Our Outlook for the Market

Our stock research is dedicated to understanding the competitive strength of individual firms and the structure and development of their industries. In turn, we develop expectations for free cash flow generation and estimate fair values for individual companies. It's a bottom-up approach to be sure, but we think it can yield valuable top-down insights as well.

Indeed, taking our individual calls together, we still think the market looks cheap. The chart below shows the median ratio of stock price to Morningstar's fair value estimate for our coverage universe since 2001. Lately, we've been at 2001-02 levels--another period that turned out to be a good time to put cash to work by buying stock in risky but productive enterprises.

Economic growth has slowed significantly in the past year, and a recession could well be under way right now. But getting bullish in an economic slowdown can make a lot of sense. The S&P 500 Index is included in the index of leading economic indicators for a good reason. Stock prices tend to drop before recessions start, remain weak in the early stages of a recession, and then go up before recoveries begin. That's why, since World War II, an explicit strategy geared to putting cash in the stock market only at the beginning of recessions would have significantly outperformed putting cash into the market continuously.
 
 

Although we think the market looks cheap, a turnaround may require patience, and certain factors could affect our fair value estimates as events unfold. For example, the economic slowdown may be longer, deeper, and have a more dramatic impact on our revenue and cash flow assumptions than we currently expect. We've been shaving expectations for revenue and cash flow in 2008 for many of our companies, but our forecasts could still be too high. In turn, persistently higher inflation could mean that our discount rates are too low, and our fair value estimates too high.

But in the cash flow analysis that drives our fair value estimates, longer-term expectations drive much of the value we see in individual enterprises. No method is perfect when estimating fair values for stocks, but our approach can be especially valuable in times of economic slowdown. The market may be too focused on immediate issues, and our fair value estimates are anchored by our longer-term expectations. We've taken a close look at them, and they appear reasonable.

The Market, Sector by Sector
Looking across our coverage universe, each of the 12 main sectors appears undervalued, just as they did last quarter. In other words, we still think there's a lot of value out there, and in a lot of places.

Sector Valuation Changes
	Current Median Price/Fair-Value	Three Months Prior	Change ( % )
Business Services	0.93	0.88	6.2
Consumer Goods	0.88	0.89	-1.4
Consumer Services	0.83	0.78	6.6
Energy	0.87	0.93	-6.0
Financial Services	0.88	0.88	-0.5
Hardware	0.91	0.85	6.7
Health Care	0.88	0.90	-2.3
Industrial Materials	0.91	0.90	1.4
Media	0.98	0.91	7.6
Software	0.92	0.88	4.1
Telecommunications	0.86	0.90	-4.3
Utilities	0.98	0.93	5.4
Data as of 06-13-08.

Below, we dig into each sector in more detail, laying out which areas--and which stocks--appear cheapest to us at the end of the first quarter.

Business Services
We think Mr. Market has unduly punished gambling, casino-related, and cruise line firms.

Consumer
Investors need to separate near-term business trends from valuation.

Energy
We've raised our outlook for oil and gas, coal, and deep-water drillers.

Financials
As the deleveraging continues, losses keep mounting

Hardware
Disks or chips? Or neither.

Health Care
Political winds could cast a cloud over health-care companies.

Industrials
Industrial production is hindered by housing and input costs.

Media
Yahoo and Microsoft are standing by as Google strengthens its wide moat.

Software
International growth should continue to benefit software companies.

Telecom
Looking into foreign-based companies has the potential to pay off.

Utilities
Regulated utilities are bearing the brunt of today's high-cost environment.

Cyclical Sensitivity
Here's another way to start looking for ideas. We cover about 2,000 companies in the 12 main sectors listed above. There are more than 100 identified subsectors, each with its own competitive dynamics as well as sensitivity to economic cycles. Much of the undervaluation we're seeing in the overall market appears to be driven by companies in subsectors that are especially sensitive to the economic slowdown. The median price/fair-value ratio for 35 subsectors we identified as economically sensitive comes in at 0.85, for example, significantly below the median ratio of 0.91 for companies in the other sectors in our coverage universe.

Looking at the financial data and the projections underlying our fair value estimates, we expect better improvement in revenue growth in the cyclically-sensitive subsectors than in the other sectors in the next two years. The cyclically-sensitive sectors also had greater margin erosion in the last two years, and we expect better margin improvement in the cyclically-sensitive sectors than the other subsectors in the next two years. That's not to say that there aren't good investments in areas that are insensitive to the business cycle, to be sure.

Here's a look at all of these subsectors and the median price/fair-value ratio for each of them. Click here to see the underlying stocks in each of these industries.