Morningstar Advisor - October/November 2009 - 74

By the Numbers: Stocks Undervalued Stocks with Wide Moats Undervalued stocks with significant competitive advantages can make attractive long-term holdings. With that in mind, we scoured our 2,000-plus stock coverage universe for highquality stocks (those boasting wide economic moats) that are trading on the cheap (rated 4 or 5 stars by our analysts). Our analysts award wide economic moats to companies that they believe possess durable competitive advantages that are likely to confer economic profits well into the future. In addition, our analysts estimate the fair value of each stock based on in-depth fundamental analysis. When a stock trades at a suitably wide discount to our estimate, we award it 4 or 5 stars. The wider the discount, the higher the star rating, and vice versa. There were 82 stocks that fit that profile as of Aug. 31, 2009, 16 fewer than made the list June 30, 2009. For months there was a bull market on bearishness. Analysts and commentators seemed to be trying to outdo each other by issuing increasingly dire forecasts. This pessimism was not completely unwarranted. The banking system was on the verge of collapse and possible nationalization, job losses were piling up, consumers shut their wallets, housing prices were plummeting, and the Fed was entering uncharted waters with its quantitative easing program. Now that the economy has begun to stabilize, many observers have backed off from their most extreme doomsday scenarios. But there is still more than a fair share of pessimism permeating the investment community. This isn’t so surprising. Analysts (and management teams for that matter) have little incentive to break from the pack and be overly bullish. Behavioral scientists have shown that people tend to feel more pain during loss than joy during gains. Companies and analysts would rather set low expectations and beat them, rather than miss an ambitious target. This isn’t to say that these conservative estimates are completely unrealistic. The economy is still sending out mixed signals; employment data is improving but weak, and consumer spending can’t seem to get out of the basement. Despite this gloominess, the major stock indexes keep hitting highs for the year. Some of this enthusiasm seems to be driven by the slew of positive earnings surprises reported this quarter. So why are so many companies outperforming? There are a few factors at work here. First, the bar was set exceptionally low, making it easy for firms to jump over. Second, companies cut costs much faster than analysts thought possible. Few firms saw growing demand for their products or any organic sales growth. But by cutting staff and other costs, they were able to earn more than anticipated. It is possible, then, that some of the firms that are beating expectations in this downturn are the ones nimble enough and flexible enough to react to a rapidly changing business environment. These are exactly the type of businesses that are likely to ride out the downturn and be able to take advantage of the recovery. Investors might be well served to look at earnings surprises, along with other fundamental valuation metrics, when seeking investment ideas. Adding fundamental metrics is key, because overpaying for a firm—even one that has had positive earnings surprises—doesn’t make sense. Name Industry Market Cap ($Mil) EPS TTM P/E Ratio (trailing) Revenue Growth % 3 Yr EPS Growth % 3 Yr Dividend Yield % Current ROE % Pg# (trailing) 3M Company MMM Abbott Laboratories ABT Altria Group Inc. MO American Express Company AXP Apollo Group, Inc. A APOL Applied Materials AMAT Autodesk, Inc. ADSK Automatic Data Processing ADP Berkshire Hathaway Inc. B BRK.B Biogen Idec, Inc. BIIB Boston Scientific, Inc. BSX Bristol-Myers Squibb Company BMY Buckeye GP Holdings L.P. BGH Campbell Soup Company CPB Diversified Drug Manufacturers - Major Cigarettes Credit Services Education & Training Services Semiconductor Equipment & Materials Technical & System Software Business Services Reinsurance Biotechnology Medical Instruments & Supplies Drug Manufacturers - Major Oil & Gas Pipelines Process & Packaged Goods 48,966 69,752 37,445 38,031 9,779 17,236 5,215 18,971 150,513 14,223 16,959 42,966 630 10,800 4.02 3.43 1.45 1.58 4.58 0.01 -0.10 2.63 63.06 2.75 -1.54 2.80 -1.73 2.08 16.56 13.40 11.86 14.41 15.08 — 87.72 15.75 59.17 17.33 — 12.24 15.72 14.97 6.08 9.75 -34.51 5.63 11.74 5.15 14.63 9.06 9.69 19.15 8.61 2.36 66.83 1.95 5.88 13.04 -22.09 -7.77 7.66 -1.39 -16.01 -0.63 -16.50 77.98 — 20.05 — 21.41 2.90 3.37 7.07 2.25 — 1.86 — 3.39 — — — 5.72 6.16 3.24 26.49 29.96 80.22 17.78 90.49 0.10 4.62 23.13 2.25 13.65 -16.54 44.79 — 49.97 74 Morningstar Advisor October/November 2009

Morningstar Advisor - October/November 2009

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