Where the bargains are now

NEW YORK (Money Magazine) -- The Dow has been setting record highs recently, but the market still contains pockets of undervalued stocks.

Among other factors, slowing economic growth has held back some industry groups, making for real opportunities now.

There are always risks, though, when you buy a single out-of-favor stock, hoping for a rebound. For any particular company, a cheap share price could be the sign that fundamental problems have developed that won't be easy to fix. So there's no guarantee that such a stock will bounce back along with its peers.

One smart and simple way around the problem is to invest in an entire sector of the market. Diversifying over an industry will eliminate the risk of being tripped up by one company's troubles. And if the outlook improves for the whole sector, most of the stocks in it should move up together.

It used to be hard, and expensive, to invest in a specific slice of the market. There were a limited number of mutual funds that focused on sectors, and they often charged high annual management fees.

But in the past few years the number of sector funds has ballooned. And growth has come even faster in exchange-traded funds (ETFs), which hold a basket of stocks and trade like the shares of individual companies. Often ETFs can give you access to highly focused groups of stocks at very low cost.

To identify today's most promising sectors, I turned first to the Leuthold Group, which does first-rate quantitative market analysis. The firm divides the overall stock market into more than 150 sectors and ranks these groups based on a number of value measures and also on current growth prospects.

Not every sector has an ETF. But I've identified three that are cheap, seem poised for high growth and can be bought via one or more convenient funds.

These picks all outpaced the Dow in the past year, but still look like bargains.

How to invest: Pharmaceutical HOLDRs (PPH)

Over the past 10 years, leading drug stocks traded at an average price/earnings ratio of 25. Today their average P/E is just 16.6.

In fact, the largest company in the group, Pfizer, goes for 12.4 times earnings and currently pays a whopping 4.3 percent dividend.

The industry's problem is that companies simply don't have enough blockbuster products in development to replace all the important drugs that will be losing patent protection over the next few years. It's all but impossible to predict which promising drugs will pan out and which will fail to live up to investors' hopes.

But thanks to the aging of baby boomers, you can expect total spending on prescription pharmaceuticals to grow faster than the overall economy. So this is a particularly good area to own via a sector fund.

Merrill Lynch sponsors baskets of stocks known as HOLDRs, which are similar to ETFs. The pharmaceutical basket (ticker symbol: PPH (Charts) is tightly focused on the largest drug stocks, so Johnson & Johnson (Charts, Fortune 500), Merck (Charts, Fortune 500) and Pfizer (Charts, Fortune 500) account for more than half the portfolio.

When you buy a HOLDR, you're actually buying shares of the stocks themselves, not a fund, so you pay little or no annual fees. One minor inconvenience: You have to buy the HOLDR in 100-share lots. That means your minimum investment at current prices is more than $8,400.

How to invest: iShares Dow Jones U.S. Telecom (IYZ)

Old-line phone stocks have long been cheap and now trade at P/Es below 16. But as they upgrade their technology, phone companies will become more competitive with cable outfits, whose stocks trade at P/E ratios richer than the S&P 500's 16.1.

On top of that, faster-growing telecom businesses, such as wireless and communications equipment, are clearly depressed. Their P/Es are higher than those of old-line phone companies, but they're a good 30 percent to 50 percent lower than their own 10-year averages.

The spread of communications devices has been astonishingly rapid, and the pace won't slow when today's text-messaging teenagers reach adulthood. But because the technology changes so fast, it's tough to pick a single coming stock.

All the better for ETFs, like Dow Jones U.S. Telecom (IYZ (Charts), offered by iShares. It's 70 percent invested in more conservative companies and 30 percent in the hot stuff.

How to invest: SPDR S&P Metals & Mining (XME)

Among the sectors that look like bargains, the big surprise is the metals group, whose stocks have had a good run. But there are three reasons to like producers of aluminum, copper and steel today.

First, the companies are highly sensitive to economic growth. So their gains could be a lot bigger once the economy picks up again.

Second, rapidly developing economies such as China, India and Brazil will greatly boost global demand for industrial metals over the long term.

Finally, like most other commodity companies, metals producers would benefit from any revival of inflation.

Other key inflation hedges - especially oil stocks and real estate - are expensive right now and vulnerable to setbacks. So if you want to protect your portfolio from the next inflation spiral, metals producers are the stocks to own.

SPDR S&P Metals & Mining (XME (Charts) offers a portfolio that's more than 80% in industrial metals.