Wide-Moat Stocks the Rally Left Behind

The market has staged a dramatic rebound over the past three months. Of the roughly 130 industries Morningstar tracks, all but two (toys and hospitals) have generated positive returns for the trailing three-month period ending June 24, 2003. Because the share prices of most widely traded stocks have surged higher, fewer stocks now qualify as cheap enough to merit 4- or 5-star Morningstar Ratings. (The Morningstar Rating for stocks is based on a comparison of the current stock price with our estimate of its fair value, and also incorporates the company's business risk and economic moat.) Only about 7% of our rating universe now earns 4 or 5 stars, down from about 14% at the end of 2002.

Even in a relatively pricey market, however, there are still some compelling opportunities. To find them, we used  Morningstar's Premium Stock Screener to home in on stocks that have posted negative returns for the year to date through June 24. But because there's no point in buying a stock simply because it has dropped in value, we limited the universe to stocks with ratings of 4 or 5 stars. Stocks earn above-average ratings if they're trading at a discount to our analysts' estimates of their fair market value. 

Only six stocks made the cut. All of them boast share prices well below their 52-week highs, as well as wide economic moats. Some of them are fairly controversial: Freddie Mac (FRE), for example, recently gave the boot to its chief executive officer, chief financial officer, and chief operating officer in the wake of significant questions about its accounting practices. While the accounting issues add considerable uncertainty, Morningstar stock analyst Rich McCaffery argues that the mortgage financer's core business hasn't changed.

Here are some more highlights on the stocks that made the list.

 Automatic Data Processing (ADP)
Economic Moat: Wide
Business Risk: Below Average
Morningstar Rating: 5 Stars
From the  Analyst Report: "Like most firms, ADP is suffering in this cyclical slowdown. But its competitive advantages, huge cash flow, pristine balance sheet, and low business risk keep us believing it's a buy in the mid-$30s."

 Cintas (CTAS)
Economic Moat: Wide
Business Risk: Below Average
Morningstar Rating: 4 Stars
From the  Analyst Report:  "While competition in the uniform-rental market is fierce, Cintas enjoys significant advantages. As the volume and service leader, Cintas gets cost savings from scale economies and exercises pricing power, which translate into at least a 400-basis-point advantage in operating margin relative to its nearest rivals. And thanks to its effective salesforce and opportunistic acquisition strategy, Cintas has been able to increase its sales at a significantly higher rate than its peers, driving market-share gains. We expect Cintas' advantages to continue providing superior financial results."

 Freddie Mac  (FRE)
Economic Moat: Wide
Business Risk: Average
Morningstar Rating: 5 Stars
From the  Analyst Report: "Freddie Mac said it expects to increase retained earnings as of December 2002 by $1.5-$4.5 billion as a result of its pending restatement. While we expected to see an increase, as well as an increase in the company's equity, the recent announcement puts some numbers on the restatement and gives us more comfort. Our fair value estimate of $78 is unchanged, and we continue to believe that the issues surrounding Freddie Mac's restatement do not affect the core business or the company's ability to compete over the long term."

 General Dynamics  (GD)
Economic Moat: Wide
Business Risk: Average
Morningstar Rating: 5 Stars
From the  Analyst Report: "Over the next five years, U.S. defense spending is set to increase as much as 6% annually. While the war on terrorism accounts for some of the increase, there's a bigger motivation: Years of defense budget cuts have left U.S. weapons systems--including aircraft and ships--in need of replacement and repair. Plus, initiatives under way to transform the military mean more money for new equipment that will make the United States more capable of responding quickly to threats around the globe."

 Harley-Davidson  
Economic Moat: Wide
Business Risk: Below Average
Morningstar Rating: 4 Stars
From the  Analyst Report: "The most significant change in our valuation model for Harley-Davidson relates to the sustainability of the company's robust returns on capital. Harley's assets have historically produced excellent returns as the firm built new factories to expand its business, and we've extended our estimate of how long it will take for these above-average returns to decline, given the firm's competitive advantages. This results in greater cash flows over the long term."

 Schering-Plough 
Economic Moat: Wide
Business Risk: Average
Morningstar Rating: 4 Stars
From the  Analyst Report: "We expect layoffs, management attrition, and legal settlements to be the headliners over the next few months, but Schering-Plough has the financial wherewithal and product lineup to rebound, in our opinion. Investors looking for a pharmaceutical fixer-upper have one in Schering-Plough, but we'd wait for the shares to dip below $18 before buying."

Click  here to run this screen yourself and see all the stocks that passed. (Note: You will need to be a  Premium Member to view and save the complete screen.) After clicking, you can save the search by using the "Save Criteria" button in the bottom right-hand corner of the screen.