Bargains Sprout Up as Market Dips

Following is a sampling of stocks that recently jumped to 5 stars. By way of background, we award a stock 5 stars when it trades at a suitably large discount--i.e., a margin of safety--to our fair value estimate. Thus, when a stock hits 5-star territory, we consider it an especially compelling value.

To get a  complete tally of stocks that have recently jumped to 5 stars--as well as our  full list of 5-star stocks--including our consider buying and selling prices, risk ratings, and moat ratings--simply take Morningstar Premium Membership for a test spin. Click here to sign up for a free trial.

AGL Resources
Moat: Narrow  |  Risk: Below Avg  |  Price/Fair Value Ratio: 0.84*  |  Trailing 1-Year Return: 13.9%

What It Does:  AGL Resources  is primarily a regulated natural-gas-distribution utility company that generates more than 95% of its revenues by servicing 2.2 million customers in Georgia, New Jersey, Virginia, Florida, and Tennessee. The company is also involved in natural-gas marketing, wholesale services, and energy investments, including LNG investments. In November 2004, the company acquired the operations of NUI Corporation for $691 million.

What Gives It an Edge: Morningstar analyst Paul Justice thinks that AGL will be a standout performer versus its natural-gas distribution peers for years to come. Regulated returns on its monopolistic infrastructure investments lay the foundation of its "narrow" economic moat, and its low operating costs and above-average customer growth give it better relative earnings growth prospects.

What the Risks Are: In Justice's opinion, AGL courts below-average business risk. The major risk for AGL is regulatory risk. Justice believes that rate design is as important, if not more so, than allowed returns on rate base, but three consecutive adverse rate cases in AGL's primary territory have illustrated how regulators can hold back growth. The benefits that regulators grant with decoupled rate structures often come at the expense of lower allowed returns. AGL must navigate the waters of its five jurisdictions carefully to achieve an attractive balance of returns versus risk.

What the Market Is Missing: AGL's regulated income stream in its largest service territory, the heart of Georgia, is among the most secure Justice has come across. AGL's revenue decoupling mechanism--a way of charging customers a standard fee regardless of how much volume is consumed--shields the company's cash flows from consumer consumption habits, including weather and price-induced conservation. Despite this income stability, regulators have still allowed the company to collect returns commensurate with its peer average. Given its strong dividend yield with above-average growth prospects, Justice thinks investors should strongly consider the shares while they're on sale.

Alleghany
Moat: Narrow  |  Risk: Avg  |  Price/Fair Value Ratio: 0.75*  |  Trailing 1-Year Return: 30.1%
What It Does:  Alleghany  is an investment holding company that uses a value-oriented philosophy to acquire interests in attractive businesses. The firm purchases fractional and outright stakes and generally holds investments for long periods. Alleghany's three insurance subsidiaries--RSUI Holdings, Capitol Transamerica, and Darwin Underwriters--supply a broad range of specialty, property, and casualty protection. Subsidiary Alleghany Properties is a Sacramento, Calif., landlord.

What Gives It an Edge: In Morningstar analyst Justin Fuller's view, Alleghany merits a "narrow" economic moat for a few reasons. First, the firm's value-oriented investment structure provides a useful advantage. By sharply focusing on buying businesses it expects to own for long periods, Alleghany's team can pursue opportunities that competing investors with shorter horizons shun. Management looks to invest at a 50% discount to fair value and balances risk by looking for opportunities with $3 of upside for every $1 of downside, which Fuller considers a sensible approach to boost returns. Second, Fuller is impressed by Alleghany's wholly owned insurance subsidiaries, as the holding company can also pledge its equity investments as insurance capital, effectively using that capital twice. The largest of these firms, RSUI, seeks to develop an expertise in lines of insurance for specialty or hard-to-place risks. This information advantage helps RSUI earn small price premiums on the policies it writes. What's more, since RSUI's underwriters are compensated only for underwriting profitability, they are encouraged to refuse business that doesn't meet the firm's underwriting criteria. As such, Fuller expects RSUI--and, thus, Alleghany's--underwriting profitability to remain strong, which should boost growth in book value per share over the long haul.

What the Risks Are: Fuller rates Alleghany's business risk as average. The firm faces the risk that a large hurricane or earthquake could cause sizable losses in its insurance subsidiaries. What's more, if Alleghany doesn't buy enough reinsurance protection--as in 2005--losses of this type could diminish the firm's liquidity. However, Fuller thinks Alleghany learned from its Katrina losses and has restructured its risk portfolio to better withstand catastrophic events. In addition, since Alleghany is very acquisitive, it could possibly overpay for an acquisition, but given management's impressive track record, Fuller views this risk as minimal.

What the Market Is Missing: In Fuller's opinion, the market is missing Alleghany's long-term orientation and apparently doesn't believe the firm's insurance operations (which provide float for investments, etc.) are as valuable as he thinks they are. Specifically, the market is missing some of the value in Alleghany's RSUI subsidiary.

