Despite the soaring inflation and a new coronavirus variant, European and UK stocks finished 2021 with an impressive return.
Both the Morningstar Europe Index and the Morningstar UK Index were up 18% last year, but the profit-taking in the first weeks of 2022 lowered valuations, particularly in developed Europe. As a result, Morningstar’s analysts now believe equities in developed Europe are slightly undervalued.
Of course, valuations differ significantly from one sector to another. In aggregate, technology, financial services and real estate stocks look undervalued, and consumer cyclical and consumer defensive sectors are the most overvalued.
Below we look at some specific undervalued stocks across sensitive, cyclical and defensive sectors – the so-called super sectors – that are among our analysts’ best ideas.
In the sensitive sector, we have technology, communication services, energy and industrials. Of these, we think the European technology sector is particularly undervalued. The median stock in our coverage universe currently trading at an 8% discount to its fair value, after being one of the key players in the post-pandemic period. In fact, the Morningstar Developed Markets Europe Technology Index down 16.80% so far this year.
Meanwhile, the communication services sector weakened in 2021’s fourth quarter and it has underperformed the broader market over the past six months with a loss of confidence in growth opportunities. The median stock in the category is now trading at a 10% discount.
Energy stocks have outpaced the broader market, but in Europe, these stocks are still 3% undervalued. Supply remains constrained and a Russian invasion of Ukraine could disrupt oil supply, but our analysts think a price spike seems unlikely even in the event of war. And, industrial stocks are slightly overvalued, but there are still some undervalued stocks to be found.
In the cyclical sector we find consumer stocks, financial services and real estate. Consumer cyclical stocks enjoyed a robust fourth quarter of 2021 and are currently fairly valued. However, nearly half of the stocks we cover are trading at 4- and 5-star levels.
Financial stocks were some of the best stocks last year, and as our director of equity research Michael Wong reminds us, interest rates are a key driver of financial sector earnings – “and they’re expected to move higher this year. Indeed, the unemployment rate and inflation point to a tightening of monetary policy.” Real estate also rebounded in 2021, and among the names we cover, only one is significantly undervalued (Unibail-Rodamco-Westfield).
On the defensive side, we find consumers, healthcare and utilities. Consumer defensive stocks are currently trading 5% above our fair value estimate, but there are several stocks that are trading within a discounted range. This is also the case for healthcare, which is at a 7% premium – but the stocks have slightly lagged the broader European market in the past six months.
Utilities enter 2022 slightly overvalued as well, at 1%. Morningstar strategist Travis Miller explains that the stocks are one of few attractive options for those looking for income. “If higher rates can ward off inflation, utilities should continue producing 7%-9% total returns for investors in 2022 and beyond,” he says.