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Stock Strategist

10 Cheap Stocks Your Broker Might Not Mention

Our analysts like these firms, but Wall Street barely covers them.

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Despite recent changes to their business models, large Wall Street brokerage houses still have incentives to cover large-cap companies. These incentives include trading commissions and spreads earned from filling customer orders. The larger a company's cap, the more widely its shares are usually held, the more liquid the market for the firm's shares, and the more trading business there is to go around. Moreover, the more volatile the shares are, the more often they are traded, which creates more opportunity for Wall Street firms to collect fees.

As a result of these incentives, it seems, Wall Street analysts seldom cover smaller firms, and the brokers who use their in-house research might not mention them to clients as often, if at all. In turn, individual investors might be less aware of these smaller companies and less likely to invest in them. Indeed, measuring how many Wall Street analysts provide earnings estimates for the 7,000 companies in our database and sorting these by the market capitalization of each firm reveals that Wall Street analysts concentrate their efforts on companies with a market capitalization well above $1 billion.

Although we see a strong connection between Wall Street research coverage and demand for companies' shares, Wall Street recommendations and investment opportunity don't necessarily go hand in hand. So, we decided to plumb our database for some investment opportunities that you may not hear about from your broker. Using Morningstar's  Premium Stock Screener, we built a screen that returns companies our analysts like because they're cheap, yet Wall Street barely covers. Our basic premise is that there might be undiscovered value in such a list.

We screened for companies with 5-star Morningstar ratings for stocks. As regular readers know, for each stock we cover, our analysts build a model of each company's earnings for the foreseeable future (at least five years) and perform a rigorous discounted cash-flow analysis. The result is our fair value estimate, which represents what our analyst believes the shares are worth today. Our star rating for stocks compares our fair value estimate with the market price. The bigger the discount to our fair value estimate is, the higher our star rating. The stocks that pass today's screen are all trading at least 25% below our estimate of their fair value.

We used the number of available 2005 earnings per share estimates to measure how many Wall Street analysts cover a firm. The average number of estimates per firm is five, so we screened for less than five analyst estimates to capture a reasonably large sample of firms with below average coverage.

Many international companies get access to U.S. investors by issuing American Depositary Receipts (ADRs), which trade on a U.S. exchange and represent a claim similar to the company's foreign shares. Wall Street brokerage houses tend to cover such firms in their local markets without issuing separate research on the ADRs, so our screen would have turned up 11 foreign firms (listed in the U.S. as ADRs) for which we couldn't be sure if they are under-covered or just not covered by Wall Street analysts as an ADR. It's an interesting list in its own right:  Click here to see the results including foreign firms, which we exclude from our final screen.

To view the results of our final screen yourself,  click here.

Our screen immediately surfaces a stark illustration of our premise that Wall Street coverage and investment opportunity don't necessarily overlap. Warren Buffett's investment vehicle,  Berkshire Hathaway (BRK.B), has a whopping $138 billion market value (our fair value estimate for the whole firm equates to $184 billion), and not a single Wall Street earnings per share estimate in our database. These shares have returned an annualized 13% to shareholders over the last 10 years, and Wall Street analysts have very rarely covered them. Low trading volume and shares that have never split might explain some of their disinterest.

Aside from market capitalizations below $1 billion, another common theme emerges among most of the other companies that passed our screen: They face some short-term challenge to their business. The bad news might account for their depressed stock price and even to some degree for their lack of coverage by Wall Street analysts, but our analysts have incorporated it into their cash-flow forecasts, and remain confident in the longer-term prospects of these companies, and therefore, they would consider buying the shares at today's prices. (If you think all the news is always reflected in the market price, I encourage you to delve into some further reading.)

Indeed, by lengthening their focus and measuring the long-term drivers of firm value, we believe investors can profitably ignore a large portion of the short-term noise that crosses the news wire. The excerpts below may highlight opportunities for what we have come to refer to as "time horizon arbitrage."

Below are some of the highlights from the list of domestic, underfollowed 5-star stocks that passed our screen as of Nov. 11, 2005:

Berkshire Hathaway Class B  (BRK.B)
Business Risk: Below average
Moat: Wide
Market capitalization: $138 billion
Number of Wall Street estimates: 0
From the Analyst Report: "Berkshire's hurricane losses are a temporary distraction--and Hurricane Wilma will add to them--but the compounding operating profits and investment income should endure. We still think Berkshire is a very attractive investment at these prices."

Diebold  (DBD)
Business Risk: Below average
Moat: Narrow
Market capitalization: $2.6 billion
Number of Wall Street estimates: 4
From the Analyst Report: "Even with [recent] management bumbling, we remain convinced of the growth prospects for Diebold's financial self-service business. The increased ATM functionality allowed by the recent Check21 legislation presents a value proposition for Diebold's banking customers. International demand remains strong. The firm is adamant that it is not losing market share and that purchases are merely pushed back due to one-time events. If this is the case (and we see no anecdotal evidence at this point indicating otherwise), Diebold should start making up lost ground in 2006."

