Two Stocks with High-Return Potential

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.

Forest Laboratories
Moat: Narrow  |  Risk: Average  |  Price/Fair Value Ratio*: 0.76  |  Three-Year Expected Annual Return*: 20.9%

What It Does: A leading player in branded, generic, and over-the-counter pharmaceuticals,  Forest Laboratories  develops, manufactures, and markets drugs in the central nervous system, cardiovascular, respiratory, and endocrinology therapeutic areas. Its top sellers include Lexapro for depression, Namenda for Alzheimer's disease, and Benicar for hypertension. Forest sells primarily in the United States but also has a presence in the United Kingdom and Ireland.

What Gives It an Edge: In Morningstar analyst Brian Laegeler's view, Forest Labs is the best specialty drug marketer Morningstar covers. Though Lexapro and Namenda are slated to lose patent protection around 2012, Laegeler thinks Forest's $3.5 billion revenue base should afford the firm the financial flexibility needed to outbid direct competitors like  King Pharmaceuticals  and  Shire  for attractive inlicensing deals. Moreover, the firm's highly reputable, 3,000-person salesforce makes it an ideal partner for smaller, research-based firms.

What the Risks Are: Laegeler believes that Forest courts average business risk, meaning that he'd invest in the shares at a moderate discount to his fair value estimate. If Forest does not make substantial headway in business development over the next several years, the decline of Lexapro sales will have a greater impact on returns. Laegeler's valuation turns on the continued success of Namenda, as well as pipeline hopefuls milnacipran and nebivolol, which he expects to contribute significant revenue starting in 2008.

What the Market Is Missing: It's hard to picture the company five years from now, as two drugs representing 80% of Forest's revenues--Lexapro and Namenda--will lose patent protection by 2012. However, Laegeler thinks investors are too focused on this uncertainty. A $400 million research budget, $2 billion war chest, and excellent track record of business development should allow the company to foster the next generation of growth.

Homex Development
Moat: Narrow  | Risk: Above Avg  |  Price/Fair Value Ratio*: 0.61  |  Three-Year Expected Annual Return*: 31.9%

What It Does:  Desarrolladora Homex  is a vertically integrated home-development company focused on affordable entry-level and middle-income housing in Mexico. Homex is one of the most geographically diverse homebuilders in the country. Since its foundation in 1989, Homex has grown to include operations in 18 of Mexico's 31 states. The company's shares trade in Mexico, and ADRs representing six shares each trade on the New York Stock Exchange.

What Gives It an Edge: In Morningstar analyst Parrish Glover's view, Homex has built a moat by becoming a low-cost provider for a product with significant untapped demand--housing in Mexico (that country's estimated housing shortfall exceeds 4 million homes). Homex taps into that demand by developing large communities (up to 6,000 units) that typically feature small units (between 450 and 850 square feet). This effectively allows the company to maximize revenue on its projects while limiting its need for land purchases.

What the Risks Are: Glover thinks that Homex poses above-average business risk. The homebuilding market in Mexico, like that in the U.S., is vulnerable to changes in interest rates. Mexico's central bank announced at the end of February that it would raise interest rates to curb inflation, sending shares of Homex down 15% in three days. Inflationary pressures could also lead to a decline of the peso against the dollar, making Homex ADRs worth less in dollar terms.

What the Market Is Missing: The market has been punishing the stocks of Mexican companies, despite continued weakness in the U.S. dollar and strong economic growth south of the border. Glover thinks the sharp decline in U.S. housing could be causing more-widespread skittishness about all construction. However, he points out that there is no correlation between the two markets. Rather, the most important factors driving new home sales in Mexico are interest rates, which are declining, and the availability of mortgage financing, which the Calderon government is funding.

Other New 5-Star Stocks
 American Reprographics Company (ARP)
 Carpenter Technology Corporation (CRS)
 Expeditors International of Washington, Inc. (EXPD)
 Lexicon Pharmaceuticals, Inc. (LXRX)
 Nucor Corp. (NUE)
 Pioneer Natural Resources Company (PXD)
 Sonoco Products Company (SON)
 Wipro, Ltd. (WIT)

* Price/fair value ratios and expected returns calculated using fair value estimates, closing prices, and cost of equity estimates as of Monday, August 20, 2007.