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Stock Strategist

20 Reasons to Love the Sell-Off

When the going gets tough, the tough go shopping.

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I tend to get a lot of calls from reporters when the market tanks, and they always ask the same question, "So why do you think the market is down?" Since "I have no idea" (I don't, and neither does anyone else) isn't very quotable, I like to reframe the question.

Instead of obsessing about why the market has sold off over the past couple of weeks--you'll never know, and besides, it's already down--why not ask instead what stocks have become cheap enough to buy? After all, when the local department store has a big sale, you don't ask why those crazy people are slashing prices. You say, "Put the kids in the car, and let's go shopping!" That's exactly the attitude to have right now about high-quality blue chips.

As I pointed out in a recent column, wide-moat large caps are pretty cheap as a group, and many are trading at their lowest valuations in almost a decade. Broadly speaking, the stocks that are cheapest right now are the ones you'll most want to own for many, many years at a stretch, which is a pretty great situation for long-term investors. We currently have  more than 120 stocks with 5-star Morningstar Ratings, and since that's a big group to sort through, I've narrowed it down to the best of the best.

These 20 stocks are not the cheapest in our coverage universe, but the ones that offer the best mix of quality and valuation. They could be core holdings for any long-term investor--we have been buying, or already own, many of them in the Tortoise and Hare portfolios that appear in Morningstar StockInvestor. I'd be willing to bet that this group will do pretty well over the next few years. Probably better than the market, and almost certainly better than a portfolio laden with emerging markets, small caps, REITs, commodities, or anything else that's topping the performance tables.

While market darlings such as  Google (GOOG) and  Apple (AAPL) have shot the lights out recently, many of tech's stalwarts are trading at what one colleague of mine has called "stupid cheap" valuations.  Dell (DELL) trades for 11 times cash flow and is still the low-cost producer in a commodity market.  Maxim Integrated Products (MXIM), an analog semiconductor firm with tremendous returns on capital and a very strong competitive position, trades for just 16 times cash flow. Speaking of wide-moat firms,  eBay (EBAY) hasn't been as cheap as it is right now since 1998--we think all the worries of Google encroaching on eBay's moat are overblown. Finally,  Electronic Arts (ERTS), which completely dominates the video game industry, has sold off recently because it's in the midst of a cyclical trough in between console releases. However, the firm remains the class act of the video game industry, which is still growing very nicely.

Financial Services
As in most areas of the market, bigger is better if you're shopping for financial stocks right now.  AIG (AIG) is clicking along just fine without Hank Greenberg, and trading about 25% below our fair value estimate, while  J.P. Morgan Chase (JPM) is still very cheap at 1.4 times book value despite the shares' recent run. We think Jamie Dimon is doing a fantastic job capitalizing on the firm's core competitive advantages, and we're not complaining about the 3% yield, nor about the fact that the stock trades about 30% below our fair value estimate. Finally, we still think  Berkshire Hathaway (BRK.B) is one of the best deals on the street right now. Its competitive advantages are firmly intact and will outlive Warren Buffett. Plus, it's got a ton of cash--almost one-third of its current market value--to put to work, GenRe is now the world's only AAA-rated reinsurer, and insurance pricing just keeps getting better and better. We think Berkshire is worth more than $4,000 per B share.

Consumer Goods and Services
Bargains abound in the land of consumer stocks, partially because "defensive" consumer-goods firms have been out of favor during the cyclical upswing of the past few years, and partially due to some firm-specific missteps. That's why you have a chance to buy  Wrigley (WWY) at its lowest valuation in a decade--we think the shares are worth 25% more than their current price. The firm has an extremely wide economic moat, it generates about 60% of its profits outside the U.S., and gum sales in emerging markets are growing at a very nice clip. We're also fans of recent Berkshire Hathaway purchase  Wal-Mart (WMT) and class-act drugstore  Walgreen (WAG). Walgreen has one of the most consistent track records of growth in corporate America, and will benefit quite a bit from two big trends--aging baby boomers buying more prescription drugs and greater consumption of generic drugs. (Walgreen makes a lot more money off generics than branded drugs.) Finally, we also think  Whole Foods (WFMI) is very attractively priced right now. Although its moat may not (yet) be as wide as the companies mentioned above, its growth prospects are absolutely stellar, and we think the stock market is not valuing that growth appropriately.

Industrials stocks have been on a tear the past few years as the economy has boomed, but there are still some bargains to be had. We're big fans of  Sealed Air (SEE), which generates a ton of free cash flow, has a strong management team, and dominates the mundane (but profitable) business for plastic packaging. And at 11 times cash flow, you're getting a great business for a good price. Speaking of mundane, you may think that few businesses are more dull than distributing maintenance and repair products to industrial firms--until you look at the amount of cash flow and shareholder value that some industrial distributors can produce.  Fastenal (FAST) and  MSC Industrial (MSM) are our two favorites in this boring-but-beautiful industry, and although they aren't dirt cheap when you look at their valuation multiples, they're enormously profitable, very shareholder-friendly firms with tons of room to grow. Both stocks currently trade for about 20% less than our fair value estimates.

Health Care
You could buy a health-care mutual fund--or you could buy  Johnson & Johnson (JNJ), which has its fingers in consumer products, pharmaceuticals, and medical devices. At 15 times cash flow, the stock trades at its lowest valuation in a decade, converts 20% of sales to free cash flow, and increases its dividend in near-lockstep with earnings. This one is as close to a no-brainer as they come, in my opinion. We're also fans of  Medtronic (MDT) and  Zimmer (ZMH), which operate in different parts of the medical-device industry and are trading at about 20% below our fair value estimates. Both are also wide-moat firms with many years of superior profitability left in them, as well.

Even in this hot sector, there are bargains to be had.  ExxonMobil (XOM) has traditionally taken the slow-but-steady approach to making money in this volatile industry, but there's no denying the company's long track record of superb capital allocation. We think the shares are undervalued by about 25% at the moment.  Kinder Morgan (KMR) operates in the decidedly unsexy pipeline business, but there's nothing dull about a nearly 8% yield and a 15% discount to our fair value estimate. Throw in a manager who was Morningstar's CEO of the Year last year, and you've got a pretty nice package. Finally, natural-gas producer  Devon Energy (DVN) is trading at a very attractive price after the recent mild winter drove natural-gas prices down from their post-Katrina highs. But with lots of gas-fired power plants in the ground, dwindling gas reserves in North America, and gas importation many years off, we think it's a good deal at the moment.

Is the sell-off over? I have no idea. Where will these stocks be in six months? I have no clue. But are these some of the best deals on the market right now for long-term investors? Yup. So stop worrying about why "the market" is down, and start thinking about which world-class businesses make sense for your portfolio--because you've got a lot to choose from at the moment.

Pat Dorsey does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.