Fairfax Financial Holdings (FFH)
Business Risk: Above average
Moat: Narrow
Market capitalization: $2.4 billion
Number of Wall Street estimates: 5
From the Analyst Report: "Fairfax reported a $13.83 per share third-quarter loss, the consequence of losing $272 million to Hurricanes Katrina and Rita. We don't anticipate making a large adjustment to our $285 fair value estimate, as we had already added these losses into our valuation model. In addition to catastrophe losses, Fairfax's runoff (discontinued) businesses continued to bleed cash and helped push the consolidated combined ratio to a dismal 126% through the first nine months of 2005. We do not expect Fairfax to be profitable in 2005. While this is disappointing, we think the insurer's $300 million equity issue will help Fairfax exploit rising insurance rates and profitably expand revenue in 2006."

Valeant Pharmaceuticals International (VRX)
Business Risk: Above average
Moat: None
Market capitalization: $1.6 billion
Number of Wall Street estimates: 5
From the Analyst Report: "Valeant announced third-quarter results� that put it on track to meet our full-year expectations, and we're sticking to our fair value estimate of $31 per share. Valeant remains in transition, and we still think much of its potential lies in its late-stage pipeline. The company continues to wait for a Food and Drug Administration decision on Zelapar (for Parkinson's disease), but its largest growth drivers--Viramidine (for hepatitis C) and Retigabine (for epilepsy)--remain in Phase III trials and, even if approved, won't hit the market until 2008 or 2009."

Compass Minerals International (CMP)
Business Risk: Average
Moat: Narrow
Market capitalization: $750 million
Number of Wall Street estimates: 4
From the Analyst Report: "Third-quarter results at Compass Minerals were as expected. Notably, realized prices for the company's salt and potash products were 8% higher than in the previous year and offset the increase in transportation costs. The company also reduced its mix of discounted, early-fill sales and increased its mix of in-season sales that usually fetch higher prices, leading us to believe that the firm is betting on above-average snowfall. Our fair value estimate is unchanged at $32 per share, and we continue to think Compass Minerals is attractively priced at this time."

Yankee Candle Company (YCC)
Business Risk: Average
Moat: Narrow
Market capitalization: $1 billion
Number of Wall Street estimates: 4
From the Analyst Report: "Yankee Candle posted disappointing third-quarter results. We recognize issues such as increased commodity costs and negative same-store sales at retail locations have put a drag on margins in recent quarters; however, we believe these are short-term problems. Our long-term view of this dominant player in the premium candle market remains unchanged, and we are sticking with our $33 fair value estimate."

Sonic Automotive (SAH)
Business Risk: Average
Moat: Narrow
Market capitalization: $891 million
Number of Wall Street estimates: 5
From the Analyst Report: "We think the remainder of 2005 and the early part of 2006 could be volatile for Sonic (and all of the publicly traded auto dealerships in our coverage universe) as high gas prices, broader economic uncertainty, and the conclusion of popular "employee discounting" programs pressure sales across the entire industry. Nonetheless, we like Sonic's business model and think the company has long-term potential despite short-term pressure."

Doral Financial (DRL)
Business Risk: Above average
Moat: Narrow
Market capitalization: $875 million
Number of Wall Street estimates: 5
From the Analyst Report: "We think Doral's mounting accounting issues have spilled over the top and are now affecting the fundamentals of the business. As such, the attractiveness of this firm has dimmed significantly, in our opinion, and we think it will ultimately be acquired by another company interested in picking up Puerto Rico's largest mortgage lender for much less than we originally thought the firm was worth. We think an investment in Doral shares is risky and appropriate only for long-term investors with a tolerance for significant volatility and uncertainty."

Triad Guaranty (TGIC)
Business Risk: Average
Moat: Narrow
Market capitalization: $627 million
Number of Wall Street estimates: 4
From the Analyst Report: "Private mortgage insurance is an attractive business, and Triad is one of eight guarantors in it. Capital requirements and a reputation for underwriting skill provide useful entry barriers, while price competition is constrained by banks that prioritize default cost minimization and efficiency. After all, customers--not lenders--pay the premiums. Triad also benefits from rising house prices, which naturally boost sales."

Lodgian (LGN)
Business Risk: Above average
Moat: None
Market capitalization: $250 million
Number of Wall Street estimates: 4
From the Analyst Report: "Lodgian announced [in September] that its board of directors has elected president Edward Rohling as CEO. replacing Thomas Parrington. We are not changing our fair value estimate since the move is no surprise, on the basis of our impression from our company visit last month as well as a recent revision in Parrington's employment contract, shortening the terms from the middle of next year to December 2005. We are impressed by Rohling's more hands-on hotel management--he plans to visit every hotel in the portfolio by the end of 2005--which we believe is what the firm lacked during its stalled turnaround efforts. We think the board decision should bode well for shareholders, as Rohling has ample experience with hotel real estate transactions and should help polish the firm to improve operations or have it ready for a complete sale."

Nicolas Owens has a position in the following securities mentioned above: CMP. Find out about Morningstar’s editorial policies.