How to Invest During a Bear Market

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. U.S. stocks entered bear-market territory this week, with the broad market indices down 20% from their recent highs. Joining me today to recap what's going on in the market and share some stocks that haven't been this cheap in more than a decade is Dave Sekera. Dave is Morningstar's chief U.S. market strategist.

So, Dave, let's start out with that recap of what's been going on in the market. Let's break things down by say, large caps versus small caps, value versus growth, and then maybe high-quality stocks versus no-moat stocks.

Dave Sekera: Hi, Susan. Yeah, it's definitely been a tough year thus far this year for the market. The Morningstar US Market index, which is our broadest measure of the U.S. stock market, is down over 22% year to date through last night's close of June 14. Now, what I would note, that the greatest losses have occurred in those areas that really would be the most negatively impacted by high inflation and slowing economic growth. So, when I break the different losses down, the preponderance of those losses have been in the growth category, and that's down over 36% year to date, whereas the value category, which had held up relatively well earlier in the year, now is down 7% this year. Now, the core or the blend category, that's in the middle of the pack and it's dropped about 21% year to date.

Now, when we look across the different market-capitalization levels, there's really not that much of a difference; everything has broadly sold off. So, in those Morningstar indices for each of large, mid, and small cap, they're down within about 2% of one another. Now, breaking things down by sector, it's technology, communications, and consumer cyclicals as the worst performers, each having dropped well over 30% thus far this year.

Now, having said that, I think the selling recently has become pretty indiscriminate, as even high-quality companies have been caught up in this most recent downdraft. I think this most recent action, when I look at the technicals, shows to me, I think a lot of portfolio managers are now at that point where they're selling what they can as opposed to what they may necessarily want to sell. For example, if we look at the Morningstar Wide Moat Composite Index, which is an index of all those companies we rate with a wide moat, that's actually down a little bit more than the overall market. Now, however, I would note that the Morningstar Wide Moat Focus Index, which is slightly different, and that's a composite of those 40 wide-moat stocks that have the lowest price/fair value metrics, has only dropped a little bit over 17% year to date, less than the broad market.

Dziubinski: Investors are often encouraged during times like this, Dave, to buy during a bear market, but how can they avoid buying those proverbial falling knives, those stocks that may just continue to keep going down? Can you avoid doing something like that in today's market?

Sekera: Well, as you mentioned, being in a bear market, we weren't actually necessarily surprised by some of the selloff earlier in the year. In our 2022 outlook, we noted that we thought, coming into the year, the market was actually a little overvalued. Now, having said that, I think the pendulum has actually swung too far to the downside at this point, and we think the broad market is becoming significantly undervalued. Now, having said that, as a word of caution, just because something is undervalued today doesn't mean that it can't become even more undervalued in the short run. But we do expect to see a lot of volatility, both to the upside as well as the downside, this summer. And we think the markets are waiting to get better clarity on a couple of different factors. The most important right now will be when will inflation start to moderate, and when will we see some stabilization in the U.S. economy.

So, in today's market, I'd focus on those companies that have an economic moat. We think those will be the companies that have the best ability to weather any economic dislocations that we see, as well as those are the companies that typically exhibit the best pricing power. Now, of course, identifying a high-quality company is only half the equation, and valuation is the other half of successful investing. So, I'd recommend for investors to focus on those stocks that do have those wide or narrow economic moats, but those that have sold often are already trading at a pretty significant margin of safety from their intrinsic valuation. The goal here really is to try and both minimize the amount of additional future losses but also be able to provide those investors the confidence that if those stocks do sell off further, that they will then go in and actually be able to buy more of those shares while they're trading cheaper.

Dziubinski: Speaking of margin of safety, you've done some research, Dave, and you've found that there are a lot of businesses out there right now that are trading at margins of safety, or discounts to their fair value estimates, that we haven't seen in a decade. Let's talk about some specific names, maybe starting out with a couple of names with wide or narrow moats.

Sekera: Sure. As I mentioned earlier, we are seeing a lot of indiscriminate selling that's bringing these stocks down. And we just think that these are just great opportunities for investors with that long-term focus. Essentially, with these stocks down as much as they are, that's providing the ability for those that do have risk appetite in cash to put that to work in today's market.

