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Stock Analyst Update

Four Stocks with 20%-Plus Expected Returns

Plus, six other new 5-star names.

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.

American International Group
Moat: Narrow | Risk: Avg | Price/Fair Value Ratio*: 0.74 | Three-Year Expected Annual Return*: 22.8%

What It Does:  American International Group  (AIG) is a diversified financial-services firm that offers property-casualty insurance, life insurance, asset management, retirement income, private banking, aircraft leasing, mortgages, credit cards, and derivative products to a global client base of individuals and institutions. Insurance makes up more than 60% of AIG's sales. The majority of AIG's life insurance sales originate in Asia, where the firm has important operations in China and Japan.

What Gives It an Edge: Morningstar analyst Matt Nellans assigns AIG a narrow moat. Nellans believes AIG has a slim edge in each operational area thanks in large part to effective and disciplined managers. The firm's breadth of businesses helps insulate AIG's balance sheet from a shock in any particular segment.

What the Risks Are: AIG's bulk and comprehensive diversification preclude the majority of nonsystemic problems from inflicting more than transitory or irritating--rather than business-ending--challenges. For example, the conglomerate's insurance reserves may prove understated from time to time--but rarely by much, and rarely for long, thanks to the company's extensive incentives that deter executives from doing this--but it would take an extreme event to blast a sizable hole in its balance sheet. Nellans believes a more important risk to AIG's value is a slowdown in its growth rate, which would compromise the firm's historical premium to its competitors.

What the Market Is Missing: Nellans stipulates AIG's stock decline largely relates to the panic-selling across the entire mortgage market, as the firm has billions of dollars invested in mortgage-backed securities and also writes credit default swaps on securities with subprime mortgage collateral. However, Nellans believes the market is ignoring the fact that the vast majority of AIG's exposures have plenty of subordination--that is, mortgage defaults must be catastrophic to provoke a permanent capital loss for AIG.

Corporate Executive Board Company
Moat: Wide | Risk: Avg | Price/Fair Value Ratio*: 0.73 | Three-Year Expected Annual Return*: 22.3%

What It Does:  Corporate Executive Board  provides best-practices research covering corporate strategy, operations, and general management topics to approximately 3,700 corporate clients. For an annual fee, clients get access to the best-practices research, executive education programs, membership meetings, and directed research. The company uses its members' experiences as the basis for its research.

What Gives It an Edge: Morningstar analyst Brett Horn believes Corporate Executive Board has carved out a great niche for itself. It has no direct competition, and Horn speculates it is unlikely to ever face any. Over 80% of the Fortune 500 are members--a strong lure to prospects, which can get access to other members' experiences and peer networking opportunities through Corporate Executive Board's programs. Additionally, the company produces gobs of free cash flow. Because it collects its annual dues upfront, cash flow is consistently higher than net income, and free cash flow over the past few years has been over 30% of revenue.

What the Risks Are: Being a member of Corporate Executive Board is a discretionary expense for its clients. When times get tough, the company has a much harder time signing up new customers and risks losing existing clients. The company's international customers--27% of its revenue base--pay U.S. dollars while its costs are partially tied to foreign currencies. This generates significant currency risk.

What the Market Is Missing: Corporate Executive Board has run into some operational issues over the past year, as it failed to increase its salesforce quickly enough to maintain its growth. The company is now in the process of ramping up the size of its sales team, but new sales people have been slow to reach full productivity. While this setback is disappointing, it appears to be a short-term problem that should be relatively easy to fix. Horn speculates the market is preoccupied with slower-than-expected growth in the near term while ignoring excellent long-term growth opportunities

Biomed Realty Trust
Moat: Narrow | Risk: Avg | Price/Fair Value Ratio*: 0.74 | Three-Year Expected Annual Return*: 21.4%

What it Does:  BioMed Realty  is a real estate investment trust (REIT) that owns and develops laboratory and office space for the life science industry. The company's tenants include biotech and pharmaceutical companies, research institutions, and government agencies. The firm's nearly 100 buildings constitute almost 9 million square feet and are located in markets recognized for life science research. BioMed also has a development pipeline and land bank that comprise about 2.4 million square feet.

