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Stock Strategist

The Seven Hottest Stocks of the Second Quarter

Despite their popularity, these stocks are trading for less than they're worth.

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When we screened for surging stocks at the end of the first quarter, we came up with a lot of businesses in the industrial materials and energy sectors, and also in the auto parts and aggregate industries. Although it's often difficult for a business to build a competitive advantage in these corners of the economy, we managed to find some--such as behemoth aluminum producer  Alcoa (AA), whose advantage derives from its large scale--that were still in 4- or 5-star territory. We also unearthed some financials and business services names last quarter, including  Fairfax Financial (FFH) and  Getty Images (GYI).

Over the second quarter, energy and industrial materials again have good representation in our initial screen, which selected for stocks that rose more than 15% for the trailing three months through July 9. Starting with Morningstar's coverage universe of 1,900-plus stocks, 508 companies cleared this hurdle. We've noticed some stocks on the move from the technology and business-services sectors whose durable competitive advantages (which we refer to as "moats") derive from factors other than scale. Moats are important to us, because investors can hold businesses that possess them more reliably over the long haul. Firms with moats continue to build economic value by consistently producing returns on capital in excess of their cost of capital. Once you snag a wide-moat business at a good price, only the erosion of its competitive advantage and/or significant overvaluation would represent compelling reasons to sell.

As always, we love to buy stocks when they're trading as far below our analysts' fair value estimates as possible. While the stocks we highlight below have surged and are not as cheap as they used to be, we believe that they still represent good bargains.

 Bayer AG (BAY)
Trailing three-month return through July 9: 19%
Economic Moat: Narrow
Business Risk: Average
Price/Fair Value Ratio: 80%
Analyst Tom D'Amore likes Bayer's move to make health care its dominant business, marked by its purchases of Schering AG and the over-the-counter drug business of Roche Holding (RHHBY) as well as the success of kidney cancer drug Nexavar. This move leverages the firm's traditional strength in chemistry and complements its crop-protection and coatings businesses well. Additionally, the firm has a successful over-the-counter business with name-brand consumer health products such as Aleve, Bayer Aspirin, and Alka-Seltzer. Although the firm has piled on some debt as a result of these purchases, D'Amore is impressed with how much debt it has already paid down and likes the prospects for future growth and profitability in health care.

 Dell (DELL)
Trailing three-month return through July 9: 23.4%
Economic Moat: Wide
Business Risk: Average
Price/Fair Value Ratio: 85%
Analyst Rick Hanna doesn't believe that Dell is out of the woods yet--it recently posted anemic revenue growth of only 3%. Still, the firm has made efforts to improve sales of notebooks and to increase its international business. Despite facing slower growth and increased competition, the firm's heralded efficiency remains intact; Dell holds inventory for an average of five days, compared to its competitors which average 15 days. This efficiency still allows Dell to achieve the highest margins and returns on capital in the PC industry.

 Expedia (EXPE)
Trailing three-month return through July 9: 22.4%
Economic Moat: Narrow
Business Risk: Average
Price/Fair Value Ratio: 70%
Analyst Sumit Desai has raised his fair value estimate for Expedia to $42 per share from $30. He has modeled various scenarios in which the firm is able to buy back different amounts of its desired amount of 116.7 million shares at prices between $27.50 and $30. These values range from $38 to $48, while assuming no share buyback yields a fair value estimate of $37. Although the online travel arena is crowded, Expedia has separated itself from the pack in Desai's opinion with its 35% market share (which gives it negotiating muscle with suppliers) and its ability to assemble vacation packages.

 Fastenal (FAST)
Trailing three-month return through July 9: 19.2%
Economic Moat: Wide
Business Risk: Average
Price/Fair Value Ratio: 67%
Analyst Matthew Warren is impressed with Fastenal's ability to take market share in the highly fragmented business of supplying nuts, bolts, screws, and anchors--more than a quarter million different types of these items in Fastenal's case. At this point in the firm's growth cycle, when its stores have many rural markets sewn up, Warren likes its move to hire more sales professionals who can deliver incremental growth with less capital investment. This isn't a sexy business, but it has returned more than 15% on equity every year for the past decade and more than 20% in most of those years. Finally, Fastenal is extremely shareholder friendly. The firm garners a Stewardship Grade of A from Warren for the firm's frugality, light issuance of stock options, reinvestment of cash in value creating activities, and heavy director ownership. The firm's boss Will Oberton received Morningstar's CEO of the year award for 2006.

 Fuel Tech (FTEK)
Trailing three-month return through July 9: 54.3%
Economic Moat: Narrow
Business Risk: Average
Price/Fair Value Ratio: 63%
Analyst John Kearney thinks this leading provider of clean energy engineering solutions has room to grow. Fuel Tech helps utilities and industrial firms comply with new pollution control mandates, and demand for its cost-effective technology should mount. Additionally, Kearney likes the firm's specialty chemical segment, Fuel Chem, which eliminates "slag," or corrosive byproducts of fuel combustion. Reduction of slag is crucial to keeping coal-fired power plants operating efficiently, making this part of Fuel Tech's business its hidden treasure, according to Kearney. Indeed the firm has achieved a 100% client retention rate for its slag-reduction process. This part of Fuel Tech's business is likely to become more important as more utilities use cheaper coal containing a higher level of impurities.

 Monsanto (MON)
Trailing three-month return through July 9: 16%
Economic Moat: Narrow
Business Risk: Average
Price/Fair Value Ratio: 81%
A strong North American corn market provides support for Monsanto, according to analyst Ben Johnson. While the firm has enjoyed stellar near-term performance, Johnson is pleased to see that Monsanto's management team is focused on the future with the development of high-tech seeds. Monsanto has a leg up on its competition in its knowledge and long experience in breeding and genetic modification technologies. Farmers are willing to pay up for Monsanto's products, which allow them to diversify their crops and hedge against problems such as weed and insect infestation. Johnson thinks Monsanto will continue to lead the pack for years to come.

 Texas Instruments (TXN)
Trailing three-month return through July 9: 25%
Economic Moat: Narrow
Business Risk: Average
Price/Fair Value Ratio: 83%
Analyst Erik Kobayashi-Solomon thinks Texas Instruments is well positioned for the future because it owns an overwhelming market share in the area of mobile phone chips called digital signal processors, and especially because of the firm's business in analog chips, which process real-world inputs such as sound, current, and heat. Analog chips are patent protected and afford their manufacturers the ability to differentiate them on the basis of functionality; they are not easily replicable commodity products. Moreover, analog chips are not as dependent as digital ones on cutting-edge manufacturing techniques, making them both more cost-effective and proprietary. This attractive combination of characteristics leads to high margins and returns on invested capital.

John Coumarianos has a position in the following securities mentioned above: TXN. Find out about Morningstar’s editorial policies.