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BOSTON ( TheStreet) -- Evidence is building that the overheated stock market is ready to take a breather, so investors may want to hunker down with high-quality, but undervalued, stocks. They may be hurt less in the event of a market tumble and have more upside in a subsequent rebound.
S&P Capital IQ's chief equity strategist, Sam Stovall, said Monday that among the indictors that a correction is nigh is that the
S&P 500's roughly 29% gain of the past six months exceeds the 24% average in the severe corrections or mild bear markets since 1945, and it is approaching the 32%, 12-month average increase seen in such recoveries.
S&P strategist Mark Arbeter predicts that the S&P 500 "could surrender 3% to 5% in a mild pullback," which would mean a decline to its 50-day moving average of around 1,370, or even to its 65-day average near 1,350, "before resuming its upward trajectory." The S&P is at 1,385 now.
With that in mind, I screened the Morningstar database of its highest-rated stocks (five-star ratings) to find which among them are trading at the biggest discount to Morningstar's "fair value" estimate.
The premise of this approach is that these high-quality stocks are less volatile and have lots of potential upside when a rising tide lifts all the boats.
Morningstar analysts assign fair-value targets based on discounted cash-flow models. Their model assumes that the stock's value is equal to the total of the free cash flows the company is expected to generate in the future, discounted back to the present. It is not the same metric used by Wall Street firm's sell-side analysts to determine a 12-month price target, as they typically use their earnings estimates and apply a predetermined ratio to come up with a price-to-earnings price, coupled with other market factors.
"Fair values are meant to provide an estimate of what the stock is worth, irrespective of what investors are willing to pay for it," says Morningstar, and therefore they tend to be lower since the approach is more conservative.
The stocks I highlight below have price-to-fair-value ratios below 50%, which means Morningstar's analysts expect that these stocks are now trading at less than half their value, per the fair value metric.
10 of Morningstar's five-star stocks with the biggest discount to the firm's fair-value estimate listed in order of highest to lowest discount: