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Stock Analyst Update

Two 5-Star Stocks That Fly under the Radar

These stocks offer 20%-plus expected returns.

Mentioned: , , , ,

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.

Webster Financial Corporation
Moat: Narrow | FV Uncertainty: Medium | Price/Fair Value Ratio*: 0.73 | Three-Year Expected Annual Return*: 22.6%

What It Does: Webster Financial (WBS) operates more than 180 branches in Connecticut, Massachusetts, Rhode Island, and New York. The bank makes residential mortgage, consumer, business, and commercial real estate loans. Assets totaled approximately $17 billion as of December 2007. The bank was founded in Waterbury, Conn., by 24-year-old Harold Webster Smith in 1935.

What Gives It an Edge: Morningstar analyst Jim Sinegal believes Webster's access to low-cost deposit funding and relatively high switching costs for depositors provide the firm with a narrow economic moat. As evidence of its advantages, Webster's return on equity averaged 11% over the past seven years, slightly in excess of its 10.5% cost of equity. Also, the bank's affluent Northeastern customers contribute to a mortgage portfolio of the highest quality. The weighted average credit score within the portfolio is a lofty 784 and loan/value ratios average 64%, leaving more than a third of a home's value as excess collateral. With such high standards in residential mortgage lending, Sinegal argues that credit losses over the long term are likely to be minimal.

What the Risks Are: Despite its proximity to desirable customers, Webster pursued growth in home equity and wholesale construction loans outside its footprint. Management discontinued these risky programs, but an overly aggressive strategy could lead to more problems with credit quality down the road.

What the Market Is Missing: Sinegal thinks Webster's exposure to riskier loans is to blame for recent weakness in the firm's share price. In an effort to boost profitability, the firm started making wholesale home equity and construction loans. However, the credit quality of these loans quickly deteriorated and the firm was forced to discontinue these operations. Now that Webster has redirected its attention back to its current retail customers, Sinegal contends that the firm is better able to withstand an economic downturn. Sinegal points out that Webster's Tier 1 capital ratio remained strong at the end of the first quarter at 7.88%, and the firm outearned its dividend by 50% despite a bad year in 2007. Additionally, Webster is embarking on a cost-cutting program similar to the one that helped PNC Financial (PNC) reduce expenses by about $300 million per year.

Carlisle Companies, Inc.
Moat: None | FV Uncertainty: Medium | Price/Fair Value Ratio*: 0.63 | Three-Year Expected Annual Return*: 28.6%

What It Does: Carlisle Companies (CSL) is a diversified manufacturing conglomerate operating in five business segments. Its products include roofing membranes, nonautomotive tires and wheels, truck trailers, off-highway brakes, food-service products, and high-performance wire and cable, among other things. The company derives more than 90% of its revenues from the U.S. market..

What Gives It an Edge: Strong competition within Carlisle's various industries prevents Morningstar analyst Min Ye from crediting the firm with an economic moat. That said, Carlisle is one of only a few firms in the roofing industry (50% of its total sales), as difficult-to-replicate distribution networks keep new firms from entering the market. Also, due to its operational efficiency and well-executed acquisitions, Ye points out that Carlisle has delivered an impressive record of profitability for 15 straight years, in spite of its mostly cyclical markets.

What the Risks Are: A potential investor should be aware that Carlisle bears various execution and integration risks as an acquisitive manufacturing conglomerate. In rebalancing its portfolio for growth opportunities, Carlisle risks buying businesses at cyclical highs and selling at cyclical lows. Moreover, Carlisle's results are dependent on various forces that are outside of the company's control, such as raw-material prices and weather.

What the Market Is Missing: Ye believes Carlisle's stock was punished along with the general slowdown in the commercial and residential construction markets. However, Ye argues that the roofing industry is less cyclical than the construction industry in general because 70% of all roofing projects are for existing homes or buildings. Moreover, Ye has identified a secular growth trend in the adoption of single-ply roofing over traditional asphalt roofing, which is being driven by the demand for increased energy efficiency. Carlisle is a market leader in single-ply roofing, where its heat-reflective TPO product has steadily gained market share. Also, building codes are expected to incorporate even higher energy efficiency requirements for commercial construction in the next few years. Ye thinks this will further increase demand for Carlisle's single-ply roofing membranes. Lastly, Ye points out that Carlisle is covered by only a handful of sell-side stock research firms, so it's likely flying under Wall Street's radar.

More New 5 Star Stocks
Satyam Computer Services, Ltd. (SAY)
Gold Fields Limited (GFI)

* Price/fair value ratios and expected returns calculated using fair value estimates, closing prices, and cost of equity estimates as of Friday, April 25, 2008.

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