Morningstar covers more than 1,700 stocks, only 34 of which receive its highest five-star rating. Of those, the following 10 trade at a deep discount to fair value. As the economy gains steam, these companies' businesses will improve and their shares will reflect intrinsic value. The stocks are predicted to rise at least 49%, and as much as 120%, in the next year. Below, they are ordered by potential return, from good to great.
10. International Speedway promotes motorsport entertainment. The company owns 13 racetracks, including Daytona and Talladega. It hosts more than 100 events a year, generating sales from tickets, concessions, merchandise and broadcasting. It has a wide "economic moat", or sustainable competitive advantage, given its monopoly of big-name tracks and their annual events.
Using a discounted cash flow model, Morningstar estimates International Speedway's fair value at $38, implying 42% upside. The major risks to its investment thesis are a decline in the company's bargaining power, which will be necessary in 2014, when long-term media contracts are renegotiated, and a still cyclically-injured NASCAR fan base. Also, NASCAR television viewership declined in the past few years.
9. China Gerui Advanced Materials is a steel producer in China, using advanced technology to make higher value-added products.
It is operating at full capacity, but plans to expand and double output in 2011, a strategy being hampered by recent floods in Northern China. Morningstar isn't accounting for such expansion in its 25% 2011 growth estimate, indicating material upside to fair value. Gerui's inventory system is unique. It purchases steel based on customer orders, minimizing costs.
Morningstar's $10 fair-value estimate is consistent with 9.2 times 2011 earnings, a conservative valuation, especially considering China's materials appetite and Gerui's expansion plan. Morningstar's estimate implies that China Gerui's stock has 68% of upside or greater.
8. KB Home builds affordable houses for first-time and move-up buyers.
KB delivered 8,500 homes in 2009 at an average selling price of $207,000. It is focused in the Western, Southwestern and Southeastern U.S. Morningstar applauds its customizable and innovative product lineup. The U.S. housing market is still suffering from a glut of inventory, weakening the outlook for homebuilders, whose starts are in a trough.
KB's fiscal third-quarter orders fell 39%. Morningstar is critical of KB's plans to ramp up building amid slack demand. Still, it sees upside in KB's stock, estimating fair value at $21, consistent with a 69% return. With $1 billion of cash and $1.8 billion of debt, KB has one of the strongest balance sheets in its industry group.
7. Navigant Consulting is a specialty consulting firm with dispute, investigative, business and economic consulting practices.
Its large employee base (roughly 1,800 consultants) allows it to compete for lengthy engagements. Also, its historical relevance (the company was founded in 1982) and industry expertise lend it a narrow economic moat, according to Morningstar.
However, sales and margins are difficult to forecast since volume is sporadic. Typical within the industry, compensation is comparatively high, crimping profit potential. Also, billing rates are difficult to adjust, so growth is contingent upon hiring. Morningstar values Navigant's stock at $16, suggesting 69% of upside. Third-quarter profit missed consensus by 26%. The stock corrected 24% on the announcement.
6. First American Financial , spun-off of First American in June, is a title and specialty insurance company, based in California.
After rising to the top of the title-insurance industry, with a leading market share, First American was recently eclipsed by Fidelity National, which purchased the title-operations of bankrupt LandAmerica. The title insurance business is dependent upon the real estate market because it is issued only upon the purchase or refinancing of property. First American executed rapid cost-saving in 2007 and 2008. Its business is now lean and mean and poised to grow in the coming years.
However, a prolonged, depressed transaction level in the real estate market is the dominant risk to Morningstar's thesis and could keep the stock trading at a discount to its fair-value estimate of $26.
5. Dean Foods is the leading processor and distributor in the U.S. dairy market (with sales about five times as large as the second-biggest competitor's). Recently, higher commodity costs and competition have displaced its dairy segment.
According to Morningstar, many consumers traded down to private-label dairy during the recession and haven't returned to brand-name products. Dean is engaging in extreme cost-cutting and pricing strategies to protect profitability while regaining customers. A sizable debt load, with a debt-to-equity ratio of 2.7, and narrow operating margin, at just 3.3%, are obvious negatives. But, investors have abandoned Dean. It is the worst-performing S&P 500 stock of 2010, down 55%. Its cash flow multiple of 2.8 reflects an 80% packaged foods peer discount.
4. Vanda Pharmaceuticals has an unusual model for biotech. Rather than licensing internal research to larger pharmaceutical companies, it in-licensed two pipeline candidates from established peers. Fanapt, an anti-schizophrenia drug, was approved in May 2009 by the Food and Drug Administration. Thus, Vanda's strategy has worked so far, but it must pay hefty royalties on approved drug Fanapt to partner Novartis. Its other candidate, Tasimelteon, is for sleep and mood disorders, with potential applications for insomnia and depression.
Morningstar is less optimistic about Tasimelteon's potential than it is about Fanapt's. And Fanapt is entering a heavily contested anti-psychotic drug market. Nevertheless, prescriptions continue to strengthen on a month-over-month basis.
3. Vimicro International designs, manufactures and sells semiconductors in China. Specifically, it is the leading chipmaker for PC webcams and has enjoyed several design wins for mobile phones, which are rapidly proliferating.
The company also has a unit focused on surveillance camera chips. Although recent losses have hurt Vimicro's stock (it is down 31% in 2010), Morningstar expects a return to profitability in 2011, with an operating margin in the low- to mid-teens. A major issue is the lack of intellectual property enforcement in China, which threatens Vimicro's market share. Also, the semiconductor industry is subject to technological obsolescence and sharp cyclical swings.
Morningstar values Vimicro at $7 with a residual income model, implying the stock could nearly double.
2. Bridgepoint Education is a new entrant in the education market. Education companies, including Devry(DV) and Strayer(STRA), were outstanding investments in the recession and initial recovery, but they've recently been criticized by the press and are seeing increased regulation by the government. The stocks sold off sharply in 2010.
However, Bridgepoint remains a compelling growth story in this traditionally profitable industry. With 99% of students taking classes online, Bridgepoint has a lean cost structure and ample margins, due to inelastic demand for financial aid. Unemployment still near 10% abets the thesis for education stocks. However, declining enrollment is evident and expected to continue in 2011. Still, Morningstar is bullish.
1. AMN Healthcare Services provides temporary health-care workers.
The company focuses on the travel-nurse segment in the U.S. Its established network of nurses and strict educational and experience requirements lend the company a narrow economic moat, according to Morningstar. With baby-boomers aging and health care spending on the rise, the company is positioned for long-term growth. A shortage of nurses in the U.S. could eat into margins going-forward, but AMN has expanded its network into Europe, Asia and South Africa to meet excess demand within the U.S.
It has a permanent physician placement division, which enjoys a higher profit spread. AMN delivered a mediocre third-quarter, with organic revenue down 7%. Morningstar proposes a fair-value target of $13.