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Stocks on Sale in a Strong Market

Use this screen to find bargains trading below their intrinsic value.

David Krempa, 06/22/2012

This article originally appeared in the June/July 2012 issue of MorningstarAdvisor magazine.  To subscribe, please call 1-800-384-4000. 

The U.S. market started the year with a tremendous rally in the first quarter as investors became increasingly optimistic about the economy. This was on top of an already strong fourth quarter of 2011. The S&P 500 was up more than 15% from the start of the fourth quarter of 2011 until the end of the first quarter of 2012, making it much harder for Morningstar’s equity analysts to find undervalued stocks. As a whole, analysts believe the market is about fairly valued, but we should be able to find individual stocks that are trading at a discount to their intrinsic value.

We saw the stock market get off to a similarly strong start in 2011 as the economy appeared to be on a strong recovery. But the market sold off later in the year on European fears and a stalled U.S. economy. To protect ourselves from getting too optimistic, we are going to search for value-oriented stocks, rather than chase growth stocks that investors have become increasingly interested in because of hopes of an rapid economic recovery. We ran this screen in Morningstar Principia.

PE Ratio Current < 12

First, we limited our search to stocks that trade at a low price/earnings ratio. We used 12 times earnings as our cut off. Although this will remove many high-growth stocks from our screen, we do not want to pay too rich of a valuation for a stock, especially if market sentiment about the economy shifts to a more pessimistic view, as it did last year.

And Revenue Growth % 3 Year > 5%

Despite looking for value stocks, we still want to find businesses that have good growth prospects. Many of the low-multiple stocks that passed our previous screen may trade at a depressed multiple for a good reason— because revenue is declining or growth prospects are weak—so this test should help eliminate declining businesses.

David Krempa is an associate analyst with Morningstar.

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