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Stock Strategist

The Six Hottest Stocks of the Quarter

These stocks have performed well in tough times, and we're bullish on their prospects.

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Hot stocks have been hard to come by. The recent market turbulence has put more than 400 stocks in 5-star territory, but it has also made it difficult to find names that have surged for the trailing three months. Consequently, given the market's poor performance, we didn't demand as great a price movement in our screen as we have in past quarters. We screened for stocks containing a Morningstar analysis that rose only 5% or more for the trailing three months through Jan. 11, and that still trade at prices representing 80% or less of the analyst's fair value estimate.

Continuing a recent trend, six of the 12 resulting stocks were energy names. Our energy analysts assume natural-gas prices in the range of $7 to $7.50 per thousand cubic feet through 2011, which should mean solid long-term profits for many domestic producers--we outlined the case for natural-gas producers in an article last fall. Our results also included some health-care and financial-services stocks. Below, we highlight six 5-star choices with narrow or wide moats.

 Chesapeake Energy (CHK)
Trailing three-month return through January 11: 6.4%
Economic Moat: Narrow
Business Risk: Average
Price/Fair Value: 69%
Chesapeake Energy is one of the largest natural-gas producers in the United States. The firm has been building up its acreage in areas with natural-gas shale deposits, making more than $11 billion in acquisitions since 2002. The firm is now moving mostly to production mode, seeking to exploit the Barnett Shale in and around Fort Worth, Texas, and other shale plays in West Texas, Oklahoma, Arkansas, and Appalachia. Chesapeake also hedges against rising service costs by taking ownership interests in drilling rigs and drilling companies. Finally, although liquefied natural gas imports will eventually make inroads for now, domestic producers don't suffer from international competition.

 Cimarex Energy Company (XEC)
Trailing three-month return through January 11: 13.8%
Economic Moat: Narrow
Business Risk: Average
Price/Fair Value: 69%
Morningstar analyst Justin Perucki finds Cimarex refreshingly different from many of its oil and gas exploration and production competitors, emphasizing returns on invested capital as opposed to obsessively boosting reserves. Cimarex's approach will cause it to take projects that won't necessarily produce quick growth of reserves but will give it more opportunity to increase its returns on capital over time. One drawback of this approach is that the firm may run low on new drilling projects, forcing it to make acquisitions. Recently, the Magnum Hunter acquisition added properties in the Gulf of Mexico that didn't provide significant competitive advantages and suffered during Hurricane Katrina. Additionally, the firm drilled several dry holes, causing production to fall off dramatically. Nevertheless, Perucki views the firm's willingness to curtail investment in the new properties as a positive sign, and though the firm's recent missteps highlight the risks associated with drilling in South Texas and Louisiana, he is confident that this won't be a chronic problem.

 Covidien Ltd. (COV)
Trailing three-month return through January 11: 5.7%
Economic Moat: Narrow
Business Risk: Average
Price/Fair Value: 77%
Covidien, a recent spin-off from  Tyco (TYC), is a leader in the medical device field, especially surgical and energy-based devices. The firm has particular expertise in devices used for the rapidly growing area of minimally invasive surgery. Morningstar analyst Alex Morozov thinks the firm's liberation from its stingy parent should allow it to spend sufficiently to maintain its industry position. The firm is spending on previously starved research and development, and also on sales and marketing, hoping to tap into global markets where its presence is currently limited. Morozov thinks the near term could be bumpy as spending increases lead to some margin compression, but he views these as temporary hurdles. Overall, he is encouraged by the firm's forward-looking capital allocation plan, a management incentive structure that emphasizes long-term results, and the recent decision to jettison its underperforming retail business. Combined with a well-respected brand and large infrastructure, these changes bode well for the health of the firm.

 EOG Resources (EOG)
Trailing three-month return through January 11: 10.4%
Economic Moat: Narrow
Business Risk: Average
Price/Fair Value: 73%
EOG Resources is the third energy company on our list. It focuses on North American natural-gas exploration and production, with 15% of its production in oil. The firm has shunned acquisitions, preferring to develop reserves on its own. Production hasn't been impressive, but the firm's low-cost structure helps improve its odds of remaining profitable during industry cycle troughs, according to Perucki. Indeed, by Perucki's calculations, the firm enjoys returns on capital well above 20%. One way the firm has been able to minimize costs has been by cutting the time it takes to drill a well. The firm has acquired a sand mine south of its Barnett Shale holdings in Fort Worth, because by using sand to fracture wells, the firm is able to cut its drilling costs. This investment exemplifies what sets EOG's management team apart, according to Perucki.

 Novartis AG (NVS)
Trailing three-month return through January 11: 7.5%
Economic Moat: Wide
Business Risk: Below Average
Price/Fair Value: 79%
Novartis remains an oasis in a desert of traditional pharmaceuticals suffering from stagnant research and development. Novartis' pipeline is robust, with an industry-leading number of new potential blockbuster drugs, according to Morningstar analyst Damien Conover. Although the firm faces near-term patent losses on hypertension drug Lotrel, fungal medicine Lamisil, and epilepsy treatment Trileptal, Conover is impressed with potential blockbusters such as diabetes drug Galvus, osteoporosis therapy Aclasta, and hypertension reducer Tekturna. Moreover, the firm should file at least six new products in 2008 in both the United States and Europe. Finally, Sandoz, the firm's generic division, takes advantage of drugs coming off patent.

 The Western Union Company (WU)
Trailing three-month return through January 11: 6.5%
Economic Moat: Wide
Business Risk: Below Average
Price/Fair Value: 67%
Western Union, which recently spun off from First Data, benefits from nearly 200 million people who work outside their country of origin, but send money back home using money transmitters. Western Union is the dominant player in the money transfer industry, processing five times as many transactions as its closest competitor  MoneyGram (MGI). The firm still only owns 17% market share, giving it plenty of opportunity to grow. Western Union's moat consists of its unrivaled network of more than 300,000 agents, making it the easiest transmitter to use in most cases, and its recognized name, conferring an element of trust relative to its rivals. These characteristics make Western Union highly profitable, as it converts 20 cents of every dollar of revenue into free cash flow. Morningstar analyst Brett Horn thinks that although the firm's capital needs will increase now that it's an independent company, it will still remain relatively small.

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