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Funds Positioned to Take Advantage of Mr. Market

We look at some recent casualties and the funds that love them.

John Coumarianos, 08/15/2006

At Morningstar, we are fond of Ben Graham's understanding of the stock market as a fellow with bipolar disorder named "Mr. Market," who elevates prices when he's manic and lowers them when he's depressed. As my colleague Josh Peters pointed out recently, Mr. Market can be a great person to trade with if you learn to take advantage of his moods instead of adopting them. Taking advantage of him, of course, means selling to him when he's manic and buying from him when he's depressed, not following him into his manias and depressions.

Mr. Market has arguably been more depressed than he is now, but we think he's still down enough to be offering up some good businesses at compelling prices. Recent market declines have made the Morningstar's stock coverage universe appear more undervalued than at any time since the end of 2002, judging from our market valuation graph. In the past few weeks, we have seen as many as 200 stocks trading at prices far enough below our stock analysts' fair value estimates to place them in 5-star territory. Many of the mutual fund managers we admire share our view about Mr. Market, and we think this presents an interesting opportunity to see which of our favorite funds have high concentrations of the battered stocks that could be due for a rebound.

Let's take a quick tour of Morningstar's stock-picking methodology and then see which funds are poised to take the most advantage of Mr. Market's current case of the blues. Investors can decide whether they want to purchase the stocks we highlight or add to the funds that own them, at least according to recent filings.

Reviewing Morningstar's Equity Methodology
First, taking advantage of Mr. Market doesn't mean simply buying anything that he's down on. After all, even a depressed person can have a justifiably negative view of something. Instead, Morningstar analysts treat stocks as pieces of businesses that are worth the net present value of their future cash flows. Once we think we know what a business is worth on this "discounted cash flow" basis, we wait for the market to serve us by offering up that business at a discount, or margin of safety, to our fair value estimate. Stocks get into 4- or 5-star territory as they trade at prices below our estimates of their fair value.

The other hallmark of our approach to stocks is the emphasis on sustainable competitive advantages, or "economic moats," borrowed from Graham's most famous student, Warren Buffett. As my colleague Elizabeth Collins has discussed, we award a business a "wide-moat" rating if we think it can sustain returns on its invested capital that exceed its cost of capital for a multiyear period. The competitive nature of capitalism makes it difficult to find these businesses; entrepreneurs and capital tend to gravitate wherever outsized economic profits exist, thereby eventually eliminating those profits. Only very special businesses can fend off competition for a long time. Finding such businesses trading at depressed prices is usually even more difficult.

Still, one should not underestimate Mr. Market's moodiness. We think he's offering the following businesses at prices that will produce good returns into the future.

Dell DELL
Star Rating: 5 Stars
Economic Moat: Wide
Funds That Love It: Longleaf Partners LLPFX, Oakmark OAKMX,  Oakmark Select OAKLX

Any list of recent casualties must include the embattled computer manufacturer and tech darling of the late 1990s. The stock has shed nearly 30% in both 2005 and 2006 through July on concerns about the growth of the computer manufacturing business, increased competition from other box makers, higher component costs, and Dell's stock-option program, which consumes a lot of cash. In his most recent Stock Analyst Note, Morningstar stock analyst Mark Lanyon also highlights Dell's inability to retain its efficient manufacturing advantage within the realm of notebook computers, where much business seems to be going. However, even if Dell grows at the rate of the industry in general, Lanyon assumes a fair value of around $30 per share compared with the current stock price of $22.

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