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Eleven stocks that win Morningstar’s top buy rating

What in the world is the common thread running among the list of companies you see below? We see seven materials companies, including two of Canada's bigger miners, Iamgold Corp. and Yamana Gold Inc. But the remaining four are a hodgepodge of industries and geographies – and you may not even have heard of them at all.

-Exelixis Inc. (EXEL-Q)

-Lexicon Pharmaceuticals Inc. (LXRX-Q)

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-Alumina Ltd. (AWC-ASX)

-POSCO (A005490-KOSE)

-Compañía de Minas Buenaventura (BVN-N)

-Energy Resources of Australia Ltd. (ERA-ASX)

-Newcrest Mining Limited (NCM-ASX)

-Iamgold Corp. (IMG-T)

-Yamana Gold Inc. (YRI-T)

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-Pacific Brands Ltd. (PBG-ASX)

-Kingsgate Consolidated Ltd. (KCN-ASX)

Well, the 11 names above do share something. Of the 1,450 or so stocks covered by the U.S. research firm Morningstar, they are the only ones that merit a five-star rating, the company's strongest buy signal.

That, to do the math for you, is less than 1 per cent. It's also validation of the view that the market's remarkable rise has left us with few, if any, bargains.

Of course, you first need to buy in to Morningstar's research process. The Chicago-based company, independent of any investment bank, assigns its star ratings by comparing its estimate of a stock's "fair value" with its market price.

The public description of its methodology runs eight pages, so I'll try to summarize. Morningstar borrows from the Benjamin Graham/Warren Buffett school, and assigns an "economic moat" rating (a term it has trademarked) to each business based on its view of the company's competitive advantages. It then develops an estimate of future cash flows, based in part on that moat. The cash-flow estimate yields a fair value for the stock.

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Morningstar also assigns an "uncertainty rating" to each stock based on the volatility of its possible results. This is important, because the star ratings are based on a stock's discount to its fair value, but Morningstar requires a bigger discount for companies with greater uncertainty.

Here, then, is how it worked in August, 2011 (the example given in the Morningstar methodology document): Stocks with low uncertainty ratings required a 20-per-cent discount to fair value to get the five-star ranking, but stocks with a "very high" uncertainty required a 50-per-cent discount.

There's an awful lot going on in that process, so I'm sure some can pick and quibble with it. Certainly, some investors don't need that deep a discount to see a "buy" signal. (Four-star stocks, of which there currently are 219, require discounts of roughly 5 per cent to 20 per cent.)

But, again, these are the small handful of stocks that Morningstar sees as the most undervalued. A quick look at them:

The mining companies – mostly gold, but not all – generally have low to average costs in their mining operations and favourable capital structures, minimizing debt in the name of equity. (There are, Canadian investors know, some gold producers that are either at the wrong end of the cost curve, have borrowed too heavily, or both.) Morningstar uses futures contracts to estimate gold prices over the next three years, and then assumes a price of $1,255 (U.S.) an ounce in 2017.

Morningstar pegs Iamgold's fair value at $7.50, nearly twice its close of $3.88 Wednesday. Yamana Gold's fair value is $17, well above its close of $9.60. Two Australian miners – uranium producer Energy Resources of Australia Ltd. and gold miner Kingsgate Consolidated Ltd. – trade at roughly one-quarter of the Morningstar estimate of fair value, making them the deepest of the deeply discounted.

In the United States, where some of the hottest stock-market action has occurred over the past several years, Morningstar tabs just two companies. Both are biotechnology concerns with market capitalizations under $1-billion. Exelixis Inc. is a developer of cancer drugs whose stock took a hit last month when it said clinical trials for its primary product had to continue, rather than end early as a success. Lexicon Pharmaceuticals Inc. has several drugs in development but none on the market, and no revenue. (Both have "very high" uncertainty, unsurprisingly.)

By now, you may be deeply skeptical. Is the market really that overvalued? Broadly, Morningstar says, no: The ratio of stock price to fair value for is coverage universe is just 1.02, below the 1.06 in December and the record high of 1.14 in 2004.

That suggests stocks are fairly priced – so much so that screaming bargains are fairly scarce.

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