The Market's Most Undervalued Stocks

By Matthew Coffina

Every month, we publish an article about the market's most overvalued stocks. Since in normal times investors tend to have a bullish tilt, this is usually an exercise in contrarianism. However, these times are far from normal. We think investors have more than enough to be pessimistic about already, so this month, we're changing this article to "the market's most undervalued stocks."With the market crashing and fear at a pinnacle, we see no shortage of bargain opportunities. Changing the theme of this article to undervalued stocks has practical implications. Our star rating system is inherently contrarian: As prices fall, stocks become cheaper relative to our fair value estimates. As of market open on Monday, October 6, we had a 1-star rating on only 35 companies. In contrast, 511 companies carried our 5-star rating. Value investors should be jumping for joy.

With discount rates and risk premiums rising across the board, now could be a good time for the strongest-stomached investors to increase their risk exposure--the market is terrified of risk, so taking on risk should be increasingly well-compensated over the long run. However, market turmoil can also be a great time to pick up core holdings at a discount. The market can be indiscriminate in marking down stock prices, throwing the good out with the bad.

Some of the best investments can be made by buying best-of-breed companies during periods of general market turmoil and holding them until the market comes to its senses. Below, we highlight five companies that passed the following screen:1. Morningstar Rating of 5 stars

2. Trading at less than half our fair value estimate

3. Morningstar economic moat rating of at least narrow

4. Stock down 20% or more year to date

5. Fair value uncertainty of low or medium

6. Debt-to-total-capitalization of less than 50%

We like these companies for the long-haul, and now looks like a great time to buy. Not surprisingly, Warren Buffett's Berkshire Hathaway (brk.b.B) agrees with us on the first three, as they were recently in Berkshire's portfolio.USG CorporationPrice/Fair Value = 0.42
From the Analyst Report: Even with the strength of USG's (NYSE:USG - News) brands and distribution, the business remains highly cyclical, with revenue closely tied to booms and busts in commercial, industrial, or residential construction. USG is able to obtain price premiums on its wallboard during hot periods, and it scales back prices at a lower rate than its competitors when building slows. At the peak of the building cycle, USG's price for wallboard was 7% higher than that for a similar product from Eagle Materials, and that premium has now increased to 10%. Although this price volatility leads to choppiness in short-term results, return on invested capital over the long run has averaged 15%--well in excess of the company's cost of capital.

UnitedHealth GroupPrice/Fair Value = 0.45
From the Analyst Report: UnitedHealth (NYSE:UNH - News) connects its 70 million U.S. customers to a network of health-care providers that includes 560,000 physicians and 4,800 hospitals nationwide. The firm reaps the benefits of the positive feedback loop that results when customers seek out UnitedHealth for access to so many care providers and when providers join the UnitedHealth network for access to all those customers. UnitedHealth has one of the strongest bargaining positions in the industry.

ConocoPhillips
Price/Fair Value = 0.48
From the Analyst Report: Conoco's (NYSE:COP - News) production and exploration business benefits from OPEC's ability to influence global supply and stabilize pricing. Ownership of an extensive natural-gas pipeline, gathering systems, and facilities to unlock stranded natural-gas resources also contributes to the company's economic moat.

News Corporation
Price/Fair Value = 0.49
From the Analyst Report: News Corp.'s (NYSE:NWS - News) largest business segment, Fox Entertainment Group, owns a vast library of motion pictures and television shows including The Sound of Music, Star Wars, Titanic, The X-Files, and The Simpsons. Besides the proven ability to create great content, News Corp. can also distribute its content around the world through its theatrical film-distribution capabilities, television networks, and satellite television providers. News Corp. also owns one of the premier online distribution channels via its purchase of MySpace in 2005.

Expedia
Price/Fair Value = 0.41
From the Analyst Report: Expedia (NasdaqGS:EXPE - News) has separated itself from the pack, however. It is almost twice as big as its closest competitor, with nearly 35% of the U.S. online travel agency, or OTA, market. The company uses its size to negotiate lower wholesale prices from suppliers, and, because Expedia is the largest OTA, more suppliers are likely to distribute through the firm. The lower costs lead to higher margins than competitors, and the diverse inventory attracts even more customers to Expedia's sites, leading to favorable network economics and an uphill battle for competing OTAs.

Note: The stocks mentioned above passed our screen as of October 6. The results of the screen may change because of daily price fluctuations or other factors.

Morningstar Premium Members get access to over 3,900 Stock and Fund Analyst Reports, Analyst Picks, and award-winning portfolio tools