Don't Get Caught with These Wall Street Darlings

Is optimism still running rampant on Wall Street?

The gut-wrenching losses in the 2000-2002 bear market probably tempered that trait a bit, as did widespread publicity about the conflicts of interest inherent in sell-side research. But while the number of "strong buy" recommendations has tapered off a bit, it's still not unusual to see Wall Street analysts pound the table on a stock if its earnings prospects look good, or if it's rolling out interesting new products that make for a good story.

Based on earnings estimates from Multex, about 70% of companies rated by sell-side analysts currently have ratings of "moderate buy" or "strong buy", while a paltry 4% have negative ratings of moderate sell or strong sell. Morningstar's stock analysts tend to be more skeptical.

We don't forecast stock prices by using momentum screens or even estimating target prices based on a multiple of earnings or sales. Instead, our analysts calculate fair value estimates by mapping out each company's future free cash flows and discounting them back to an equivalent value in today's dollars. It's always dangerous to assume that the future will be as rosy as the past, so we try to be conservative in our estimates for future growth. 

We also require a margin of safety for companies to earn topnotch ratings. A company doesn't earn a top Morningstar Rating unless its stock is trading at a price significantly lower than the price of our fair value estimate. The end result: About 8.2% of the companies in our coverage universe currently earn 4- or 5-star ratings, while a hefty 56% earn 1 or 2 stars. So our ratings have a decidedly more negative slant than the majority of Wall Street research.

For this week's Five-Star Investor, we used Morningstar's Premium Stock Screener to find stocks where this dichotomy is particularly apparent: We located those stocks that have average ratings of "strong buy" from Wall Street analysts but earn only 1 star in our rating system. While it's always possible that we're being too conservative in our estimates, we consider these stocks risky bets because of the high expectations built into their prices.

 Intel (INTC)
Stock price as of Dec. 4: $33.61
Morningstar's Fair Value Estimate: $21
From the  Analyst Report: "With little new coming out of Intel's winter analyst meeting, our fair value estimate is unchanged at $21. Chip demand continues to improve, especially in emerging markets like Western Europe and Asia. We think the ability to lower manufacturing costs remains one of Intel's most compelling competitive strengths. Another key advantage is its ability to integrate new features like wireless networking alongside its microprocessor chips. But we have already factored a sharp rebound in Intel's business into our model and see little reason to change our outlook. At its current price, the stock offers no margin of safety."

 Ameritrade Holding 
Stock price as of Dec. 4: $12.64
Morningstar's Fair Value Estimate: $4
From the  Analyst Report: "If frequent trips to Vegas have lost their allure, you might want to consider Ameritrade stock. Otherwise, steer clear of this leveraged bet on market volatility. We have lowered our fair value estimate to $4 per share from $6; this takes into account Ameritrade's stellar growth thus far in 2003."

 Andrx Group 
Stock price as of Dec. 4: $22.90
Morningstar's Fair Value Estimate: $14
From the  Analyst Report: "Despite efforts to build up its drug business, Andrx isn't the best candidate for lasting success, in our view. We'd consider this narrow-moat company as a valuation play only if the shares traded at a 50% discount to our fair value estimate."

 Illinois Tool Works (ITW)
Stock price as of Dec. 4: $80.68
Morningstar's Fair Value Estimate: $57
From the  Analyst Report: "We like ITW's operations, but its weak growth prospects don't provide the justification required to pay the market's current price for the stock. We'd pass for now."

To run this screen yourself and see all the stocks that passed,  click here. (The stocks mentioned above passed our screen as of Dec. 5, 2003. The results of the screen may change due to daily price fluctuations or other factors.) After clicking, you can save the search to use later by clicking the "Save Criteria" button in the bottom right-hand corner of the screen. (Note: You will need to be aPremium Memberto view and save the complete screen.)