Three Stocks That Look Poised to Notch 15%-Plus Returns
Plus, the market dumps dozens of other stocks in the bargain bin.
Following is a sampling 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.
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Moat: Narrow | Risk: Below Average | Price/Fair Value Ratio*: 0.84 | Three-Year Expected Annual Return*: 15.5%
What It Does: Ecolab (ECL) produces and sells cleaning products and services to institutional, hospitality, and industrial customers. The company's products include detergent, vehicle-care, and pest-elimination products, among others. Ecolab's major customers are restaurants, hotels, hospitals, and schools. The firm has a strong international presence: Almost half of its revenue comes from abroad.
What Gives It an Edge: In Morningstar analyst Ben Johnson's view, Ecolab's primary advantage over rivals is its scale. In the highly fragmented global cleaning and sanitizing market, Ecolab is the only player large enough to serve big accounts like McDonald's (MCD) and Four Seasons in all corners of the globe. Furthermore, portions of its business have a razor-and-razor-blades model, where the firm has an installed asset on its client site (such as a dispenser for dishwashing detergent) and also provides the consumable (the actual detergent). This creates substantial switching costs for Ecolab's customers and simultaneously generates a lucrative recurring revenue stream. Taken together, these advantages earn Ecolab a "narrow" economic moat.
What the Risks Are: A pronounced economic downturn could decrease the number of meals consumers purchase outside the home or the quantity and duration of hotel stays. Either of these factors would cause a substantial decrease in demand for Ecolab's products and services. Because roughly half of its sales are made overseas, Ecolab also faces significant currency risk.
What the Market Is Missing: While Ecolab's North American business is firing on all cylinders, its overseas operations have historically been a sore spot. The firm is in the midst of a massive overhaul of this business and has been investing heavily to help bring its performance in line with its North American operations. As a result of this increased level of spending, the international business' operating margin has stagnated over the past few quarters. Johnson continues to believe that these investments will pay off over time and that the international segment will perform neck-and-neck with North America over the long run.
Moat: Wide | Risk: Avg | Price/Fair Value Ratio*: 0.76 | Three-Year Expected Annual Return*: 20.2%
What It Does: International Speedway (ISCA) is a leading promoter of motor sports in the United States. It owns and operates 12 tracks, including the mecca, Daytona International Speedway in Daytona, Fla.--also the location of the firm's headquarters. Although its mainstay is a steady supply of Nextel Cup stock car races, International Speedway hosts truck, motorcycle, and other competitions as well. The France family has controlled both Nascar and International Speedway since inception.
What Gives It an Edge: Morningstar analyst Joel Bloomer sees two primary facets to International Speedway's wide moat: barriers to entry and intangible assets. ISC tracks range in size from 35,000 to nearly 170,000 (more than twice the size of the largest NFL stadium). There are few markets that can support stadiums of this size in different sports, and virtually none that can support two racetracks of this caliber. With the largest number of high-profile tracks in attractive markets, ISC is way ahead of the competition. Intangible assets also contribute to ISC's wide moat as fans identify with storied racetracks such as Daytona International Speedway just as they do Wrigley Field here in Chicago. However, unlike Wrigley, Daytona and other racetracks aren't restricted by historical landmark status. Thus, as demand grows, ISC can add grandstand seats, luxury suites, and merchandise points to its stadiums, making the construction of competing tracks even less attractive and strengthening ISC's intangible asset advantage.
What the Risks Are: Bloomer believes that International Speedway courts average business risk. The primary risk facing International Speedway is antitrust litigation. There have been complaints in the past that race allocation has not been competitive. Previous litigation has ended without doing much damage to ISC's operations; still, future disputes may not end favorably. In Bloomer's opinion, Nascar has consumers' best interests in mind, and he thinks there's enough demand to support more competition without damaging ISC's moat.
What the Market Is Missing: In Bloomer's view, the market is focusing too much on short-term challenges and not enough on ISC's ability to generate cash. The company failed in its attempts to gain sufficient support for the construction of two new tracks: one in the Northwest and one in the Northeast. While this diminishes growth potential, Bloomer was happy to see management nix the deals when prospective returns were depressed to unacceptable levels by the demands of local governments. In addition, the extremely difficult process in gaining approval for new track construction highlights the advantages that ISC's existing tracks currently enjoy. Also weighing on the stock is an antitrust case that's been brought against ISC and Nascar, alleging collusion in race-schedule development. It's difficult to know what the outcome of this litigation will be, but, in Bloomer's opinion, the demands (such as competitive bidding for race dates) would be detrimental to the sport and fans, making an adverse ruling unlikely. Meanwhile, ISC's solid free cash flow generation continues.
Moat: Narrow | Risk: Below Avg | Price/Fair Value Ratio*: 0.83 | Three-Year Expected Annual Return*: 16.9%
What It Does: Based in San Rafael, Calif., WestAmerica (WABC) focuses its lending activities on small business and commercial real estate. The bank offers commercial lending, mortgage banking, cash management, and other financial services. WestAmerica has more than $5 billion in assets across more than 80 branches in Northern and Central California.
What Gives It an Edge: WestAmerica carved out a very profitable niche serving small to midsize businesses and their owners. WestAmerica combines the personal attention of a community bank with the sophisticated products of a large institution to attract high-quality customers. By emphasizing the personal touch, the bank strives to form long-lasting relationships with its clients. In Morningstar analyst Michael Kon's opinion, these relationships widen the bank's economic moat and reduce its business risk.
What the Risks Are: Kon believes that WestAmerica poses below-average business risk. With the majority of its loans in commercial real estate in Northern California, WestAmerica's concentrated book of loans poses a risk. Despite its strong balance sheet, Kon believes the business would suffer if the regional economy produced an extended decline in real estate values.
What the Market Is Missing: WestAmerica trades at a discount because the market has doubts about future growth and the impact of the downturn in real estate. Kon, however, is confident that this enormously profitable bank will continue to produce good results.
* Price/fair value ratios and expected returns calculated using fair value estimates, closing prices, and cost of equity estimates as of Monday, August 13, 2007.
Jeffrey Ptak has a position in the following securities mentioned above: MMM. Find out about Morningstar’s editorial policies.