Skip to Content
Stock Analyst Update

Eight Stocks That Should Return at Least 15%

Plus dozens of other new 5-star stocks.

Mentioned: , , , , , , , , ,

Following is a roundup of stocks that recently jumped to 5 stars. By way of background, we award a stock 5 stars when it trades at a suitably large discount--i.e., a margin of safety--to our fair value estimate. Thus, when a stock hits 5-star territory, we consider it an especially compelling value.

Barnes & Noble
Moat: None  |  Risk: Below Avg  |  Price/Fair Value Ratio: 0.83  |  Three-Year Expected Annual Return: 17.6%

What It Does:  Barnes & Noble (BKS) is the largest bookseller in the U.S. It operates 695 Barnes & Noble bookstores and 98 mall-based B. Dalton Bookseller stores. It is also a publisher of trade books through Sterling Publishing, owns BN.com, and holds a 74% interest in Calendar Club.

What Gives It an Edge: Though Barnes & Noble lacks an economic moat, in Morningstar analyst Joe Beaulieu's opinion, it does boast some competitive advantages in the book retailing business. It is a strong operator, has been a slow-but-consistent grower, and has done a good job, Beaulieu says, of identifying its best customers and tailoring its merchandise to them.

What the Risks Are: Beaulieu thinks that Barnes & Noble courts below-average business risk. The biggest risk to Barnes & Noble shareholders is increased competition from Borders and Amazon. Margins are already narrow, and all major players discount heavily on new releases, so Barnes & Noble can ill afford more price pressure.

What the Market Is Missing: Beaulieu doesn't think that the market is missing anything, per se. The stock is getting beaten up along with the rest of the retail stocks in our coverage universe. Even if consumers dial back their discretionary spending as some fear, Beaulieu still thinks that Barnes & Noble's long-term prospects remain undiminished.

Bayer
Moat: Narrow  | Risk: Avg  |  Price/Fair Value Ratio: 0.74  |  Three-Year Expected Annual Return: 20.8%

What It Does:  Bayer (BAY) operates major business segments: health care, material science, and crop science. The company's health-care unit offers prescription drugs including Betaseron for multiple sclerosis, the antibiotic Avelox, and the fertility control medication Yasmin. Over-the-counter products include Aleve, One-A-Day vitamins, and the famous Bayer aspirin.

What Gives It an Edge: Morningstar analyst Tom D'Amore thinks that Bayer has several competitive advantages that support its narrow moat. The company offers world-class chemistry research and development expertise that it deploys across all three of its major business segments. A second crucial competitive advantage is the company's decentralized management structure. Bayer operates three independent service units that provide the company's plant construction, engineering and maintenance, and information technology support. The service units operate with an independent profit and loss statement and outsource excess capacity to outside companies. The structure helps to keep overhead costs from dragging down operating margins. Third, the breadth and depth of Bayer's health-care business is also a crucial competitive advantage. Bayer is a top-tier supplier of branded pharmaceutical drugs, over-the-counter pharmaceuticals, and diagnostic medical products. The diversity of its health-care business provides stability to its revenue streams and allows for substantial cross synergies in R&D and distribution among the health-care sub-units.

What the Risks Are: D'Amore thinks that Bayer poses average business risk, meaning that he'd invest in the shares at a moderate discount to his fair value estimate. Bayer faces pipeline failure risk. If one of its major drugs in late-stage testing were to fail, the stock price would likely be impacted immediately, although to a lesser extent than a pure pharma company. Bayer's crop science business is subject to swings in sales based on unpredictable global agricultural developments, including crop prices.

What the Market Is Missing: D'Amore believes the market is missing two factors that he thinks will drive Bayer's stock price higher. First, the company's prescription drug pipeline is in excellent shape. Nexavar for kidney cancer recently received FDA approval and is being tested for additional indications, including liver and skin cancer. Rivaroxaban, a promising new drug for hypertension, is in Phase III testing. The company also has eight other drugs in late-stage testing that are potentially significant revenue contributors. Second, D'Amore believes Bayer has excellent prospects for operating margin improvement. The company is capturing substantial operating leverage due to its decentralized operating structure and has been able to negotiate more flexible contracts with its labor unions than many European companies in the manufacturing sector. D'Amore thinks that Bayer will generate operating margins of 15% this year (up about 1 percentage point from 2006 after adjusting for nonrecurring items) and boost operating margins by another 4 percentage points by 2010.