What Gives It an Edge: Morningstar analyst Heather Smith thinks BioMed has carved out a narrow moat by focusing on an underpenetrated niche in the commercial real estate market--laboratory space in the life sciences. The firm has built a collection of premier facilities in life sciences cluster markets such as San Francisco, Boston, and San Diego, and also possesses a large network of contacts in order to make wise leasing decisions. Tenants are also extremely sticky given their substantial investments in customizing lab space, and they sign multiyear leases that cover most property operating expenses.

What the Risks Are: Because BioMed is focused exclusively on the life sciences, it is vulnerable to any slump in the sector. A decline in research-and-development spending at pharmaceutical companies, or a drop in government funding for research, would adversely affect cash flows and the company's ability to fully cover the dividend.

What the Market Is Missing: Shares of REITs have taken a tumble year to date on worries about a cooling U.S. economy and wider credit spreads. BioMed's stock has plunged significantly despite strong earnings reports and promising new development projects. Given its conservative capital structure and business strategy, Smith believes the company has little exposure to rising interest rates and considers its shares to be attractively valued at current levels. The firm's growth prospects remain bright, as more pharmaceutical companies sell their real estate, and funding for life sciences research climbs.

Wyndham Worldwide Corporation
Moat: Narrow | Risk: Avg | Price/Fair Value Ratio*: 0.76 | Three-Year Expected Annual Return*: 21.3%

What It Does:  Wyndham Worldwide (WYN) sells and manages timeshare resorts, operates a vacation exchange, and franchises more than 530,000 rooms in 6,400 hotels. Timeshares are sold under the Trendwest and Fairfield brand names and exchanged over the RCI network. Hotel brands include Wyndham, Ramada, Days Inn, Knights Inn, Howard Johnson, Super 8, and Baymont.

What Gives It an Edge: According to Morningstar analyst Jeremy Glaser, Wyndham has earned a narrow moat thanks to the long-term nature of its hotel franchising contracts, the firm's prowess in building timeshares, and the network effect inherent to its vacation exchange business. Wyndham's hotel franchising agreements have terms of 15-20 years; breaking these contracts would be costly to owners and confusing to consumers, as the hotels would have to change brands. This tends to keep hotels in the Wyndham system for a long time. The firm's timeshare business is also in a strong competitive position. Wyndham has one of the largest pipelines of timeshare resorts under construction, and the firm's RCI timeshare exchange business keeps attracting more resorts to its system.

What the Risks Are: A sharp downturn in consumer spending could lead to a dip in timeshare sales. This would force Wyndham to lower prices or sit on unsold inventory. Continued high gas prices might keep many of Wyndham's economy travelers at home, depressing room rates and occupancy. The consumer financing arm responsible for helping vacationers pay for their timeshares is exposed to the credit risk of its clients.

What the Market Is Missing: Glaser attributes the decline in Wyndham's shares to the fear of a slowdown in consumer spending, which would put a damper on leisure travel and pressure Wyndham's hotel and timeshare businesses. Although Glaser believes that a slowdown will have some effect on the company, he asserts that the market's worries are overblown. Wyndham is not as vulnerable to drops in travel as hotel owners, as the firm receives a fee stream even when hotels are empty. On the timeshare front, baby boomers continue to buy units as they start thinking about retirement; their purchasing power should help keep sales from drying up.

Other New 5-Star Stocks
 Arkansas Best Corporation (ABFS)
 E*Trade Financial 
 Grubb & Ellis 
 KeyCorp (KEY)
 Littelfuse (LFUS)

* Price/fair value ratios and expected returns calculated using fair value estimates, closing prices, and cost of equity estimates as of Friday, Nov. 2, 2007.

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