Pullback Makes Pockets of Value

After a volatile six months, stocks are entering the second half of the year down about 5% for the year to date. With the market lower but corporate profitability continuing to improve, stocks are beginning to look more reasonably valued at today's levels.

We reach that conclusion by aggregating the fair value estimates of the 1,700 companies covered by Morningstar's equity analyst staff to calculate a bottom-up market fair value--which stood at 0.92 (or 8% undervalued) as of June 30.

True, the screaming buys of a year ago are gone. But this is not to say there aren't individual stocks and sectors that look attractive.

Health care looks like the most attractively priced sector today. These companies have been in the spotlight all year as Congress debated and eventually passed health-care reform. Even after the bill passed, the uncertainty surrounding the industry hasn't completely lifted because it isn't clear what the real impact of reform will be when it is actually implemented in the coming years.

This uncertainty is likely a major driver of the sector's 13% discount to intrinsic value, based on our underlying health-care company fair value estimates. Morningstar analysts' take is more optimistic than the market's. They see reform as a potential net positive for many firms, as pricing pressure will be offset by larger volumes.

Business services (also 13% undervalued), financial services (10% undervalued), and energy (9% undervalued) also have better valuations than the market as a whole.

Breaking the market apart by company quality can reveal even more bargains. Morningstar assigns every company we cover an "economic moat" rating, which is a measure of a firm's long-term competitive advantages. Less-advantaged no-moat firms (4% overvalued) and narrow-moat firms (9% undervalued) are roughly in line with the broader market.

The real surprise is that wide-moat firms, those with the greatest competitive advantages, are trading at a 17% discount. These firms are likely cheap for a few reasons. First, companies with strong businesses tend to have big market caps, and large caps have been underperforming small and mid-caps so far this year. Second, throughout the recent rally, equity investors had been seeking out risk, and these great businesses aren't perceived to offer the same potential returns as riskier stocks.

Given these valuation levels, we think that wide-moat stocks, including  3M (MMM),  ExxonMobil (XOM), and  Pfizer (PFE), offer investors compelling long-term values at today's trading prices.

On the other hand, the sectors with the richest valuations today are software and hardware, which look 7% and 3% overvalued, respectively, as of June 30. Investors are enthusiastic about the prospect of increased corporate tech spending and believe that many of these companies will be able to ride the wave of a global recovery as IT spending rebounds.

The tech industry is also an expert at hyping its products and selling us on how they are going to change our lives. The buzz surrounding the emerging tablet market, among others, has led tech, on both the software and hardware side, to be one of the few sectors that is still talked about as a growth story in this economy.

At the corporate level,  Apple (AAPL) captured headlines in the second quarter not only for the iPad and fourth-generation iPhone, but also for eclipsing  Microsoft (MSFT) in market cap. Based on Morningstar analyst Toan Tran's fair value estimates for the two firms, however, Microsoft is the better bargain for investors today, trading a discount to his $32 fair value estimate, while Apple stock looks overvalued compared with his $238 estimate of fair value.