Market Rebound Leaves This 5-Star Stock Behind

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.

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As the U.S. stock market plunged during the first weeks of January 2008, more and more high-quality stocks sank into 5-star territory each week, creating opportunities for astute investors willing to weather the storm. Last week, buyers were rewarded, as the market rebounded sharply, lifting the Dow Jones Industrial Average 4.4%. These market gyrations are not for the faint of heart, and at Morningstar we tend to overlook short-term stock-price movements, instead anchoring investment decisions to the fundamental values of the underlying businesses. This strategy allows us to separate market "noise" from the individual businesses' true worth, and take advantage of potential mispricings.

Just as plunging stock prices caused new 5-star stocks to sprout up each week, the market's rally has trimmed this week's list to only a few. However, we think these two stocks have been unjustly left behind and offer patient investors an opportunity to earn healthy returns.

EMC Corporation
Moat: Narrow | Risk: Avg | Price/Fair Value Ratio*: 0.73 | Three-Year Expected Annual Return*: 22.0%

What It Does: EMC  is a leading provider of hardware, software, and services for enterprise network storage. Its legacy was built on leading-edge proprietary storage hardware. During the last couple of years, the company has increased its focus on its software and services segments, which now generate more than 50% of overall revenue. About 50% of sales are through partners including original-equipment manufacturers and resellers.

What Gives It an Edge: EMC is the market leader in networked storage hardware and software. Morningstar analyst Grady Burkett thinks the vendor's competitive advantage stems from its large installed customer base and focus on product integration and support. The amount of data stored on corporate systems is roughly doubling every two years, and the growing volume is leading to increasingly complex data centers. As a result, businesses look to EMC to provide better software management and integration services to meet their evolving storage needs. Furthermore, IT managers fear network disruptions above all else. Burkett believes EMC's customers find it safer and easier to buy more products and services from EMC than assume the risk of installing a competitor's solution.

What the Risks Are: EMC faces significant competition from established storage companies, such as IBM (IBM) and Hitachi (HIT), as well as a reorganized Hewlett-Packard (HPQ). Profit margins could be pressured as EMC is forced to offer lower-cost systems to compete in the small and medium business market. Additionally, EMC's large number of acquisitions brings a significant and continual degree of integration risk.

What the Market Is Missing: Burkett thinks the market fears a repeat performance of the technology meltdown from seven years ago, when EMC's sales fell nearly 40% over a two-year period. Because EMC has taken deliberate steps to reduce this risk, Burkett believes the company is in a much better position to weather an economic slowdown this time around. In 2000, the bulk of EMC's sales came from its storage systems hardware, with software and services accounting for less than one fourth of revenues. IT departments are typically quick to cut hardware spending during rough economic times, while renewing software licenses and service contracts to ensure business continuity. EMC now has its hands in all aspects of data management, and it generates more than half its revenues from its stickier software and service offerings. Burkett thinks the company has also done a nice job of diversifying its customer base, with more revenues coming from international markets and smaller enterprises than in 2000.

* Price/fair value ratios and expected returns calculated using fair value estimates, closing prices, and cost of equity estimates as of Friday, Feb. 1, 2008.