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Stock Strategist

Look to These 5-Star Stocks for Big Returns

These stocks offer 15%-plus expected returns.

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Following is a sampling 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.

To get a  complete tally of stocks that have recently jumped to 5 stars--as well as our  full list of 5-star stocks--including our consider buying and selling prices, risk ratings, and moat ratings--simply take Morningstar Premium Membership for a test spin. Click here to sign up for a free trial.

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.

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.

Another New 5-Star Stock
AstraZeneca   (AZN)

* 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.