Stock Star Rating Performance Update

Our stock star ratings held up relatively well under the first-quarter market rally. Five-star stocks, and the strategies based on 5-star stocks, both outperformed the cap-weighted and equal-weighted S&P 500. Even more pronounced was the outperformance of lower quality stocks, which marked much of the 2009 rally, and persisted in the first quarter of 2010.

Star Ratings
To construct our average star rating portfolio returns, we calculate the equal weighted average returns of all stocks with a given rating on a daily basis. We then take the geometric average of those daily returns over the relevant time period. Our average star returns show that 1-star stocks had enormous returns over the last year, lifting all of their trailing period returns. Excluding 1-star stocks, the returns line up roughly as we would hope, with 5-stars outperforming lower rated stocks.

One reason our 1-star stock average portfolio had such high returns is because, as Pat Dorsey mentioned in our 2009 year-end performance article, we were skeptical of how quickly stocks were pricing improvements in the credit markets, which caused us to be behind a few of the higher-risk stocks that exploded over the last year.

In addition, we rated very few stocks 1-star at the bottom of the market in early 2009. In fact, of March 7, 2009, the day the S&P 500 bottomed, only 58 stocks of our 2,102 stock coverage universe were rated 1-star. \

As a result, each stock that remained in the portfolio had significantly more influence over the average return, and a few outliers were able to considerably skew the returns of the average portfolio.

To counter this outlier effect, we also construct portfolios that are reconstituted daily, but use the median return for each rating on a given day to construct portfolio returns. Our median returns line up as we would hope over the last one, three, and five years.