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Bargains Still Exist--Even in This Market

Here are three growth stocks that we think are attractively priced.

Haywood Kelly, 11/14/2006

Morningstar's 100 stock analysts cover 1,800 companies. Their full analyst reports are available through Morningstar Principia Stocks Advanced and Morningstar Advisor Workstation Office Edition.

Since we launched the Morningstar Rating for stocks in 2001, there have been three extended periods when we thought stocks in general were bargains: immediately after 9/11, the period from the spring of 2002 to the spring of 2003, and, most recently, the middle months of 2006.

This third period was the least extreme of the bunch--the median stock we cover was 4% undervalued in July, which is hardly something to get excited about--and it appears to have come to a close. The median price/fair-value ratio of our coverage universe now stands at 1.03, meaning that the median stock we cover is 3% overvalued, in our view. The number of stocks with 5-star ratings--our highest rating--has dropped to less than 100, which is only 5% of our coverage universe.

Where have all the 5-star stocks gone? To a large extent, the stocks of high-quality companies have appreciated nicely. Many of the stocks that have long dominated the 5-star list are no longer there, including Wrigley WWY, Johnson & Johnson JNJ, and CarMax KMX. Even Coca-Cola KO, which had been 5 stars for more than two years running, has appreciated enough to shed a star.

What's an Investor to Do?
We're not fans of making wholesale shifts in and out of the market based on overall stock-market valuations. But we do advocate regularly rebalancing portfolios to make sure it doesn't drift away from you. One reason we're skeptical of shifting money wholesale in and out of the market is that there's usually something out there that's attractively priced. Even if the vast majority of stocks we cover don't look particularly interesting right now, there are still around 100 5-star stocks, after all.

And many of those belong to high-quality companies. As you can see in the table below, although wide-moat stocks trade at a price/fair value that's at a 52-week high, they're still the cheapest group.

 Price/Fair Value Estimate by Moat Rating

Price/Fair Value

Morningstar Coverage Universe
Wide Moat
Narrow Moat
No Moat
Data as of 11-06-06

Below, I've listed three wide-moat companies still solidly in 5-star territory. We own two of them in the Hare portfolio that appears in Morningstar StockInvestor. (The Hare focuses on stocks with wide moats and high-return potential.) The third stock, Fastenal FAST,is a holding in our Morningstar GrowthInvestor portfolio. Each company is increasing its revenues at a double-digit pace and has plenty of room for further growth, in our opinion.

If you're holding stocks that have appreciated to fair value or beyond, these would be promising candidates to plow your sales proceeds into. PAGEBREAK

Western Union WU
Business Risk: Below Average
Economic Moat: Wide
From analyst Mark Weber's updated report on Oct. 25: "After reviewing Western Union's third-quarter results, we are maintaining our $32 fair value estimate. Total revenue climbed 13% through the first three quarters of the year, driven by a 27% increase in consumer-to-consumer transactions and a 15% increase in consumer-to-business transactions. We continue to expect 12% revenue growth for the full year. The firm's operating margins were a bit lower than we expected, but the difference wasn't enough to move the needle on our fair value estimate."

Business Risk: Below Average
Economic Moat: Wide
From analyst John Owens' updated report on Oct. 19: "After reviewing eBay's third-quarter results, we are keeping our fair value estimate at $45 per share. Overall, the company's performance was in line with our expectations, as revenue and underlying earnings per share both increased 31%. EBay's forecast for 2007 (calling for growth of 17%-21% on the top line and 20%-plus in earnings per share) was a little below ours. However, management plans to refine its outlook in January, after gaining additional insight into the business's performance over the important holiday shopping season, its rebalancing initiatives in the U.S. marketplace, and the progress of new offerings, including eBay Express and its advertising partnership with Yahoo YHOO. We expect the company will beat its initial targets for next year. Even if we incorporated management's more cautious guidance into our discounted cash-flow model, the shares would remain significantly undervalued, in our opinion."

Fastenal FAST
Business Risk: Below Average
Economic Moat: Wide
From analyst Matthew Warren's update on Oct. 11: "Fastenal reported solid third-quarter results Wednesday, with sales and earnings up 16.9% and 17.8%, respectively, from last year. Management continues to press forward with growth-oriented investments, while focusing on cost controls in other areas. While selling costs and inventory levels are still creeping higher (as a percentage of sales) as the firm bulks up sales teams, delivery fleets, product selection, and store hours at existing high-potential branches, the firm has managed to improve gross and operating margins by hauling more of its freight internally and increasing direct sourcing of less brand-intensive products. Fastenal also continues to have success opening new stores at a rapid clip and improving accounts receivable collection. We are impressed by the firm's long-term focus, ability to respond quickly to its markets, and aggressive pursuit of profitable growth. We're maintaining our $53 fair value estimate."

Haywood Kelly, CFA, is chief of securities analysis at Morningstar.He has a position in the following securities mentioned above: KMX and EBAY.

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