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5-Stars with More Certainty

The future for these stable firms is easier to forecast--and looks bright for shareholders.

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At Morningstar, we spend a lot of time thinking about the range of possible outcomes for the companies we cover, even though the fair values we publish are point estimates. One of the key steps in our approach to stock investing is determining the "fair value uncertainty" for each company. Fair value uncertainty is meant to give investors an idea of how tightly we feel we can bound our fair value estimate for any given firm.

To measure fair value uncertainty, analysts consider sales predictability, operating leverage, financial leverage, and exposure to contingent events. Based on these factors, they classify the stock into one of several uncertainty levels: low, medium, high, very high, or extreme. The greater the level of uncertainty, the greater the discount to fair value required before a stock can earn 5 stars, and the greater the premium to fair value must be before a stock earns a 1-star rating.

The diagram below illustrates the premium/discount to fair value necessary for each uncertainty level to earn a particular star rating. As you can see, there is a big difference in the discount required to earn 5 stars on a company with a low uncertainty rating versus a company with a very high uncertainty rating. A company with low uncertainty only has to be priced below 80% of its fair value to earn 5 stars, while a company with a very high uncertainty rating would need to be under 40% of its fair value. In simple terms, when there is more risk associated with a company, we build in an extra cushion to help hedge against unpredictability.

It's important to keep fair value uncertainty in mind when you are looking for 5-star stocks, as they can behave very differently based on their risk profiles.

Five-star stocks with low fair value uncertainty ratings are likely to be large, established companies that we think are undervalued. These are frequently industry leaders, and they may not keep their 5-star ratings for long because even a small price change could move them out of "consider buying" range. We used the  Premium Stock Screener to search for 5-star stocks with low fair value uncertainty. Click  here to run this screen yourself. (The screener is a benefit of Premium Membership. If you're not a Premium Member, give us a try free for 14 days.)

Here are a few examples from the list:

 3M (MMM)
Fair Value Uncertainty: Low | Fair Value Estimate: $85 | Current Price: $60.25
From the  Analyst Report:
Over its long history, 3M has invented some of the world's greatest products. We think that the firm's innovative culture, defensible patents, and low-cost manufacturing have carved a wide moat around its business that will enable the company to reap outsize rewards over the long run. Through its wide diversification, 3M's portfolio is generally insulated from geographic-specific economic issues. 3M's balance sheet is also very healthy, which gives the company the opportunity to finance future acquisitions with debt.

 Novartis (NVS)
Fair Value Uncertainty: Low | Fair Value Estimate: $73 | Current Price: $40.12
From the  Analyst Report:
In an industry plagued by stagnant growth, Novartis emerges as a juggernaut with diversified operating platforms and an industry-leading number of new potential blockbuster drugs. Strong intellectual property supporting multi-billion-dollar products combined with a plethora of late pipeline products create a wide economic moat for the firm. Novartis derives its strength from a diversified operating platform that includes branded pharmaceuticals, generics, vaccines, diagnostics, and consumer products. The combination of relatively low near-term patent exposure and a diverse operating platform should translate into reliable growth during the next several years.

 Kellogg Company (K)
Fair Value Uncertainty: Low | Fair Value Estimate: $59 | Current Price: $46.82
From the  Analyst Report:
We remain impressed by Kellogg's ability to produce solid sales and profit growth, despite rising commodity costs and weakening economic conditions. In our opinion, the firm's continued focus on driving efficiency improvements, and its subsequent investments in marketing and product development, have enabled Kellogg to stand out in the packaged foods industry, while others have struggled in the face of challenging industry dynamics.

 

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