High-Quality Stocks in the Bargain Bin

Does a rising tide really lift all boats? Not necessarily. There's been a big divergence in performance in this year's market rally: The smallest and most speculative stocks have surged, while bigger, higher-quality names have fallen behind.

Unless you're trying to ride a wave of market momentum (which is a pretty risky game, because you never know when the tide will reverse course), you're better off digging through the stocks that have lagged instead of those that are hitting new highs.

For this week's Five-Star Investor, we used Morningstar's  Premium Stock Screener to find stocks that are trading close to their 52-week lows. To help weed out "cigar butt" stocks that have dropped because of serious fundamental problems, we also added some quality screens to the mix.

We started out by screening for stocks that are currently trading within 15% of their 52-week lows. Fewer than 10% of the 6,595 companies in Morningstar's equity database passed the first test. We narrowed down the list by requiring Morningstar grades of C or better for growth, profitability, and financial health. That eliminated some downtrodden stocks with shaky fundamentals, such as Trump Hotels & Casino Resorts . We limited the final cut to companies with some sort of economic moat (a competitive advantage that can help them sustain above-average profits over time). Companies often capture investors' attention if they have a nifty new product or an intriguing strategy, but we're firm believers that those with defensible moats will make the most profitable holdings over time.

The results show some pretty clear-cut patterns. Several of the companies on the list are health-care firms, which have lagged because of worries about anemic new-drug pipelines and pressure to hold down prices on prescription drugs. (Merck's (MRK) recent warning that top- and bottom-line results will be lower than expected for the fourth quarter cast another shadow on the industry this past week.)

Numerous consumer-goods firms also made the final cut. Overall, about half of the companies that passed all the hurdles fall in Morningstar's classic growth stock type, which was among the worst performers of any stock type for the 12 months ending Sept. 30. When the economy is on the rise, cyclical and speculative stocks often attract the most attention, while classic growth bellwethers such as Anheuser-Busch (BUD) tend to lag behind.

There's no guarantee that these stocks will bounce back anytime soon, and just because they're trading near their 52-week lows doesn't mean our analysts consider them cheap enough to buy right now. At the very least, however, combing through the recent laggards offers some interesting watch-list ideas--in high-quality companies to boot. Here are some highlights:

 Pfizer (PFE)
Stock price as of Oct. 23: $31.01
52-week low: $27.90
Morningstar Rating: 5 Stars
From the  Analyst Report: "Third-quarter results strengthen our expectations that Pfizer will continue to be a powerhouse within the pharmaceutical industry. Its cash-generating power, marketing muscle, and unparalleled collection of high-margin blockbuster drugs should solidify the company's leading position. We would look to invest in the shares below $32."

 Anheuser-Busch Companies (BUD)
Stock price as of Oct. 23: $49.60
52-week low: $45.30
Morningstar Rating: 4 Stars
From the  Analyst Report: "As the 800-pound gorilla of the U.S. beer industry surrounded by a few orangutans, Anheuser-Busch remains one of our favorite beverage stocks. We wouldn't require more than a 20% discount to our fair value estimate to consider the shares a bargain."

 Washington Post (WPO)
Stock price as of Oct. 23: $709.40
52-week low: $650.03
Morningstar Rating: 3 Stars
From the  Analyst Report: "Strong businesses and topnotch management make Washington Post a good stock to own at the right price."

 Gillette 
Stock price as of Oct. 23: $31.31
52-week low: $27.57
Morningstar Rating: 3 Stars
From the  Analyst Report: "It will take more than a four-bladed competing product from Energizer's (ENR) Schick to dent Gillette's formidable long-term competitive advantages in the razor industry. We'd view a price dip in Gillette to $24-$25 as a buying opportunity."

 Johnson & Johnson (JNJ)
Stock price as of Oct. 23: $50.30
52-week low: $49.00
Morningstar Rating: 3 Stars
From the  Analyst Report: "Impressive third-quarter results confirmed our view that Johnson & Johnson continues to benefit from a solid product portfolio and unmatched diversification. We would snap up shares at a 20% discount to our fair value estimate."

To run this screen yourself and see all the stocks that passed, click  here. (The stocks mentioned above passed our screen as of Oct. 23. The results of the screen may change due to daily price fluctuations or other factors.) After clicking, you can save the search to use later by clicking the "Save Criteria" button in the bottom right-hand corner of the screen. (Note: You will need to be a Premium Member to view and save the complete screen.)