Chances Are These Stocks Are Undervalued

Investing in stocks entails risk. As a visitor to Morningstar.com, you probably already understand this. But not all risks are created equal. There are unhealthy risks--say, investing all of your 401(k) assets in the stock of one company--and healthy risks, such as investing in a broadly diversified portfolio of stocks and bonds designed to match your needs.

For stock investors, Morningstar tries to provide some risk guidance to go along with its fair value estimates for stocks by including a fair value uncertainty rating. Fair value estimates are a useful measure of what Morningstar analysts believe a stock is intrinsically worth, even if the market doesn't (or doesn't yet) agree. But along with that estimate comes a measure of the analyst's level of confidence in the estimate.

In determining the range of potential outcomes for a stock's price, Morningstar analysts consider factors such as future sales, operating and financial leverage, and contingent (or possible) events such as a natural disaster or costly lawsuit. Companies with more of these wild cards in play will tend to garner higher uncertainty ratings than those without them. Analysts assign an uncertainty rating of low, medium, high, very high, or extreme to the fair value estimate, and this rating helps determine the margin of safety--or the size of the discrepancy between the fair value estimate and the price at which Morningstar believes the stock is a good buy. The higher the level of uncertainty, the greater the discount the analyst demands to see before he or she will recommend a given stock.

For stocks with high uncertainty ratings, the Consider Buying price (which corresponds to a Morningstar Rating of 5 stars) kicks in when the stock is selling at 60% or less of its fair value estimate, whereas a stock with a low uncertainty rating need only sell for 80% or less of its fair value estimate to garner a 5-star (Consider Buying) rating. Conversely, that stock with a high uncertainty rating needs to sell at 155% or more of its fair value estimate to reach Consider Selling (1-star) territory while the stock with the low uncertainty rating only has to reach 125% of its fair value estimate. Incidentally, 2- and 4-star ratings kick in at intervals closer to the fair value estimate, while a 3-star rating is awarded when the stock is selling at close to its fair value estimate. For more on the methodology used by Morningstar's equity research team, click here.

Given the role the uncertainty rating plays in Morningstar's equity analysis process, we thought it would be interesting to look at stocks with low uncertainty ratings and high star ratings; in other words, stocks that our analysts are pretty sure are selling at discounts. Using our  Premium Stock Screener, we screened on stocks with low fair value uncertainty ratings and 4- or 5-star ratings. Out of 64 stocks with the low uncertainty ratings, just 20 made the cut as of June 25. Half of these were energy stocks, with several health-care and consumer names also in the mix. Click  here to see the full screen, and below, you can read about a few of these companies.

 3M (MMM) (
)Despite this manufacturing giant's sensitivity to economic downturns, its long-term growth prospects are bright, says Morningstar equity analyst Adam Fleck. The Dow 30 company has a highly diversified portfolio and innovative culture that contribute to its wide-moat rating. Overseas sales have become an increasingly important revenue source. About two thirds of revenues currently come from outside North America, with especially high margins in Asia and Latin America. 

 Boardwalk Pipeline Partners  This master limited partnership operates 11 underground storage facilities and 14,000-plus miles of pipelines through some of the nation's most promising natural gas shale areas. The system is well-positioned to deliver to users across the Southeast, Midwest, and Northeast, and Morningstar's equity analyst team calls Boardwalk's growth prospects "among the most favorable in its peer group." About 80% of revenue comes from reservation fees, which customers pay to reserve pipeline capacity and which must be paid regardless of volume. Given the difficulty of building competing pipelines, the company enjoys a wide economic moat. The tax treatment of MLPs means it's a good fit for a taxable account. (This article explains the tax treatment of MLPs in greater detail.)

 Westpac Banking  Australia's oldest bank is one of the two 5-star stocks on our screen. It's also one of just four major banks operating in Australia and New Zealand, catering to the consumer, small business, corporate, and institutional markets. Despite the inherent risks in banking today, Morningstar analyst David Ellis writes that the company "is among a handful of banks around the globe currently retaining very high credit ratings," with a Standard & Poor's rating of AA. Its strong balance sheet and operational discipline are also cited as strengths.