20 Great Businesses, 20 Cheap Stocks

The steady upward climb of U.S. markets over the past year has brought welcome relief to investors punished by what will arguably go down as the worst U.S. economic downturn since the Great Depression. Although there are many reasons to be optimistic about the long-run health of the U.S. economy and future corporate profits, the extended rally has plucked most of the low hanging fruit, leaving the U.S. equity market, as a whole, slightly overvalued by our estimates. It seems that market participants have put the 2008 crisis firmly in the rearview mirror, even though current market valuations would be hard-pressed to maintain their lofty levels should the economy retreat again during the near term.

Despite this uninspiring investment backdrop, we continue to believe that patient investors, who give thoughtful consideration to business quality and valuation, will do well over time. The Morningstar Wide Moat Focus Index captures this belief in an investable strategy. This index is composed of the cheapest wide-moat firms in our 1,700-stock coverage universe. Index constituents possess their industries' strongest competitive advantages, which we believe will persist many years into the future.

Only 160 companies that we cover (fewer than 10%) carry our wide economic moat rating. For inclusion in this index, we pick the 20 cheapest (based on price/fair value ratio) wide-moat firms every three months, and we readjust the holdings to equal-weight them at 5% of the portfolio apiece. The result is a fresh collection of high-quality firms with undervalued stocks. The latest reconstitution occurred on March 19.

The previous portfolio of 20 stocks underperformed the S&P 500 on a total return basis, gaining 2.7% between December 21 and March 19, its most recent reconstitution, versus 4.1% for the S&P 500. However, through March 30, the Wide Moat Focus Index's trailing one-year total return of 74.9% handily outpaced the S&P 500's 52.2% gain during the same period. Over the past five years, the Wide Moat Focus Index's annualized performance of 9.2%, versus 2.0% for the S&P 500, reinforces our view that quality matters, valuation matters, and patience matters.

Constituent Performance
Twelve constituents posted positive returns during their three-month run.  Genzyme  led the index with a 23.9% return between Dec. 21 and March 19. Although Genzyme's manufacturing issues persist, solid 2009 financial results helped remind the market that the firm's diverse product portfolio and strength in rare disease treatments afford Genzyme plenty of opportunity to overcome its manufacturing missteps. Genzyme's shares continue to be significantly undervalued in our view, and it remains in the Wide Moat Focus index. Senior analyst Karen Andersen met with Genzyme's management last week in Boston, and her insights from this visit are available for institutional clients on our Select site.

 General Electric (GE) turned in the second best share price performance, gaining 17.6% during the three month period. General Electric has faced myriad issues, from collapsing demand to poor capital allocation decisions to significant write-downs in its loan portfolio. Still, our General Electric analyst, Dan Holland, believes the firm is making significant strides in refocusing the business on high return areas, such as energy infrastructure, and he expects these efforts to eventually flow through to GE's financial results. Dan continues to believe the shares are undervalued, and GE remains in the Wide Moat Focus index.

The two biggest laggards in our previous portfolio turned out to be  Western Union (WU) (-13%) and  Weight Watchers (WTW) (-11%). Western Union's mixed fourth-quarter results and tepid guidance sent its shares on a downward trajectory, while Weight Watchers continues to face falling demand for its core services. We continue to believe in each firm's ability to earn economic profits over the long run, and expect eventual improvements in Western Union's and Weight Watchers's financial performance. In our view, the market has priced in a worst case scenario for each firm, and is now offering shares of each at a large enough discount to intrinsic value to provide an adequate margin of safety for investment.

Economic cross-currents will always be present, and the market will likely continue to misprice risk from time to time, as was arguably the case in both the trough last March and the peak in 2007. We continue to believe that a disciplined strategy of identifying high quality businesses with undervalued stocks will do well over the long run. The annualized seven percentage point outperformance of our Wide Moat Focus index over the past five years supports this belief. We offer readers the following look at our current constituents.

The current portfolio contains five new additions--firms that weren't cheap enough to include in the prior portfolio, but are cheap enough for us now. The most undervalued of this group is  KLA-Tencor (KLAC), trading at 64% of its fair value estimate as of March 19. KLA sells diagnostic and processing equipment used in the production of semiconductor chips. While the cyclical nature of the semiconductor equipment industry is well known, the most recent downturn forced KLA's customers to be particularly stingy with their capital investment dollars. Senior analyst Andy Ng expects this trend to reverse as chipmakers increase production to accommodate new DRAM demand spurred from a corporate PC refresh cycle and flash memory demand from increasing adoption of smartphones and solid state drives. Andy writes a quarterly outlook for the Semiconductor Equipment industry that our institutional clients can access on our Select site.

Rounding out the group of newcomers are previous constituent  American Express (AXP), third-party logistics provider  Landstar System (LSTR), stone and gravel quarries firm  Martin Marietta (MLM), and orthopedic device maker  Zimmer Holdings (ZMH). Although KLA-Tencor is the only newcomer cheap enough to warrant our 5-star rating, all five wide-moat firms are among our cheapest, and therefore are worthy of our attention. Click through to these companies' Analyst Reports or visit Morningstar.com to see for yourself why our analysts are bullish on these undervalued, wide-moat stocks.