2-star, 1-star, I’d probably steer clear. Now, if they’re a 3-star-rated stock, again, I’d much prefer if they had a margin of safety. But again, I don’t think it would be wrong to buy a 3-star-rated stock.
I would just say I would probably start with a partial position. Make sure you leave yourself some dry powder, so that way, if the stock sells off or the market sells off and pulls it down, you’ve got the ability to be able to dollar-cost average in and be able to buy some more when you’re able to get it cheaper.
Managing Core Positions
Dziubinski: Now we talked on a previous episode of The Morning Filter, and it really seemed to have resonated with our audience, this idea of, as an investor, you’re not really buying and holding indefinitely. You termed it more of it’s a “buy and manage” type of approach to stock investing.
So talk specifically, Dave, about how a buy-and-manage strategy works when we’re talking about core stocks, specifically.
Sekera: Everything’s always got a price that you want to own it, and everything’s got a price that you don’t want to own it. And that’s more of how I think about this buy-and-manage strategy. That’s some advice I got earlier in my career from Jimmy. He was the ex-Salomon Brothers trader that I worked for for a number of years, and it was really great training, thinking about how to be able to manage positions.
So, of course, you have a position on, and when you think about a position, you own it every day. Every day, market opens up, and you can decide, either I should be buying more of this, I should be holding it, or I should be selling it. So in this case, with that buy-and-manage perspective, I think you need to really realize, OK, well, what’s the valuation of the stock? Where is it trading? Is this something I still want to own today?
And if not, if there’s been a change in maybe the investment thesis for the company, your outlook is changing, the valuation has gotten too high, no one ever went broke taking a profit, so it’s always good to peel some off.
Or conversely, even if that stock is selling off, again, if there’s a change in your investment thesis and you’re no longer as confident about your outlook for the company, maybe you think that revenue isn’t going to keep up with what you thought it was going to be before, maybe margins are contracting and there’s a change or a paradigm shift within the industry itself that you don’t think that that’s just a short-term blip and that maybe that’s something that really is impairing the value of the company, then go ahead and certainly take some off of the table.
But again, I think you need to approach it with that viewpoint: Every day you can either buy more of this or sell more of this, and I think you want to have that base position. And again, for these type of stocks, more often than not, if they’re selling off and they get into 4-star and 5-star territory, you definitely want to have that dry powder to be able to add more in and then that way when it moves back up, you can take some of the profit off the table, or if you’re at your full core position, you can hold it there. And conversely, sometimes the market just gets overly exuberant in a specific sector or a certain name, and at that point in time, if it’s moved up, go ahead, take some of that profit off the table. You can put that money to work elsewhere.
So again, I think it’s really managing that position as opposed to just putting away and forgetting about it.
Best Core Stock: GOOGL
Dziubinski: All right. Well, let’s talk a little bit about picks, some core stock picks. Now again, these aren’t necessarily all buys today, but these are core stocks that are great companies to own at the right price. They’re definitely all, at the very least, watchlist companies.
And you did something cool this time, not that you’re not cool all the time, Dave, but this time, you went and you surveyed Morningstar’s sector directors, and you asked them basically what is the best core stock in your sector. And we’re going to talk about five of the responses that you received today.
The first one is going to be—our sector director from the communication services sector picked Alphabet. Walk us through the case for why Alphabet GOOGL is a great core stock to own.
Sekera: Yeah. And I mean, this is a stock. I mean, you and I have talked about ad nauseam over multiple years at this point in time. Our fair value on the stock today is $433 a share. It’s a company we rate with a wide economic moat, and I’d say not just only a wide economic moat, but it’s one of the handful of stocks. I think maybe there’s only three, that we use four of those five moat sources to identify that wide moat. So I think the only one that we don’t use is efficient scale, and to be honest between you and I, I think I could probably argue that it probably has that moat source as well.
But again, it’s just a company that just dominates the areas that it competes in today, and they of course have just a huge research and development budget, and they’re in just pretty much every part of forward-looking technology today, whether it’s Gemini, their AI platform, Google Cloud, where they’re hosting AI generation or computing for other people.
So again, no matter where technology is going, I think they’re going to be there at the forefront of that technology for the foreseeable future.
Dziubinski: And again, a really high capital allocation—exemplary rating—on this company, too, reflecting that, right?
Sekera: Exactly. So it is an exemplary rating. I think part of the exemplary rating is really just because when you look at the investments that they’ve been making in the past, just how well those have worked out, whether it’s Gemini or whether it’s the Google Cloud.
Best Core Stock: LOW
Dziubinski: All right. So your second core stock is from the consumer cyclical sector. Sector director here says Lowe’s LOW is the best core stock in the sector.
Review Morningstar’s thesis on Lowe’s. We’ve talked about it maybe on occasion on the show, but probably not very deeply, and talk about what makes it really a core stock to hold.
Sekera: Taking a look at Lowe’s, our fair value on that stock right now is $258 per share, medium uncertainty rating, wide economic moat, that moat being based on cost advantages and intangible assets.
Now, a lot of people might look at Home Depot HD. I’m not going to argue against Home Depot. I just think Lowe’s is actually in a little bit better position right now. One of the reasons that the analysts talked about is they’re actually moving more into that pro sector. That’s an area that Home Depot is actually done very well in. So we’re actually looking for some earnings acceleration as they build out that part of their business. But even away from the earnings acceleration in that part of the business, she just talked about the amount of pent-up demand that she sees just because housing turnover has been relatively low on aging housing stock. These are just all good long-term tailwinds.
And again, this is another one that has that exemplary capital allocation rating, strong returns on invested capital, very strong balance sheet, which, of course, for a retail like this, you really want to see that strong balance sheet. And other than that, they just have had very good proven reinvestment strategy, being able to put money to work in the stores just to be able to evolve as consumer purchasing habits have changed.
