Four Stocks That Should Return at Least 15%

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.

To get a  complete tally of stocks that have recently jumped to 5 stars--as well as our  full list of 5-star stocks--including our consider buying and selling prices, risk ratings, and moat ratings--simply take Morningstar Premium Membership for a test spin. Click here to sign up for a free trial.

Bayer
Moat: Narrow  | Risk: Avg  |  Price/Fair Value Ratio: 0.74  |  Three-Year Expected Annual Return: 20.8%

What It Does:  Bayer  operates major business segments: health care, material science, and crop science. The company's health-care unit offers prescription drugs including Betaseron for multiple sclerosis, the antibiotic Avelox, and the fertility control medication Yasmin. Over-the-counter products include Aleve, One-A-Day vitamins, and the famous Bayer aspirin.

What Gives It an Edge: Morningstar analyst Tom D'Amore thinks that Bayer has several competitive advantages that support its narrow moat. The company offers world-class chemistry research and development expertise that it deploys across all three of its major business segments. A second crucial competitive advantage is the company's decentralized management structure. Bayer operates three independent service units that provide the company's plant construction, engineering and maintenance, and information technology support. The service units operate with an independent profit and loss statement and outsource excess capacity to outside companies. The structure helps to keep overhead costs from dragging down operating margins. Third, the breadth and depth of Bayer's health-care business is also a crucial competitive advantage. Bayer is a top-tier supplier of branded pharmaceutical drugs, over-the-counter pharmaceuticals, and diagnostic medical products. The diversity of its health-care business provides stability to its revenue streams and allows for substantial cross synergies in R&D and distribution among the health-care sub-units.

What the Risks Are: D'Amore thinks that Bayer poses average business risk, meaning that he'd invest in the shares at a moderate discount to his fair value estimate. Bayer faces pipeline failure risk. If one of its major drugs in late-stage testing were to fail, the stock price would likely be impacted immediately, although to a lesser extent than a pure pharma company. Bayer's crop science business is subject to swings in sales based on unpredictable global agricultural developments, including crop prices.

What the Market Is Missing: D'Amore believes the market is missing two factors that he thinks will drive Bayer's stock price higher. First, the company's prescription drug pipeline is in excellent shape. Nexavar for kidney cancer recently received FDA approval and is being tested for additional indications, including liver and skin cancer. Rivaroxaban, a promising new drug for hypertension, is in Phase III testing. The company also has eight other drugs in late-stage testing that are potentially significant revenue contributors. Second, D'Amore believes Bayer has excellent prospects for operating margin improvement. The company is capturing substantial operating leverage due to its decentralized operating structure and has been able to negotiate more flexible contracts with its labor unions than many European companies in the manufacturing sector. D'Amore thinks that Bayer will generate operating margins of 15% this year (up about 1 percentage point from 2006 after adjusting for nonrecurring items) and boost operating margins by another 4 percentage points by 2010.

Moody's
Moat: Wide  |  Risk: Below Avg  |  Price/Fair Value Ratio: 0.82  |  Three-Year Expected Annual Return: 16.0%

What It Does:  Moody's (MCO) publishes credit opinions, research, and ratings on fixed-income securities, issuers of securities, and other credit obligations. It has offices in foreign countries and is expanding into developing markets through joint ventures or affiliations with local rating agencies. Customers include corporate and governmental issuers of securities as well as investors, depositors, creditors, investment banks, commercial banks, and other financial intermediaries.

What Gives It an Edge: Two dominant players, Moody's and Standard & Poor's, claim about 40% apiece of the credit rating market. In Morningstar analyst Michael Corty's opinion, the credit-rating business is a naturally concentrated market because, while most debt products require two independent ratings, both debt issuers and investors want to use as few rating agencies as possible. Debt issuers, for instance, want to limit the time they must spend with credit analysts. Investors, for their part, favor fewer voices to many, because excessive competition could lead issuers to choose the agency that provides the highest rating or the lowest price.

What the Risks Are: Corty believes that Moody's poses below-average business risk. Unfavorable changes in the volume of debt securities issued would have a negative impact on Moody's financial results. The company faces litigation from time to time from parties claiming damages related to ratings actions. As Moody's international business expands, these types of claims could increase as foreign jurisdictions may not have legal protections or liability standards comparable with those in the U.S.

