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Stock Analyst Update

Look to These 5-Star Stocks for Big Returns

These stocks offer 15%-plus expected returns.

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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.

Abbott Laboratories
Moat: Wide | Risk: Below Average | Price/Fair Value Ratio*: 0.81 | Three-Year Expected Annual Return*: 16.9%

What It Does: Abbott (ABT) manufactures and markets pharmaceuticals, medical devices, blood glucose monitoring kits, and nutritional health-care products. Products include prescription drugs, coronary and carotid stents, and nutritional liquids for infants and adults. Abbott generates just under 60% of revenue from pharmaceuticals, about 17% from nutritional products, 17% from diagnostics, and the rest from its vascular business.

What Gives It an Edge: According to Morningstar analyst Damien Conover, Abbott has dug a wide economic moat based on its large portfolio of branded drugs, leading diagnostics business, strong nutritional division, and emerging vascular group. Utilizing patent protection and economies of scale in selling and developing products, Abbott consistently generates returns on capital in excess of its cost of capital. Conover expects the company's operating lines to continue to generate strong returns and to drive growth.

What the Risks Are: While Abbott maintains diverse operations, the company depends heavily on its products Humira and Xience for future growth. Further, the company's pipeline isn't as large as those of rivals, making any failures with late-stage candidates very costly. Also, the company faces typical industry risks including drug delays or nonapprovals as well as an increasing aggressive generic and managed-care industry.

What the Market Is Missing: Conover points to concerns in the credit markets and general recession fears for unfairly pushing Abbott into 5-star territory. Conover believes Abbott will continue to post strong growth in a slowing economy, since the company's inelastic product sales hold a low correlation to the overall economy. Further, Conover contends that Abbott's diverse operating lines and relatively low patent exposure should provide for a stable investment in uncertain times.

Westar Energy, Inc.
Moat: Narrow | Risk: Average | Price/Fair Value Ratio*: 0.74 | Three-Year Expected Annual Return*: 21.0%

What It Does: Westar Energy (WR), through its Western Resources and Kansas Gas and Electric Company subsidiaries, is the largest electric utility in Kansas, providing generation, transmission, and distribution services to about 670,000 customers in the central and eastern regions of the state. The company has about 6,000 megawatts of generating capacity with 55% from coal, 9% from nuclear, and 36% from natural gas or oil.

What Gives It an Edge: Morningstar analyst Travis Miller credits Westar Energy with a narrow economic moat. With more than $3 billion in capital investment projects planned through 2016 to strengthen Kansas' power infrastructure, Miller believes this regulated utility has some of the brightest growth prospects of any regulated utility in the country. Given the relatively low energy costs in the Midwest, Miller expects Westar to push through higher utility rates in 2009 that will convert its capital projects into shareholder profits at nearly 11% returns on equity. While lower interest rates could pressure regulated returns, Miller still thinks accommodative regulators in Kansas will benefit Westar shareholders through the next decade.

What the Risks Are: In Miller's view, customer resistance to higher rates is the key risk to Westar's growth. Like all regulated utilities, the company must obtain regulators' approval to charge higher rates to fund investments. If regulators don't incorporate adequate profits in allowed rates--at least as high as current allowed returns on equity of 10% to 11%--the company might cut investment. A favorable regulatory system in Kansas minimizes some of these risks.

What the Market Is Missing: While Wall Street waits for the company to start collecting profits from its projects, Westar's stock has dropped more than 10% so far in 2008. Miller argues that Westar's high dividend yield, payout stability, and growth should be attractive for income-seeking investors, especially as credit concerns have threatened the viability of other income-producing stocks.

Telecommunications Indonesia
Moat: Narrow | Risk: Above Average | Price/Fair Value Ratio*: 0.63 | Three-Year Expected Annual Return*: 33.6%

What It Does: Telecommunications Indonesia (TLK) is the largest integrated telecommunications provider in Indonesia. It is the principal provider of fixed-line services in Indonesia, and its 65%-owned subsidiary, Telkomsel, is the largest wireless carrier in the country, with about 55% market share. The company services more than 50 million customers in the fixed-line and wireless markets combined. Singapore Telecom, Singapore's leading telecommunications provider, owns the remaining 35% of Telkomsel.