Best Core Stock: PG
Dziubinski: Another core stock with another exemplary capital allocation rating, this is from the consumer defensive sector, and it’s Procter & Gamble PG. Talked a little bit about this one on the podcast before, and this one seems very much like kind of a steady-Eddie stock. Is that fair to say about it?
Sekera: It is, and it isn’t. So I would say this is actually a really good example of that buy-and-manage investment philosophy.
If you look at this stock, I think back in 2015, 2016, it was probably pretty fairly valued. And then for whatever reason, the market lost confidence, had negative sentiment, and the stock fell in 2018, and it was a 4, I might have even touched on 5-star territory at that point in time. And we held our fair value through that, and then the stock moved up quite substantially the couple years thereafter. And in fact, it actually moved up so high, it went into 2-star territory for quite a while, and it stayed overvalued for quite a number of years.
So again, this was a great one where if you had that position, you could have added to it and then when it moved up into that overvalued territory, peel some of that off.
I mean, in fact, if you look at the chart, it has sold off the past couple of months. It looks much more fairly valued today. So if you’re not involved now, it might not be the worst time in the world to be able to start a position there. But again, I think this is a good one where that stock had kind of gone nowhere for several years. I mean, you’re at least clipping a dividend coupon there, but again, it’s one of those ones where that buy-and-manage strategy would’ve worked out pretty well over time.
Now getting away from the stock in and of itself, we do rate the company with a wide economic moat, a couple of different factors behind that, a low uncertainty rating. Overall, when you just think about the company, like you said, kind of a steady-Eddie, household consumables, the types of things that you just need day-in, day-out.
But the other part of the company that I think that we really find attractive is just the strength of their brands. And when you think about what they sell, as a consumer, when you go into the supermarket, grocery store, or whatever, and there’s certain items that you’re looking for, you expect retailers to have those specific brands you’re looking for. And in this case, I think that gives the company a lot of leverage against their own clients to be able to make sure that they can extract as much economic value as they can out of that brand strength.
Dziubinski: Now, what was the fair value on this one? You might’ve said it.
Sekera: Oh, sorry. It was $148 a share.
Best Core Stock: XOM
Dziubinski: Great. All right. So the next core stock to own is from the energy sector. We’ve talked about this one on occasion on The Morning Filter. It’s ExxonMobil XOM. So what makes Exxon really stand out from its peers as the core stock to own in the energy sector?
Sekera: A core stock in the energy sector is going to have a little bit different attributes than what I look at for some of the other sectors. So in this case with Exxon, our fair value is currently $156 a share.
Now, unlike the other ones, this one only has a narrow economic moat, and a lot of that is just due to the factors of being in the energy sector, with it being such a commodity-oriented item that, while they do have cost advantages, they’re still going to be subject to the swings that you’re going to see in the underlying commodity price. Then we also have a high uncertainty on this one as well.
But again, in this sector, it’s very difficult to find anything you’d have with a low or medium because of the cyclicality and the commodity nature of the business overall. But in this case, the company just has some geographical positioning and some of the best oil reserves globally. So that’s really what’s driving that cost advantage, but it’s not just that. I mean, they also have their upstream business, their downstream business, their chemical business, their refining business. So they’re across the entire petroleum chain, and we think that also benefits the company in a number of different ways as well.
And lastly, also another company that we rate with an exemplary capital allocation rating. And to some degree, I think part of the reason that that one is exemplary is if you look at what a lot of the oil companies have been doing in the last couple of years, a lot of them have been getting into areas that they just don’t have core competencies. They’re getting into renewable energy, green energy, and a lot of those efforts just have not panned out, a lot of wasted capital in those areas because, again, it just wasn’t a core competency.
What we’ve seen with Exxon, with management there, really sticking to their guns, sticking with what they know, and that’s really worked out in order to help drive excess returns for them over time.
Best Core Stock: JPM
Dziubinski: All right. We have one more core stock we’re going to talk about today. This one’s from the financial-services sector, and it’s one we have not talked about very much because it seems like it’s always overvalued when we would have an opportunity to talk about it, and it’s JPMorgan Chase JPM. So why is this the core stock to own in the financial-services sector?
Sekera: Our current valuation on JPMorgan is $311 per share. Again, a company with a wide economic moat; that’s going to be based on its cost advantages and its switching costs. Medium uncertainty rating. And there’s just really a whole host of reasons why JPMorgan is so strong, so strong compared to even their other large competitors in the marketplace, but it’s not necessarily just the scale that they have compared to their competitors. But when you look at the individual business lines that JP Morgan’s involved in, for the most part, their number one or number two market share in each of those individual underlying businesses. And even where they’re not the number one or number two market share, our analyst team still thinks that those businesses that they have, they’re still really strong competitors. So again, it’s not just the scale, but it’s the position within all of those different types of banking businesses.
Again, another one that we rate with an exemplary capital allocation rating. When I go through the checklist here, as far as strong balance sheet, just phenomenal track record of the investments they’ve been making, and just thinking about how they balance shareholder returns, whether that’s dividends, buybacks, reinvesting in organic growth, making good, solid acquisitions at the right prices, it just seems like they always do everything right.
Dziubinski: So definitely should be on that watchlist.
Sekera: Exactly.
Dziubinski: All right. Well, Dave, good to see you in person today. Thanks for your time.
Sekera: Of course. Thank you, Susan.
Dziubinski: Viewers and listeners who’d like more information about any of the stocks they’ve talked about today can visit Morningstar.com for more details. We hope you’ll join us next Monday for The Morning Filter podcast at 9 a.m. Eastern, 8 a.m. Central. In the meantime, please like this episode and subscribe. Have a great week.
