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Stock Strategist

Buy These Stocks While They're New

The IPO market in 2006 wasn't hot, which we think created good buying opportunities.

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During 2006, investor demand for initial public offerings (IPOs) was again fairly tepid: By our tally, about 200 companies went public--roughly the same number as the previous two years--but well below the overheated figures seen during the heady times at the end of the 1990s. Morningstar has been tracking the ranks of newly public companies for years, looking for businesses (and stocks) worthy of attention. But more recently, we've increased the amount of attention paid to the IPO market, and our analysts have taken a hard look at many of the firms that went public last year.

We bring the same research process to a firm regardless of its tenure as a public company, looking for firms with strong competitive positions and stocks trading well below our assessment of fair value. Because we have a broad array of industry expertise, we're able to put a new offering in proper industry context (though there are times when we have the opportunity to learn about new businesses--see  Grupo Aeroportuario del Pacifico (PAC)). Since firms tend to go public when valuations favor the seller (a disadvantage to investors), we spend time thinking about why a company is going public and looking at demand for the shares shortly after the offering.  MasterCard (MA) is a great example of a situation in which insiders were selling stock for reasons other than maximizing their returns. The banks that owned MasterCard were looking to raise funds to cushion against and separate themselves from potential legal liabilities.

While every firm should be judged on its own merits, one way to guard against buying into an IPO at peak valuations is to examine which sectors are "hot." Health-care, energy, and financial services have been the most active recently; of the roughly 80 firms that went public in the fourth quarter of 2006, half fell in or around these three sectors. Getting in on an offering in a hot sector can produce a quick gain, but predicting which stocks will be popular can be risky. For example, within health care, Trubion Pharmaceuticals (TRBN) is up more than 50% since going public in October, whereas Catalyst Pharmaceuticals Partners (CPRX), which went public three weeks later, is down 35%.

Also, with energy prices high throughout the year, it's no surprise that a number of firms with ties to oil and gas have sought to raise funds. As energy prices have fallen, though, the sector has performed poorly: About a third of fourth-quarter IPOs are below their initial offer price. We actually think there are some interesting companies in this group, particularly among pipeline operators, to which we often assign our highest wide-moat rating based on their strong competitive positions.

In the space below, we'll take a look at a handful of the newly public firms we think have attractive stocks and businesses. We'll review these firms again and take a look at another crop of ideas after the first quarter. To see our full Analyst Research, fair value estimates, and risk and moat ratings on these and more than 1,900 other stocks, take a free Premium Membership trial today.

 SAIC (SAI) is a defense contractor that went public in October. The firm distinguishes itself with its broad scientific and technological expertise that runs the gamut from future combat systems and integrated port inspection systems to advanced robotics and even biopharmaceuticals. Owing to a diverse base of engineers and scientists, the firm has successfully identified and capitalized on several emerging technologies. As long as defense intelligence and technological advancement are crucial on the battlefield, we believe SAIC will remain a strategic partner of the government and a good long-term bet.

One of the reasons SAIC chose to go public was to create liquidity for employee stockholders. Employees have long received equity in the firm based on contributions to contracts and cultivation of new business opportunities. This ownership culture has helped the firm build a deep bench of engineers who remain loyal to the company.

 Stanley (SXE), which also went public in October, does extensive information technology (IT) services work exclusively for federal government agencies, including the Defense Department. By focusing its resources strictly on federal agencies, Stanley has developed highly specialized expertise in systems and processes that positions it to benefit from the government's increasing affinity for outsourcing.

On the civilian side, more than half of revenue comes from nonappropriated programs. For example, visa and passport user fees fund Stanley's passport processing contract, and bank fees fund its work for the Federal Reserve. On the military side, Stanley's contracts are not, for the most part, dependent on events, such as military engagements. As an incumbent vendor, the firm has the upper hand when contracts are renewed; consider that since Stanley won the State Department's passport-processing contract in 1992, the re-competes in 1997 and 2002 went uncontested, as rivals determined that its position was unassailable. Also 55% of Stanley employees have secret or top-secret clearances.

Energy Transfer Equity LP
 Energy Transfer Equity (ETE), the general partner for  Energy Transfer Partners (ETP), went public 11 months ago. The partnership units have had a nice run since, but we think they're still worth a look. We love the natural-gas pipeline business, and ETE, via ETP, operates one of the best natural-gas distribution networks in the industry, in our view. The Barnett Shale continues to be the hottest natural-gas play in the country, and we believe ETP is in the best position among pipeline operators to benefit from production growth there. The firm's 2006 acquisition of the Transwestern pipeline offers access to markets in the western United States, and building a pipeline with  Kinder Morgan (KMP) to reach the East will give it a system that enables producers to sell into whichever market offers the best price for gas at any given time.

ETE's current yield is low, compared with those of similar partnerships, which typically fall in the 6%-10% range. But ETE holds incentive distribution rights that give unitholders an increasing share of ETP's cash flow as the firm grows. For example, a 10% increase in distributions to ETP's unitholders would result in nearly 20% more cash flow to ETE. So, while ETE investors may not receive a big yield today, we think the shares will appreciate nicely over time.


Michael Hodel does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.