What Gives It an Edge: Morningstar analyst Jacqueline Zhang assigns Telecommunications Indonesia (Telkom) a narrow economic moat. As the incumbent telecom provider in Indonesia, the firm's extensive coverage and high-quality network have allowed it to dominate the country's fixed-line and wireless services with more than 50% share in both markets. Furthermore, the company continues to plow immense capital back into its networks to maintain its network quality. Zhang points out that the firm enjoys much higher revenue per user than its competitors, thanks to its affluent customer base. In addition, Telkom's high-spending clientele, along with immense scale advantages, has enabled the firm to consistently generate outstanding margins that are high among the most profitable wireless carriers in the world.

What the Risks Are: Telkom will likely see increasing competition in the near future. Also, the government's role as Telkom's majority shareholder, regulator, and major customer poses multiple conflicts of interest, which could hurt minority shareholders. Additionally, if regulators find Telkom too profitable, they could take steps such as reducing interconnection rates to lower profits. However, Zhang does not expect the government to take such actions as long as it remains Telkom's majority shareholder. Political and social instability in Indonesia also make long-term prospects unpredictable and could make the Indonesian currency volatile. The government has also been discussing the possibility of buying back shares of Telkom's competitor  Indostat (IIT), which could further misalign the interests of the government with those of shareholders if the buyback occurs.

What the Market Is Missing: Zhang thinks Telkom's stock has been beaten down in recent periods partly due to fear of a global slowdown caused by U.S. markets. Also, Zhang believes the market is concerned that increasing competition from new entrants such as Hutchison Telecom could hurt Telkom's business. While Zhang admits that greater competition could lead to some market share losses for Telkom, Zhang counters that the company will continue to dominate the Indonesian telecom industry because of its extensive presence and superior network quality, which are both difficult and expensive to replicate. Additionally, Indonesia's low wireless penetration coupled with its immense population presents immense growth prospects for the company.

Quest Software, Inc.
Moat: Narrow | Risk: Average | Price/Fair Value Ratio*: 0.72 | Three-Year Expected Annual Return*: 24.1%

What It Does: Quest Software (QSFT) develops and sells software development and management tools to enterprise software developers and system administrators. Quest's tools enable customers to fine-tune software applications and more effectively administer IT services. The company sells management tools for a variety of platforms and derives more than 35% of its revenues from international sales.

What Gives It an Edge: According to Morningstar analyst Sunit Gogia, recurring revenues from a large, loyal customer base give Quest Software a narrow economic moat. Quest Software provides software tools that enable IT personnel to improve the performance of software applications. Once deployed, these troubleshooting and management tools tend to be very sticky and are unlikely to be replaced unless they cease serving customers' needs. Customers pay Quest annual fees for access to technical support, thereby providing the company with recurring revenues from an installed base of more than 50,000 customers.

What the Risks Are: Quest's primary competitive risks are from improvements in free management tools provided by platform vendors and the more comprehensive product portfolios of its larger rivals. Additionally, Quest's growth strategy is heavily dependent on successful acquisitions, and is therefore inherently unreliable, in Gogia's view. Finally, market demand for Quest products depends on the market success of the platforms targeted by Quest's management tools, and is thus beyond the company's direct control.

What the Market Is Missing: Gogia believes Quest's recent issues with internal accounting controls have contributed to its lower stock price as investors flocked to safer investments. Quest was forced to restate earnings after a lengthy investigation regarding its stock option granting practices. The SEC has followed up by issuing Wells Notices, indicating the Commission's intention to file civil charges against current and former executives, including Vincent Smith, the CEO and chairman of Quest. However, Gogia argues that Quest's accounting issues are behind it and that the SEC action should not affect the company's revenues and earnings going forward, making the firm a solid long-term investment.

Other New 5-Star Stocks
Sanofi-Aventis (SNY)
AstraZeneca   (AZN)
Genuine Parts Company (GPC)

* Price/fair value ratios and expected returns calculated using fair value estimates, closing prices, and cost of equity estimates as of Friday, March 7, 2008.

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