Still No Margin of Safety in the Stock Market

Stocks have had a bit of a tumultuous week. Mixed earnings pointed to economic weakness overseas, Spain and the rest of Europe's sovereign debt woes remained in focus, and investors continued to fret over the fiscal cliff. The broad-based U.S. Market Index dropped 3% on the week, with a similar magnitude of decline across all parts of the Morningstar Style Box and across industry sectors. 

But this modest sell-off has not left stocks particularly cheap, and given the huge amount of uncertainty that remains in the market, investors remain well-served by being selective in their stock investments.

The market is essentially fully valued at the moment. The current median price/fair value ratio for the entire market is 0.94 according to our equity analyst staff, not much lower than the 52-week high of 0.98 which the market hit in September. There is more of a valuation spread across sectors. Real estate is the most overvalued sector (median price/fair value of 1.06), and energy looks the cheapest (0.88). 

  - source: Morningstar Analysts

The overall picture is that the market as a whole isn't offering investors a suitable margin of safety, and that is likely a big problem right now given the number of potentially destabilizing events on the horizon. Although it might sound like a broken record at this point, Europe could possibly get much worse. Even if some of the very near-term risk has been taken out of the system, the underlying problems (Greece and Spain, in particular) are far from resolved. Building a unified fiscal union won't be easy, and it won't happen overnight. A collapse of the euro would be an incredible strain on the global financial system and have unknowable consequences for U.S.-based investors.

And don't forget about the fiscal cliff that is looming in the United States. If Congress does nothing, the nonpartisan Congressional Budget Office predicts that the economy will plunge into at least a mild recession. Unfortunately, doing nothing seems to be Congress' specialty these days. Given that neither side is likely to emerge from the election with a resounding mandate, it is going to be difficult to come up with a workable solution during the so-called lame duck session. Chances are good Congress will fix some of the fiscal cliff, but likely not all. As we saw during the fiscal cliff debate in the summer of 2011, even if the crisis is averted at the last minute, the debate itself can have significant effects on firms' investment decisions and consumer confidence.

These issues, along with others, such as a potential slowdown in China or Middle East turmoil leading to a rise in energy prices, mean that investors need to look for margins of safety before diving in. Buying a stock at a fraction of what you think it is really worth creates a buffer against something going wrong in the global economy. Because this margin doesn't exist in the broader market, stock-picking has become increasingly important. Investors need to look for firms that have good competitive advantages to fend off competitors and have the strength to withstand whatever the economy throws at them. To find these cheap stocks, we used Morningstar's  Premium Stock Screener tool to uncover companies with wide or narrow economic moats and Morningstar Ratings for stocks of 5 stars. You can run the screen for yourself  here. Below are three stocks that passed.

 Halliburton Company (HAL)      
Economic Moat: Narrow | Fair Value Uncertainty: Medium   
From the  Premium Analyst Report
For more than a decade, Halliburton has been working on integrating its drilling services to fully optimize drilling performance while lowering costs. The company began by placing its drilling engineering applications under one roof, which includes fluids, bits, and directional drilling. Over time, the firm has integrated its services into a single solution, which means that a customer could obtain substantially greater well performance and reduced levels of nonproductive time by standardizing on Halliburton's services rather than mixing services from multiple services providers.

 Johnson Controls (JCI)      
Economic Moat: Narrow | Fair Value Uncertainty: Medium     
From the  Premium Analyst Report
Already one of the leading auto-parts suppliers, Johnson Controls continues to diversify itself. Growth in its building efficiency and power solutions group helps offset vicious cyclical declines in the automotive experience group. Until recently, the Detroit automakers had been experiencing significant losses and worsening market share, and further major declines would not be favorable to Johnson Controls' profitability. Still, the company sells to every major automaker, so it is not solely reliant on Detroit to stay afloat. We don't think Johnson Controls would be forced into bankruptcy should a major automaker ever liquidate.

 Applied Materials (AMAT)      
Economic Moat: Wide | Fair Value Uncertainty: Medium     
From the  Premium Analyst Report:
Applied Materials is the behemoth of the semiconductor equipment industry, with unmatched scale and a broad product portfolio. The firm has been steadily establishing its solar equipment business in an effort to drive growth. However, Applied's business tends to be fairly cyclical, and the firm is currently facing an uncertain demand environment.

All data as of Oct. 26, 2012.