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These High-Quality Companies Are on Sale

With relatively low valuations and a history of down-market outperformance, wide-moat stocks could be ready to shine.

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It's been a bummer of a summer for U.S. stock market investors. As if China's equity-market rout weren't enough of a headwind, the current corporate earnings season has been lackluster.  Apple (AAPL), the world's most valuable company (by market value), posted disappointing earnings last week, dragged down by disappointing sales of the Apple Watch. U.S. multinationals also have seen their earnings crimped by the still-strong U.S. dollar. The S&P 500 is clinging to a gain for the year to date, but only barely. 

Yet, even as equity-market volatility has been picking up, the stars could be aligning for what Morningstar calls wide-moat stocks--companies with sustainable competitive advantages. True, they'll rarely be the first or biggest movers in rallies, but wide-moat stocks tend to earn their keep in turbulent times. Wide-moat stocks held up better than the S&P 500 in 2008, for example, and they also outgained the broad market in 2011's skittish market environment. 

Not only does their historical performance pattern bode well for wide-moat stocks if the market continues to be rocky, but wide-moat stocks also look attractive on a bottom-up basis right now. The typical wide-moat company in Morningstar's coverage universe is nearly 10% undervalued currently, the lowest average price/fair value for wide-moat stocks since late 2013. That means that the wide-moat universe is a good hunting ground for investors concerned that the six-plus-year rally could be long in the tooth. 

With that as the impetus, we used  Morningstar's Premium Stock Screener to hunt for companies with wide moats and 4- or 5-star ratings (meaning that our analysts think they're cheap, currently). In addition, we added a screen for low fair value uncertainty ratings, which indicate that our analysts have a high degree of confidence in their fair value estimates. The universe of companies with high fair value uncertainty ratings is, in aggregate, cheaper than the group of companies with low fair value uncertainty ratings right now. But the high fair value uncertainty businesses are generally more cyclical in nature, so they could be hit harder if the global economy faces a setback of some kind. 

As of July 28, 2015, 16 companies fit all three criteria (wide moat, 4 or 5 stars, and low fair value uncertainty ratings). Energy stocks dominated the list (six companies), followed by consumer-defensive names (five firms). The rest of the companies are scattered across industries. Note that many of them are mega-cap firms that are widely represented in mutual funds, so prospective investors should be sure to check their portfolios' existing exposures (using the Stock Intersection view of Morningstar Portfolio Manager's X-Ray function) before backing up the truck for any of these names. 

Premium users can click  here to view the complete list or tweak the criteria. Here's a closer look at three of the companies that made the cut. 

 Magellan Midstream Partners (MMP)
Master limited partnerships have faced pressure from a number of different directions in the past year. Sliding commodity prices have weighed on the asset class, and concerns about rising interest rates have depressed a host of income-producing securities, including MLPs. Having dropped more than 20% in the past year, the Alerian MLP Index is now officially in bear-market territory. Equity analyst Peggy Connerty believes the selling has been overdone in the case of Magellan Midstream, one of the largest pipeline players. Connerty notes that 15% of Magellan's operating income comes from commodity-sensitive activities, but also points out that its core fee-based transport and storage operations are the bulk of its business and continue to see healthy demand. This was one of a tiny handful of wide-moat, low-fair-value-uncertainty companies to rate 5 stars (rather than just 4 stars) as of late July 2015. 

 Merck (MRK)
Although patent losses have weighed on Merck's results in recent years, sector director Damien Conover believes that the investment community is underestimating this drug stalwart's growth potential. Cancer drug Keytruda, in particular, is poised to be a blockbuster, in Conover's view, and he also thinks that diabetes drug Januvia will remain best in class. Thanks to its patents, economies of scale, and pipeline, he affirms the company's wide-moat status and thinks its shares are on sale at current levels. 

 Wal-Mart (WMT)
There's plenty of worry about with Wal-Mart: Analyst Ken Perkins notes that the world's largest retailer faces competitive pressures from the likes of  Costco (COST),  Amazon  (AMZN), and the dollar stores. While he acknowledges that those challenges could continue to crimp Wal-Mart's near-term results, he believes those considerations are already fully priced into the firm's shares, which have dropped by nearly 16% so far in 2015. Not only does Perkins believe the company's smaller-store and e-commerce efforts could bear fruit, but the company's scale--the source of its moat--should continue to allow it to deliver on its four key business pillars of operating for less, buying for less, selling for less, and growing sales.

Christine Benz has a position in the following securities mentioned above: WMT. Find out about Morningstar’s editorial policies.