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Stock Strategist

Five Companies We Love

Check out this quintet of well-managed firms.

As investors with access to around-the-clock cable television news and an ever-increasing amount of information on the Internet, it's all too easy to get distracted by the headlines we come across each day: quarterly earnings, new product launches, brokerage upgrades and downgrades, and daily gyrations in the market. Sometimes it pays to step back and ask some more-basic questions: Is it a good business? Is the management team 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 today's Stock Strategist, 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, our 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. These 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 1,400 companies, 86 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 investment opportunities because they help fend off competitors and sustain above-average returns on capital. Twenty-eight companies made the final cut as of Jan. 24, 2006. Many 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. For example, (AMZN) meets the criteria but earns only a 1-star rating because the shares are trading above our estimate of fair value. But a handful of companies on the list offer both great fundamentals and reasonably attractive stock prices.

Avon Products 
Morningstar Rating: 5 Stars
Business Risk: Average
Avon's stock was hammered after some operating miscues hurt the company's recent financial results, but we like the firm's long-term prospects. From the  Analyst Report: "Avon has built a wide moat in the highly competitive cosmetic industry with its direct-sales business model. Over the past five years, torrid sales growth has followed wherever the firm has exported its model. While the company has encountered headwinds recently, we believe its problems are short term. Avon's management has consistently demonstrated that it can cope with a variety of challenges. We think the firm has a lot on its plate at the moment, and we expect efforts from its recently announced restructuring will not begin to correct its problems until late 2006. Since its returns on invested capital have well exceeded its cost of capital for years, we see no reason to doubt that Avon will emerge from its current slump."

J.P. Morgan Chase & Co. (JPM)
Morningstar Rating: 5 Stars
Business Risk: Average
J.P. Morgan Chase & Co. turned in a solid fourth-quarter performance and appears well-positioned for the future. From the  Analyst Report: "J.P. Morgan Chase looks like a reinvigorated giant. This financial conglomerate offers an attractive combination of businesses that range from good to superior, a talented management team focused on creating shareholder value, and a reasonably priced stock. Morgan's businesses appear to either be endowed with a good set of competitive advantages, or they are working to sharpen their edge. The net result: Since J.P. Morgan acquired Bank One, returns on equity have steadily ticked up, and we think the firm can achieve much more."

Fifth Third Bancorp (FITB) 
Morningstar Rating: 5 Stars
Business Risk: Below Average
Fifth Third faces growing competition, but the bank's strong management and long history of superior cost controls lead us to believe patient investors will be rewarded. From the  Analyst Report: "Several Midwestern banks now boast a decentralized model, and the slowdown in Fifth Third's deposit growth is evidence of the improved sales at these banks. However, a decentralized model requires extra layers of managers operating independently, and we haven't seen any bank execute on cost controls like Fifth Third. The bank's efficiency ratio hovers around 52%, compared with the industry's 57% average, and its efficiency has remained superior to that of peers in each of the past 10 years. We believe the low-cost structure is at the core of the bank's strategy, making it very difficult for any rival to compete on price. It's no wonder many banks have failed to overcome this wide moat."

Microsoft (MSFT)
Morningstar Rating: 5 Stars
Business Risk: Below Average
New products could reignite growth at Microsoft. From the  Analyst Report: "The past few years have been a legal morass for the world's largest software company, but we think Microsoft shareholders will be rewarded for their patience. The firm's core software franchises are as dazzling as ever, and the introduction of Windows Vista and a new version of Office will add another chapter to Microsoft's long history of growth. In addition, Microsoft's $6-$7 billion annual research-and-development budget dwarfs those of competitors and ensures the continued innovation that spurs software upgrades."

Kinder Morgan Energy Partners 
Morningstar Rating: 3 Stars
Business Risk: Below Average
We selected CEO Rich Kinder as our CEO of the Year, and we'd gladly buy the shares with an adequate margin of safety. From the  Analyst Report: "KMP is the premier "roll-up" in the energy transportation and storage industry. Beyond acquisitions, significant opportunities for internal growth exist, as demand for moving energy should grow as the economy expands. KMP expects that it can increase partnership distributions by nearly 8% per year from internal opportunities alone. We also like Kinder's management. CEO Kinder does not receive any compensation beyond his $1 annual salary. He got his stake in KMP the old-fashioned way--he bought it--and makes money purely from increasing per-share cash flow and distributions. We are extremely impressed by how well top management's interests are aligned with public owners' interests."

To run this screen and see all the stocks that passed, click  here. Note: The stocks mentioned above passed our screen as of Jan. 24, 2006. The results of the screen may change daily due to 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.

A version of this article last appeared on Oct. 24, 2005.

John Novak does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.