10 Undervalued UK Stocks

Prior to the invasion, Imperial Brands (IMB) and British American Tobacco (BATS) were regular members of the 5-star club, but the list has broadened to include food delivery, insurance, airlines, an online fashion firm and even British Gas owner Centrica (CNA).

In some cases, entering the most undervalued category is down to a fall in the share price. In others, it’s down to our analysts raising their fair value estimate (FVE) for the stock.

Occasionally, the market value of a stock rises to close the gap with its fair value over a short timeframe. But there’s no guarantee of this. Oil company Shell (SHEL) was a 5-star stock for much of the pandemic period and only recently moved close to its fair value after the oil price surged.

The Margin of Safety

While not strictly a “buy” recommendation, assigning a 5-star rating to a stock is a sign of “how attractive the stock as an investment right now”, says Alex Morozov, Morningstar’s director of equity research.

Our analysts talk of a “margin of safety” for investors taking the leap to buy a stock. Investing in a 1-star stock, which is significantly overvalued, for example, carries more risk because of the chance that the share price will fall back. 2020’s outlier Tesla (TSLA) was a 1-star stock last year but a 23% fall in the share price so far in 2022 has nudged it into 2-star territory.

On top of the valuation screen, our analysts also add an “uncertainty rating” to the stock. Morozov says this rating shows “how likely are those earnings to be very volatile over the next 5 to 10 years”. A few of these have an uncertainty rating of “very high”, and it’s no coincidence that the stocks are some of the biggest fallers so far this year. For instance, investors have lost patience with the “jam tomorrow” narrative of the food delivery firms.

In a recent video, Morningstar analyst Ioannis Pontikis explains why they may have to be patient for a while longer with companies like Just Eat Takeaway (JET) and Deliveroo (ROO). Just Eat Takeaway’s fair value estimate is significantly above its current price – the shares would have to rise 300% from their current level to get back to par, for example.

Two of the 10 companies on our list have economic moats, meaning they have sustainable competitive advantages to back up their attractive valuations. One is wide-moat Imperial Brands and the other is Just Eat Takeaway, whose shares have fallen more than 30% this year.

What Next for Airlines?

Airlines are well represented on the list because of geopolitical uncertainty, and its impact on people's desire to fly. That new reality is starkly reflected in the share price performance of Morningstar sector favourite Wizz Air (WIZZ), the eastern-Europe focused airline whose shares have fallen 40% this year.

Despite this fall, Wizz is the only one of three airlines on this list – including BA owner IAG (IAG) and its budget rival easyJet (EZJ) – to have recovered from its 2020 share price low. “Airlines will be affected by airspace restrictions and hesitance to travel in Eastern Europe,” says analyst Joachim Kotze.

At the same time, he expects the effects from the Ukraine crisis to be temporary, at least in terms of valuations in the travel industry.

“Despite the impact from a demand and cost perspective on the airline and commercial aerospace companies we cover, we don’t foresee any structural long-term changes to their prospects and as such don’t anticipate any major changes to our fair value estimates," he says.

Centrica is one of two companies on the list to see a positive change in the share price this year, helped by soaring energy prices. It’s also unusual among these stocks in that the momentum is behind it rather than against it, like many of the other stocks on the list.

Morningstar analyst Tancrede Fulop has just raised the fair value estimate for the gas and electricity provider from 70p to 120p. He says the surge in energy prices has provided a turning point for Centrica from an earnings perspective – earnings per share (EPS) is forecast to rise almost fourfold by 2023.

“After years of churn from new entrants and regulatory deterioration, the energy crisis has improved the competitive landscape of the UK retail energy market, especially for market leader Centrica,” he adds. A spike in providers going bust is also likely to help Centrica, which is adding customers after a period of losing them to cheaper new entrants.

A Smart Shortcut

Morningstar behavioural economist Sarah Newcomb explains more on the "fair value estimate" and why it matters. 

"It's a smart shortcut that can help you determine whether the price of a stock is high or low compared with its fundamental value," she says.

"It's a much more reasonable estimate of the long-term fair value of a stock than 'whatever people are willing to buy it for today'".

As such, the fair estimate is based on analysis of the company's balance sheet rather than on current market sentiment and should not be seen as a price target.