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Stock Strategist

Five Underdiscovered Fast-Growing Companies

Walk the road less traveled with these potential growth stocks.

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When people hear the term "growth stock," a few old, reliable standbys may immediately spring to mind:  Microsoft (MSFT),  Johnson & Johnson (JNJ),  General Electric (GE),  Medtronic (MDT), and  IBM (IBM), among others. Some people might then shake their heads and sigh, "I almost bought that little company called Microsoft in 1986! If only I had!"

It's been many a year since the above companies were brash upstarts eager to prove themselves, waging guerilla warfare against the goliaths in their respective industries. Against long odds, they prevailed and in the process dug enviable moats around their domains, laying a foundation that might allow them to expand for decades to come. However, one might be forgiven for thinking that the glory days of these giants are over. Despite steadily increasing revenue and profits, investor returns in these companies range from 3.4% per year over 10 years for GE, to 8.5% per year for IBM. This isn't bad at all when compared with the paltry 2.3% compounded return racked up by the S&P 500, highlighting the strengths these franchises possess. However, these results won't exactly inspire bubbly letters to Grandma either.

At Morningstar, we think some of these powerful stalwarts are underpriced and will make solid holdings for many investors. However, we do our best to find the next-generation of titans, as well. This is a daunting challenge, and we don't promise to find the next Microsoft, but we think we have devised a pretty good place to start. We examine stocks by using a screen with three simple criteria:

1. Increasing operating income by at least 15% per year for the last three years
2. A 4- or 5-star rating by Morningstar
3. Less than 6% of shares owned by mutual funds

The first two criteria are fairly self explanatory. We want companies with a solid record of growth. But we want to avoid fly-by-night companies, or companies with business models that may fall apart at any second. More importantly, we want to buy these businesses for a decent price. However, it is the last criterion that adds a little spice to the mix. By focusing on companies little-known to mutual funds (which we use as a proxy for institutional investors), we stand a much better chance of picking up some quality franchises early in their life cycles, potentially reaping some rich rewards.

Granted, this screen isn't perfect. For example, it may pick up some cyclical companies approaching their peaks. Also, past growth is not always indicative of future growth. However, we think this is a fairly fertile hunting ground from which to scout some interesting firms, a few of which we will highlight below. As you will see, this list is filled by international companies, which is perhaps a consequence of the recent weakness in emerging markets. All of these companies file their financials with the SEC, allowing U.S. investors to assess and take advantage of the situation.

 Central North Airport Group (OMAB)
Moat Rating: Wide | Fair Value Uncertainty Rating: High | Morningstar Rating: 5 Stars
From the  Analyst Report: "Grupo Aeroportuario del Centro Norte (OMA) continues to reap the rewards from increasing Mexican air traffic with its geographic stranglehold on airports throughout central Mexico� Recently, new low-cost Mexican airlines have helped to drive robust passenger growth through OMA's airports, and we expect this trend to continue. These new carriers strongly benefit OMA, as more than 80% of its passengers are domestic."

 Telecommunications Indonesia (TLK)
Moat Rating: Narrow | Fair Value Uncertainty Rating: High | Morningstar Rating: 5 Stars
From the  Analyst Report: "Although competition is growing in Indonesia's telecom industry, we believe that Telekomunikasi Indonesia's (Telkom) advantages will allow the firm to maintain its dominance� The country's wireless customer base doubled to about 60 million in less than three years. Despite this expansion, wireless penetration rates remain low, at about 35%, presenting tremendous growth opportunities� As the incumbent telecom carrier and market leader in Indonesia, Telkom enjoys significant scale advantages that its competitors lack."

 China Medical Technologies, Inc. (CMED)
Moat Rating: Narrow | Fair Value Uncertainty Rating: High | Morningstar Rating: 4 Stars
From the  Analyst Report: "Riding the wave of a government commitment to heal the ailing Chinese health-care industry, China Medical Technologies has leading technology and cost advantages that give it an edge over its competitors� Growth has also been driven by the need for product upgrades because, among the 175,000 hospitals and clinics, about 15% of their medical devices were made in the 1970s."

 Satyam Computer Services (SAY)
Moat Rating: Narrow | Fair Value Uncertainty Rating: Medium | Morningstar Rating: 4 Stars
From the  Analyst Report: "As the fourth-largest India-based information-technology firm, Satyam is often misunderstood. Most of its revenue comes from on-site or near-shore delivery, so its operating margins are low compared with its Indian peers (about 20%), but its returns on invested capital are still stellar at about 50%... We are fans of Satyam's strategic positioning, with its offerings spanning the IT services value pyramid, from business process outsourcing to application maintenance and development to consulting."

 Home Inns & Hotels Management, Inc. (HMIN)
Moat Rating: None | Fair Value Uncertainty Rating: Medium | Morningstar Rating: 4 Stars
From the  Analyst Report: "Since opening its first budget-minded hotel in 2002, Home Inns has expanded to 200 properties sprinkled throughout China� Not surprisingly, Home Inns is not the only game in town. Domestic competitors, such as Jinjiang Star and Motel 168, along with international brands, such as Wyndham Worldwide's (WYN) Super 8, and Accor's Ibis, are all going after the same economy market. This intense competition will make it increasingly difficult for Home Inns to secure the best locations and may lead to overbuilding� Nevertheless, the market is clearly big enough to support several major players, and we believe Home Inns will be one of them."

To run this screen and see all the stocks that passed,  click here. Note: The stocks mentioned above passed our screen as of May 14, 2008. The results of the screen may change because of daily price fluctuations or other factors. After clicking, you can save the search to use later by clicking the "Save Criteria" button in the bottom right-hand corner of the screen. (You will need to be logged in as a Premium Member to view and save the complete screen.)

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