The right stocks for this market

As the rally matures, it will shift from speculative plays to rock-solid companies.

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By Pat Dorsey, director of equity research for Morningstar

pat_dorsey_2009a.03.jpg
Pat Dorsey is the director of equity research for Morningstar.

(Money Magazine) -- Since the market began to rally in March, just about every type of investment has shot up. But the riskiest ones -- like junk bonds, emerging-market stocks, and shares of companies with a lot of debt -- have soared the highest.

That's to be expected in the early stages of a rebound. However, once the initial euphoria dies down, investors will turn their attention back to fundamentals like earnings and valuations, which will guide the market to high-quality blue-chip stocks.

Of course, "quality" can be an elusive concept. At Morningstar, our hunt for quality centers on companies with "economic moats," or distinct competitive advantages.

The search begins by looking for companies that have a long history of high returns on capital, which is a sign of profitability and dominance. How do you find them? One way is to check a firm's return on equity, which measures profits per dollar of capital that shareholders have invested. In general, firms with ROEs above 15% are viewed favorably. (You can look up ROE figures for stocks at morningstar.com.)

Then, look for competitive advantages, or moats, that give you confidence the company can keep competitors at bay -- which ensures future profits and dominance.

Moats come in many forms. Tiffany's brand is a moat because consumers will pay about a third more for a diamond if it comes in a pale-blue box. UPS's fleet of vans is also a moat because Big Brown can deliver packages to more places at a lower cost than almost anyone else.

This is actually a great time to look for firms with wide moats. Because high-quality companies are so profitable, they tend not to have much debt. That's a huge advantage in a still-skittish economy. And Morningstar estimates that shares of high-quality firms are priced at a 20% discount to their fair value.

Here are a couple of my favorite low-cost, high-grade stocks:

Mastercard (MC) (P/E: 15.8) With consumers on their backs, you might be inclined to run away from credit card companies. But MasterCard is really a payment-processing network that is exposed to virtually no credit risk from deadbeat consumers. Yet it still controls nearly a third of the world's plastic. And while the company lags rival Visa in the fast-growing debit card market, its lower valuation more than compensates. Based on price/earnings ratios, MasterCard's shares trade at about a 25% discount to Visa's.

J.P. Morgan Chase (JPM, Fortune 500) (P/E: 14.4) The words "quality" and "bank" haven't exactly been synonymous lately. But I think it's worth looking at some of the strongest players in the field, like J.P. Morgan, which has already taken market share from weaker competitors.

Not only is J.P. Morgan dominant in many lines of banking, but it is now thoroughly diversified: 30% of its revenue comes from retail banking, 23% from investment banking, and 20% from credit cards. And though its shares have risen off their recent lows, the current price still doesn't reflect the bank's long-term potential earnings power.

Pat Dorsey is the director of equity research for Morningstar. To top of page

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