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Stock Analyst Update

Three Stocks with 20%-Plus Expected Returns

Plus, a number of other new 5-star names.

Following is a roundup 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.

Moat: Wide | Risk: Avg | Price/Fair Value Ratio*: 0.75 | Three-Year Expected Annual Return*: 20.7%

What It Does:  Genentech  develops and produces biologics. Products include treatments in oncology, immunology, ophthalmology, and respiratory conditions. The firm also manufactures growth hormones for children and adults and a de-clotting enzyme (Activase) used to treat strokes. Genentech primarily sells its products in the United States with partner  Roche (RHHBY) selling the products internationally.

What Gives It an Edge: Morningstar analyst Damien Conover assigns Genentech a wide moat. According to Conover, a portfolio of best-in-class drugs affords Genentech strong competitive advantage. The firm's drugs hold strong patents that should keep competition at bay for many years. The company's next generation drugs combined with new indications for existing drugs should drive strong long-term growth.

What the Risks Are: Genentech faces regulatory risks in developing new treatments and possible generic threats with the likely introduction of generic biologic legislation. Also, the company's high-priced products can easily become a target for both cost control groups and governmental reforms.

What the Market Is Missing: Genentech's shares have declined recently due to a negative Food and Drug Administration panel vote regarding Avastin use in breast cancer. Conover believes that while the market has largely written off this drug's use in breast cancer, Avastin should receive an approval for this indication by 2010. Conover's conviction rests on the strong activity Avastin has shown in clinical trials combined with the lack of effective treatments. As such, he believes the recent price decline represents a good entry point to a high-quality biotechnology company.

Sunoco Logistics Partners L.P.
Moat: Narrow | Risk: Avg | Price/Fair Value Ratio*: 0.75 | Three-Year Expected Annual Return*: 21.1%

What It Does:  Sunoco Logistics Partners  holds a portfolio of pipelines and terminals that primarily connect  Sunoco's  refineries to its retail distribution system. The firm also buys and sells crude oil, a practice that earns slim profits. Sunoco Logistics was formed as a master limited partnership, which means the firm avoids taxation at the company level but it must pay out all of its excess cash to its investors.

What Gives It an Edge: Sunoco Logistics operates an attractive portfolio of crude-oil and refined product pipelines and terminals, generating steady earnings and increasing cash distributions. Pipelines are highly capital-intensive, hard-to-replicate assets subject to federal and state regulations. Once in the ground, pipelines generate steady cash flows while requiring relatively little maintenance. Because of this, Morningstar analyst Jason Stevens thinks Sunoco Logistics has a narrow economic moat.

What the Risks Are: Despite admirable customer diversification, Sunoco Logistics still depends on its parent, Sunoco. Any struggles at Sunoco could hurt the partnership. Other risks include leaks or spills that would expose the partnership to environmental liabilities, regulatory changes that could affect its tax-exempt status, and commodity price exposures, especially with the partnership's crude-oil marketing business.

What the Market Is Missing: Stevens believes the market's got the wrong take on master limited partnerships in general, and Sunoco Logistics in particular. Stevens thinks fears of a credit crunch shutting down access to capital are overblown, creating a great buying opportunity for a high-quality, stable, and growing business.

VF Corporation
Moat: Narrow | Risk: Avg | Price/Fair Value Ratio*: 0.76 | Three-Year Expected Annual Return*: 21.1%

What it Does:  VF Corporation (VFC) manufactures and markets clothing, specializing in jeans, sportswear, outdoor apparel, and footwear. Its apparel brands include Lee, Wrangler, The North Face, Nautica, Majestic Athletic, and John Varvatos. Other brands include JanSport, Eastpak, and Eagle Creek backpacks and Vans and Reef footwear. VF also makes Red Kap work clothes, sold primarily to commercial clothing companies, and Bulwark safety apparel. International sales account for roughly 25% of revenue.

What Gives It an Edge: VF has successfully made the transition from being a manufacturer of low-priced denim and lingerie to a global marketer of diversified apparel brands. Morningstar analyst Brady Lemos believes the company established itself as an extraordinary acquisition integrator and brand builder in the process. Thanks to VF's well-balanced portfolio of strong apparel brands, Lemos thinks returns on invested capital should remain well above the firm's cost of capital, a sure sign the company has a narrow economic moat. 

What the Risks Are: Growth by acquisition is a risky strategy for any company. VF risks overestimating the value of a business, accounting inconsistencies, integration problems, and any other issue that pulls management's attention away from its core operations.

What the Market Is Missing: According to Lemos, the stock has traded down as of late due to fears of a decline in consumer spending. However, Lemos believes that VF is well positioned to withstand such slowdown, should it occur, thanks to its strong brand portfolio and expansive geographic and sales channel reach. VF's latest acquisitions, Seven For All Mankind and lucy, help fill a void in its merchandise portfolio by catering to affluent young women, a group VF has been trying to target on a larger scale. Lemos anticipates that VF will leverage its world-class sourcing and distribution infrastructure to accelerate the brands' expansion into new product categories and markets.

Other New 5-Star Stocks
 IHOP Corporation 
 Prestige Brands Holdings (PBH)
 Thomson Corporation 

* Price/fair value ratios and expected returns calculated using fair value estimates, closing prices, and cost of equity estimates as of Friday, Dec. 7, 2007.

Alex Morozov does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.