Companies We Love

As a stock investor, it's all too easy to get distracted by the details: quarterly earnings, new product launches, who's in and out in the executive suite, and daily gyrations in the stock price. Sometimes you've got to step back and ask some more-basic questions: Is it a good business? Is the management team in charge on your side? These questions aren't easy to answer, but getting them right can make a huge difference in the quality of your portfolio over time.

For this week's Five-Star Investor, we focused on two of the more qualitative aspects of stock investing, both of which are central to Morningstar's investment approach. First, we screened for companies that earn a Stewardship Grade of A, the highest grade. These grades are designed to measure how well company boards and management teams fare in demonstrating a commitment to shareholders and acting as stewards of investor capital. The grades are based on three key areas: transparency of reporting, shareholder friendliness, and overall stewardship, including management incentives and equity ownership. Morningstar's analysts have assigned Stewardship Grades to approximately 500 companies, 58 of which receive grades of A.

We then narrowed the list to focus on companies with wide economic moats, which we love to see in potential stock ideas because they help companies fend off competitors and sustain above-average returns on capital. Twenty one companies made the final cut as of Feb. 11, 2005. Most of the companies on the list earn middling Morningstar Ratings, meaning that we'd wait for a larger margin of safety before investing in the shares. One of them, Avon Products , earns only a 2-star rating because the shares are trading above our estimate of their fair value. The company has also struggled to develop a successful product mix for the domestic market in recent years. But a handful of companies on the list offer both great fundamentals and reasonably attractive stock prices. Here are some of the highlights:

Fifth Third Bancorp (FITB)
Morningstar Rating: 5 Stars
Business Risk: Below Average
From the Analyst Report: "Fifth Third Bancorp creates value through great execution... Fee income has grown at a compound annual rate of 16% over the past five years and now represents more than 40% of total revenue, above the industry average. This diverse revenue stream--which includes ATM processing, deposit fees, and asset management--helps Fifth Third produce more in revenue per dollar of assets than typical banks. Meanwhile, operating expenses are usually only about 45% of net revenue, which is more efficient than rivals. Together with a fat equity base (typically about 10% of assets), earnings quality is consistently strong."

First American (FAF)
Morningstar Rating: 5 Stars
Business Risk: Average
From the Analyst Report: "We like the economics of these 'knowledge provider' businesses; established databases are very hard to compete with. The cost to develop a database with sufficient historical information can be huge, while the cost to produce a report is tiny, given that most processing is now automated. Potential rivals couldn't charge the high prices required to earn an acceptable return on the large investment needed to build a competing database. A consolidating lender base may try to negotiate lower fees, but they won't be able to cost-effectively replicate First American's data, in our opinion."

Iron Mountain (IRM)
Morningstar Rating: 5 Stars
Business Risk: Below Average
From the Analyst Report: "Robust competitive advantages and a highly capable management team bode well for Iron Mountain's long-term prospects. The mainstay of Iron Mountain's business is document storage. Regulatory requirements force companies in the medical, legal, financial, and some other industries to maintain large volumes of records for extended periods. Iron Mountain charges recurring rental fees to store its customers' files, and then generates additional revenue every time a customer wants to retrieve, move, or dispose of a box. The number of cartons the company stores is rising steadily; volume from existing customers grows about 5% per year. Meanwhile, because most of Iron Mountain's expenses are fixed, the company doesn't incur much additional cost as it fills its warehouses."

Paychex (PAYX)
Morningstar Rating: 5 Stars
Business Risk: Below Average
From the Analyst Report: "Paychex's operating leverage is impressive. First, signing up clients and hooking them into the payroll-processing infrastructure is a high-margin exercise. The fixed infrastructure cost has already taken place, and the variable cost associated with processing another client is small, so profits increase as the client base grows. Second, providing additional products to existing clients carries an even lower variable cost, because the data required to process add-on services are already in the Paychex system. Incremental margins for add-ons can be as high as 70%."

Microsoft (MSFT)
Morningstar Rating: 4 Stars
Business Risk: Below Average
From the Analyst Report: "CEO Steve Ballmer and Chairman and founder Bill Gates own about 4% and 10% of the company, respectively. Neither Gates nor Ballmer has taken any stock options in the past decade, and by the standards of the technology industry, their compensation packages are small. They have done a great job for shareholders, especially in making the transition from the hypergrowth of the late 1990s to the slower growth of today, and returns on invested capital have been an eye-popping 64% over the last five years. In addition to the reasonable executive salaries, the recent decision to return $75 billion to shareholders through stock buybacks and a one-time dividend combined with the replacement of employee stock options with restricted-stock grants are signs that management has become quite shareholder-friendly."

Renaissance Re Holdings (RNR)
Morningstar Rating: 4 Stars
Business Risk: Above Average
From the Analyst Report: "In an industry where management is a critical determinant of value creation, the team at Renaissance Re has excelled. Chairman and CEO James Stanard has led Ren Re since its formation in 1993; he brings extensive reinsurance underwriting and pricing experience to the firm. He owns 5.4% of the company, which should be more than enough to dissuade him from accepting poorly priced business. Stanard earned about $5 million in 2003, which we think is richly deserved for consistently delivering the best results in the reinsurance business. Directors and officers collectively own 10.4% of the shares, which we think is fantastic."

To run this screen and see all the stocks that passed, click here. Note: The stocks mentioned above passed our screen as of Feb. 11. 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. (You will need to be logged in as a Premium Member to view and save the complete screen.)