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The Hottest Stocks This Year

Some surprising names have performed well this year--and they have room to run.

John Coumarianos, 04/29/2008

This quarter, we decided to focus exclusively on wide-moat stocks for our hot stocks article. As a refresher, a wide-moat rating denotes a business with a sustainable competitive advantage, and one that Morningstar equity analysts think can achieve returns on capital that outstrip its cost of capital for the foreseeable future. Less than 10% of the stocks in our 2,000-stock coverage universe garner this rating.

Despite a volatile a market, we managed to find some wide-moat stocks that distinguished themselves as relatively hot performers for the first quarter of 2008. We screened for stocks that eked out gains of at least 4% for the trailing three months through April 17, and we limited our scope to those that still trade at 65% or less of our analysts' fair value estimates.

While we had many energy names on our last list, gains in the energy patch, especially among natural-gas producers, rendered many firms in that sector too expensive to make our current list. This time, we were surprised to find some financials and retailers, a media outlet, and a cement/aggregate producer. Here they are, in alphabetical order:

Allied Irish Banks AIB
Trailing three-month return through April 17: 4.8%
Economic Moat: Wide
Fair Value Uncertainty: Medium
Price/Fair Value: 62%
Equity analyst Erin Davis anticipates a slowdown on the Emerald Isle but still thinks the conservatively run Allied Irish Banks will ride out the storm with minimal damage. Allied Irish and its competitor Bank of Ireland IRE control more than 70% of the Irish market for personal accounts. The firm's duopoly status and Ireland's strict banking regulations, which make it difficult for competitors to take share, constitute the firm's moat. Allied Irish avoids 100% mortgage exposure and has a 45% average loan/value ratio on its mortgage portfolio. Additionally, the firm stress-tests its mortgages, assuming a 2-percentage-point rise in interest rates. Davis thinks these policies will moderate increases in nonperforming loans as property markets cool off. Finally, the bank's ability to provide a high level of service to its customers abroad has allowed it to achieve double-digit growth in oligopolistic markets where it isn't a dominant player.

American Express Company AXP
Trailing three-month return through April 17: 5.2%
Economic Moat: Wide
Fair Value Uncertainty: Low
Price/Fair Value: 64%
American Express is the most successful "closed-loop" credit card network in the United States. Instead of splitting profits with other outfits that process transactions, it owns the entire value chain of a card transaction. Additionally, American Express cardholders spend around $11,000 per year on their cards, allowing the firm to charge merchants a hefty fee for each transaction. Most recently, the firm has decided to open up its loop by allowing banks to issue its cards to clients. Equity analyst Michael Kon thinks this is a good move, since it will help the firm reach more clients and spur wider acceptance of the card among merchants. Although this could take the firm's focus away from its high-net-worth clients, Kon doesn't think the firm is abandoning its core or endangering its moat by doing this.

Home Depot HD
Trailing three-month return through April 17: 8%
Economic Moat: Wide
Fair Value Uncertainty: Low
Price/Fair Value: 64%
Although a slowing housing market is taking its toll on this retail home-improvement behemoth, equity analyst Brady Lemos thinks Home Depot will weather the storm. The firm's wide moat consists of its scale advantages and prime real estate portfolio. After concentrating for years on acquiring wholesale distributors under its former embattled CEO Robert Nardelli, the firm is refocusing on its retail operations. It is aggressively reinvesting in its stores, refining its supply chain, adding more full-time sales staff, and trying to cater to more profitable professional customers. Home Depot has taken on some debt with an eye toward buying back stock, and Lemos thinks the firm's balance sheet can handle the additional stress. The near-term looks difficult for this retailer, but it should emerge from the housing slump in fine shape.

Lowe's Companies, Inc. LOW
Trailing three-month return through April 17: 12.9%
Economic Moat: Wide
Fair Value Uncertainty: Low
Price/Fair Value: 63%
As with its competitor, Home Depot, the difficult housing market is exacting a toll on home-improvement retailer Lowe's. However, Lemos thinks the firm will continue to gain market share in the still-fragmented home-improvement market. Lowe's boasts industry-leading customer service, shopper-friendly stores, and a proven business model to expand profitably both domestically and abroad. Lowe's has kept its stores well-staffed and has consistently beaten Home Depot in customer satisfaction ratings. Lemos is pleased that the firm is concentrating on its core retail strategy by opening new stores in the United States, Canada, and Mexico (the latter beginning in 2009). Taking share from Home Depot won't be easy, but with 10% of the market, Lowe's can leverage its strong customer service scores into a greater piece of the home-improvement pie. 

Time Warner Cable TWX
Trailing three-month return through April 17: 4.8%
Economic Moat: Wide
Fair Value Uncertainty: Medium
Price/Fair Value: 64%
Equity analyst Michael Hodel thinks Time Warner Cable's combination of scale and network quality puts it a cut above the average cable firm and forms the basis of its wide moat. After splitting Adelphi's assets with Comcast CMCSA, TWC now serves nearly one fourth of all households in the United States. Additionally, TWC and Comcast swapped operations, giving both firms tighter geographic focus. After these moves, Hodel thinks TWC now is well-positioned to consolidate the cable industry, with the ability to add to its scale at attractive prices. TWC is able to offer more services to its customers than any other firm in the majority of its markets. Although  AT&T T and  Verizon VZ have begun to compete to provide voice, data, and video through one line, their progress has been slow. Additionally, Hodel thinks the cost of upgrading their systems and the need to generate returns on their investments will prevent the telephone companies from engaging in a destructive price war with their cable competitors. The future looks bright for TWC.

Vulcan Materials VMC
Trailing three-month return through April 17: 8.1%
Economic Moat: Wide
Fair Value Uncertainty: Medium
Price/Fair Value: 49.8%
Vulcan Materials' moat is based on its location, according to equity analyst Matthew Warren. Sand, gravel, and stone are difficult to transport cheaply, meaning the producers in areas undergoing development will profit handsomely. Indeed, Vulcan owns quarries in nine of the 10 fastest-growing cities in the nation. Additionally, the noise, dust, and truck traffic endemic to quarries means permits are elusive, further solidifying Vulcan's position by insulating it from competition. Vulcan's size also gives it an advantage in negotiating with plant and equipment suppliers, allowing it to ration new supply to the market before a new entrant can make progress. Finally, although the firm's exposure to homebuilding has hurt it a bit recently, Vulcan profits from public infrastructure projects, which are politically popular for the jobs they create and tangible benefits they confer on constituents.

John Coumarianos is a stock analyst with Morningstar.

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