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Five Great Innovators at Great Prices

These companies know what it takes to stay fresh.

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As the famed growth investor Philip Fisher stated in his seminal work Common Stocks and Uncommon Profits, the truly worthwhile accomplishments in the business world nearly always require a considerable degree of pioneering, in which ingenuity has to be seasoned with practicality. This probably seems like plain common sense to most readers, but these words bring us to the core of a key business question: How does a business continue to grow decade after decade, even as its products become obsolete after a few years?

Often, the underappreciated answer is "research and development." R&D isn't all lasers and rocketships; it can be incredibly frustrating and risky (just ask  Pfizer (PFE)). Money goes out the door to hire scientists and conduct studies, and it may never come back in the form of new products and profits. The SEC now makes companies expense R&D immediately, taking a bite right out of net income. In this backdrop, it may be tempting for investors to demand cuts in the R&D budget, especially for struggling companies, as this would produce an immediate improvement in margins and cash flows. However, this move is often shortsighted, akin to dumping fuel out of a plane in order to fly higher and faster. It might work, but only until the plane plummets into the unforgiving ground.

R&D is a critical component of a company's growth engine. Properly conducted, it will keep competitors at bay and help grow profits year after year. Continuous innovation capitalizes on a company's existing intellectual property and actually widens a company's lead versus its competitors, strengthening its economic moat. The resulting profits can then be reinvested back into the business, creating a virtuous cycle. However, if improperly done--either through bad luck or incompetence--R&D can also be a huge drain on company resources. The trick is to find companies that have active R&D programs that continue to successfully innovate. These tend to be companies with great competitive advantages that are widening their leads against competitors, with room to grow year after year.

To achieve this, we have created a screen with these criteria:

  1. R&D expenditures greater than 10% of sales for each of the last three years
  2. Return on equity greater than 15% per year for each of the last three years
  3. Morningstar Rating of 4 stars or better

Screening for a consistently high return on equity is critical. Although not perfect, this metric will help weed out companies that tend to waste their R&D dollars, or companies without viable products to begin with, such as speculative biotechs. Although this will miss some situations--such as startup companies on the verge of a major breakthrough--we can greatly simplify the situation for prospective investors by focusing on proven companies.

Here are a few undervalued companies we've uncovered using this screen:

Applied Materials
Moat Rating: Wide | Fair Value Uncertainty Rating: Medium | Morningstar Rating: 5 Stars

From the Analyst Report: " Applied Materials (AMAT) is the behemoth of the semiconductor equipment industry, with its unmatched scale and broad product portfolio... It is the dominant player in a fragmented industry and...competes in nearly every segment of the market, giving the firm a near-ubiquitous presence in chip production."

Autodesk Inc.
Moat Rating: Wide | Fair Value Uncertainty Rating: Medium | Morningstar Rating: 5 Stars

From the Analyst Report: " Autodesk (ADSK) will continue dominating the market for computer-aided design (CAD) software. The company has more than 8 million CAD users, making its products the de facto standard in digital design... Customers reduce production costs by using AutoCAD to digitally design, simulate, and analyze products before moving to physical production."

Blackbaud Inc.
Moat Rating: Narrow | Fair Value Uncertainty Rating: Medium | Morningstar Rating: 5 Stars

From the Analyst Report: "As the dominant provider of fundraising and operations management software to nonprofit organizations,  Blackbaud (BLKB) is very well-positioned to continue growing profitably and creating shareholder value. Blackbaud's most popular and profitable product is The Raiser's Edge... Once customers start using Raiser's Edge, the product stores and analyzed all donor data, making it hard to switch to rival products."

Ctrip.com International Ltd. 
Moat Rating: Narrow | Fair Value Uncertainty Rating: Medium | Morningstar Rating: 4 Stars

From the Analyst Report: "As the dominant player in Chinese online travel booking,  Ctrip (CTRP) benefits from a fast-growing yet highly fragmented market... The firm's strong execution has enabled it to build the largest customer base in China and a network of 6,000 hotels domestically and 25,000 hotels abroad. We have high hopes for Ctrip's air ticketing services as the mandated rollout of e-ticketing in China should provide a level playing field for ticket bookers."

Mentor Corporation
Moat Rating: Narrow | Fair Value Uncertainty Rating: High | Morningstar Rating: 5 Stars

From the Analyst Report: "With several antiwrinkle products in development,  Mentor (MNT) looks poised to take an ever greater share of the plastic surgery market in the years to come. We credit the firm with a narrow economic moat, owing to its specialized salesforce and 50% share of the U.S. breast implant market."

To run this screen and see all the stocks that passed,  click here. Note: The stocks mentioned above passed our screen as of July 30, 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.