Molson Coors Brewing Company
Moat: Narrow  |  Risk: Avg  |  Price/Fair Value Ratio: 0.74*  |  Trailing 1-Year Return: 32.1%

What It Does:  Molson Coors (TAP) is the fifth-largest brewer in the world. Major brands include Coors Light, Molson Canadian, Carling, Blue Moon, Killian's, Zima, Caffrey's, Worthington's, and Keystone. Its largest markets by volume are America (56%), the U.K. (26%), and Canada (19%). Broken down by comparable operating profit, the company's largest operations are Canada (61%), America (30%), and the U.K. (10%). The company recently sold its majority interest in Brazilian brewer Kaiser.

What Gives It an Edge: In Morningstar analyst Matthew Reilly's view, Molson Coors' Canadian operations are indicative of a wide-moat firm. It is part of a duopoly with a very rational competitor in Ambev that is unwilling to compete on price. While a tough competitive environment in Europe and Molson's sub-scale positioning to  Anheuser Busch (BUD) in the U.S. keep it from a wide-moat rating overall, Canada still accounts for over 60% of companywide operating profits.

What the Risks Are: Reilly believes Molson Coors courts average business risk. The merged company faces integration risk. Prolonged pricing wars in its main markets would depress profits, as happened in 2005. The company is at a major scale disadvantage to Anheuser-Busch in the U.S. beer market in terms of production and distribution. In the beer industry, weak volume can quickly lead to declining profitability because of high fixed costs. Converting Canadian dollars and U.K. sterling into U.S. dollars entails constant foreign-exchange risk.

What the Market Is Missing: Reilly thinks that the integration of Molson and Coors is ahead of schedule, and that management's projected cost cuts are obtainable. Profitability in Europe seems to have stabilized after a couple of terrible years, and the company has right-sized the operation after suffering volume declines. Coors' U.S. operations have also been notoriously inefficient due to long shipping distances from Golden, Colo., but some of these costs should be reduced by the opening of a modern brewery in Shenandoah, Va., and continued cost synergies with Molson. While Reilly's analysis is fundamental and discounted-cash-flow-driven, Molson Coors could also be in the crosshairs of industry consolidator SABMiller, as evidenced by recent comments from SABMiller's Norman Adami and the recent adoption of a golden parachute plan for Molson Coors management. Reilly does not think that this is a growth story by any means. Rather, it is a cost-cutting story, but one that seems to be working amid a challenging commodity-cost environment.

Thomson ADR
Moat: Narrow  |  Risk: Avg  |  Price/Fair Value Ratio*: 0.73  |  Trailing 1-Year Return: 4.0%

What It Does:  Thomson  offers digital media hardware, software, and distribution services to the entertainment and media industries. The company operates three divisions: services (DVD, VHS, and CD replication and distribution), systems and equipment (television broadcast cameras and set-top boxes), and technology (patent and software licenses).

What Gives It an Edge: Thomson boasts an edge over competitors in a few areas. Thanks to its new asset base, Thomson has become a centralized provider of digital media solutions and content distribution around the globe. As movie studios and networks continue to demand fast replication and secure delivery of content, Thomson has emerged as one of the few firms capable of satisfying their pressing needs. Given the company's globally integrated processing and distribution capabilities, Morningstar analyst Irina Logovinsky believes Thomson has built a "narrow" economic moat around its operations. Logovinsky also thinks Thomson's edge in the DVD replication business is helping the company to grow its content services segment (i.e., editing and special effects). The market for such services is still largely fragmented, and given Thomson's resources and existing customer relationships, it should be able to acquire a substantial market share. Furthermore, a continued migration to a digital format should benefit many of Thomson's operations, such as providing cinemas and networks with digital equipment as well as content preparation for digital distribution.

What the Risks Are: Thomson faces a multitude of risks, including its ongoing integration of multiple acquisitions and its ability to manage so many new and unfamiliar business lines. The company's DVD replication business is quickly maturing and is more susceptible to cyclical forces. The low-end nature of many of Thomson's current services and customer concentration are also concerns.

What the Market Is Missing: The market is concerned that Thomson's DVD business is going to fall off the cliff due to the proliferation of digital downloading of movies from the Internet. True, the DVD-replication business has decelerated, but that's largely because consumers have finished upgrading their home DVD collections. However, they're still buying DVDs, but now they are more selective, purchasing just their new favorite titles. Logovinsky also thinks we're likely years away from a large-scale shift away from DVDs for a few reasons. First, a lack of digital rights management standards and the slow adoption of fiber-optic cable (capable of quick high-definition movie delivery over the Internet) mean that the DVD business is here to stay, at least for the foreseeable future. Second, movie studios are still dependent on DVD sales, which constitute a large portion of their profits, and studio executives remain very committed to physical media. Third, the DVD business is hampered by a war between two high-definition standards (HD DVD and Blu-Ray), but it should recover once a single standard emerges and consumers start adopting the new technology.

* Price/fair value ratios calculated using fair value estimates and closing prices as of Thursday, June 7, 2007.