Mine for Values in These Sectors

Despite worries about growth in the United States and the European sovereign debt crisis, the last few weeks and months have been surprisingly good to stock investors. The broad-based U.S. Market Index is up 3.4% during the past four weeks, almost 13% year to date, and more than 20% during the last year.

Has this runup in stock prices left equities too pricey? Last weekend we looked at some defensive sectors that do appear to have very full valuations. Investors looking for income and safety have bid up the real estate, consumer defensive, and utilities sectors to prices higher than Morningstar analysts' fair value estimates. But just because some areas of the market are expensive doesn't mean that there are no values to be found. Stocks as a whole remain modestly undervalued, with a median price/fair value ratio of 0.93, and some areas of the market look even cheaper.

Right now the cheapest sectors are basic materials, communication services, and energy. In basic materials and energy, investors are concerned that anemic global growth will slow energy demand and end up being a drag on commodity prices and profitability. Competitive pressures in the wireless space have dented communication stocks particularly in Europe and Latin America. Many of these fears are overblown and have left a number of high-quality stocks trading well below their fair value estimates.

Buying stocks cheaply is especially important right now. With all of the uncertainty in the global marketplace, having a margin of safety makes it more likely that your investment will be a success over the long run. Buying a stock that isn't priced for perfection allows some room for error. If the economy takes an unexpected turn, or the company has a few missteps, your investment could still make money over time.

Within the three most undervalued sectors, investors have a decent selection of cheap stocks from which to choose. In the basic materials, communication services, and energy sectors, there are 32 companies with Morningstar Ratings for stocks of 5 stars. These sectors now contain nearly half of all 5-star stocks, even though they only represent one fifth of U.S. stocks that currently have a Morningstar rating. Even better for investors, 25 of those stocks in the most undervalued areas of the market have a narrow or wide economic moat. That means that you can get a good margin of safety, combined with a great long-term business.

To find these investment candidates, we used Morningstar's  Premium Stock Screener to find 5-star stocks with narrow or wide moats in the three cheapest sectors. You can run the screen for yourself  here. Below is a preview of three stocks that passed.

 Alcoa
Moat: Narrow | Fair Value Uncertainty: High | 1-Year Return: -30%
From the  Premium Analyst Report: 
Alcoa is one of the top players in the aluminum industry, being the largest producer of alumina, a major smelter of aluminum, and a leading manufacturer of aluminum products for beverages, cars, aircraft, and building construction. The company's size and vertical integration enable strategic advantages such as lower input costs, greater efficiency, and access to financial resources. But like all commodity industries, aluminum is a challenging business, as profitability is linked to cyclical demand and volatile price movements.

 NTT DoCoMo
Moat: Narrow | Fair Value Uncertainty: Medium | 1-Year Return: -9%
From the  Premium Analyst Report:
NTT DoCoMo is the largest wireless telecom operator in Japan with about 46% market share. Although subscriber growth has slowed significantly, the firm has been cutting costs to boost margins. Japan has historically been a broad technology leader, with DoCoMo out in front in the wireless business. DoCoMo was the first company in the world to offer 3G services and wireless Internet access through its i-mode service in 1999, meeting the Japanese public's general desire for cutting-edge technology and allowing the firm to grow rapidly. Although growth has slowed as wireless penetration nears saturation, DoCoMo's business has shifted heavily toward data--57% of wireless service revenue in its fiscal fourth quarter--as customers have rapidly adopted 3G service.

 Devon Energy (DVN)
Moat: Narrow | Fair Value Uncertainty: High | 1-Year Return: -15% 
From the  Premium Analyst Report: 
Since late 2009, Devon has closed on almost $10 billion in asset sales as part of its shift toward U.S. and Canadian onshore resource plays. The result is a broad portfolio of growth-oriented oil and gas assets and a rock-solid balance sheet to aggressively develop these resources during the next several years. The firm's acreage includes sizable positions in the Rocky Mountains, Permian Basin, and Barnett and Cana-Woodford Shales, as well as conventional development projects and oil sands complexes in Canada. Devon's balanced production and reserve mix should help the firm generate attractive economics even in the face of continued low gas prices, with growth driven by its oil- and liquids-rich plays.

Data as of Aug. 14, 2012.