As you mentioned, I did do a quick analysis of stocks with a wide and narrow economic moat that are trading at 4- and 5-star ratings. Then I rank order them by what percentage of time they've traded at 4 and 5 stars over the past decade. There's some examples, like wide-moat semiconductor manufacturer Nvidia. It's now at a 4-star level, and I think that's actually the first time it's hit 4 stars since 2012. Just as an indication of how fast things have moved in the marketplace, that stock was actually overvalued--it was rated with 2 stars as recently as March, and it was a 1-star stock last November.

Dziubinski: Wow.

Sekera: A couple of others that we're watching today is Zoetis. That's another stock that since 2013 had only ever traded with a 4-star rating 1% of the time. Zoetis sells health products for both pets and animals, we assign the company with a wide moat, and it currently trades at a 15% discount to our fair value. Also, in the healthcare industry, we're looking at medical device maker, Boston Scientific, that one is rated with a narrow economic moat, it's currently trading at a 22% discount to our fair value, which puts it into that 4-star territory, and it's only traded here less than 5% of the time over the past 10 years.

Dziubinski: On an industry level, you've looked at this on the individual stock level and an industry level, you say that some businesses that are tied to the bond market have been especially hard-hit. Why is that and what are some companies here that we might consider?

Sekera: In the fixed-income markets, we're seeing a lot of losses there, especially as interest rates are continuing to rise. And with that, that's also pressured a lot of the companies whose businesses are centered around the bond market, a lot of them have dropped well over 30% thus far this year. For example, rating agencies Moody's and Standard & Poor's are both rated 4 stars, and they're both trading at discounts of over 20% to our fair value. Over the past decade, Moody's has only traded here, at a discount this great, about 10% of the time. And S&P it's even more rare, it only traded four stars about 3% of the time. Now, similarly, in the same vein: wide-moat MarketAxess. They run an electronic fixed-income trading portal, that's also rated 4 stars. That stock is down 34% thus far this year; we think that's trading at a 22% discount to our fair value.

Dziubinski: Let's pivot. Another industry you've talked a little bit about is cybersecurity. What's been going on there, and what looks undervalued?

Sekera: I think cybersecurity has just really compelling attributes for investors today. Cybersecurity stocks did pretty well earlier this year, specifically after the Russian invasion of Ukraine, but we have seen a lot of those stocks get caught up in this recent downdraft as well. For example, Fortinet is rated 4 stars, it's trading at a 21% discount to our fair value. We do assign the company with a wide moat, and I would note that we think that that's one of the companies in the cybersecurity industry that's at the forefront of the convergence between cybersecurity and networking technologies. Since we've picked up coverage of Fortinet in 2015, it's only ever traded with 4 stars about 5% of that time. Within the cybersecurity space, another two companies I would highlight to investors would be CrowdStrike and Zscaler, both are assigned with narrow economic moats, both are trading with 4 stars, and those two stocks are trading at 20% and 30% discounts, respectively.

Dziubinski: The industrial sector also has some stocks trading at rarely seen discounts. Tell us about those.

Sekera: So again, the heightened concerns of higher probability of a near-term economic slowdown has certainly taken its toll on the industrial sector, and there's numerous examples of companies with wide moats trading at a significant margin of safety. For example, one I would highlight would be wide moat-rated Roper, it's only traded with 4 stars about 5% of the time over the past decade. A couple of other 4-star-rated wide-moat industrial names I'd highlight would be Honeywell and 3M.

Dziubinski: Lastly, there's a pretty well-known brand that's trading at a rare deep discount. Tell us what that is.

Sekera: Well, there's actually a number of high-quality consumer-branded products that are all now trading at significant discounts, but the one I'll leave you with will be Clorox. Again, it's currently rated 4 stars, trades at a 23% discount to our fair value, and over the past decade, it's only ever traded at this discount or lower 15% of the time.

Dziubinski: Well, Dave, thanks for your time today, for the recap, the perspective, and the stock ideas. We appreciate your time.

Sekera: All right. Well, thank you, Susan. I appreciate it.

Dziubinski: I'm Susan Dziubinski with Morningstar, thanks for tuning in.