Market volatility will be a way of life in 2013, as Europe continues to work on solving its debt problems, China’s growth remains closely scrutinised, and the US grows in fits and starts. In this environment, we think stock-picking will make a comeback, and investors focusing on specific stock opportunities will do well given this backdrop.
Overall Market is Nearing Fair Value
We continue to view the market as pretty close to fairly valued, with global stocks under Morningstar coverage trading at 92% of fair value in mid-December, using a market-capitalisation-weighted average. This is not materially different than last quarter, when our coverage universe was trading at 91% of fair value.
The valuations of European firms under Morningstar coverage are no longer less demanding than we see for our North American companies, on average. Our European coverage is trading at 93% of fair value, while our North American coverage universe is currently priced at 92% of fair value. This could have more to do with our coverage universe in Europe than the overall market condition; the approximately 250 European firms we cover tend to be larger-cap, moaty, higher-quality businesses that the market has sought out over the past year. That being said, these names did rally quite a bit in the past three months, as the market was pricing our European coverage universe at 87% of fair value just a quarter ago.
Hope for the US Economy
There’s general agreement that a positive return in the US market will come from multiple expansion, as margins are already high by historical standards. Although we agree that margins seem pretty high already and that the market’s valuation is not overly demanding at these levels, we see two alternative outcomes for the market in 2013. First, our research shows the market is close to fairly valued, so we don’t expect much multiple expansion. Second, we think there’s the potential for positive surprise from revenue growth. There are plenty of signs that things are improving for the US economy, at least marginally, and we expect the economy to continue to strengthen in 2013, which could mean some earnings growth even without further margin improvement.
A Comeback for Stock Selection
All that being said, as the market crawls ever closer to fair value, it becomes increasingly difficult to predict its direction. The good news, in our opinion, is that stock selection is becoming increasingly important. Over the past five-plus years, there have been never-ending comments about how correlated markets are, and that stock selection no longer mattered—all that mattered was getting the macro calls right and positioning your portfolio accordingly. In 2012 we have seen some signs that stock-picking is starting to have a bigger impact again, and we expect that will be a continuing theme throughout 2013.
Pockets of Opportunity
So where do we see the next pockets of opportunity in the market? We like to focus on wide- and narrow-moat companies, because we believe these firms will earn excess returns for longer periods of time than their no-moat counterparts. As of mid-December, we have about 30 firms with 5-star ratings amongst our wide- and narrow-moat coverage list. (A five-star rating indicates Morningstar believes the shares are being significantly undervalued by the market.) These 30 firms include a decent number of European firms and energy companies. (Energy is among our most undervalued sector.) However, there are also some large, global companies on the list, such as 
Apple (AAPL) and Rio Tinto (RIO). In addition to energy, we also see the technology sector as particularly undervalued.
Below you can find information about one company per sector that has been singled out by Morningstar analysts. These are moaty companies from around the world that are currently undervalued by the market, according to Morningstar's fair value estimates.
Sector: Basic Materials
Nucor (NUE)
"Nucor’s favourable cost structure and low financial leverage should withstand tepid US steel fundamentals," said analyst Morningstar Elizabeth Collins.
Sector: Consumer Cyclical
Weight Watchers International (WTW)
"There is plenty to like in the firm’s long-term story including current obesity trends around the world, the upgrade of its current North American locations, and penetration of the more profitable online business," said Morningstar analyst Peter Wahlstrom.
Sector: Consumer Defensive
Molson Coors Brewing Company (TAP)
"Although a recovery could be more than a year away, we still think the market is currently undervaluing Molson Coors’ intrinsic value," said Morningstar analysts R.J. Hottovy and Erin Lash.
Sector: Energy
Ultra Petroleum (UPL)
"Ultra’s Pinedale and Marcellus assets represent one of the best one-two punches in North American upstream. The company remains well positioned to take advantage of a secular recovery in natural gas prices, thanks to its low cost structure and long runway for growth," said Morningstar analyst Stephen Ellis.
Sector: Finanacial Services
Julius Baer Gruppe (BAER)
"We’re optimistic about Baer’s acquisition of Merrill Lynch’s non-U.S. wealth management operations, which we think will help the bank to build scale in fast-growing markets and lessen its dependence on Swiss offshore banking," said Morningstar analyst Jim Sinegal. "While Julius Baer may not enjoy the same worldwide name recognition as some of its Swiss competitors, we see that as an advantage—the private bank’s brand has been relatively untarnished by scandals or heavy losses during the financial crisis."
Sector: Health-Care
Covidien (COV)
"As we’ve been advocating for several years, Covidien is spinning off its underperforming pharmaceutical business. We believe this transaction will allow investors to appropriately judge the company and its core device business; we consider the shares undervalued," said Morningstar analyst Alex Morozov.
Sector: Industrials
Caterpillar (CAT)
"Near term, the company will face headwinds in its European and Asian operations (about half of sales), but we expect US operations to enjoy strong results in the coming quarters," said Morningstar analyst Keith Schoonmaker.
Sector: Technology
Apple (AAPL)
"Although Apple’s current market price implies maturity, we expect continued growth," said Morningstar analyst Grady Burkett.
Find out more by reading the article, "5 Undervalued Tech Stocks".
Sector: Energy
NRG Energy (NRG)
"NRG Energy’s $1.7 billion merger with GenOn Energy this year is another example of what we think is management’s keen eye for value-creation opportunities. This downcycle has been tough on NRG’s wholesale generation fleet, and that’s likely to continue until power markets rebound. But NRG’s aggressive move into countercyclical retail and stable-return renewable energy businesses is cushioning earnings and shareholder returns," said Morningstar analyst Travis Miller.
This is an abridged version of a longer Morningstar research paper titled "Market Outlook: Q1 2013". It was published on December 21, 2012.
