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Insights From the 'Best on the Street'

Hear industry outlooks and best ideas from the 12 Morningstar analysts named by The Wall Street Journal among the "Best on the Street."

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Jeremy Glaser: For Morningstar, I’m Jeremy Glaser. Twelve Morningstar equity analysts were recently named among the Best on the Street in the annual Wall Street Journal survey, with one analyst winning in two industries Morningstar was the most honored firm this year. We sat down with several of these winners to get their best ideas, but first we talk to Morningstar's global director of equity research, Heather Brilliant, for her insights on our research methodology.

Heather, thanks for joining me.

Heather Brilliant: Thanks for having me, Jeremy.

Glaser: Let's talk about the research process that won all these awards. Can you walk us through how Morningstar analysts value companies?

Brilliant: Sure. So there are a couple of elements that I think are really instrumental to our process. The first is that we analyze the economic moat of any company that we cover, so we are really looking for businesses with sustainable competitive advantages. Second is that we analyze the valuation by building a discounted cash flow model on each of the companies that we cover. So we put a lot of time into customizing the key assumptions that determine what are driving the revenue and earnings growth of a given company, and then we put that into an overall model that's really consistent across all of our companies. So we can compare and look at a company in the consumer sector and see how that compares with a company in the technology sector, for example, and it gives us, I think, a better overall picture of how companies are doing.

Glaser: So how do you reach that [Morningstar Rating for stocks] then? How do you know when it's time to buy, when it’s time to sell, or when you should just hold shares?

Brilliant: Essentially we're looking for companies that are trading at a premium or a discount to their intrinsic value. So we use that discounted cash flow model to estimate the intrinsic value, and then from there we look at where the stock price is trading relative to that. So a company that's trading meaningfully below its intrinsic value and below the required margin of safety that we would wait for would be a 5-star stock, and one trading meaningfully above would be a 1-star stock.

Glaser: When you look across the entire equity universe, where do you see valuations right now?

Brilliant: Overall, we think stocks are fairly valued. We see them trading almost exactly at fair value at this point across our entire universe. We see the biggest opportunities in basic materials and energy, and we think that some of the more defensive sectors are the most overvalued at this point.

Glaser: You said that correlations are starting to decline a little bit. Is that a trend that you see continuing, and why does that make stock-picking that much more important?

Brilliant: We have seen some signs that it’s continuing. I mean, we’re looking at correlation data in a couple of different ways. We have started to see that the correlation between industries has not really decreased, but the correlation between global markets has really started to come down. And interestingly, tech has really decoupled from the rest of the sectors out there, in large part because Apple is really the key driver in tech right now, so that's had a big effect.

Sometimes when correlations are really high, everything trades in conjunction with each other. So it doesn't matter if you pick a great stock or find something that's really undervalued, it's going to move just in line with the general market. That's really frustrating when you're a stock-picker, because then you don't see the work you do on the individual names actually play out in an idea that works or doesn't. As long as you are calling the market right, you are getting your ideas right. So now that we are starting to see the market matter less and the stock ideas matter more, we expect our process will continue to do very well.


Glaser: Given that it is the stock-pickers' market, we sat down with five of the Best on the Street analysts to see what their best idea is right now, and also to talk about some of their favorite picks for their radar screens in case there is a pullback.

Karen Andersen: One of my favorite ideas right now is actually Gilead. It's a large-cap biotech name. We assign it a narrow-moat rating, and really the foundation of this business here is in HIV. They have several marketed products here. They dominate the market, and really the innovation that they’ve had is with these single tablet regimens. So people just have to take one pill a day, and it controls the virus. By doing so, compliance is higher and patients stay healthier. So they've got 70% of new patients in the U.S., who are going on therapy, are going on one of Gilead’s single-tablet regimens.

Gilead has been incredibly profitable consistently. Free cash flows have been about 30% of sales over the past several years. I think that's only going to improve in the future. In terms of valuation, this is trading now at a 25% discount to our fair value estimate. It's one of our best ideas right now in biotech.

Michael Corty: Time Warner is one of our favorite names right now. It's a stock we've had great success recommending in the past. Currently, the stock is trading near our $60 fair value estimate, so we recommend investors to keep this one on their radar screen. The stock has had a great run, essentially doubling since the fall of 2011. Therefore, we’d kind of wait for the stock to pullback, perhaps into the low $50 range, and we’ll get excited about recommending the shares again.

Time Warner is a bet on quality-television content and fits our theme that content is king. As the number of distributors increases, we think the value of high-quality programming actually increases over time. And Time Warner has great assets highlighted by HBO and the Turner Cable Networks, which are growing both domestically and internationally.

Furthermore, an often overlooked part of Time Warner is their content studio, which supplies the major broadcast and cable networks with television programming. It's often not known that hit shows like The Big Bang Theory, which currently show on CBS, get monetized in many different ways. In fact, over the last five years, syndication with traditional partners as well as Netflix and have only increased the value of hit shows that Time Warner produces in its studio.

Finally, we really like the management team here. They've done a great job of protecting their content, while getting additional licensing revenue from new distribution partners like Amazon and Netflix, and we think the management team is very shareholder-friendly. Since 2009, they've repurchased about 25% of their outstanding shares in an average price much lower than what the stock is trading at today.

So all in all, Time Warner is a great company with a great management team, and we’d welcome the opportunity to buy the shares again if they traded lower.

Brett Horn: One stock that I think is worth taking a look at, or at least keeping on your radar, is a company called Fiserv. Fiserv is one of the leading, what they call, bank-technology providers. Its base product is what they call core processing. This is kind of the nuts-and-bolts system that banks use to run day-to-day operations, to keep track of how much money is in each person's account, so on and so forth. So it's extremely mission-critical, and as a result, banks almost never switch.

So there are very high switching costs, and you have 80%-85% of revenue recurring. So you have very stable revenue base, and ultimately that very kind of steady cash flow generation and relatively high returns on invested capital. So, it's a very attractive, profitable company, safe company. Right now, it's about fairly valued, but if there were a decent pullback in the stock, we think it's a great idea.

Erin Lash: My best pick right now would probably be Sysco, ticker SYY. Sysco is the largest North American food-service distributor. They possess about 18% of this $230 billion market, and they maintain a vast network and significant economies of scale that have enabled them to operate with pretty high operating margins in this very fixed-cost environment. Operating margins run around 5%, and the company has been investing significantly behind it, making that network even more efficient, which we think is going to enable them to go after additional customers that they haven't targeted before, the bulk of which are large chain restaurants that they have previously not serviced.

Beyond that, we think that Sysco pays a decent dividend, which is yielding around 3.5%. So we think the stock also appeals to income investors, as well, and it's trading at a slight discount to our fair value right now.

Jim Ryan: Three stocks we were recommending over the past year and half, all of which have approached our fair value estimates as of today. Yet, these are still great businesses, which we think could be bought on a pullback in either the stock or the market, all things being equal. The three stocks are First American Financial, a title insurer; American International, AIG; and Old Republic International.

Old Republic might be particularly attractive even today because of its 5% dividend yield. The stock has increased 75% since last August when we were recommending a buy on the stock, but it's still 15% below our fair value estimate. Most importantly, it is very dividend-friendly. The stock yields today a 5% dividend, and the company has paid a cash dividend every year for 71 years and has increased it every year over the past 32 years, including two special dividends. The stock is driven by its general insurance operations, which are generally better than most of their peers, which we think gives it a narrow moat. The company also owns the third largest title insurer in the United States.

Glaser: Congratulations to all the winners. For Morningstar, I'm Jeremy Glaser.

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