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Cheap, Local, and On a Roll

Use this screen to find focused funds with stellar risk/reward profiles.

Timothy Strauts, 08/30/2011

This article first appeared in the August/September 2011 issue of Morningstar Advisor magazine. Get your free subscription today!

U.S. stock market has been on a great run over the past two years. Since the March 2009 low, the S&P 500 is up just more than 100%. If your clients have been fully invested these past two years, they should be pretty happy, but there are many investors who still have cash on the sidelines. For those investors looking to put money to work, where should they invest today?

For this screen, we will focus on the domestic-tock exchange-traded fund universe.

Security Type = ETF
And Morningstar Category = Domestic Stock
And Holding Average Star Rating > 3.30
And Total Return 12 Month > 28.0%

To find areas of the market that are still undervalued, we will lean on Morningstar's equity analysts for guidance. The average star rating for an ETF's holding is an asset-weighted average of the Morningstar Rating for stocks in the portfolio. This average star rating offers the insight into the valuation of the equity holdings in a portfolio and draws on the research of Morningstar's stable of in-house equity analysts. Many people are familiar with the ETF and mutual fund star rating methodology, which ranks funds based on risk-adjusted returns for three-, five-, and 10-year time periods. So an ETF's star rating is a backward-looking measure. A stock's star rating, however, is forward-looking.

The Morningstar Rating for stocks has nothing to do with the stock's historical performance and is calculated by comparing a stock's current market price with Morningstar's estimate of the stock's fair value. The rating system also includes a risk adjustment, so it's more difficult for a company with above-average business risk to earn a 5-star rating. The margin of safety our analysts demand before giving a stock 5 stars is determined by their assessment of business risk. Our analysts assign stocks to one of three business-risk ratings.

Each of the five star-rating levels is defined based on expected returns, which assume that the stock's market price and our fair value estimate for the stock eventually converge. Under the system, 3-star stocks are those that should offer a "fair return," one that compensates for the risk of the stock, or a rate of return that's comparable to the stock's cost of equity. (The cost of equity is often called a "required return" because it represents the return an investor requires for taking on the risk of owning the stock.)

Momentum investing is a strategy of buying investments that have had strong returns over the past six to 12 months, and it's based on the idea that markets aren't random and trends exist. Research has shown that momentum generates outperformance in almost every market and asset class tested. Momentum's profitability seems to contradict the fact that many retail-level performance-chasers underperform the market. There is no contradiction. They lose out because they hold on to hot investments for far too long, riding collapsing trends down.

Timothy Strauts is an ETF analyst at Morningstar.

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