While the S&P 500 Index is up more than 30% from its March lows, the returns have been largely driven by the top ten companies in the index. Many companies that have been more directly impacted by the Covid-19 pandemic are still down significantly.
Several of these companies are correctly valued, but there are a select few stocks that have been unjustly punished for being in the “wrong” industries. We have identified five companies that we believe are currently undervalued and have near term growth potential to outperform the broader market.
Southwest Airlines Co (LUV)
Southwest Airlines has a very strong balance sheet, and it is an industry leader trading at a discounted price. The company is very consistent company in generating profits, and in the last 10 years they have grown revenue by 8% compounded annually. In addition, their free cash flow has been positive for 9 out of the last 10 years.
For the trailing 12 months, they generated a substantial $2.1 billion in free cash flow. Of the four largest airlines, Southwest has the highest return on invested capital at 12%.
Although there is a short-term impact in air travel demand, the overall growth of the economy will lead to a rebound in the airline industry. As air travel gradually returns, it appears that domestic travel will be the first to return as many international borders remain closed, and Southwest’s revenue is primarily generated from domestic flights.
The company has the best downside protection compared to other airlines with ample liquidity, highest market share, and most profitability. The stock is down nearly 40% year-to-date. We believe this is a good pick for a recovery in a diversified portfolio.
Ford Motor Company (F)
Auto sales over the past five years have been consistently above 16 million units annually. The pandemic cause a dramatic drop in sales to below an annualized rate of 8.58 million units at the end of April.
Ford is one of many global automakers experiencing extreme stress as a lack of revenue, high debt, and a general lack of liquidity drove the stock down by more than 30%. While we expect negative company earnings through 2020, we are modeling a return to profitability in the second half of the year and earnings per share of $0.50 through 2021 as overall consumption returns to normal.
We believe Ford’s favorable valuation makes it a tactical buy for the next six to 12 months. However, we expect the company’s culture and broken business model will challenge Ford from remaining a long-term holding.
AT&T Inc. (T)
AT&T is down 20% in 2020, with underperformance driven by a halt in box office sales out of WarnerMedia and increased churn rate in the mobile segment due to the higher unemployment rate. With AT&T trading at 10 times forward earnings of $3.35 in 2021, we believe it is a good buy right now for three reasons.
First, the pandemic has accelerated the move towards digital media due to social distancing, and the combination of Turner, Warner and HBO media catalogs give AT&T a solid footing in the shift. Second, we still believe 5G will drive incremental growth starting in 2021, and AT&T’s low band spectrum build up is well above all competitors aside from the T-Mobile post-merger. Last, AT&T’s dividend yield of 6.35% is adequately covered by over $25 billion in free cash flow, which pays investors to wait for a recovery and mitigates price volatility.