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Stock Strategist

The Six Hottest Stocks of the Third Quarter

Prices on these stocks have surged, but we still think their shares are undervalued.

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Buying stocks because other investors or traders seem to be bidding them up is not a legitimate investment strategy. However, avoiding stocks because you've missed what appear to be their lows isn't a legitimate approach either. In both cases, you're letting market action dictate your moves.

At Morningstar, we base our analysis on the intrinsic value of a stock's underlying business. We arrive at our understanding of value by estimating a business's future free cash flows and discounting them to the present. (Discounting means adjusting for the fact that we don't have that cash in our hands today.) If a stock trades at a price far enough below what we think its underlying business is worth, it boasts a 5-star rating--Consider Buying territory--regardless of its recent movements.

This past quarter, a number of stocks we like surged in price but still trade at prices that we think are attractive based on their underlying business values. We ran a screen for stocks that sport a narrow or wide moat, rose 10% for the trailing three months, and still trade at a price/fair value ratio of 0.80 or less. The screen came up with six names, which we highlight for your portfolio below.

 Abraxis BioScience, Inc. (ABBI)
Trailing three-month return through October 11: 14%
Economic Moat: Narrow
Business Risk: Above Average
Price/Fair Value: 68%

Abraxis is not for the faint of heart, according to Morningstar equity analyst Brian Laegeler. The firm was formed in early 2006 through the combination of American Pharmaceutical Partners and privately held American BioScience. The merger appears to have benefited only the controlling shareholder Patrick Soon-Shiong at the expense of minority shareholders. Now, Soon-Shiong has plans to reverse the combination, giving one share of APP to shareholders for each share of Abraxis. Laegeler likes APP's injectable drugs business, though Soon-Shiong plans to saddle it with considerable debt in the breakup. Laegeler maintains concerns about Soon-Shiong, whose own brother sued him once for fraud and self-dealing.

 BankAtlantic Bancorp (BBX)
Trailing three-month return through October 11: 13.7%
Economic Moat: Narrow
Business Risk: Average
Price/Fair Value: 58%

Many regional and super-regional banks have been hurt by subprime worries. Although BankAtlantic has no subprime exposure, according to Morningstar equity analyst Ryan Lentell, it has made $135 million in loans to investors for land that is under contract to be sold to large national homebuilders. Lentell has stress-tested his valuation model to account for a worst-case scenario of the builders walking away from all the loan contracts. Even this difficult situation (which Lentell believes will not occur) only shaves $2 off his $15 fair value estimate. Additionally, a flat yield curve has exacted a toll on the profitability of many banks, which depend on an upward-sloping curve for the ability to borrow at a lower rate than that at which they lend. The Federal Reserve's recent decision to lower interest rates has ameliorated this problem.

 eBay, Inc. (EBAY)
Trailing three-month return through October 11: 16.3%
Economic Moat: Wide
Business Risk: Below Average
Price/Fair Value: 80%

Morningstar equity analyst Larry Witt calls eBay a classic example of a moat built on a network effect: Buyers go to eBay because that's where the sellers are, and sellers go there because that's where the buyers are. The more people who use eBay, the more other people are encouraged to use it. So powerful is this network effect that other online auction businesses such as  Yahoo's (YHOO) have shut down. Witt likes eBay's purchase of PayPal, which also benefits from the network effect. Although the firm's purchase of Skype didn't pan out as hoped, the $1.7 billion impairment charge related to it doesn't affect Witt's valuation. Witt expects revenue growth, operating margins, and returns on capital to remain robust at eBay.

 Molson Coors Brewing Company (TAP)
Trailing three-month return through October 11: 18.7%
Economic Moat: Narrow
Business Risk: Average
Price/Fair Value: 78%

Morningstar equity analyst Matthew Reilly likes the proposed merger between Molson Coors and  SABMiller (SBMRY). He thinks the combination will achieve cost savings of $500 million, especially in the realm of distribution. Beer is heavy, and it costs a lot to ship it from Colorado to, say, New York City. The merger will allow the combined firm to produce beer closer to where people drink it. The new firm will also own 30% of the domestic beer market, making it the number-two producer behind  Anheuser-Busch Companies (BUD), which owns 50% of the market. This rationalization of the market bodes well for investors as the mass producers face competition from craft brews and spirits. Although there might be regulatory hurdles to the merger, Reilly thinks that Anheuser's market share will be the trump card allowing it to clear antitrust review.

For more Molson Coors-SABMiller deal, see Pat Dorsey's recent video report.

 Ultra Petroleum Corporation (UPL)
Trailing three-month return through October 11: 14.2%
Economic Moat: Narrow
Business Risk: Above Average
Price/Fair Value: 80%

Ultra Petroleum previously engaged in the exploration and production of oil and natural gas in the Green River Basin in Wyoming and offshore in Bohai Bay, China. However, it recently agreed to sell its interests in China. Morningstar equity analyst Eric Chenoweth likes the firm's Wyoming resources and thinks it's one of the lowest-cost producers. Wells recently drilled in the relatively undeveloped region have been impressive, and Chenoweth thinks Ultra can earn returns on capital well above its cost of capital for years to come. Chenoweth notes that risks include environmental obstructions and deficient pipeline capacity in the Rocky Mountain region.

 Whole Foods Market, Inc.  (WFMI)
Trailing three-month return through October 11: 27%
Economic Moat: Narrow
Business Risk: Average
Price/Fair Value: 70%

Morningstar equity analyst Mitchell Corwin thinks Whole Foods will cement its premium brand in food in a way similar to  Starbucks' (SBUX) in coffee. Whole Foods has no peer, in Corwin's view, as a unique food retailer that provides a pleasant shopping experience with higher-margin products. Whole Foods' unique culture and emphasis on organic, healthy foods allows its average outlet to generate nearly $600,000 per week in sales compared with $350,000 per week for the average supermarket. Additionally, Whole Foods converts $8 out of every $100 in sales into operating cash flow compared with $3 to $5 for a typical large grocer. Corwin sees years of healthy profits and growth ahead for the firm.


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