Our sector-by-sector take on the big themes and the best bargains.
By Haywood Kelly, CFA | 06-25-07 | 05:00 PM | Email Article

Heading into the third quarter, the overall market appears slightly undervalued to us. To be precise, we think the S&P 500 Index is trading 4% below its fair value. How do we come up with that figure? We look at our fair value estimates for all of the underlying stocks in the S&P and sum them up to arrive at what we think the index is really worth. Using the same methodology, we arrive at a 6% discount for the Dow Jones Industrials.

Haywood Kelly, CFA, is head of global research at Morningstar.

But a closer examination of market-wide valuations uncovers a stark contrast between a small group of mega-cap stocks--which have a disproportionate effect on these two indexes--and the rest of the market. Mega-caps are cheap, in our view. You'll currently see names like  Bank of America ,  Wal-Mart ,  Procter & Gamble , and  Johnson & Johnson  on our list of 5-star stocks.

Valuations get dicier as we move down the size spectrum. All told, there are only 104 names  currently on our 5-star list, out of a coverage universe of close to 2,000 stocks. The median stock in our coverage universe is about 3% overvalued, in our opinion. That's in contrast to a year ago, when our view was that the median stock was about 4% undervalued. With most indexes up 20% or more over the past 12 months, prices appear to have overshot fair value in many cases.

As the table below shows, only two of Morningstar's 12 sectors--consumer services and utilities--are undervalued when we look at simple medians and averages with no market-cap weighting.

 Sector Valuations
 
Median Price/
Fair Value
Avg Star
Rating
Business Services
1.04
2.60
Consumer Goods
1.01
2.86
Consumer Services
0.98
3.03
Energy
1.11
2.37
Financial Services
1.03
2.80
Hardware
1.05
2.66
Health Care
1.05
2.73
Industrial Materials
1.08
2.45
Media
1.05
2.72
Software
1.03
2.64
Telecommunications
1.12
2.32
Utilities
0.97
3.09
Data as of 06-15-07.

Our Outlook by Sector
As we've done in each of the past two quarters, we again bring you a digest of our outlooks for each market sector. As you'll see, despite the tilt toward overvalued stocks in the overall sector averages, our analysts are still finding pockets of value throughout the market.

Business Services: Several of our highest-rated business-services industries are benefiting tremendously from globalization, outsourcing, and global economic expansion.

Consumer: Aside from the homebuilders, we don't see any large pockets of value. However, a handful of high-quality 5-star stocks are scattered across the sector.

Energy: The re-emergence of the upstream master limited partnership (MLP) is currently one of the more important trends in U.S. energy markets, in our opinion.

Financial Services: Much of the second-quarter action in the financial-services world centers around ready money, cheap debt, and private equity.

Hardware: Two common themes underlie these investment opportunities: exposure to the telecom equipment food chain, and companies in the midst of restructuring programs that should improve margins.

Health Care: We still think the health-care industry is generally slightly overvalued.

Industrials: Many of the industrial companies we cover have seen their market valuations soar over the past year.

Media: We currently think radio is the most overvalued sector, while most of our undervalued names are in the media conglomerates segment.

Software: Despite our view that the software industry overall isn't cheap, we do have quite a few stocks that are worth putting on your radar.

Telecom: Finding a good deal on a telecom stock today is as challenging as finding a good deal on a souvenir at Disneyland.

Utilities: We remain long-term believers in electric utilities' ability to deploy unprecedented amounts of capital into infrastructure investments in North America over the next decade.

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Haywood Kelly, CFA has a position in the following securities mentioned above: JNJ Find out about Morningstar's editorial policies.
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