This Quarter's Hottest Stocks

This quarter, we've focused on wide-moat stocks again for our hot stocks article. At Morningstar, we assign moat ratings to stocks to reflect our opinion of the competitive advantages of their underlying businesses. A wide-moat designation is the best a stock can get, and it means that Morningstar analysts think the underlying business can achieve returns on capital that outstrip its cost of capital for the foreseeable future. Currently, 186 stocks in our 2,000-stock universe (less than 10%) garner this coveted rating.

While our screen produced some financials and retailers last quarter, the bump that stalwarts such as  American Express (AXP) and  Home Depot (HD) received proved short-lived, as those stocks pulled back again (though we think that's only made them more compelling long-term buys). We ran our wide-moat screen searching for stocks that rose 5% for the three trailing months through July 18 but still trade in 5-star territory. (To run the most up-to-date version of this screen yourself,  click here.) This quarter, health-care names had a strong showing. In fact, when we relaxed the search criteria and allowed for stocks that had moved into 4- and 3-star territory because of their strong runs, we saw health-care dominance from firms such as  Amgen (AMGN),  GlaxoSmithKline (GSK), and  Medtronic (MDT). However, it's important to note that we've excluded two health-care names that passed our original screen-- Schering-Plough  and  Boston Scientific (BSX)--given the recent pressure on their share prices.

Our hottest stocks list also includes names from the hardware and software sectors, reflecting the fact that growth indexes have recently outperformed value indexes, which is where financial stocks reside. Only one financial name made our list this time. Here's the list in alphabetical order:

 ARM Holdings PLC 
Trailing three-month Return through July 18: 11.3%
Economic Moat: Wide
Fair Value Uncertainty: High
Price/Fair Value: 50%
ARM Holdings licenses microprocessor blueprints and silicon physical layer designs for applications in cell phones, automobiles, and other electronic products. ARM is essentially a design contractor for chipmakers, according to Morningstar equity analyst Dan Su, and the firm's wide moat stems from its comprehensive design library, allowing customers to select appropriate configurations of performance, chip size, and power consumption. Su estimates that it would take competitors years to reproduce a portfolio of similar breadth and depth. Additionally, ARM has third-party vendors that tailor software and development tools to support ARM designs, increasing customer stickiness and creating entry barriers. Su worries that the firm could overspend for acquisitions and that it faces competition from  Intel (INTC) in the mobile Internet space, but she still expects ARM to continue generating strong returns for years into the future.

 Autodesk (ADSK)
Trailing three-month return through July 18: 8.2%
Economic Moat: Wide
Fair Value Uncertainty: Medium
Price/Fair Value: 72%
Autodesk is the leading vendor of computer-aided design software to manufacturing, infrastructure, building, media, and entertainment firms. Morningstar equity analyst Rafael Garcia thinks that, despite competition from  Dassault Systems (DASTY) and Parametric Tech (PMTC), Autodesk benefits greatly from switching costs; it takes time to learn a new design software application, discouraging firms from sacrificing operational disruption costs to that end. Autodesk has a subscription model that provides it with a stable source of revenue, and the firm's gross margins have been in the high 90% range. Garcia thinks the firm can increase its subscription base from around 1.5 million, where it stands now. He also thinks more subscribers will migrate from 2D software to the more profitable 3D version, which provides a richer analysis. Finally, Autodesk has opportunities for growth in emerging economies, which accounted for 10% of revenue in 2003 and 17% in 2008.

 Novartis AG (NVS)
Trailing three-month return through July 18: 19.6%
Economic Moat: Wide
Fair Value Uncertainty: Low
Price/Fair Value: 78%
Novartis manufactures and develops health-care products in four main operating segments: branded pharmaceuticals, generic pharmaceuticals, diagnostics and vaccines, and consumer products. Morningstar equity analyst Damian Conover thinks Novartis is well-positioned because of its diversified operating platform and industry-leading number of new potential blockbuster drugs. Novartis' potential blockbuster drugs include Galvus for diabetes, Aclasta for osteoporosis, and Exforge and Tekturna for hypertension. Additionally, the company should file at least six new products in 2008 in both the United States and Europe. Conover also expects the sluggish generic business to pick up steam soon as several key branded drugs lose patent protection.

 The Western Union Company (WU)
Trailing three-month return through July 18: 25.8%
Economic Moat: Wide
Fair Value Uncertainty: Low
Price/Fair Value: 81%
Western Union is in the money transfer business. Morningstar analyst Brett Horn estimates 200 million people live outside their country of origin, driving money transfer growth at the rate of about 8% annually. Western Union's moat comes from its size and its network effect. First, the money transfer business is scalable because the incremental costs of processing additional transactions are minimal. Second, each additional agent to the firm's current 335,000 agents makes it incrementally more convenient for customers. Still, despite the fact that it dwarfs its closest competitor  MoneyGram  in transactions, Western Union has plenty of room to grow, as it only has 17% market share. Additionally, the firm has barely penetrated India and China, which only account for 5% of its revenue.

 Waters Corporation (WAT)
Trailing three-month return through July 18: 14.5%
Economic Moat: Wide
Fair Value Uncertainty: Low
Price/Fair Value: 83%
Waters provides analytical instruments for pharmaceutical, biochemical, and industrial customers, such as liquid chromatography (LC), mass spectrometry (MS), and thermal analysis tools. According to Morningstar equity analyst Alex Morozov, Waters' relentless emphasis on innovation helps separate it from its peers and allows it to generate high returns on capital. The firm's bread and butter is liquid chromatography, where even four years after its 2004 introduction, the Acquity Ultra Performance system still provides a level of technical performance that is unsurpassed. Indeed, the firm has produced returns on assets in excess of 13% and returns on equity in excess of 30% over the past few years. Morozov thinks the firm's renewed emphasis on mass spectrometry and its strategy of bundling its MS offerings with Acquity is a wise move, given customers' desire to have hybrid LC/MS systems.