Clorox
Moat: Narrow  |  Risk: Below Avg  |  Price/Fair Value Ratio: 0.84  |  Three-Year Expected Annual Return: 15.3%

What It Does:  Clorox (CLX) mainly produces chlorine and nonchlorine bleaches, food products, and cleansers. The company also makes other well-known consumer products, including Pine-Sol and Formula 409 household cleansers, S.O.S. soap pads, Glad plastic wrap, and Kingsford and Match Light charcoal products. In addition, it produces Liquid-Plumr drain openers, Brita water filters, Armor All automotive-cleaning products, and STP automotive additives.

What Gives It an Edge: In Morningstar analyst Lauren DeSanto's view, Clorox has trenched out a narrow economic moat. Clorox boasts a lineup of very strong brands in a variety of mid-sized categories. While the brands are a bit of a hodge-podge--the firm sells its namesake bleach, Kingsford charcoal, Hidden Valley Ranch Salad dressing, and Formula 409, to name a few--they occupy the number-one or number-two market share position in 12 of the 17 categories in which the company competes. Clorox has a solid balance sheet, generates strong, consistent free cash flow, has robust returns on invested capital and offers a very healthy dividend yield.

What the Risks Are: DeSanto thinks that Clorox poses below-average business risk, meaning that she'd invest in the shares at a lesser discount to fair value than she might other, riskier businesses. Clorox's strong brands face a consolidating retail environment in which pricing power isn't guaranteed. During fiscal 2006, the firm's five largest customers accounted for 41% of revenue, with  Wal-Mart (WMT) at 26% of sales. Manufacturing improvements that have boosted gross margins during the last few years might be harder to come by, and weather always affects a variety of Clorox's product categories, including charcoal, salad dressings, and barbecue sauces.

What the Market Is Missing: Currently the shares are the cheapest they've been in years, based on historical P/E multiples. The market is apparently worried about temporary promotional and inventory problems that Clorox encountered during its fiscal fourth quarter, as well as other, longer-term challenges like rising commodity costs and increased competition. DeSanto thinks Clorox can cycle through its inventory issues and believes it is well-positioned to weather rising costs and ward off rivals on store shelves. It has leading brands in its categories, it is underpenetrated in overseas markets where its core Clorox bleach brand has room to grow, and it has opportunities to generate savings and offset higher costs. Moreover, management is in the midst of rolling out an economic profit business model throughout the organization, which should further enhance the firm's ability to allocate capital and deliver excess returns. Finally, DeSanto wouldn't be surprised to see Clorox accelerate its share repurchase program in light of the stock's recent sell-off.

Moody's
Moat: Wide  |  Risk: Below Avg  |  Price/Fair Value Ratio: 0.82  |  Three-Year Expected Annual Return: 16.0%

What It Does:  Moody's (MCO) publishes credit opinions, research, and ratings on fixed-income securities, issuers of securities, and other credit obligations. It has offices in foreign countries and is expanding into developing markets through joint ventures or affiliations with local rating agencies. Customers include corporate and governmental issuers of securities as well as investors, depositors, creditors, investment banks, commercial banks, and other financial intermediaries.

What Gives It an Edge: Two dominant players, Moody's and Standard & Poor's, claim about 40% apiece of the credit rating market. In Morningstar analyst Michael Corty's opinion, the credit-rating business is a naturally concentrated market because, while most debt products require two independent ratings, both debt issuers and investors want to use as few rating agencies as possible. Debt issuers, for instance, want to limit the time they must spend with credit analysts. Investors, for their part, favor fewer voices to many, because excessive competition could lead issuers to choose the agency that provides the highest rating or the lowest price.

What the Risks Are: Corty believes that Moody's poses below-average business risk. Unfavorable changes in the volume of debt securities issued would have a negative impact on Moody's financial results. The company faces litigation from time to time from parties claiming damages related to ratings actions. As Moody's international business expands, these types of claims could increase as foreign jurisdictions may not have legal protections or liability standards comparable with those in the U.S.

What the Market Is Missing: In Corty's view, the stock price has fallen in reaction to the recent tightening of the credit markets and worries about potential litigation risk (from parties claiming damages related to the firm's rating actions--in particular, the company's ratings on residential-mortgage-backed securities and related credit derivative products). Yet, the company has faced litigation in the past and has yet to suffer a material loss. The firm is viewed by the courts as a publisher and is protected by the First Amendment, which allows for freedom of speech in publishing its ratings opinions. Thus, Corty doesn't think Moody's will be held materially liable for its rating opinions. Of course, if the credit markets continue to tighten for an extended period, Moody's revenue will decelerate from its robust levels of the past several years. Corty thinks revenue from publishing ratings on structured finance products such as credit derivatives could face some headwinds over the near team to mid-term; however, he's confident in his long-term valuation assumptions for Moody's.

