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Stock Strategist

Number of 5-Star Stocks Way, Way Up

With the market down, we've seen a lot more attractively priced stocks.

If you have signed up to receive our 5-Star Stock Updates, you'll have noticed a steady stream of stocks hitting 5-star Morningstar Ratings over the past two weeks.

For most of 2006, we've hovered right around 70 5-star stocks, but as of Thursday, we were up to 135. These include the stocks of some truly outstanding businesses:  Wrigley ,  Whole Foods ,  Fastenal (FAST),  McDonald's (MCD),  MSC Industrial Direct (MSM), and many others.

With the S&P 500 down about 5% from its high this year and the Nasdaq down 9%, more stocks have slipped far enough for us to award them higher star ratings.

So while many of us may bemoan the paper losses in our portfolios after the May stock-market declines, the good news is that there are more attractive places to allocate capital than at any time in well over a year.

 Star Rating Distribution
Date 1 Star (%) 2 Stars (%) 3 Stars (%) 4 Stars (%)

5 Stars (%)

09/30/04 26 12 43 14 5
12/31/04 37 15 40 6 2
03/31/05 27 11 45 12 4
06/30/05 27 11 45 12 4
10/31/05 22 10 46 16 6
12/31/05 26 11 46 12 5
3/31/06 29 10 44 12 4
5/30/06 22 8 45 18 8

As a refresher, a stock needs to drop below our fair value estimate to earn 4 or 5 stars. And the riskier the stock--as quantified in our Business Risk measure--the steeper the discount we require before raising its star rating. Fastenal, for example, traded at $43 on Thursday, and our analyst Matthew Warren figured the fair value of the company was $53. Because of the low-risk nature of Fastenal's fastener-distribution business--for more on how good the distribution business can be, see Paul Larson's recent analysis--the stock needed to trade at a price/fair value ratio of 0.85 or less to earn 5 stars. At $43, Fastenal's price/fair value ratio of 0.81 was below the bar. Thus the 5-star rating. 

As you can see in the table below, the median stock we cover trades right at fair value. This means that out of the 1,800 stocks we cover, half trade above fair value and half below. The more interesting statistics are the median price/fair value ratios broken out by moat. For both wide-moat and narrow-moat universes, more stocks are undervalued than overvalued. And across all subgroups, stocks trade at price/fair value ratios near their 52-week lows.

 Price/Fair Value Estimate by Moat Rating
 

Median
Price/Fair Value

52-Week
High/Low
All-Time
High/Low
Morningstar Coverage Universe 1.00 1.11-0.99 1.14-0.78
Wide Moat 0.90 0.96-0.90 1.06-0.81
Narrow Moat 0.97 1.08-0.97 1.11-0.79
No Moat 1.08 1.23-1.07 1.27-0.75
Data as of 05-30-06.

A disproportionate share of cheap stocks belong to high-quality companies--a point made by my colleague Pat Dorsey in two recent columns ("20 Reasons to Love the Sell-Off" and "Buy Quality, Buy It Now"). Among our 165 wide-moat companies, for example, 23 trade within 5% of their 52-week low. (To see a complete list, click  here.)

New 5-Star Stocks
The last time I published a version of this column was October 2005, when we saw the number of 5-star stocks spike upward, though not as dramatically as we have in 2006. I highlighted three stocks in that piece that had recently hit 5 stars:  TJX Companies (TJX), which has since risen to $23.45 from $21.53 (8.9%),  Golden West Financial , which has jumped to $72.73 from $58.73 (23.8%), and  DirecTV , which has risen to $17.47 from $14.22 (22.9%). I won't guarantee similar results for the following three stocks, but I will say our analysts think they appear very attractively priced. Premium members can view the complete list of our 5-star stocks here.

 Whole Foods 
Business Risk: Average
Economic Moat: Narrow
From analyst Mitchell Corwin: Whole Foods sets the standard for differentiation in the supermarket industry, in our opinion. The firm doesn't look at itself simply as a delivery vehicle for everyday foods, like so many of the traditional supermarkets. Rather, it has created a brand image that connects with high-end food shoppers.

 MasterCard (MA)
Business Risk: Average
Economic Moat: Wide
From analyst Ryan Batchelor: We think of MasterCard as a brand and a transaction processor, and we're big fans of both things. The firm receives about two thirds of its revenue from its processing functions (operations fees), and the remaining third comes from assessments it charges its members to use the MasterCard brand, based on how much the cards are used.

 CDW 
Business Risk: Average
Economic Moat: Narrow
From analyst Andrew Golomb: Narrow-moat CDW continues to grow in the competitive IT distribution industry. Its salesforce focuses on serving small and medium-size businesses, allowing the firm to capture market share and consistently realize impressive financial returns.

Haywood Kelly, CFA has a position in the following securities mentioned above: MA. Find out about Morningstar’s editorial policies.