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Stock Analyst Update

Four Stocks with High-Return Potential

Why the market's got it wrong on these 5-star names.

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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.

Forest Laboratories
Moat: Narrow  |  Risk: Average  |  Price/Fair Value Ratio*: 0.76  |  Three-Year Expected Annual Return*: 20.9%

What It Does: A leading player in branded, generic, and over-the-counter pharmaceuticals,  Forest Laboratories (FRX) develops, manufactures, and markets drugs in the central nervous system, cardiovascular, respiratory, and endocrinology therapeutic areas. Its top sellers include Lexapro for depression, Namenda for Alzheimer's disease, and Benicar for hypertension. Forest sells primarily in the United States but also has a presence in the United Kingdom and Ireland.

What Gives It an Edge: In Morningstar analyst Brian Laegeler's view, Forest Labs is the best specialty drug marketer Morningstar covers. Though Lexapro and Namenda are slated to lose patent protection around 2012, Laegeler thinks Forest's $3.5 billion revenue base should afford the firm the financial flexibility needed to outbid direct competitors like  King Pharmaceuticals (KG) and  Shire (SHPGY) for attractive inlicensing deals. Moreover, the firm's highly reputable, 3,000-person salesforce makes it an ideal partner for smaller, research-based firms.

What the Risks Are: Laegeler believes that Forest courts average business risk, meaning that he'd invest in the shares at a moderate discount to his fair value estimate. If Forest does not make substantial headway in business development over the next several years, the decline of Lexapro sales will have a greater impact on returns. Laegeler's valuation turns on the continued success of Namenda, as well as pipeline hopefuls milnacipran and nebivolol, which he expects to contribute significant revenue starting in 2008.

What the Market Is Missing: It's hard to picture the company five years from now, as two drugs representing 80% of Forest's revenues--Lexapro and Namenda--will lose patent protection by 2012. However, Laegeler thinks investors are too focused on this uncertainty. A $400 million research budget, $2 billion war chest, and excellent track record of business development should allow the company to foster the next generation of growth.

Homex Development
Moat: Narrow  | Risk: Above Avg  |  Price/Fair Value Ratio*: 0.61  |  Three-Year Expected Annual Return*: 31.9%

What It Does:  Desarrolladora Homex (HXM) is a vertically integrated home-development company focused on affordable entry-level and middle-income housing in Mexico. Homex is one of the most geographically diverse homebuilders in the country. Since its foundation in 1989, Homex has grown to include operations in 18 of Mexico's 31 states. The company's shares trade in Mexico, and ADRs representing six shares each trade on the New York Stock Exchange.

What Gives It an Edge: In Morningstar analyst Parrish Glover's view, Homex has built a moat by becoming a low-cost provider for a product with significant untapped demand--housing in Mexico (that country's estimated housing shortfall exceeds 4 million homes). Homex taps into that demand by developing large communities (up to 6,000 units) that typically feature small units (between 450 and 850 square feet). This effectively allows the company to maximize revenue on its projects while limiting its need for land purchases.

What the Risks Are: Glover thinks that Homex poses above-average business risk. The homebuilding market in Mexico, like that in the U.S., is vulnerable to changes in interest rates. Mexico's central bank announced at the end of February that it would raise interest rates to curb inflation, sending shares of Homex down 15% in three days. Inflationary pressures could also lead to a decline of the peso against the dollar, making Homex ADRs worth less in dollar terms.

What the Market Is Missing: The market has been punishing the stocks of Mexican companies, despite continued weakness in the U.S. dollar and strong economic growth south of the border. Glover thinks the sharp decline in U.S. housing could be causing more-widespread skittishness about all construction. However, he points out that there is no correlation between the two markets. Rather, the most important factors driving new home sales in Mexico are interest rates, which are declining, and the availability of mortgage financing, which the Calderon government is funding.

Mueller Water Products
Moat: None  |  Risk: Avg  |  Price/Fair Value Ratio*: 0.74  |  Three-Year Expected Annual Return*: 23%

What It Does: Based in Atlanta,  Mueller Water Products (MWA) designs, manufactures, and sells goods for use in U.S. and Canadian drinking and waste water infrastructure. Primarily, these include valves, pipes, fire hydrants, and pipe couplings through the company's three segments: Mueller, U.S. Pipe, and Anvil. Founded in 1857, Mueller was spun off from former parent Walter Industries in 2006.

What Gives It an Edge: Morningstar analyst Adam Fleck thinks Mueller has an edge in its self-titled segment that primarily produces fire hydrants and specialty water valves. Many municipal governments either require or strongly prefer to use the same manufacturer for infrastructure replacements and quality assurance. Mueller holds the largest market share in this business, and Fleck expects the segment to continue generating lofty returns. However, the company's U.S. Pipe segment faces greater competition from other ductile-iron pipe manufacturers as well as substitute products (PVC, concrete, etc). As a result, the segment enjoys far less pricing power, thereby preventing Mueller from trenching out an economic moat.

