Stocks the Rally Left Behind

"What now?" is likely the question on many investors' minds as 2004 begins. The S&P 500 Index charged ahead 28% in 2003, and the Nasdaq Composite Index gained 50% for the year. Whether the market as a whole will continue to climb or make a turn for the worse this year is not the topic on our analysts' minds, however. We remain focused on finding well-rounded, smartly managed companies whose shares trade below our best estimate of their shares' intrinsic value. As we highlighted in a Dec. 22 column, several stocks still look interesting despite the market's strong performance in 2003.

For this week's Five-Star Investor, we used Morningstar's  Premium Stock Screener to search for companies that have demonstrated better-than-average profitability and cash flows whose stocks appear undervalued by the market. We started our search by filtering companies whose return on assets were ahead of the market over the past year. (ROA is a good indicator of how well management is putting the firm's capital to use, including equity and debt.) Additionally, we screened for firms whose net margins over the past year are above the firm's sector average. This eliminated the bottom half of the roughly 6,500 stocks in our database.

Next, we homed in on firms whose free cash flow margins over the past year were in the top quartile of all firms. (At the time of writing, the top 25% of all firms had free cash flow margins of at least 7.79%.) Reported free cash flow is less susceptible to manipulation than reported earnings. More important, strong free cash flow measures a company's ability to invest in new business lines, pay dividends, or buy back stock. This screen narrowed our result to just 15% of all firms.

Finally, we screened for stocks whose current price to cash/flow ratio was below their three-year average and whose stocks rated at least three stars by our analysts. This series of screens yielded 55 companies. Below, we've highlighted five companies that passed our screen, but just one now trades at a deep enough discount to our fair value estimate that we'd buy the shares.

 First Data  
Stock price as of Jan. 2: $41.05
Morningstar's Fair Value Estimate: $53
From the  Analyst Report: First Data boasts dominant market share, defensible competitive advantages, and large, recurring cash flow. We'd pick up the shares at a 20% discount to our fair value estimate.

 Colgate-Palmolive (CL)
Stock price as of Jan. 2: $49.91
Morningstar's Fair Value Estimate: $60
From the  Analyst Report: Colgate will likely overcome its short-term troubles and prove a good investment. We think long-term investors would do well to pick up shares in the mid- to high-$40s.

 Equifax (EFX)
Stock price as of Jan. 2: $24.50
Morningstar's Fair Value Estimate: $28
From the  Analyst Report: High entry barriers help leading credit reporter Equifax earn healthy cash flows and attractive returns on capital. A strong core credit business and emerging service extensions make Equifax an outstanding long-term investment.

 John Wiley & Sons  (JW.A)
Stock price as of Jan. 2: $26.07
Morningstar's Fair Value Estimate: $30
From the  Analyst Report: Often perceived as offering the most attentive, personalized service in the book publishing industry, Wiley's wide moat is firmly intact. We'd buy the stock in the mid-$20s.

 Merck (MRK)
Stock price as of Jan. 2: $46.94
Morningstar's Fair Value Estimate: $53
From the  Analyst Report: Despite some short-term negatives in the quarter, we're confident Merck will continue to be a leader in the pharmaceutical industry. We would look to pick up shares if they fell below $42.

To run this screen to see all the stocks that passed, click  here. The stocks mentioned above passed our screen as of Jan. 2, 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 logged in as a Premium Member to view and save the complete screen.)