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Stock Strategist

After Five Years, This Firm Finally Hit 5 Stars

This stock offers 20%-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.

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Laboratory Corporation of America Holdings
Moat: Narrow | FV Uncertainty: Medium | Price/Fair Value Ratio*: 0.74 | Three-Year Expected Annual Return*: 21.3%

What It Does: Laboratory Corporation of America (LH) is the nation's second-largest independent clinical laboratory, with about 20% of the independent lab market. The company operates more than 1,600 patient-service centers, offering a broad range of clinical lab tests, ranging from routine blood and urine screens to complex oncology and genomic testing.

What Gives It an Edge: Morningstar analyst Jeffrey Stafford believes LabCorp's vast national infrastructure gives it scale advantages over small regional labs and is the base of the company's narrow economic moat. LabCorp and competitor Quest Diagnostics (DGX) operate in the independent diagnostic-services industry as a duopoly; jointly the two players control more than 50% of the market. According to Stafford, LabCorp's network also makes the firm an attractive partner for large managed-care organizations that value the cost efficiency provided by large-scale automated testing. LabCorp has been adding to its infrastructure advantage by acquiring regional labs, a trend Stafford expects will continue.

What the Risks Are: LabCorp faces intense competition from its larger rival, Quest. Increased pricing pressure from managed-care providers and the government remains a challenge for both companies, as payers try to rein in rising health-care costs. As point-of-care testing becomes more widely available, LabCorp could see volume decline in routine testing. Drugstores could also put a dent in the company's routine test volume by adding diagnostic facilities in their locations.

What the Market Is Missing: Stafford thinks investor concerns over the lower-than-average pricing terms of LabCorp's deal to be the exclusive provider of testing services to UnitedHealth Group (UNH) has kept a lid on LabCorp's share price the past few years. In short, by accepting subpar pricing to secure higher volumes from UnitedHealth, Stafford believes LabCorp spooked the market into thinking that a long-term precedent had been set, possibly leading to future bidding wars between diagnostic firms and lower industry profitability. While Stafford acknowledges that the company's relationships with managed-care providers have undergone a significant transformation over the past few years, he disagrees with those worried that the bargaining power in contract negotiations has forever shifted to large managed-care organizations. In Stafford's opinion, LapCorp's deal with UnitedHealth is a unique situation aimed at expanding the company's footprint in the valuable Northeast market. As such, Stafford expects pricing behavior at the firm to revert to the industry norm in the long run, stabilizing LabCorp's revenue growth and cash flows and making the firm a bargain at today's prices.

* Price/fair value ratios and expected returns calculated using fair value estimates, closing prices, and cost of equity estimates as of Thursday, July 3, 2008.

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