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A strong economic moat is necessary for any company that wants to survive in the marketplace. We managed to dig up three undervalued stocks with strong pricing power. These companies have impressive gross margins which suggest that they have been able to set prices without consideration of the cost of goods sold.

Using our proprietary tool, we screened over 5,500 companies to find these companies that are undervalued with strong pricing power and fundamentals. These stocks are overvalued according to their growth rate (FCF), using a 15% discount rate. We hope you’ll use this list as a starting point for your analysis.

Forest Laboratories Inc. (NYSE:FRX)

Forest Laboratories develops, manufactures and sells branded and generic forms of ethical drug products. Its principal products include Lexapro, which treats depression in adults and adolescents, Namenda for the treatment of Alzheimer’s disease and Bystolic for the treatment of hypertension.

FRX’s net income rose to $258.1 million, which is a two-fold rise from the year earlier quarter while revenue rose 8.7% to $1.15 billion from the year earlier quarter. It has recently announced positive preliminary top-line results of a Phase III study of Levomilnacipran to treat adults with major depressive disorder.

Pro:

  • Consistently excellent CROIC. (52% CROIC in 2011)
  • Strong balance sheet but liabilities are growing. (TL-to-TA 0.21 in 2010)
  • Growing positive free cash flow. (1.11B FCF in 2010)

Con:

  • Overvalued according to net current asset price by 64.17%.
  • No dividend history.

Current Price: $37.41

Growth Price: $60.92

Undervalued by: 62.86%

Gross Margin 2011: 78.19%

Vuru Grade: 91/100

Shanda Interactive Entertainment Ltd. (NASDAQ:SNDA)

Shanda Interactive Entertainment operates as an entertainment media company in the People’s Republic of China. It engages in the development and operation of online games on an integrated platform. The company offers a portfolio of online entertainment content including massively multiplayer online role-playing games.

Shanda is currently seeking acquisition opportunities in China and abroad and could spend $200 million in the next year. It also seeks to boost ties between social-networking websites and the multiplayer online role-playing games by letting users display their in-game achievements on social networking sites.

Pro:

  • Profits have been consistently reinvested 7 out of 10 years.
  • Steady positive free cash flow since 2002. (1.43B FCF in 2010)
  • Strong return on equity but has been declining since 2009.

Con:

  • Increasing capital intensity has been eating into profits. 32.37% of profits. spent on capital expenditures.
  • Weak divided history but 6.94% dividend yield in 2004.

Current Price: $36.31

Growth Price: $67.88

Undervalued by: 86.95%

Gross Margin 2010: 61.35%

Vuru Grade: 92.86/100

Tessera Technologies Inc. (NASDAQ:TSRA)

Tessera develops, licenses and delivers miniaturization technologies and products for electronic devices worldwide. It operates in microelectronics, which offers semi-conductor packaging technologies encompassing interconnect, and substrates as well as thermal management technology. Its imaging and optics segments provide image management technologies, which enhance the quality of digital images, and micro electro mechanical systems-based single-chip solutions that enable auto focus functionality and image quality comparable with digital still cameras.

Tessera’s profit has risen year over year by an average of 52.5% while revenue has gone up for the third straight quarter.

Pro:

  • Amazing balance sheet history. (TL-to-TA 0.07)
  • Efficiently investing capital since 2002. (48.13% CROIC in 2010)
  • Strong economic moat, but inconsistent since 2008. (19.03% net profit margin in 2010)

Con:

  • Overvalued by stability price by 18.35% and net current asset price by 45.88%.
  • Inconsistent return on equity, mediocre results since 2007. (8.63% ROE in 2010)

Current Price: $16.57

Growth Price: $35.21

Undervalued by: 112.48%

Gross Margin 2010: 92.77%

Vuru Grade: 91.29/100

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: 3 Undervalued Stocks With Strong Pricing Power