MoneyGram
Moat: Narrow  |  Risk: Avg  |  Price/Fair Value Ratio: 0.67  |  Three-Year Expected Annual Return: 25.2%

What It Does:  MoneyGram (MGI) provides domestic and international money transfers through its global network of 110,000 outside agents. It is the second-largest money transfer company in the world, behind  Western Union (WU). MoneyGram also provides money orders, manages outsourced official check services for banks, and offers bill payment services for consumers.

What Gives It an Edge: Morningstar analyst Brett Horn thinks MoneyGram's most appealing aspect is its money transfer segment. Size is crucial in money transfers, as it generates cost, brand, and network effect advantages. While MoneyGram is dwarfed by industry leader Western Union, it is much bigger than the other players. The company has used its size advantage to steal market share from smaller competitors and is well-positioned to remain a solid number-two player. Horn believes that while the other part of the company, the official check and money order businesses, will decline in the long term as people use fewer and fewer checks, that business should continue to produce solid free cash flow that MoneyGram can use to grow its money transfer business.

What the Risks Are: Horn thinks that MoneyGram courts average business risk. Approximately 38% of MoneyGram's revenue is derived from interest on the float generated by its money order, official check, and money-transfer business. This exposes the company's revenue to fluctuations in interest rates. Due to the passing of the Patriot Act and concerns about illegal immigrants, regulators are closely monitoring money transfer businesses. Any violations at MoneyGram or its agents could have serious consequences.

What the Market Is Missing: MoneyGram's stock has been somewhat undervalued for some time due to short-term pressure on the money transfer segment stemming from the immigration debate and concerns about alternative transfer methods eating away at the business. More recently, Horn observes, the market has been unduly punishing MoneyGram for the mortgage-backed securities that the company holds in its investment portfolio. (These holdings are generated by the firm's official check business.) Horn has reviewed the company's investment portfolio and believes that any future impairment is unlikely to have a large effect on his fair value estimate. To get the fair value estimate to approximate the stock's current price, Horn had to assume that the mortgage-backed security holdings would lose roughly half their value, a prospect that he thinks is highly unlikely given the securities' AAA to A-ratings.

Morgan Stanley
Moat: Wide  |  Risk: Avg  |  Price/Fair Value Ratio: 0.76  |  Three-Year Expected Annual Return: 24.4%

What It Does:  Morgan Stanley (MS) is a large investment bank organized in three segments. Its institutional securities group focuses on capital raising, financial advisory, corporate lending, trading, and proprietary investing. Global wealth management has more than 8,000 financial advisors, one of the largest brokerage networks in the U.S. The asset-management group operates under the Morgan Stanley and Van Kampen brands. In 2006, the group managed more than $470 billion in client assets.

What Gives It an Edge: In Morningstar analyst Ryan Lentell's view, Morgan Stanley's moat lies in its investment banking unit, which is among the best on Wall Street. The division delivered a 30% return on equity last year. CEO John Mack is currently working to streamline Morgan, centering its strategy on the core investment bank. To that end, he has been divesting businesses like  Discover (DFS), which do not provide obvious synergies, while focusing on groups, such as wealth management, that provide product distribution capabilities for the bank. Going forward, Lentell believes this should only help to further solidify the firm's moat as it eliminates distractions of the past.

What the Risks Are: Lentell thinks that Morgan Stanley is an average-risk business. Similar to other investment banks, Morgan's main risks are associated with a downturn in the capital markets. A prolonged slump would probably hurt almost all aspects of the firm's business. In a downturn, investment banking revenue, trading volume, and assets under management would decline, while credit quality in corporate lending would deteriorate. Additionally, the company is subject to various types of legal risk, as investors are always on the lookout for someone to sue when investments go bad.

What the Market Is Missing: In Lentell's view, Morgan has been pulled down, along with many of the big financial companies, over fears in the real estate and credit markets. Investors apparently fear the dislocation in the credit markets will lead to problems at the major investment banks. In Lentell's opinion, while the recent downturn could affect Morgan earnings in the short run, the company is well capitalized. Further, Lentell believes that Morgan's renewed focus under Mack's leadership should help the company prosper in the long run.

NuStar Energy, LP
Moat: Narrow  |  Risk: Below Avg  |  Price/Fair Value Ratio: 0.81  |  Three-Year Expected Annual Return: 18.1%

What It Does: San Antonio-based  NuStar Energy LP (NS) is a master limited partnership that was spun out of refiner Valero Energy. NuStar holds most of Valero Energy's pipelines, terminals, and storage facilities. The 2005 acquisition of the Kaneb companies more than doubled NuStar's asset base to 9,300-plus miles of crude-oil and refined-product pipelines, 86 terminal facilities, and four crude-oil storage facilities.

