Finding quality stocks trading at a cheap price can be a challenging and time-consuming task. You not only need to identify whether a company has a tangible edge over its peers. You also need to assess whether a stock is over- or under-valued.

The Global Best Ideas list (available for Morningstar Investor subscribers) is compiled by Morningstar’s equity analysts every month. To earn a spot on the list, these stocks have high analyst conviction in their future prospects and are trading at a price significantly below what our analysts calculate them to be worth.

Buying stocks when they are undervalued gives investor’s a higher margin of safety, therefore reducing the risk of an uncertain future.

Additionally, analysts consider the stock’s moat rating. This rating is an indication of the analyst’s expectations for the company to maintain a sustainable competitive advantage. A wide moat rating is awarded to companies that are expected to maintain and grow their earnings for at least the next 20 years, a narrow moat for the next 10 years.

Brian Han, Director of Equity Research, says of the list “These Best Ideas are sourced from all main sectors of the market, to provide a diversity of names across the spectrum. The last thing investors want is a Best Ideas list chock-full of cheap mining stocks when commodity prices tank, or a litany of oversold retail stocks when consumer sentiment slumps.”

In the May edition of our best ideas there were no changes to the 14 ASX names on the list. The cheapest share on the list is Lendlease Group (ASX: LLC) which is trading at a 52% discount to our fair value estimate of $13.30.

Lendlease trades near net tangible assets. We think this is overly pessimistic, given that much of the group's earnings before interest, taxes, depreciaton and amortisation (“EBITDA”) comes from intangible sources of income in its development construction and investment businesses that are excluded from net tangible assets.

Despite headwinds, core operating profits rebounded in fiscal 2023. We expect further substantial uplift in development earnings in 2024 and management earnings longer term. Management reaffirmed at its annual results in August 2023 that it's on track for more than $8 billion of development completions in fiscal 2024. The target looks reasonable, since development work in progress increased to $23 billion (up from $18 billion at December 2022). Downside risks look more than priced in, and we see substantial upside if Lendlease reaches its targets in 2024 or 2025.

Lendlease Group (ASX: LLC)

Lendlease is a diversified global property developer, landlord, property manager, fund manager, and builder on a range of development projects, funds, and completed properties around the world. Interests have included include apartments, offices, retail property, aged care facilities, retirement and military accommodation, roads, and rail tunnels.
The group is evolving on numerous fronts: exiting noncore businesses; seeking better returns on capital; accelerating its development pipeline; and advancing projects outside its homebase of Australia.

Lendlease sold its risky engineering business in calendar 2020, though it retained liability for engineering/construction projects with several years to run. Lendlease found a buyer for its engineering services business after two years of marketing, and the price was respectable. Lendlease is also gradually reducing its exposure to retirement living and military housing. Lendlease’s project mix will then predominantly comprise residential and commercial property.

The group’s ongoing business comprises three segments: development, investments, and construction. We don’t expect much growth in construction earnings, that business is primarily to preserve scale and construction expertise in support of Lendlease’s development business.

The investments division houses a wide range of businesses including, military housing, property asset management and funds management. We expect the latter two business lines to grow substantially as Lendlease sells stakes in its development projects. This is a trade-off, relinquishing potential development profits in return for lower risk management fees, performance fees, and capital to accelerate its development pipeline.

Economic moat

Learn more about identifying companies with a sustainable competitive advantage or moat.

We do not ascribe a moat to Lendlease due to the competitive industries in which it operates. Development accounted for more than half of EBITDA in 2019 and 2020 and we estimate it will grow to more than two thirds of EBITDA over the next decade, based on a large pipeline of work. We assume attractive margins on this pipeline, but there are risks that are largely outside of Lendlease’s control, including market demand, rival developments, construction costs and potential delays, and political risk.

That said, we think the projects in its pipeline look attractive for Lendlease, and give it some moat-like characteristics. The planning approvals, development contracts and preferred developer agreements Lendlease has with municipalities, landowners, and planning bodies are valuable intangible assets. They allow Lendlease the right to develop a large area, over a long period of time, thereby minimizing nearby competition and the risk of localized property gluts.

