Morningstar Advisor - February/March 2009 - 63

financial health grade. And so far the results are encouraging. Of the stocks that dropped more than 80% during the June-October time frame, two thirds of them earned financial health grades of D or F. To begin the screen, we’ll require a financial health grade of A. Roughly 10% of Morningstar’s universe receives an A grade. value estimates well above the current market price earn a 5-star rating. For investors, this gives an added margin of safety in case growth, profitability, or financial health deteriorate. Expeditors Intl of WA EXPD And Morningstar Rating 5 {{{{{ Financial Health Grade > A– Five companies passed the screen on Nov. 21, 2008. They’re a good list to start with if you’re looking to take advantage of market volatility to pick up some solid companies on the cheap. Applied Materials AMAT Expeditors International of Washington is the performance leader among non-asset-based freight-forwarding and third-party logistics providers. Investors seeking exposure to the growing international shipping market will be hard-pressed to find a more profitable firm. Expeditors’ record of steady growth, high margins, and high returns on invested capital supports a wide economic moat that will deliver the goods for years to come. Fastenal FAST Let’s narrow our list by focusing on companies with decent growth and profitability. We can use Morningstar’s growth and profitability grades, which we also retooled within the past year to make them more robust. The growth grade measures how rapidly a company has been able to increase its revenues over the past five years. For the purposes of this screen, we’re not so much looking for blow-out growth numbers as looking to eliminate firms that may be in secular decline or stagnation. The profitability grade measures how high and steady a company’s return on equity has been over the past five years. And And Growth Grade Profitability Grade > > B B Applied has a wide moat for several reasons. Its installed base has expanded to more than 22,000 tools, and the firm has engineers in nearly every chip-manufacturing facility in the world. Applied’s scale and trusted name have allowed it to develop close relationships with customers, giving the firm insight into current and future customer technology needs. Further, Applied’s substantial resources allow it to compete successfully in various market segments, in aspects ranging from pricing and marketing to research and development. Few firms can rival Applied’s roughly $1 billion annual R&D budget. A strong balance sheet gives the company flexibility in a deeply cyclical industry and allows it to enter new markets with relative ease, either through internal development or acquisitions. Cisco Systems CSCO While Fastenal’s growth is likely to slow because of the developing manufacturing recession, it has defied the weak economy through the third quarter, with sales and earnings both up 17% from the year-ago third quarter. Morningstar analysts attribute Fastenal’s relative strength versus its peers and the broader economy to a strategy aimed at harvesting share gains at existing stores via additional salespeople. Gross margins expanded nicely as the company continues to add new (more profitable) small and mediumsize clients, pushes harder on less profitable sales or accounts, and reaps the benefits of commodity inflation flowing through the business model. Microsoft MSFT Next, we require that a company earn a wide economic moat rating. This is a measure of the strength of a company’s competitive position, as judged by our staff of 110 equity analysts. Because they dominate their markets, wide-moat companies are those in the best position to weather tough economic times. And Economic Moat 5 Wide Finally, we’ll focus on just those stocks that trade at a steep discount to fair value. For this we use the Morningstar Rating for Stocks, which is based on the fair value estimate our analysts derive using a detailed discounted cash-flow analysis. Only stocks that have fair We believe Cisco Systems continues to be well-positioned to gain momentum in emerging, high-growth products and services as the next wave of Internet connectivity takes form. Cisco’s proven reliability, scale, and large installed base of enterprise and carrier customers are the source of its competitive advantage. As data have become a critical component of business, customers prefer established, trusted vendors and are loath to switch to unproven suppliers. The company’s growing cash hoard is a key competitive advantage to sustain technological dominance via continued strategic acquisitions that expand Cisco’s addressable market. While its high-growth days are long gone, Microsoft can still post solid growth as the worldwide installed base of PCs and servers expands. Entry into new markets like video games, business software, and mobile devices will also help move Microsoft’s top line upward. Microsoft is extremely profitable. Operating margins hover in the high-30% range, and the firm generates more than $1 billion in cash per month. Even after buying back $40 billion of stock over the past two years, Microsoft’s fortresslike balance sheet still boasts $30 billion of cash and long-term investments against only $36 billion in total liabilities. Haywood Kelly, CFA, is vice president of equity research at Morningstar. MorningstarAdvisor.com 63

http://www.MorningstarAdvisor.com

Morningstar Advisor - February/March 2009

Table of Contents for the Digital Edition of Morningstar Advisor - February/March 2009