Why a Bottom-Up Approach to Market Analysis Can Help Investors in the Long Term

On this episode of The Long View, Dave Sekera, chief US market strategist for Morningstar Research Services, talks about a bottom-up approach to market research, and how investors can use Morningstar’s new podcast, The Morning Filter, to find what they need to pay attention to in the markets, new research, and stock picks and pans every week.

Here are a few highlights from Sekera’s conversation with Morningstar’s Christine Benz and Dan Lefkovitz.

Why a Bottom-Up Approach to Market Analysis Strays From Other Firms

Christine Benz: Dave, I sense that a lot of people who wear that market strategist cap at other firms are kind of top-down. They’re not necessarily leveraging the bottom-up research that you are. Do you think that’s true that they oftentimes are looking at things like inflation and the health of the economy, and that leads them to have views on various market sectors? Do you think the way you approach it is different from a lot of other people who are also strategists?

David Sekera: I do think that we have a differentiated approach when we think about market valuation overall. As you mentioned, in the course of my career, what I’ve always seen from a lot of other market strategists is that they’ll oftentimes have a model, algorithm, formula, or something to come up with what they think S&P 500 earnings is going to be at the end of the year. Then they have some sort of forward P/E multiple that they apply to that, and they get to whatever their price target is. More often than not, it always seems like it’s really more an exercise in goal-seeking. It always seems like other market strategists are telling you the market’s always 8% to 10% undervalued. Whereas we do the exact opposite. We cover over 700 stocks that trade on US exchanges. We take the intrinsic valuation of all of those stocks, and then we compare that to where they’re actually trading in the marketplace. We put together this price/fair value metric. So really, it’s just the market-cap weighting of all of those stocks that we cover divided by what we think that intrinsic valuation is. That gets us to whether or not we think the market is trading at a premium or a discount to that combined valuation.

How Valuation-Consciousness and a Focus on Economic Moats Lead to Distinguished Performance in Down Markets

Dan Lefkovitz: Dave, would you say that Morningstar’s valuation-consciousness and focus on economic moats lead to distinguished performance in down markets, or is that too much of a generalization?

Sekera: I think that’s a correct generalization. But you have to be very careful about how you speak about performance. There’s a lot of SEC rules and regulations about that. But one of the things I always really like to highlight to people is the performance of the Morningstar Wide Moat Focus Index. That is an index of the most undervalued stocks that we rate with a wide economic moat, and then it’s reconstituted every quarter. If a stock is in that index, and that stock is trading up, and it’s no longer one of the most undervalued, then it gets pulled out of the index and then replaced with another stock that has a wide moat and is undervalued.

When you look at the performance of that versus the Morningstar US Market Index, which is our broadest index of the stocks in the US, it’s outperformed on a trailing 10-year basis. But not only on a 10-year basis, it’s outperformed the broad market index really since its inception 18 years ago. I also have to say there have been periods where that index has underperformed the market. Right now, on a trailing 12-month basis, it has underperformed the broad market. The reason is because that index is focused on those stocks that we consider to be undervalued. So, if something is fairly valued or overvalued—and in this case, a lot of those stocks that have driven the market thus far this year are becoming even further overvalued—it isn’t incorporated in that index.

Right now in the index, we have Alphabet GOOG, we have Amazon AMZN, we have Microsoft MSFT. But if you think about the FANG stocks or the “Magnificent Seven″ stocks, the other four aren’t in there. So, as those stocks become even further and further overvalued, they aren’t within that index. But I’d also note that when you look at the performance of that index on a quarterly basis, we found it has both attractive upside capture and attractive downside capture attributes to it. What we find is that to the downside, these high-quality names that have wide economic moats oftentimes will hold their value better to the downside. And then once the market recuperates and starts to rally because these are the stocks that we thought had the best valuation characteristics, they are also the ones that usually perform the best to the upside.

How The Morning Filter Can Help Investors Build a Fundamentals-Based Portfolio

Benz: Dave, I want to ask about The Morning Filter, which is a YouTube video series and is also on Morningstar.com, that you and Susan Dziubinski do together. When I look at YouTube and our best-performing videos, it’s usually right there on top. And you’re going to be launching it as a podcast. Can you talk about the genesis of that show and who you’re trying to serve and what you’re trying to help them with?

Sekera: When I think about our audience, it’s really for everybody—from anyone who has an interest in investing. So, we definitely try to address it to individual investors. We find a lot of investment advisors also really enjoy the show. And we have a number of our institutional investor clients who will watch the show as well. But the intent of the show is to help people understand the difference between noise versus signal. When we work on our show every week, we try and figure out the things that investors should pay attention to that can move markets, move individual stocks, highlight those, and then ignore a lot of the other noise that you hear out there. Every week, the show is always the three same segments.

It’s always going to start with, “Hey, what’s coming up the week ahead that you should be paying attention to?” It might be important economic indicators, important inflationary indicators that are coming out, what the consensus is, what our view might be, and whether or not they come out higher or lower. If there are important earnings that are coming out from some of the mega-cap stocks or some of the AI-leveraged stocks. When they come out with earnings, you might see some second derivative action with other companies within that same sector or maybe that same business line or maybe some of their suppliers where those stocks could be affected by how those earnings come out as well. The second part of the show is trying to highlight Morningstar research that we think is particularly interesting. That might be some sector research that’s been published or earnings notes that have come out, but things that we think are the most important for investors to notice. And then we always like to try and make the show as action-oriented as we can.

So, we’ll wrap up that show with our picks and our pans. Some weeks, it might just be a couple of different buy ideas, stocks that we think are undervalued and look attractive. Some weeks, we might highlight different sell ideas, stocks where we think the market is overestimating too much growth for too long; those stocks have risen too much. We’ll look at different types of swap ideas. Maybe find a sector where you might want to swap out a couple of stocks that have risen too far and a couple of stocks that lag and look attractive. So again, trying to bring to the forefront different ideas. Now, you can’t get too deep into talking about any one individual stock, so I’ll try and give the broad investment thesis, maybe a couple of metrics or parameters around it. And then, of course, investors who do have an interest in any one of those individual stocks, can go to whichever Morningstar platform they use and research and learn more about those stocks before they make any kind of investment decision, whether or not to buy or sell those individual stocks.