Two Stocks with 20%-Plus Expected Returns

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American International Group
--Moat: Narrow
--Risk: Avg
--Price/Fair Value Ratio*: 0.74
--Three-Year Expected Annual Return*: 22.8%

What It Does: American International Group (NYSE: - ) is a diversified financial-services firm that offers property-casualty insurance, life insurance, asset management, retirement income, private banking, aircraft leasing, mortgages, credit cards, and derivative products to a global client base of individuals and institutions. Insurance makes up more than 60% of AIG's sales. The majority of AIG's life insurance sales originate in Asia, where the firm has important operations in China and Japan.

What Gives It an Edge: Morningstar analyst Matt Nellans assigns AIG a narrow moat. Nellans believes AIG has a slim edge in each operational area thanks in large part to effective and disciplined managers. The firm's breadth of businesses helps insulate AIG's balance sheet from a shock in any particular segment.

What the Risks Are: AIG's bulk and comprehensive diversification preclude the majority of nonsystemic problems from inflicting more than transitory or irritating--rather than business-ending--challenges. For example, the conglomerate's insurance reserves may prove understated from time to time--but rarely by much, and rarely for long, thanks to the company's extensive incentives that deter executives from doing this--but it would take an extreme event to blast a sizable hole in its balance sheet. Nellans believes a more important risk to AIG's value is a slowdown in its growth rate, which would compromise the firm's historical premium to its competitors.

What the Market Is Missing: Nellans stipulates AIG's stock decline largely relates to the panic-selling across the entire mortgage market, as the firm has billions of dollars invested in mortgage-backed securities and also writes credit default swaps on securities with subprime mortgage collateral. However, Nellans believes the market is ignoring the fact that the vast majority of AIG's exposures have plenty of subordination--that is, mortgage defaults must be catastrophic to provoke a permanent capital loss for AIG.

Corporate Executive Board Company
--Moat: Wide
--Risk: Avg
--Price/Fair Value Ratio*: 0.73
--Three-Year Expected Annual Return*: 22.3%

What It Does: Corporate Executive Board (NasdaqGS: - ) provides best-practices research covering corporate strategy, operations, and general management topics to approximately 3,700 corporate clients. For an annual fee, clients get access to the best-practices research, executive education programs, membership meetings, and directed research. The company uses its members' experiences as the basis for its research.

What Gives It an Edge: Morningstar analyst Brett Horn believes Corporate Executive Board has carved out a great niche for itself. It has no direct competition, and Horn speculates it is unlikely to ever face any. Over 80% of the Fortune 500 are members--a strong lure to prospects, which can get access to other members' experiences and peer networking opportunities through Corporate Executive Board's programs. Additionally, the company produces gobs of free cash flow. Because it collects its annual dues upfront, cash flow is consistently higher than net income, and free cash flow over the past few years has been over 30% of revenue.

What the Risks Are: Being a member of Corporate Executive Board is a discretionary expense for its clients. When times get tough, the company has a much harder time signing up new customers and risks losing existing clients. The company's international customers--27% of its revenue base--pay U.S. dollars while its costs are partially tied to foreign currencies. This generates significant currency risk.

What the Market Is Missing: Corporate Executive Board has run into some operational issues over the past year, as it failed to increase its salesforce quickly enough to maintain its growth. The company is now in the process of ramping up the size of its sales team, but new sales people have been slow to reach full productivity. While this setback is disappointing, it appears to be a short-term problem that should be relatively easy to fix. Horn speculates the market is preoccupied with slower-than-expected growth in the near term while ignoring excellent long-term growth opportunities

Other New 5-Star Stocks
--Arkansas Best Corporation (NasdaqGS: - )
--Con-way (NYSE: - )

* Price/fair value ratios and expected returns calculated using fair value estimates, closing prices, and cost of equity estimates as of Friday, Nov. 2, 2007.

Alex Morozov, CFA, does not own shares in any of the securities mentioned above.