In December 2023 Lendlease had an estimated end value in its development pipeline of $103 billion. Of this, about $87 billion are urbanization projects. Most of the targeted development production from 2023 to 2026 already has masterplanning approval, bestowing a high likelihood that the projects will proceed.

There are risks to this, including community opposition to projects, construction cost blowouts, rising interest rates, and myriad others, and we factor these into our estimated development margins. Ultimately the final number and value of assets is unknown even to Lendlease, and development margins are subject to a variety of execution and market risks, precluding us from awarding a moat.

The group benefits from switching costs in its investments business. Wholesale investment vehicles only allow withdrawals at predetermined windows, roughly every five years depending on the fund. This protects clients who want long-term investments alongside similarly minded co-investors, minimizing transaction costs and asset churn in the funds. Lendlease benefits as it makes it unlikely that large swathes of investors will exit at once, given the staggered nature of redemption windows.

Other switching costs include the significant transaction costs and tax consequences of selling property, and the time lag in exiting a fund. Lendlease can apply a waiting period on large redemptions for up to two years in some funds, providing time to liquidate assets, which we think deters impulsive sell decisions. Where possible, Lendlease will replace departing investors with incoming ones, retaining funds and negating the need to sell assets.

By contrast most equity or bond fund managers have no lock-up, with redemptions often processed within 24-48 hours. They also face competition from passive fund managers and ETFs, which do not generally exist in the direct property market. That said, Lendlease is not immune to withdrawals. For example pressure on retail property values from e-commerce prompted substantial redemption requests from clients over the course of 2018/19, exacerbated by covid-19 in 2020.

We expect some clients will ultimately leave, and that Lendlease will likely offer fee discounts for clients that choose to remain. Fortunately Lendlease’s investments business is well diversified, including approximately 20 different funds and mandates, meaning that funds under management has continued to rise despite these challenges.

We don’t see any moaty characteristics in other parts of the investments business such as military housing, retirement accommodation, or property management. Likewise, the construction business has a large number of competitors and razor thin margins that typically vary from 0 – 4%. Lendlease retains its construction business primarily to maintain expertise and scale to support its development business. We expect Lendlease to bid on construction projects in the gateway cities that it wants to maintain a development presence, which include Sydney, Kuala Lumpur, San Francisco, New York, Chicago, London, Milan and others.

Risk and uncertainty

Learn more about how an investor should think about business risk in their portfolio.

Despite selling its engineering and services businesses, Lendlease retains risks on the Melbourne Metro project. Our base case is that existing provisions will cover future costs, but risk remains through to completion by approximately 2026.

Lendlease’s remaining business is opaque, but becoming more transparent. The bulk of the value of the company is in multi-decade urbanization projects, where end values and margins cannot be accurately estimated until the projects are substantially completed.
Even if Lendlease knew what revenues and margins are likely to be, contract terms are largely confidential. Projects face political, social, and environmental risk, given they involve redeveloping large tracts of inner urban land, in collaboration with local municipalities, land owners and other stakeholders. These ESG issues contribute to our High Morningstar Uncertainty Rating.

Development risks include rising interest rates, a decline in secular demand for offices and apartments, or mispricing of contracts by Lendlease. A risk for the investment segment is that demand from institutions wanes, prompting outflows from Lendlease funds. Investors may fear rising rates, or limited upside with rates near the zero-bound.

Changes to pension, tax or investment regulations could cause institutions to move away from illiquid assets. We got a taste of that risk in Australia in 2020 when the government allowed individuals in financial hardship to make superannuation withdrawals amid the covid-19 crisis. That saw industry super funds saddled with illiquid property assets as they sold liquid assets to fund redemption requests. Lendlease experienced redemptions from its retail property funds due to headwinds for that asset class, and its possible that these headwinds could spread to office and apartment assets.

Another risk is competition, because most major REITs are attempting to establish property funds management businesses.