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Fund Spy

Funds Positioned to Take Advantage of Mr. Market

We look at some recent casualties and the funds that love them.

At Morningstar, we are fond of Ben Graham's understanding of the stock market as a fellow with bipolar disorder named "Mr. Market," who elevates prices when he's manic and lowers them when he's depressed. As my colleague Josh Peters pointed out recently, Mr. Market can be a great person to trade with if you learn to take advantage of his moods instead of adopting them. Taking advantage of him, of course, means selling to him when he's manic and buying from him when he's depressed, not following him into his manias and depressions.

Mr. Market has arguably been more depressed than he is now, but we think he's still down enough to be offering up some good businesses at compelling prices. Recent market declines have made the Morningstar's stock coverage universe appear more undervalued than at any time since the end of 2002, judging from our market valuation graph. In the past few weeks, we have seen as many as 200 stocks trading at prices far enough below our stock analysts' fair value estimates to place them in 5-star territory. Many of the mutual fund managers we admire share our view about Mr. Market, and we think this presents an interesting opportunity to see which of our favorite funds have high concentrations of the battered stocks that could be due for a rebound.

Let's take a quick tour of Morningstar's stock-picking methodology and then see which funds are poised to take the most advantage of Mr. Market's current case of the blues. Investors can decide whether they want to purchase the stocks we highlight or add to the funds that own them, at least according to recent filings.

Reviewing Morningstar's Equity Methodology
First, taking advantage of Mr. Market doesn't mean simply buying anything that he's down on. After all, even a depressed person can have a justifiably negative view of something. Instead, Morningstar analysts treat stocks as pieces of businesses that are worth the net present value of their future cash flows. Once we think we know what a business is worth on this "discounted cash flow" basis, we wait for the market to serve us by offering up that business at a discount, or margin of safety, to our fair value estimate. Stocks get into 4- or 5-star territory as they trade at prices below our estimates of their fair value.

The other hallmark of our approach to stocks is the emphasis on sustainable competitive advantages, or "economic moats," borrowed from Graham's most famous student, Warren Buffett. As my colleague Elizabeth Collins has discussed, we award a business a "wide-moat" rating if we think it can sustain returns on its invested capital that exceed its cost of capital for a multiyear period. The competitive nature of capitalism makes it difficult to find these businesses; entrepreneurs and capital tend to gravitate wherever outsized economic profits exist, thereby eventually eliminating those profits. Only very special businesses can fend off competition for a long time. Finding such businesses trading at depressed prices is usually even more difficult.

Still, one should not underestimate Mr. Market's moodiness. We think he's offering the following businesses at prices that will produce good returns into the future.

 Dell (DELL)
Star Rating: 5 Stars
Economic Moat: Wide
Funds That Love It:  Longleaf Partners (LLPFX),  Oakmark (OAKMX),  Oakmark Select (OAKLX)

Any list of recent casualties must include the embattled computer manufacturer and tech darling of the late 1990s. The stock has shed nearly 30% in both 2005 and 2006 through July on concerns about the growth of the computer manufacturing business, increased competition from other box makers, higher component costs, and Dell's stock-option program, which consumes a lot of cash. In his most recent Stock Analyst Note, Morningstar stock analyst Mark Lanyon also highlights Dell's inability to retain its efficient manufacturing advantage within the realm of notebook computers, where much business seems to be going. However, even if Dell grows at the rate of the industry in general, Lanyon assumes a fair value of around $30 per share compared with the current stock price of $22.

Among the funds that have significant percentages of their assets in the troubled stock is Longleaf Partners. Dell is Longleaf's biggest holding and soaks up more than 7% of the assets in the fund. Managers Mason Hawkins and Staley Cates still think that Dell has a cost advantage over its rivals and that the company's share repurchase plan benefits shareholders even more as the price of the stock declines. Incidentally, other 4- and 5-star stocks that occupy sizable positions in Longleaf's portfolio include cement maker  Cemex (CX), package carrier  FedEx (FDX), wireless-service provider  Sprint Nextel (S), and brewer  Anheuser-Busch (BUD).

Another manager who has picked up shares of Dell is Bill Nygren of Oakmark and the more concentrated Oakmark Select. Dell occupies a nearly 2% position in Oakmark and a nearly 4% position in Oakmark Select. Nygren views Dell as a great business that still generates lots of cash and trades more cheaply than it has in many years. Additionally, seven out of Oakmark's top 10 holdings are in 4- or 5-star territory, and nine out of Oakmark Select's top 10 holdings are in 4- or 5-star territory. Five-star holdings for Oakmark include  Time Warner (TWX),  J.P. Morgan Chase (JPM), and  Pulte Homes (PHM).

