Despite full valuations and the higher likelihood of market volatility, high-quality stocks remain a good option for long-term investors.
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By Jeremy Glaser | 07-14-13 | 06:00 AM | Email Article

The S&P 500 reclaimed its all-time highs this week as the easing of Fed worries and a decent start to earning season sent stocks higher. The natural question as stocks reach new highs is "have valuations become too stretched?" Broadly speaking, the answer is no. To be sure, stocks are fully valued, but they aren't trading at unreasonable levels. And given the lack of good alternative investment in this environment, it doesn't make sense to abandon equities en masse. But it is likely to be a bumpy ride from here and investors would be well-served to only pay up for high-quality holdings that will be able to withstand any economic volatility.

Jeremy Glaser is the Markets Editor for Morningstar.com.

The proximate cause of this week's rise in stocks prices was a big reduction in worries over the Fed's tapering of mortgage-backed security purchases after some soothing words from the central bank. Bernanke's statement that we are going to have highly accommodative policy for the foreseeable future along with the release of meeting minutes showing Fed officials deeply divided on when to take their foot off the accelerator seem to have convinced the market, for now, that monetary policy isn't changing anytime soon. 

The 3% rise in stocks this week brings the year-to date return of the broad-based Morningstar US Index to more than 19%. The rally has brought the median price/fair value ratio for stocks covered by our equity analyst to 1.02, up from 0.96 on June 24 and a far cry from the 52-week low of 0.88 in July of 2012. That means that generally speaking, the fundamentals of corporate America support current stock market valuations, but investors aren't getting any margin of safety. If things don't turn out as currently forecast, stocks could easily sell off. This dynamic was on display the last couple weeks, when a fully valued market had some fairly large declines after investors began to believe that the Fed was beginning the slow the process of monetary policy normalization. It wouldn't be surprising if during the coming weeks and months if new news shows the global economy isn't growing as quickly as expected or the read on the Fed changes again, and stocks are sent reeling again as a result.

Full valuations, and the potential for volatility, aren't reasons to shun stocks right now, however. Investment decisions aren't made in a vacuum. Stocks have to be evaluated against alternatives like cash or fixed income. And for investors with a long-term horizon, those alternatives don't look all that great right now. Fixed income is going to be under pressure as rates rise and trying to time to market by moving all of your assets to cash is an exceedingly difficult proposition. That doesn't mean you shouldn't own those asset classes at all. In the context of a portfolio, fixed income still plays a vital role, and having a cash stake allows you to take advantage of opportunities as they come along.  Even at today's valuation levels, the long-term return potential for equities looks like a better bet than cash or bonds right now.

However, the lack of bargains does suggest that investors should pay closer attention to the quality of businesses they are buying. When you are paying $0.50 for $1 of intrinsic value, you are able to accept more company risk and a greater likelihood of things going wrong. When you are paying full price, you want to make sure you paying up for a company that is going to be able to withstand any short-term issues while still producing a solid earnings stream in any environment. The firms that will be able to do this are those with economic moats--businesses that have sustainable competitive advantages that will allow them to earn excess returns over the long haul.

Fortunately, at the moment firms with wide economic moats are actually slightly cheaper than the broader market. The median price/fair-value ratio of wide-moat stocks is 1.1. There are no wide-moat names that currently have Morningstar Ratings for stocks of 5 stars, but there are a few dozen that have a 4-star rating. That means you are both getting some margin of safety and get to own a great company. Not a bad combination.

To find these undervalued companies we used the Morningstar  Premium Stock Screener to search for wide-moat companies rated 4 stars. You can run the screen for  yourself here. Below are three securities that passed.

 Berkshire Hathaway 
From the  Premium Analyst Report:
Berkshire Hathaway's economic moat has been built on the firm's record of acquiring and managing a portfolio of businesses with enduring competitive advantages. Whether through direct ownership of individual companies or via significant stock holdings, famed value investor Warren Buffett has typically looked to acquire firms that have consistent earnings power, generate above-average returns on capital, have little to no debt, and have solid management teams. Once purchased, these businesses tend to remain in Berkshire's portfolio, with sales occurring rarely. Buffett strives to raise capital as cheaply as possible to support Berkshire's ongoing investments and measures the success of the portfolio by per-share growth in intrinsic value. Given the current size of the firm's operations, the biggest hurdle facing Berkshire will be its ability to consistently find deals that not only add value but also are large enough to be meaningful. The other major issue facing the company is the longevity of Buffett and managing partner Charlie Munger, both of whom are octogenarians.

 Kinder Morgan Energy Partners 
From the  Premium Analyst Report:
KMP's operations span the entire midstream energy space, with a network of pipeline and storage assets that crosses the continent and is capable of transporting and storing natural gas, natural gas liquids, crude oil, refined product, and ethanol. Kinder even does a fair amount of business handling coal and steel for export in its terminals segment. With its presence in many segments and dominance in some, Kinder routinely earns well in excess of its capital costs, supporting its wide moat rating. In this business, the bigger the asset footprint, the greater the opportunity set for new investment, allowing firms like Kinder with competitive advantages to maintain their competitive position.

 General Electric
From the  Premium Analyst Report:
General Electric positions itself to be a leader in all markets in which it competes. After shedding underperforming businesses during the past few years, the firm has energy infrastructure square in its sights. We believe GE will emerge as a leader in the power infrastructure market, which will be the backbone for the firm's growth. 

General Electric's wide economic moat stems from three factors that provide a solid foundation for sustainable profitability: strong service support for its installed base, a shift in the portfolio toward more moatworthy assets, and strong economies of scope that are very difficult to replicate quickly. 

All data as of July 12.

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Jeremy Glaser does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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