Pat Dorsey's Picks: Education, Energy, and Financials

Pat Dorsey: Hi, I'm Pat Dorsey, director of equity research at Morningstar. As part of Ideas Week here in December, as you're thinking about investments for 2010, where you should be putting new money in your portfolio, we thought we'd run through some of our favorite ideas in the equity universe.

Big picture, we're seeing a lot less opportunity than we were back in March. Back in March, easily a third to almost 40% of our equity universe was 5-star rated. Now that number is down quite a bit, to maybe 60 or 70 5-star stocks, as the market has run up rather quickly and, in many ways, has priced in the economic recovery that's going forward. That said, we do still think there are some opportunities, so let me just run through a number of them for you, kind of going sector by sector.

In the consumer area, not a lot of stuff that we're very excited about right now. Probably the one area we're focusing on the most are the for-profit education stocks, companies like Apollo and Strayer, which have been hit by some negative news recently. Apollo's had an informal SEC investigation. There are some possible regulatory changes on the horizon.

Net-net, we think that these companies are cheap, despite the bad news coming in, and that they've priced in a lot of this negative information. For-profit education tends to be a very profitable industry with very high returns on capital, very high levels of free cash flow.

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Apollo is definitely the cheapest name in the group. It also has the most hair on it, as we say in equities. Strayer would be probably the highest-quality name. The Strayer CEO was our CEO of the year a couple of years ago. An incredibly well-managed business. A little pricier than Apollo, but a wonderful business that should do well in the future, with very high returns on capital and a long, long growth runway ahead of it.

In energy, we're not seeing a lot of value right now among the big majors, Chevron, Exxon, and so forth. About fairly valued, just not a ton of opportunity there.

Most of the opportunity we see is in some of the pipeline companies, like Energy Transfer Partners, and also in mid-cap exploration and production companies. Two I would highlight there would be Ultra Petroleum and Range Resources. Ultra has some very low-cost production assets in the Pinedale Anticline in Wyoming that are very good cash-flow assets, and then it's expanding into the Marcellus Shale, which is in the Appalachian area.

A little bit higher-risk, and perhaps higher upside, would be Range Resources, which is pretty much focused in the Marcellus Shale. Has some other assets as well that are free-cash-flow positive, but really all of the upside for Range comes in the Marcellus. Your risk with Range is that if natural gas prices don't really increase next year, they could wind up having to sell off some of their land at perhaps lower prices than they would like, simply because they're unable to develop it economically without those higher gas prices.

In financials, we're still seeing some value despite the massive runup in a lot of these companies. Wells Fargo would be one of our favorites among the big banks right now. Shares are about $27, fair value is about $39. We think they're going to squeeze a lot of cost savings out of the Wachovia acquisition and that their solid underwriting should do well at kind of cleaning up the mess that Wachovia left them.

PNC would also be one of our favorites. They're doing well with the National City acquisition, and we think the shares have further upside there.

Outside of the banking area, Capital One would be a name worth looking at, the big credit-card company. They bought North Fork Bank some years ago, so they have a nice, stable base of low-cost assets where they can re-deploy in the credit-card arena. Shares are very, very cheap right now.

Again, there is some risk, if you get kind of a double-dip consumer recession, but we think the shares have priced this in pretty well and that people are really expecting higher ongoing levels of charge-offs than we think are likely. We think it's very possible that consumer charge-off levels may have peaked back in the summer and should be slowly on their way down, which would give some further upside to Capital One shares.

That's a lot of names for you to think about, a lot of options for you in 2010. Happy hunting.