What the Market Is Missing: In Corty's view, the stock price has fallen in reaction to the recent tightening of the credit markets and worries about potential litigation risk (from parties claiming damages related to the firm's rating actions--in particular, the company's ratings on residential-mortgage-backed securities and related credit derivative products). Yet, the company has faced litigation in the past and has yet to suffer a material loss. The firm is viewed by the courts as a publisher and is protected by the First Amendment, which allows for freedom of speech in publishing its ratings opinions. Thus, Corty doesn't think Moody's will be held materially liable for its rating opinions. Of course, if the credit markets continue to tighten for an extended period, Moody's revenue will decelerate from its robust levels of the past several years. Corty thinks revenue from publishing ratings on structured finance products such as credit derivatives could face some headwinds over the near team to mid-term; however, he's confident in his long-term valuation assumptions for Moody's.

Morgan Stanley
Moat: Wide  |  Risk: Avg  |  Price/Fair Value Ratio: 0.76  |  Three-Year Expected Annual Return: 24.4%

What It Does:  Morgan Stanley (MS) is a large investment bank organized in three segments. Its institutional securities group focuses on capital raising, financial advisory, corporate lending, trading, and proprietary investing. Global wealth management has more than 8,000 financial advisors, one of the largest brokerage networks in the U.S. The asset-management group operates under the Morgan Stanley and Van Kampen brands. In 2006, the group managed more than $470 billion in client assets.

What Gives It an Edge: In Morningstar analyst Ryan Lentell's view, Morgan Stanley's moat lies in its investment banking unit, which is among the best on Wall Street. The division delivered a 30% return on equity last year. CEO John Mack is currently working to streamline Morgan, centering its strategy on the core investment bank. To that end, he has been divesting businesses like  Discover (DFS), which do not provide obvious synergies, while focusing on groups, such as wealth management, that provide product distribution capabilities for the bank. Going forward, Lentell believes this should only help to further solidify the firm's moat as it eliminates distractions of the past.

What the Risks Are: Lentell thinks that Morgan Stanley is an average-risk business. Similar to other investment banks, Morgan's main risks are associated with a downturn in the capital markets. A prolonged slump would probably hurt almost all aspects of the firm's business. In a downturn, investment banking revenue, trading volume, and assets under management would decline, while credit quality in corporate lending would deteriorate. Additionally, the company is subject to various types of legal risk, as investors are always on the lookout for someone to sue when investments go bad.

What the Market Is Missing: In Lentell's view, Morgan has been pulled down, along with many of the big financial companies, over fears in the real estate and credit markets. Investors apparently fear the dislocation in the credit markets will lead to problems at the major investment banks. In Lentell's opinion, while the recent downturn could affect Morgan earnings in the short run, the company is well capitalized. Further, Lentell believes that Morgan's renewed focus under Mack's leadership should help the company prosper in the long run.

NuStar Energy
Moat: Narrow  |  Risk: Below Avg  |  Price/Fair Value Ratio: 0.81  |  Three-Year Expected Annual Return: 18.1%

What It Does: San Antonio-based  NuStar Energy LP (NS) is a master limited partnership that was spun out of refiner Valero Energy. NuStar holds most of Valero Energy's pipelines, terminals, and storage facilities. The 2005 acquisition of the Kaneb companies more than doubled NuStar's asset base to 9,300-plus miles of crude-oil and refined-product pipelines, 86 terminal facilities, and four crude-oil storage facilities.

What Gives It an Edge: In Morningstar analyst Jason Stevens' estimation, NuStar continues to do what it does best: delivering crude-oil feedstocks to refiners and transporting refined products to end-user markets. We're attracted to pipeline operators because of their wide economic moats. Without a demonstrated economic need, new pipelines and system expansions are not approved by regulators. Up-front capital costs also present a sizable barrier to entry. While Stevens thinks that NuStar's aggressive build-out of terminal storage facilities narrows its moat, due to the lower economic returns associated with storage assets, he applauds the company's strategic tradeoff: more growth at slightly lower returns versus slow growth at higher returns.

What the Risks Are: Stevens thinks that NuStar poses below-average business risk. Refinery turnarounds can dramatically reduce the amount of crude and petroleum products NuStar moves through its pipes and terminals. We think dependence on refiners like  Valero Energy (VLO) and Citgo for volume carries some risk, but he thinks customer diversification mitigates this to a large extent. Fires, spills, and changing regulations are risks that all pipeline operators face.

What the Market Is Missing: Stevens thinks the market is missing the boat on master limited partnerships in general, and NuStar is one of the more-attractive MLPs sporting a "for sale" sign today.

Other New 5-Star Stocks
 American Express (AXP)
 Amgen (AMGN)
 International Speedway 
 Pfizer  (PFE)
 Sprint Nextel 
 Wachovia 
 Walt Disney (DIS)

* Price/fair value ratios and expected returns calculated using fair value estimates, closing prices, and cost of equity estimates as of Friday, August 3, 2007.