 Intel (INTC)
Star Rating: 5 Stars
Economic Moat: Wide
Funds That Love It:  Third Avenue Value (TAVFX), Oakmark Select

Chipmaker Intel, also a former tech darling, has fallen on hard times, dropping nearly 30% in 2006 through July after an 8% gain in 2005 but a 27% dive in 2004. Morningstar stock analyst Alex Ross is impressed with the competition from smaller rival  Advanced Micro Devices (AMD), but he thinks that Intel's longer-term future looks bright. Hopes are high for Intel's new chips, and the company is rebuilding its inventory to avoid product shortages that have hampered it in the past. Ross thinks this should allow Intel to do well before the release of AMD's new chips in 2008. He thinks Intel can maintain its market position and continue to produce returns on invested capital that exceed its cost of capital. Ross values the stock at $23 per share.

Morningstar favorite Third Avenue Value has recently been a big buyer of Intel. According to veteran manager Marty Whitman's most recent shareholder letter, the bursting of the tech bubble has resulted in large, well-established companies "where cash holdings alone are well in excess of total book liabilities; and where the price to earnings ratio at the time of purchase was not much more than 10 times peak earnings of past years." Intel meets these criteria for Whitman, who views the long-term outlook for the business favorably. Whitman also remarks that he has filled 4% of the fund with other fallen technology names. We should note that Whitman made a brilliant bet picking up battered semiconductor stocks from 2000 through 2002.

Additionally, manager Bill Nygren has been among the most aggressive recent buyers of the giant chipmaker in Oakmark Select, again emphasizing that its earnings are greater and its stock price lower than they were in 1999.

Star Rating: 5 Stars
Economic Moat: Wide
Funds That Love It:  John Hancock U.S. Global Leaders (USGLX)

Parcel carrier UPS belongs to the fallen-growth category, having slumped 10% in 2005 and 8% in 2006 through July. It is also off nearly 20% to around $68 from its recent highs in the low $80s. Morningstar stock analyst Peter Smith concedes that the company's outlook for the rest of the year is less robust than he might have thought. He has accordingly shaved 6% off of its fair value from $94 to $88. Nevertheless, Smith thinks the market has taken an "overly pessimistic view of UPS' earnings and outlook." Smith views the company's plans to create shareholder value through buybacks positively, and thinks the shares represent an "excellent long-term investment opportunity" at their current $68 price.

Among the funds that have concentrated positions in the stock is John Hancock U.S. Global Leaders. This fund's managers like global businesses that are leaders in their industries and sport high returns on invested capital. UPS fits the bill for them, and takes up 4% of the fund's assets.

In addition to UPS, the fund holds other 5-star, wide-moat stocks such as  Amgen (AMGN),  Johnson & Johnson (JNJ),  Home Depot (HD),  Microsoft (MSFT), Dell, and  Wal-Mart (WMT). This fund has fallen on hard times recently, due to its lack of energy exposure and its holdings in many of the high-quality large-cap names that have been out of favor, but we think it's poised for better results.

 3M (MMM)
Star Rating: 5 Stars
Economic Moat: Wide
Funds That Love It:  Jensen (JENSX),  ABN AMRO/Montag & Caldwell Growth  (MCGFX),  Mairs and Power Growth (MPGFX)

After lackluster performance in 2004 and 2005, 3M surged in the spring of 2006 only to come back down in July on news of poor results from its display and graphics group, which makes components for flat-screen TVs. Morningstar stock analyst Scott Burns lowered the company's fair value from $93 to $89, based on his projections of LCD TV sales and margins for the display graphics that 3M makes.

Nevertheless, Burns is optimistic about 3M's prospects, due to its emphasis on innovation and ability to find new uses for its technologies. Moreover, 3M has a good combination of patented products and surprisingly profitable mundane products such as sandpaper, adhesives, Post-it Notes, and Scotch tape. Moreover, Burns views the departure of CEO James McNerney, who engineered the company's turnaround, as less significant than others seem to. At $68, the stock trades well below Burns' new fair value estimate.

Our favorite funds with concentrated positions in 3M are Jensen and ABN AMRO/Montag & Caldwell Growth. Jensen runs a concentrated portfolio of 25 names, all of which must display 10 straight years of 15% or more returns on equity and trade below the management team's estimate of fair value. This emphasis on consistent profitability excludes economically sensitive or cyclical businesses and virtually guarantees very-high-quality companies. 3M is the fund's fourth-biggest holding and takes up 5% of assets. Other 5-star, wide-moat picks in this fund's portfolio include Johnson & Johnson, orthopedic device maker  Stryker (SYK), and payroll processor  Paychex (PAYX).

Manager Ronald Canakaris and his team at ABN AMRO/Montag & Caldwell also run a concentrated portfolio of large-cap stocks, but want them to have 10% or more growth every year. The team uses a combination of macroeconomic and fundamental factors to pick stocks. 3M currently takes up 4.5% of the fund's assets. Other 5-star, wide-moat holdings include UPS, Stryker, Paychex, and Amgen.

Finally, all-cap stalwart Mairs and Power Growth has more than 4% of its portfolio in the stock. The managers at this fund pick industry leaders, many of which are based in the fund's home state of Minnesota, that they can hold for the long haul. The fund also has large positions in wide-moat, 5-star stocks  Medtronic (MDT) and Johnson & Johnson.

John Coumarianos has a position in the following securities mentioned above: MMM, JNJ, JENSX, TAVFX. Find out about Morningstar’s editorial policies.