Top Picks from Top Investors

A good watch list is crucial to an investor's success, and in managing the Morningstar Ultimate Stock-Picker's Portfolio, I'm constantly monitoring my watch list for both new and existing ideas with attractive three-year annual expected returns. Presently, a few stocks have migrated to the top of my watch list, and although I don't plan to add a new position to the Ultimate Stock-Picker's Portfolio as this juncture, I always want to have a few ideas ready to eventually recycle the portfolio's capital into higher-expected-return opportunities when the time is right. To continue receiving regular updates to my watch list, please be sure to sign up for my free e-mail alerts.

While most of you are already quite familiar with my methodology in both managing this portfolio and compiling my watch lists, I wanted to provide a reminder to some of my newer readers. In short, the Morningstar Ultimate-Stock Picker's Portfolio essentially asks the question, "What would someone like  Berkshire Hathaway (BRK.B) CEO Warren Buffett buy, and are these particular stocks still attractively valued enough for me to earn good returns on my capital over time?" To this end, I routinely aggregate the holdings of a group of very well respected investment managers with excellent long-term track records to determine which stocks are most commonly held by a group of 20 of the best investment minds around. I then overlay these picks with Morningstar's equity research to determine if these stocks are presently priced to offer new investors the opportunity to still earn good returns on their capital. A stock held by a few of these managers and rated 5 stars by Morningstar analysts typically presents what I think is a very compelling investment opportunity. And even better, I've created a model portfolio based on some of these stock picks, which has outperformed its S&P 500 benchmark since its inception in September 2006. (Please stay tuned for a performance update in the coming weeks, where I'll weigh in on the portfolio's performance through Sept. 30, 2007).

As I mentioned above, I'm not presently considering adding a new name to the portfolio, though I may use some of my liquidity to add to one or two of the existing positions. However, I always want to be ready with new ideas should I be offered the opportunity to recycle capital from a fairly valued stock (a 3-star Morningstar Rating) to a higher-expected-return stock (a 5-star Morningstar Rating). In the table below, I've listed a few of the stocks that are on my current watch list, based on second-quarter manager holdings. (Third-quarter manager holdings won't be out for a few more weeks.) I've also included Morningstar's fair value estimate, three-year annual expected return metrics, and the Morningstar Rating for each of these stocks.

My Current Watch List
	Number of Funds Holding*	Fair Value Estimate** ( $ )	3-Year Annual Expected Return** ( % )	Morningstar Rating**
Home Depot (HD)	8	44	20.1
Citigroup (C)	7	64	22.3
J.P. Morgan Chase (JPM)	6	63	22.2
USG Corporation	6	60	26.6
Bank of America (BAC)	6	70	22.2
Lowe's Companies (LOW)	6	39	21.3
* As of 06/30/2007; ** As of 10/03/2007

It isn't too surprising that all of these stocks are the within the financial and housing sectors, given the recent sell-off due to the global liquidity crunch in late August, and the continued worries about further deterioration in credit quality. While the Federal Reserve worked to address liquidity concerns by lowering the federal funds rate by 50 basis points last month, many remained concerned that a weakening credit environment will eventually hurt these firms' earnings potential. While there is certainly the potential for credit to get worse before it gets better, the long-term investor--think a three- to five-year time horizon--is currently being offered the opportunity to buy a fractional ownership interest in some truly outstanding global banking franchises, such as Citigroup, Bank of America, and J.P. Morgan, at very reasonable valuations. Even better, each stock sports a nice dividend yield, which could provide some downside protection for the shares. As for Home Depot, Lowe's, and USG Corporation, each should be able to eventually emerge from the current cyclical downturn in the housing sector, to become stronger players over time. Here is a snapshot on each of these companies from our most recent Analyst Reports.

 Citigroup  (C)
Our Analyst Report for Citigroup states, "Citigroup is perhaps the pre-eminent financial-services firm in the world. However, such a distinction hasn't prevented this behemoth from experiencing execution problems, as expense growth has far outpaced revenue growth over the past year. Nonetheless, we believe Citigroup can get past this hurdle and deliver high-quality earnings. We would rush to own shares of this wide-moat bank at an appropriate discount to our fair value estimate."

 Bank of America  (BAC)
Ganesh Rathnam recently commented about Bank of America's growth potential, "Perhaps the biggest growth driver for B of A is its wealth-management business. Including its Columbia mutual funds, B of A already has more than $500 billion in assets under management. However, only 10% of B of A's estimated 8 million affluent customers currently avail themselves of its wealth-management products. B of A can rapidly increase fees in this division just by roping in more of its checking account customers. Retail and corporate bank employees are given incentives to make referrals to the private bank. We believe that B of A holds an edge over competitors like  UBS (UBS) because of its ubiquitous branch network."

 J.P. Morgan  (JPM)
Ganesh also thinks management should be able to effect change at J.P Morgan's retail bank, recently writing, "We believe J.P. Morgan could make improvements at the retail bank to extract more value. It has a formidable presence, boasting the second-largest deposit base in the U.S., and it is the number-one bank by market share in key cities like New York and Chicago. Controlling expenses and improving performance at recently acquired branches from  Bank of New York (BK) and fixing the mortgage business--which lost money in 2006--are the main goals for management in 2007."

 Home Depot  (HD)
My colleague Brady Lemos recently wrote about Home Depot, "While the slowing housing market could pressure Home Depot's sales over the next few quarters, we expect this retailer to weather the storm and emerge as a more dominant force in the home-improvement market. We believe Home Depot has one of the widest economic moats in retail, thanks to its scale advantages and prime real estate portfolio. This is evidenced by consistently high returns on invested capital."

 Lowe's  (LOW)
Similar to Home Depot, Brady also has a favorable view on competitor Lowe's, recently writing, "We think the housing market will remain challenging through 2007 and into 2008, yet we are still optimistic about Lowe's long-term growth prospects. In our opinion, Lowe's is well positioned to emerge from this cyclical downturn as a dominant force in the home-improvement market."

 USG  
My colleague Parrish Glover recently commented on USG's second-quarter results, "Driven by the rapid collapse in new residential construction, USG reported dramatic declines in second-quarter earnings. Compared with 2006, sales fell to $1.4 billion from $1.6 billion, a decline of 10.5%, and operating income dropped to $88 million from $318 million. The decreases were due to lower shipments and prices for the company's gypsum wallboard products. However, other aspects of the business continue to perform well, and the company's signature Sheetrock brand still generates a premium price. The long-term prospects of the business remain unchanged, as does our fair value estimate."

If you'd like to track and analyze the stocks mentioned above, click here to create a watch list. Then simply click "continue," name your watch list, 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.

This and That
I hope that you enjoyed my recent video interview with David Winters of the  Wintergreen Fund . (Visit the Ultimate Stock-Picker's Portfolio home page to see this and other video interviews.) I cannot thank David enough for sharing some thoughts from his investment philosophy with me, and I hope these insights were as beneficial to your investment practice as it has been to mine.

Please stay tuned for an upcoming video interview with Wally Weitz of the  Weitz Value Fund (WVALX) in the coming weeks. For those of you unfamiliar with Wally, he has delivered excellent long-term returns for his fundholders using a disciplined approach to investment analysis, which is somewhat consistent with our approach here at Morningstar.

Finally, in the next few weeks, I'll also weigh in on the performance of the Ultimate Stock-Picker's Portfolio through Sept. 30, 2007. As a reminder, only those of you who have signed up for my free e-mail alerts will be able to see my full unabridged chat with Wally and his coportfolio manager, Brad Hinton. Subscribers will also be among the first to have access to my most recent performance update.