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Stock Strategist

The Seven Hottest Stocks This Year

These solid businesses have soaring stock prices--and are still reasonably priced.

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At Morningstar, we treat stocks as businesses with future streams of profit, and we want to buy those future profits for less than we think they're really worth today. Big stock price declines often pique our interest, because they can mean that the market has unfairly punished a stock and priced its future profits at a discount.

However, when a quarter ends, it can be fun to see which stocks roared, and (better yet) check if they're still trading at prices below our fair value estimates, despite their gains. Accordingly, we ran a screen for the 1,900 stocks under our coverage that have posted the best performances through April 5, 2007.

We found that many of the 422 stocks that surged 15% or more were in the steel, aluminum, energy, auto parts, and aggregate (rocks, sand, and gravel used in construction and road pavement) industries and sectors. With the possible exception of aggregate, these can be tough corners of the economy in which to build a durable competitive advantage--or what we call a moat. However, we managed to find some companies among these top-performing stocks that have established moats, and are also cheap enough to be trading in four- or five-star territory. A few financials and business services outfits showed up on our list as well. We've culled some of last quarter's hot performers for you to peruse below.

 Alcoa (AA)
Year-to-date return through April 5: 16%
Economic Moat: Narrow
Business Risk: Average
Price/Fair Value Ratio: 86%
Rumors that aluminum producer Alcoa might be purchased by rivals  BHP Billiton (BHP) and  Rio Tinto (RTP) fueled its first-quarter surge. Analyst Scott Burns notes that Alcoa faces tough challenges to its dominance of the aluminum market, although global consumption of aluminum products has increased and Alcoa's cost-cutting has been effective at boosting profits. Alcoa's narrow moat is derived from its size, affording it economies of scale and low-cost production. It also controls 24% of the word's bauxite reserves and produces aluminum on every continent, supplying businesses from automakers to beverage producers.

 First American (FAF)
Year-to-date return through April 5: 28%
Economic Moat: Narrow
Business Risk: Average
Price/Fair Value Ratio: 85%
Analyst Jim Ryan was impressed with title insurer First American's first-quarter results, despite an awful housing market. Although revenues declined, operating margins increased across all product lines. First American's narrow moat derives from the vast array of real estate services the company provides, such as title insurance and closing services, and from favored treatment from state regulatory authorities. Although the firm is still dependent on the sheer volume of real estate transactions, it is moving into less-cyclical information services. It is also making inroads abroad.

 Fairfax Financial Holdings (FFH)
Year-to-date return through April 5: 17%
Economic Moat: Narrow
Business Risk: Above Average
Price/Fair Value Ratio: 83%
Analyst Justin Fuller thinks Toronto-based insurance conglomerate Fairfax Financial is a promising option for long-term investors who can ride out some bumps. Fairfax had a solid record of using debt to acquire other insurers up until about eight years ago, when a misstep led it to several troubled companies whose businesses the firm couldn't turn around. Resulting heavy casualty losses proved near-fatal, and the company remains at risk today. However, Fuller thinks that management's ongoing repair work has made recovery prospects appealing. Fairfax has extended its debt maturities until 2012, improved its liquidity by canceling a contract with Swiss Re (SWCEY), and successfully raised more than $1 billion in equity financing.

 Getty Images (GYI)
Year-to-date return though April 5: 17%
Economic Moat: Wide
Business Risk: Average
Price/Fair Value Ratio: 72%
Getty Images is the one wide-moat stock on our list, and it's also the one trading at the biggest discount to our fair value estimate. Analyst Jonathan Schrader is impressed with Getty's size in the image-licensing business. The image-distribution market favors a few players with large collections that advertising agencies can tap easily. Schrader also thinks Getty's move to digitize and distribute its inventory of images on the Internet has propelled the firm to its current dominance. Agencies can now scour Getty's inventory easily for the perfect image. Indeed, Getty's Internet dominance has encouraged smaller rivals to get distribution through Getty's Web site, increasing Getty's importance to both image buyers and sellers.

 MSC Industrial Direct Co. (MSM)
Year-to-date return through April 5: 22%
Economic Moat: Narrow
Business Risk: Average
Price/Fair Value Ratio: 79%
MSC Industrial distributes industrial supplies through field salespeople, catalogs, and the Internet. By stocking 500,000 less-than-common items available for next-day delivery, MSC is able to cut into larger players' business, such as Home Depot Supply, despite its higher inventory carrying costs. Analyst Matthew Warren expects MSC to experience strong internal growth as the industry consolidates. A new contract win from the U.S. Postal Service, extreme operating leverage, and a history of savvy capital allocation bode well for MSC's future, according to Warren.

 Pioneer Natural Resources (PXD)
Year-to-date return through April 5: 17%
Economic Moat: Narrow
Business Risk: Average
Price/Fair Value Ratio: 86%
Pioneer Natural Resources surged 17% through April 5 after selling its deep-water resources and Argentine operations in favor of focusing on onshore American operations. Analyst Catharina Milostan applauds Pioneer's decision to shed higher-risk and higher-cost deep water U.S. and Argentine operations in favor of lower-risk drilling. Longer-lived onshore properties should smooth out Pioneer's production growth and reduce uncertainty, Milostan forecasts. Although the firm's profits are dependent on commodity prices, its narrow moat stems from its mix of mature properties generating excess cash flow and longer-lived resource plays.

 Vulcan Resources (VMC)
Year-to-date return through April 5: 32%
Economic Moat: Narrow
Business Risk: Average
Price/Fair Value Ratio: 82%
Analyst Matthew Warren raised his fair value estimate of Vulcan after its recent proposed acquisition of Florida Rock (FRK). The acquisition has since been completed. In fact, most of Warren's reassessment has come from new, industrywide pricing assumptions rather than from the deal itself. Consolidation in the industry should help pricing trends, which have already been robust. Warren notes that companies in the industry reported significant price hikes in the fourth quarter of 2006, despite declining homebuilding activity. Finally, Warren notes that Vulcan's moat stems from the location of its quarries in numerous attractive markets with fast-growing economies.

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