Avoid Summer's High Tides with These Three Stocks

It's summer, which got us thinking of the beach. That, in turn, reminds us of the old Warren Buffett adage, "It's only when the tide goes out that you discover who's been swimming naked." Given the recent sea of private equity liquidity, the view toward the shoreline could prove to be quite interesting. But instead of speculating, we like to focus on what's left behind when the tide goes out: undervalued stock gems. Like seashells uncovered by the tide, most of them are badly damaged or broken, but a few gems can still be found if you search long enough.

With Morningstar as your guide, you know your search for undervalued stocks won't take long at all. You have at your fingertips a staff of nearly 100 equity analysts covering close to 2,000 stocks and combing the proverbial beach day after day for you. When the tide goes out, we lay our best gems--our 5-star rated stocks--at your feet. It's up to you to decide which stocks to add to your portfolio.

Generally speaking, we think that stocks with market values between $2 billion and $10 billion (mid-caps) can make for excellent investments. Mid-cap companies typically are an attractive blend of their small-cap and large-cap brethren: small enough to maneuver nimbly in their industries but large enough to offer some measure of safety (often through a solid track record and an established set of customers). To see a complete list of our 4- and 5-star mid-cap stocks,  click here.

Today, we want to bring your attention to three mid-cap stocks that are still on sale even though the broader market is up quite a bit so far this year. In a rising tide, these beauties are still lying on the beach just begging to be added to your portfolio. It's important to note that in terms of risk, these stocks as a group have a lower-than-average risk profile, lending further to the predictability of their future cash flows.

If you'd like to track and analyze these mid-cap stocks, click here to create a portfolio. Then simply click "Continue," name your portfolio, and click "Done." (If this link does not work, please register with Morningstar.com--registration is free--or sign in if you're already a member, and try again.) This will allow you to save and monitor these holdings within our Portfolio Manager.

 Republic Services (RSG)
Business Risk: Below Average
Economic Moat: Narrow
Price/Fair Value Ratio*: 0.83
Consider Buying: $30.70 or Below
Consider Selling: $47.30 or Above
Although Republic is not the largest or most vertically integrated waste hauler, the garbage collector's lasting landfill network and exclusive, long-term franchise contracts build a narrow economic moat around its business. Regional deals, which are essentially monopolies granted by the government, shut out competition in nearly 40% of its revenue base, translating into impressive levels of profitability in these markets (20%-plus operating margins). Further separating Republic from the pack is its geographic exposure to the faster-growing Sunbelt states (67% of revenue), which, due to their higher-than-average population growth, help the firm outpace competitors in terms of waste volume expansion. Morningstar equity analyst Brian Nelson thinks that Republic should be a key beneficiary of the industry's fresh focus on return on invested capital, which is driving real pricing growth.

Why is Republic languishing on the beach? Nelson suspects that it is being overlooked because of concerns that the industry's pricing power isn't sustainable. But, in an oligopolistic industry with management teams focused on profitability, he is convinced that a new era has dawned. Pricing discipline is basically the best way for Republic,  Waste Management , and  Allied Waste  to realize the value of their landfills.
Full Analyst Report:  Republic Services

 Cimarex Energy 
Business Risk: Average
Economic Moat: Narrow
Price/Fair Value Ratio*: 0.71
Consider Buying: $44.00 or Below
Consider Selling: $71.40 or Above
Cimarex's primary talent and strategy center on the drill bit. This oil and natural gas exploration and production firm shuns unconventional projects such as coal bed methane and sets its sights on conventional basins in the Mid-Continent, Texas, and Gulf of Mexico. Like Republic Services, management here has a desire to earn high returns on invested capital; as a result, the firm is lured to projects with sound economics in areas that its competitors would probably avoid, trumping any desire to expand reserves. This means that Cimarex isn't likely to be the fastest-growing E&P company. However, it does have a good shot at adding shareholder value over time and consequently earns our narrow economic moat rating, thanks to management's ROIC discipline and the stranded nature of natural gas.

Why is it a good find? Uncharacteristically, Cimarex ran into some operational issues in its Gulf Coast program during 2006. The firm drilled several dry holes and experienced some mechanical failures on some of its high-performing wells. As a result, production fell from 106 million cubic feet per day in the first quarter to 69 mmcf/d during the fourth quarter. Morningstar equity analyst Justin Perucki believes the firm is making the necessary changes to recover from its missteps and does not think the issues will be a chronic problem. He also thinks that the firm's long-run potential is not reflected in its reserve estimates, which are systematically conservative by excluding proven but undeveloped reserves.
Full Analyst Report:  Cimarex Energy

 Fastenal (FAST)
Business Risk: Below Average
Economic Moat: Wide
Price/Fair Value Ratio*: 0.65
Consider Buying: $53.70 or Below
Consider Selling: $82.70 or Above
Fastenal has leveraged its vast product selection and efficient distribution network into decades of profitable growth. This wide-moat firm continues to turn out new stores, dominate the fastener niche, and take market share in a highly fragmented market. As the name suggests, this company focuses on fasteners--everything from nuts and bolts to screws and anchors. By offering more than a quarter million types of fasteners (and a similar variety of maintenance, repair, and operations, or MRO, products) through its 2,000-plus stores, Fastenal provides far more selection and convenience than broad-line or regional distributors.

Why is this company now a bargain? It could have something to do with management's decision to ratchet back new store growth to about 8%. Morningstar equity analyst Matthew Warren thinks that this decision makes sense. At this point in its life cycle, Fastenal expects that ramping up its hiring pace for outside sale professionals who pound the pavement in search of new accounts will help it maintain its growth curve but will require less capital reinvestment. As the firm slows its reinvestment rate, Warren expects growing free cash flow to be returned to shareholders in the form of higher dividend payments and/or share buybacks.
Full Analyst Report:  Fastenal

* Price/fair value ratios were calculated using fair value estimates and closing prices as of June 12, 2007.

Morningstar Senior Equity Analyst Mike Ford-Taggart contributed to this article.