What the Risks Are: In Fleck's opinion, Mueller rates average business risk. About half of Mueller's demand stems from residential homebuilding, which is inherently cyclical. As a result, the company's revenue stream could be lumpy and unpredictable. In addition, many of the company's products face substitutes and cheaper foreign imports, which could hamper margins and weaken revenue growth. Mueller will probably need substantial capital expenditures to expand capacity, which would affect free cash flow.

What the Market Is Missing: Currently, the market seems to be overlooking two aspects of Mueller's long-term potential. First, roughly half of the company's revenue stems from infrastructure replacement. Fleck believes the U.S. will need to spend billions of dollars over the next decade to upgrade the current water-infrastructure system, which is plagued by aging pieces and high leakage rates. Though Mueller stands to benefit from such investment, it may be several years before replacement is kicked into high gear. That lull seems to be giving some investors pause. Second, since water infrastructure spending is also closely tied to residential home construction, the homebuilding slump has weighed on the firm's shares. Nevertheless, Fleck believes that as housing starts gradually improve over the next two to three years (a forecast that informs our thesis on the many homebuilding stocks that we cover), Mueller should be able to capitalize on its strong market position.

Security Capital Assurance
Moat: Narrow  |  Risk: Above Avg  |  Price/Fair Value Ratio*: 0.62  |  Three-Year Expected Annual Return*: 31.6%

What It Does:  Security Capital Assurance (SCA) is a monoline financial guarantor with interests in primary and reinsurance lines of business. The firm insures municipal bonds and offers other forms of credit enhancement. Security Capital's primary and reinsurance subsidiaries are rated AAA.

What Gives It an Edge: In Morningstar analyst Jim Ryan's view, SCA's moat derives from the AAA credit rating that the firm has received from Moody's, S&P, and Fitch. This puts SCA in very select company, as there are only a few financial guarantors that have attained a unanimous AAA rating. Consequently, the firm is well-positioned to land lucrative bond insurance business, as bond issuers are typically most eager to do business with the highest-rated guarantors.

What the Risks Are: An investment in Security Capital stock courts above-average risk in Ryan's view. Competition for a slice of a smaller pie could lead to relaxed underwriting standards or severe price competition, neither of which would bode well for Security Capital. Expansion into uncharted international territory carries a greater risk than traditional insurance because there is less history to assess from a risk-selection standpoint.

What the Market Is Missing: SCA, like all financial guarantors, has taken a hit amid rampant investor concern over the firm's exposure to mortgage defaults, with loans to subprime borrowers being a particular worry. If investors in residential mortgage-backed securities or Collateralized Debt Obligations (CDOs) were to suffer deep losses, financial guarantors like SCA could end up on the hook. Yet, Ryan points out that financial guarantors only write policies when they are convinced that the risk of loss is extremely small (explaining why such firms tend to reserve far less than would, say, a mortgage insurer). True, the coming months are likely to prove trying as the carnage in the mortgage arena continues to unfold and investors tally their losses. However, Ryan believes that the market is overlooking the attractive long-term fundamentals of SCA's business, which are burnished by the long-tail nature of the financial guaranty business. Since the average policy lasts about 10 years, SCA can be selective in writing new insurance while premiums from its past book of business supports income. That, in turn, relieves the pressure on the firm to court excessive underwriting risk. However, our risk-rating for SCA and all financial guarantors is above average and we caution potential investors to take this into account.

Other New 5-Star Stocks
 American Express Company (AXP)
 American Reprographics Company (ARP)
 Anheuser-Busch Companies, Inc. (BUD)
 Arcelor Mittal (MT)
 Boardwalk Pipeline Partners LP (BWP)
 Carpenter Technology Corporation (CRS)
 Cemex Corporation (CX)
 Centex Corporation (CTX)
 Credit Suisse Group (CS)
 Digirad Corporation (DRAD)
 E*Trade Financial Corporation (ETFC)
 Eagle Materials, Inc. (EXP)
 Expeditors International of Washington, Inc. (EXPD)
 Flamel Technologies (FLML)
 Grubb & Ellis Company (GBE)
 Hovnanian Enterprises Inc. (HOV)
 Lexicon Pharmaceuticals, Inc. (LXRX)
 Limited Brands, Inc. (LTD)
 M.D.C. Holdings, Inc. (MDC)
 Maguire Properties, Inc. (MPG)
 McGraw-Hill Companies, Inc. (MHP)
 Microsoft Corporation (MSFT)
 Monsanto Company (MON)
 Nucor Corp. (NUE)
 Orleans Homebuilders, Inc. (OHB)
 Photon Dynamics, Inc. (PHTN)
 Pioneer Natural Resources Company (PXD)
 Polycom, Inc. (PLCM)
 Reliance Steel and Aluminum (RS)
 Ryland Group, Inc. (RYL)
 Sonoco Products Company (SON)
 Spherion Corporation (SFN)
 STMicroelectronics NV (STM)
 Telecom Italia SPA (TI)
 Wipro, Ltd. (WIT)
 WNS (Holdings) Limited (WNS)

* Price/fair value ratios and expected returns calculated using fair value estimates, closing prices, and cost of equity estimates as of Monday, August 20, 2007.

Jeffrey Ptak has a position in the following securities mentioned above: AXP, MSFT. Find out about Morningstar’s editorial policies.