A seismic shift in the market away from growth stocks and towards value stocks was evident during the October selloff, Morgan Stanley observes. "October's relative outperformance [by value stocks] in a down market is encouraging and we think signals a more important, longer lasting leadership change," they write in their current Weekly Warm Up report. Morgan Stanley screened for value stocks that "materially underperformed the market since the recent peak and where our analysts maintain a positive view on risk-reward." Among the 19 stocks that passed their screens were these 7: Baker Hughes, a GE Co. (BHGE), Continental Resources Inc. (CLR), SVB Financial Group (SIVB), State Street Corp. (STT), Caterpillar Inc. (CAT), World Wrestling Entertainment Inc. (WWE) and Valero Energy Corp. (VLO).
This is the first of multiple articles that Investopedia will devote to this report. The table below presents Morgan Stanley's assessment of the upside potential for the 7 stocks listed above.
7 Stocks With Attractive Risk-Reward Profiles
Source: Morgan Stanley
Significance For Investors
Morgan Stanley finds that 3 sectors offer particularly attractive risk-reward profiles overall. They say that "Energy, Financials, and Industrials all screen well with most of the stocks offering some downside protection due to their Value tilt."
Morgan Stanley applied 8 screens to produce a list of 19 stocks "that have seen large underperformance from the market peak and where our analysts still have a positive view, substantial upside to their price targets, and positive risk-reward skews." Regarding what they call risk-reward skews, Morgan Stanley looked for stocks in which the upside to the analyst's bullish scenario was more than twice the downside to the bearish scenario for each stock. All the stocks on the list have market caps greater than $5 billion, overweight ratings from Morgan Stanley's analysts and upsides to their price targets of more than 20%.
The screens for recent underperformance selected stocks that were down by more than twice the market's percentage dip from the Sept. 20 peak to Nov. 2, and which had a beta-adjusted return since Sept. 20 that was worse than the market. A screen for financial strength was a net debt to EBITDA ratio of less than 3 times. Lastly, both the analysts and Morgan Stanley's equity strategists were able to apply their own discretion based on macro risks.
Value Sectors With Best Risk-Reward Tradeoffs
Source: Morgan Stanley
Petrochemical refining and marketing company Valero stands out with by far the largest risk-reward skew ratio among the 19 stocks on Morgan Stanley's list. According to Morgan Stanley analyst Benny Wong, the upside to his bullish scenario is more than 48 times the magnitude of the downside to his bearish scenario for Valero. The stock dropped by 16.9% from Sept. 20 to Nov. 2, for a dip that was 2.4 times the decline in the market overall. As indicated in the first table above, Wong has a price target that implies 47% upside.
Morgan Stanley recommends these stocks in the context of a report that also predicts a volatile, but ultimately flat market through the rest of 2018, as described in another Investopedia article. Rising interest rates, a diminishing boost to EPS from tax cuts, and cost pressures on profit margins are among the macro issues that the report sees weighing on stocks. Note that while industrials are among the sectors that have the most attractive risk-reward tradeoffs, the same report finds that it also is one of the sectors in which revisions in earnings estimates have the sharpest downward trend.
Morgan Stanley has a bear case of 2,400 for the S&P 500 Index (SPX), which would be a drop of more than 13% from the Nov. 7 open. If that comes to pass, it may be difficult for the stocks mentioned above to swim against the tide. Outperformance may end up being the result of falling less than the overall market.