Many investors relished the pullback in stock prices last quarter--not so much because they liked the red ink splashed across their portfolios, but because they saw the decline as an opportunity to buy on the dips.
And that isn't necessarily a bad idea. Buying undervalued stocks is like getting a pound for 50 pence. It improves your chances of getting a decent return, gives a larger margin of safety if something goes wrong, and is much preferable to piling in to very expensive stocks. And today, even after the recent bounce-back, stocks still look reasonably undervalued as a whole. Our equity analyst staff reckons that the median stock in our coverage universe is trading at only 85% of its fair value at the moment.
But that doesn't mean indiscriminate buying of equities on a dip is a good idea, either. Frequently stocks are selling off for a good reason. Over the last few months, there have been very real fears about European sovereign debt, weak economic indicators in the U.S., and the potential of slowing growth in emerging markets. A blowup in Europe could have a real impact on the future earnings power for all sorts of firms. The decline in some share prices could be due to a real decline in value. And there are cases where stocks go from ridiculously overvalued to merely overvalued. In other words, just because something has sold off a lot doesn't mean that it's cheap.
To uncover these mirages in the value desert, we've highlighted below those London Stock Exchange-listed stocks under our coverage that are rated 1-star, 2-star and 5-star. Morningstar's Star Rating for stocks is calculated by comparing a stock's current market price with Morningstar's estimate of the stock's fair value. If a stock has a high star rating, that means we think the shares have good upside potential and that prospective investors might want to keep them on their radar; a low star rating denotes the opposite. Find out more here.
1-Star Stocks
Shire
Shares in Shire (SHP) have recovered much of the early-August decline but are still 0.6% weaker over the past three months as a whole. Despite this, Morningstar's analysis denotes that the shares remain overvalued and the stock therefore carries a 1-star rating. Read Morningstar's Research Report including fair value estimate here.
2-Star Stocks
ARM Holdings
Shares in ARM (ARM) also suffered at the hands of the August sell-off but have since more than recovered those losses and as at October 14 were trading 4.4% higher than their three month-ago levels. As such, the stock currently carries a 2-star rating. Read Morningstar's Research Report including fair value estimate here.
On the flipside, Morningstar research shows numerous LSE-listed stocks that carry 4 stars and are therefore deemed to be trading below their fair value. Several of the U.K. banks feature on the 4-star list, as do a handful of the global diversified miners, among others. Just two LSE stocks under our coverage currently carry 5-star ratings, as shown below.
5-Star Stocks
BG Group
Shares in BG Group (BG.) remain 2.7% lower over the three months to October 14 but despite rallying 12.5% over the last 12 months the natural gas producer, one of our favourite energy names, trades almost a third lower than our fair value estimate. Read Morningstar's Research Report including fair value estimate here.
Royal Dutch Shell
Shares in Royal Dutch Shell (RDSB) were hit hard at the start of August, losing almost a quarter of their value in a matter of weeks, but even though the stock has recovered much of this drop, and is down just 1.7% over the past three months, our analysis points to the market still undervaluing this oil supermajor. Read Morningstar's Research Report including fair value estimate here.
All Morningstar.co.uk users can see a stocks' Star Rating on its Morningstar Stock Report; Morningstar Research is available only to Premium subscribers.
