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Stock Strategist

What Sets This 5-Star Industrials Firm Apart

We think this narrow-moat firm is poised to gain nearly 30%.

Mentioned: ,

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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ABB, Ltd.
Moat: Narrow | FV Uncertainty: High | Price/Fair Value Ratio*: 0.63 | Three-Year Expected Annual Return*: 29.5%

What It Does: ABB (ABB) is a Switzerland-based provider of power and automation products and systems. Power products and systems represent approximately 30% and 18% of sales, respectively. Automation products and systems represent about 27% and 20% of sales, respectively. Robotics products represent approximately 4% of sales.

What Gives It an Edge: According to Morningstar analyst Daniel Holland, ABB's narrow moat is the result of its strong products in niche markets as well as the institutional knowledge that it possesses in managing large-scale power infrastructure projects. In Holland's view, ABB benefits because few firms can actually build a power plant (irrespective of the energy source), much less manage the process well. For example, Siemens (SI) ran into stumbling blocks on this front that ultimately caused the firm to take a charge of $1.3 billion. As Europe's dominant player in this field, Holland believes ABB is well positioned to take advantage of the coming infrastructure investments.

What the Risks Are: ABB's primary risk is its sensitivity to economic swings and cycles, particularly in Europe, where the company generates about half its sales. In addition, ABB generates about 14% of sales from China and India, which are currently growing rapidly. Should those markets experience a downturn in demand, ABB's sales growth would probably decline. Additionally, the company's shift from a strategy of internal growth to a strategy of growth by acquisition boosts the risk to equity investors.

What the Market Is Missing: Holland thinks strong recent sentiment that emerging-markets growth is slowing is the main culprit for ABB's weak stock price. He points out, however, that China, India, and the Middle East have quite a ways to go in their overall infrastructure to get anywhere close to parity with industrialized nations. Also, Holland thinks the aging infrastructure in developed economies has been overlooked by the markets, which should provide a solid growth foundation for ABB. For instance, in the United States, 70% of transformers are older than 20 years. As the need for replacement significantly increases at 30 years, Holland expects transformer demand in the United States to accelerate and spur the beginning of a long power infrastructure cycle. Additionally, Holland predicts that there will be robust demand coming from an increased focus on renewable energy, such as linking wind and solar sources to existing energy grids.

*Price/fair value ratios and expected returns calculated using fair value estimates, closing prices, and cost of equity estimates as of Friday, Sept. 5, 2008.

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