3 top stocks named at Morningstar conference

Morningstar director of equity research Adam Fleck (left) joined by equity analysts Brian Han, David Ellis and Gareth James

These well-known stocks spanning finance, telecommunications and education headed our equity analysts' top picks at the Morningstar Individual Investor Conference 2018.

Investor gloom weighs down Telstra

Media and telecommunication analyst Brian Han is well aware of the dark clouds hanging over narrow-moat Telstra (ASX: TLS), but maintains his assessment that the stock is undervalued. He says investor captivation with several risks facing the group is weighing on the price.

"I understand the reasons why shareholders hate this stock so much, with mobile earrings eight per cent below their 2016 peak, fears surrounding the impending entry of TPG Telecom and the NBN "basket case" messing with broadband economics of all operators," Han said.

"I think Telstra is undervalued, but at this point, you must be thinking, what is he smoking?

"I think the question to ask going forward is not what can go wrong. We all know what can go wrong. My parents-in-law and Uber drivers tell my every weekend what can go wrong with Telstra. At the current depressed stock price, you should be asking yourself what can go right?"

So, what can go right? Han detailed four reasons why he thinks the stock is trading at an attractive discount. Firstly, he believes Telstra boasts the strength to compete in an increasingly contested market, given its sustainable cost advantage from unrivalled scale, infrastructure footprint, and consistent capital spending to maintain this competitive edge.

Second, he says that at the current price, the market is assuming that Telstra fails to plug the $3 billion EBITDA hole from the National Broadband Network. Han thinks this is an excessively bearish view, given "the group’s competitive position, its solid record of replacing lost earnings over the past decade and the significant room for cost cuts/productivity gains."

Third, while the impending entry of TPG Telecom as a fourth player in the Australian mobile market will reduce Telstra’s dominance, Han sees the overall impact on group earnings as less than 10 per cent, given the "likely inferiority of TPG's network in terms of quality and coverage."

Finally, he thinks Morningstar's recently revised dividend estimates from fiscal 2019 are sustainable, providing investors with an attractive 5 per cent-plus fully franked yield at current prices. "This provides Telstra with sufficient financial flexibility to fight for and retain customers in the current competitive telecom environment," Han said.

Shares in Telstra are currently trading at a discount to Morningstar's $4.40 fair value estimate.

Sticking by Westpac

The big four banks have been the subject of a wave of negative press since the release of the royal commission interim report, but banking analyst David Ellis is sticking by wide-moat-rated Westpac (ASX: WBC).

"It's been a really tough time for the major banks, and rightly so.
"However, we think in the long term, based on a relatively stable, most strength in the Australian economy that the bank will continue to grow at a modest level, supported by its high dividend yield," Ellis said.

The royal commission saw a wave of negative press hit the big four, including Westpac

Competitive advantages, stronger earnings growth potential, and operational efficiency are among the reasons Westpac is Ellis's preference among the big four.

"Westpac recently led an increase in general home loan rates, growing their rates by 14 basis points in late August. CBA and ANZ followed a few days later," Ellis said.

"The reason they increased their variable home loan rates was because of higher wholesale short term funding costs. Funding costs went up, the banks absorbed that higher cost for a few more months than I expected, but eventually they exercised their pricing power, and restored their net interest margins, which of course flowed through to earnings."

He also noted Westpac is not bridled with the same restructuring risk as its peers, having successfully integrated its subsidiary wealth management firm BT Financial into its retail banking platform.

In the medium term, Ellis expects modest economic growth in Australia continuing to support favourable operating conditions for the major banks.

The stock is attractively priced, trading below Morningstar's AUD 35 fair value estimate.

Overly-negative sentiment creates opportunity

An oversupply of childcare centres in Australia has driven a share price slump for no-moat G8 Education (ASX: GEM), but technology analyst Gareth James believes the current share price reflects a market overreaction, and that supply challenges are cyclical rather than structural.

"Population growth and growing female workforce participation underpin demand for childcare, an essential service, and we expect the July introduction of the generous childcare subsidy to boost demand further," James said.

"Although G8 is experiencing weakening occupancy rates currently, and its lack of an economic moat means the company is vulnerable to competitive pressures, we expect the demand tailwind to boost occupancy rates over the next two years."

James says G8’s balance sheet is in reasonable shape following the debt refinancing in mid-2018. In addition to a manageable net debt/EBITDA ratio, he notes G8's relatively capital-light business model – enabling regular fully franked dividend payments at a high payout ratio.

And the party isn't over yet. In early 2017, listed Chinese investor China First Capital Group (CFCG) invested $96 million in G8 Equity at $3.88 per share. James says the recent weakness in G8's share price and CFCG's share price strength may encourage the Chinese childcare group to invest more in the company and provide a catalyst to narrowing the price/fair value discount.

G8 Education shares are trading significantly below Morningstar's $3.50 fair value estimate.

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Emma Rapaport is a reporter with Morningstar Australia, based in Sydney.

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