The Market's Got It Wrong on These 5-Star Stocks

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.

Best Buy
Moat: Narrow  |  Risk: Avg  |  Price/Fair Value Ratio: 0.76*  |  Trailing 1-Year Return: -14.3%

What It Does:  Best Buy (BBY) is the largest specialty retailer of consumer electronics in North America, with about 900 stores in the United States and Canada. The company sells a variety of merchandise, including video and audio equipment, personal computers, and home appliances. Best Buy operates electronics stores in Canada and China under the names Future Shop and Five Star, respectively, and specialty stores Magnolia Home Theater, Pacific Sales Kitchen and Bath, and Geek Squad in the United States.

What Gives It an Edge: Morningstar analyst Brady Lemos thinks Best Buy is taking the right steps to differentiate itself from competitors and capitalize on new growth opportunities. By placing specially trained sales associates in customized store environments, Best Buy is able to provide a unique shopping experience unmatched by mass merchants and online retailers. Best Buy is also expanding its Geek Squad computer support service and integrating Magnolia high-end home theater departments into many of its stores. The firm's flexible merchandising platform and willingness to adapt should be valuable assets as the company enters new markets, such as China. Thanks to this differentiated approach to retailing, Lemos believes Best Buy should continue to generate impressive returns on invested capital.

What the Risks Are: Lemos thinks that Best Buy poses average business risk. Best Buy's performance is sensitive to consumer spending, so anything that could pressure shoppers' budgets, such as rising interest rates or geopolitical events, could hurt sales. Expanding into unfamiliar categories such as home remodeling and new markets such as China are also risky propositions for the consumer electronics retailer.

What the Market Is Missing: Consumer electronics retailers have posted generally disappointing results over the past few quarters, and this has forced many of Best Buy's rivals--including  Circuit City , CompUSA, and Tweeter--to close a significant number of stores in 2007. As pricing pressure intensifies, Lemos expects Best Buy to further distance itself from its peers and emerge as an even more dominant specialty retailer once consumer spending rebounds. He's especially encouraged by the fact that Best Buy's leading market share is at an all-time high and that customer satisfaction scores are increasing.

Navigant Consulting
Moat: Narrow  |  Risk: Avg  |  Price/Fair Value Ratio: 0.73*  |  Trailing 1-Year Return: -9.2%

What It Does:  Navigant  is a consulting firm that specializes in litigation but also offers electronic data recovery, government contracting, claims management, mergers and acquisitions, and operations advisory services. The company employs approximately 1,900 consulting professionals and works primarily with companies in the financial services, health-care, energy, and insurance industries.

What Gives It an Edge: Navigant is one of only a few large consulting firms in the United States that focuses on helping its corporate customers through the litigation process. When looking for help, these companies' options are limited for a few reasons, says Morningstar analyst Brett Horn. First, with large amounts of money at stake, companies are unlikely to take any chances and look to larger firms, such as Navigant, that have a trustworthy reputation. Additionally, Navigant, with approximately 1,900 consultants, has enough flexibility to quickly tackle even the largest assignments. Finally, through its experience, Navigant has developed long-standing relationships with corporate clients and law firms that help ensure that Navigant is their first call.

What the Risks Are: In Horn's opinion, Navigant courts average business risk. It relies heavily on its senior employees, who manage its customer relationships and provide the expertise that makes the company's services valuable. If a substantial portion of its senior employees left, Navigant would be hard-pressed to replace them quickly, and its results could suffer.

What the Market Is Missing: Horn believes the market is overreacting to a somewhat poor first quarter, in which the company had low consultant utilization rates. However, as the company has to manage almost 2,000 consultants working on a few thousand different projects every year, variation in utilization rates quarter to quarter is inherent to the business and not necessarily a sign of any fundamental decline. Also, the market isn't giving the company any credit for its recent recapitalization, Horn says. The company recently bought back almost 20% of its stock in a Dutch auction and financed this buyback with debt. As the resulting debt load is manageable and the company's shares are trading at a discount to their fair value, he thinks this buyback was a good move.

Starbucks
Moat: Wide  |  Risk: Avg  |  Price/Fair Value Ratio: 0.71*  |  Trailing 1-Year Return: -30.1%

What It Does:  Starbucks' (SBUX) 13,000-plus stores sell coffee, espresso, tea, and cold blended drinks. The stores also offer food, whole bean coffee, coffee-making equipment, music CDs, and other merchandise. The firm sells its coffee (under the Starbucks, Seattle's Best, and Torrefazione Italia brands) and Tazo Tea to grocery stores and warehouse clubs. Through joint ventures and other agreements, the firm produces and sells branded bottled Frappuccino and espresso drinks, ice creams, and liqueurs.

What Gives It an Edge: Starbucks has seized a huge first-mover advantage in specialty coffee retailing by securing more than 9,800 plum locations in attractive U.S. markets (which excludes more than 3,900 stores in 39 foreign countries), says Morningstar analyst John Owens. This provides excellent convenience for its customers. No other specialty coffee retailer has more than 500 domestic units. The company also boasts a very motivated workforce. Starbucks offers its employees an attractive pay package, which includes stock options and health benefits, and ample opportunities for advancement. Because of this, Starbucks can recruit high-caliber employees and retain them for longer, which leads to better customer service, Owens adds. This, along with its high-quality coffee, stylish cafes, and commitment to social responsibility, contributes to the strength of Starbucks' brand, which allows the company to command a premium price for its coffee. Many of its loyal customers routinely purchase their coffee five to seven times per week at their local store.

What the Risks Are: In Owens' view, Starbucks poses average business risk. As the firm continues to penetrate existing markets, same-store sales growth could weaken because of cannibalization. Furthermore, the company is facing increasing competition from the likes of  McDonald's (MCD), Dunkin' Donuts, and  Tim Hortons . Increases in labor, coffee, and dairy costs could weigh on profits. Starbucks also faces heightened economic, legal, and political risks in international markets like China.

What the Market Is Missing: Market sentiment has turned very negative on Starbucks, with the stock falling 36% from its 52-week high. Same-store sales growth has slowed. Growing competition from McDonald's, Dunkin Brands, and other fast food chains, and a leaked memo from Howard Schultz (worrying about the commodification of the Starbucks' brand), have also stoked market fears. Furthermore, concerns about consumer spending and higher labor and commodity costs have weighed on the shares as well. Owens thinks this has all been priced into the stock and then some. His forecast already calls for domestic same-store sales growth to slow to the low single digits. He believes that fast-food competitors will find it very difficult to match the experience and level of service that Starbucks' customers have grown to love. Owens likes the fact that Schultz remains vigilant about protecting the Starbucks' brand. Also, the macroeconomic pressures will not persist indefinitely, in his view. Finally, he does not believe the market appreciates how much investment is currently flowing through Starbucks' income statement, including the preopening costs, a ramp up in general and administrative costs to support future growth, and a nascent international business. Owens thinks the payback from these investments will lead to more profits and higher returns on invested capital.

* Price/fair value ratios calculated using fair value estimates and closing prices as of Friday, June 22, 2007.