What Gives It an Edge: In Morningstar analyst Jason Stevens' estimation, NuStar continues to do what it does best: delivering crude-oil feedstocks to refiners and transporting refined products to end-user markets. We're attracted to pipeline operators because of their wide economic moats. Without a demonstrated economic need, new pipelines and system expansions are not approved by regulators. Up-front capital costs also present a sizable barrier to entry. While Stevens thinks that NuStar's aggressive build-out of terminal storage facilities narrows its moat, due to the lower economic returns associated with storage assets, he applauds the company's strategic tradeoff: more growth at slightly lower returns versus slow growth at higher returns.

What the Risks Are: Stevens thinks that NuStar poses below-average business risk. Refinery turnarounds can dramatically reduce the amount of crude and petroleum products NuStar moves through its pipes and terminals. We think dependence on refiners like  Valero Energy (VLO) and Citgo for volume carries some risk, but he thinks customer diversification mitigates this to a large extent. Fires, spills, and changing regulations are risks that all pipeline operators face.

What the Market Is Missing: Stevens thinks the market is missing the boat on master limited partnerships in general, and NuStar is one of the more-attractive MLPs sporting a "for sale" sign today.

Perot Systems
Moat: Narrow  |  Risk: Avg  |  Price/Fair Value Ratio: 0.74  | Three-Year Expected Annual Return: 22.1%

What It Does:  Perot Systems (PER) provides information technology services, primarily to health-care companies and the federal government. Its services include business and systems integration, application development, and information technology infrastructure. These services are typically provided via long-term contracts. The firm was founded by Ross Perot and a group of associates in 1988. Clients include Tenet Healthcare, Triad Hospitals, the U.S. Navy, and the U.S. Air Force.

What Gives It an Edge: In Morningstar analyst Mike Ford-Taggart's opinion, Perot Systems boasts a narrow economic moat. Perot's business is fortified by barriers to entry that include relationships with CIOs, strong reference accounts, strong name recognition, high levels of technology spending, and experience implementing solutions. These barriers are especially relevant in Perot's health-care offerings. It is also in a business that has high switching costs.

What the Risks Are: The biggest risk facing Perot (and most IT services firms) is the mispricing of long-term contracts. IT firms use several types of contracts, one of which is a fixed-rate contract. Under this type, the IT firm gets paid a predetermined amount to complete an agreed-upon project. In 2005, Perot became aware of a project in which costs spiraled out of control because of a larger-than-anticipated infrastructure, which it believes the client did not disclose. In the end, the dispute was resolved amicably, but it was a distraction. Future conflicts may not have such a happy ending.

What the Market Is Missing: Ford-Taggart believes the market is missing the long term. The stock has been in a relatively narrow trading range for four years, with fluctuations typically caused by investors' reaction to quarterly results or comments by management on earnings calls. In Ford-Taggart's view, the market is ignoring the shareholder value that Perot is unlocking and will create in the future.

Other New 5-Star Stocks
 Ambac Financial Group (ABK)
 American Express (AXP)
 Amgen (AMGN)
 AMIS Holdings (AMIS)
 AMN Healthcare Services (AHS)
 Boyd Gaming (BYD)
 Children's Place Retail Stores (PLCE)
 Cincinnati Financial (CINF)
 Comverse Technology (CMVT)
 Finish Line (FINL)
 First Mariner Bancorp (FMAR)
 Grubb & Ellis (GBE)
 Health Management Associates (HMA)
 Infinity Property and Casualty (IPCC)
 International Speedway (ISCA)
 Interpublic Group of Companies (IPG)
 K-Swiss (KSWS)
 LandAmerica Financial Group (LFG)
 Legg Mason (LM)
 Lexmark International (LXK)
 Limited Brands (LTD)
 Macy's (M)
 Maguire Properties (MPG)
 Martha Stewart Living Omnimedia (MSO)
 Monster Worldwide (MNST)
 Ness Technologies (NSTC)
 New Jersey Resources (NJR)
 Nucor  (NUE)
 Pfizer  (PFE)
 Republic Services (RSG)
 Sempra Energy (SRE)
 Sonoco Products (SON)
 Spherion (SFN)
 Sprint Nextel (S)
 Sunstone Hotel Investors (SHO)
 Synovus Financial (SNV)
 TCF Financial (TCB)
 Texas Instruments (TXN)
 Trimeris (TRMS)
 Urban Outfitters (URBN)
 Wachovia (WB)
 Walt Disney (DIS)
 Wilmington Trust (WL)
 Wyndham Worldwide (WYN)

* Price/fair value ratios and expected returns calculated using fair value estimates, closing prices, and cost of equity estimates as of Friday, August 3, 2007.

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