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The Year in Stocks: The Rally Continues

Mid-caps and energy lead the way; growth shows signs of life.

John Coumarianos, 01/03/2006

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Stocks ended 2005 with a surge, pushing all the Morningstar diversified equity categories firmly into positive territory. Mid-caps and energy-related issues are leading the way, and growth stocks are showing signs of life. The rally in equities continued for the third straight year after the bursting of the technology bubble sent stocks reeling from 2000 through 2002. The Morningstar U.S. Market Index rose 6.5% for the year, adding about 3% in the final quarter.

The market shrugged off debt downgrades at automaker General Motors GM, legal troubles and weak research pipelines at pharmaceuticals Merck MRK and Pfizer PFE, struggling traditional media and newspaper stocks Time Warner TWX and Dow Jones DJ, and airline and auto-parts bankruptcies. Difficulties at these businesses meant good news for rivals such as Toyota TM, Google GOOG, and Genentech DNA. Additionally, mergers, acquisitions, and restructurings also supported equities. Among the bigger announcements and consummations were SBC/ AT&T T, Procter & Gamble PG/Gillette, Chevron CVX/Unocal, and ConocoPhillips COP/Burlington Resources BR. Notable spin-offs included Expedia EXPE (from InterActiveCorp IACI) and CBS (from Viacom VIA.B). Morningstar analysts currently view Google as overvalued, but find newspapers and both InterActiveCorp and Expedia attractive.
 
While influential financiers sometimes instigated these corporate events, legendary investor Warren Buffett characteristically remained content to leave the managers of his holdings alone. His company Berkshire Hathaway BRK.B picked up shares of brewer Anheuser-Busch BUD, home improvement retailers Home Depot HD and Kingfisher PLC, computer-printer maker Lexmark LXK, and industrial conglomerate Tyco TYC. Morningstar Analyst Dreyfus Neenan views Berkshire as a bargain.
 
Equity markets also mostly ignored political and macroeconomic problems such as continued difficulties in Iraq, the "twin" budget and trade deficits, surging oil prices, the Federal Reserve's interest-rate-raising campaign, and the destruction wrought by Hurricane Katrina.

Bonds, however, finally felt some of the Fed's pressure as they struggled to eke out gains, with the Lehman Brothers Aggregate Index up a modest 1.91% through Dec. 21. Nevertheless, a "flat" yield curve (little difference between short-term and long-term yields) bespeaks their continued resilience, which is keeping the housing market humming. Alan Greenspan's successor, Ben Bernanke, will have to manage this, as he seeks to curb inflation without halting growth. Homebuilding stocks such as Toll Brothers TOL, Pulte PHM, and Centex CTX suffered a fourth-quarter swoon, but still tacked on healthy gains for the year.

Surveying the Sectors

Energy surged for the second straight year, leading all sectors and posting a 32.9% gain for the year. However, the sector stumbled in the fourth quarter, shedding about 6%. Many of the larger exploration and production companies faltered toward the end of the year. In the fourth quarter, ConocoPhillips lost 16.4% and ExxonMobil XOM lost 11.2%, though they posted 2005 gains of 35.6% and 11.8%, respectively.
 
Morningstar analysts have been modeling lower commodity prices for the future, leaving the list of 5-star stocks bereft of an energy representative, save Suburban Propane SPH. Analyst Elizabeth Collins says, "Suburban's core business--propane distribution--enjoys high customer switching costs and generates impressive returns on invested capital." Morningstar energy analysts are also fond of the energy pipeline business, and Justin Perucki recently recommended Northern Border Partners NBP and TC Pipelines TCLP, when they briefly descended into 5-star territory.
 
Utilities finished as the second-best sector of the year, putting up a 14.6% gain for the year. The sector's strong multiyear run has also left it too rich to have a representative on the 5-star stock list.
 
Only media posted a loss for the year, as newspaper and radio stocks lagged. Nevertheless, analyst Jim Walden continues to find value in Dow Jones, New York Times NYT, and Tribune TRB.
 
Industry Performance

Although oil products companies such as refiner Valero VLO and oil services companies such as Schlumberger SLB finished first and third for the year in industry performance, business and online service companies such as Google took second place. Analyst Rick Summer has awarded Google a narrow moat for its pre-eminence in online search, but he views the stock as too rich for purchase. Other online businesses enjoying strong performance include online advertising agency and consultant aQuantive AQNT and provider of online educational content Blackboard BBBB. Both of these stocks are currently trading above their fair values, according to our analysts.
 
Paper companies such as Domtar DTC brought up the rear. Although Domtar is trading in 5-star territory based on Morningstar's fair value estimate, the business does not have a moat and has had difficulty generating free cash flow recently. Radio station content provider Westwood One WON also suffered, as advertising moved to the Internet. Nevertheless, analyst Michael Corty awards Westwood a narrow moat based on its lock on traffic reporting and information gathering abilities.

Uncovering Value

Although the market was up overall, high energy prices, interest-rate increases, and a flat yield curve (often signaling an economic slowdown) restrained stocks for most of 2005. Our Market Valuation Graph, which is available here, shows stocks as slightly overvalued, but the current 5-star list encompasses about 80 names, including some businesses that have earned Morningstar's wide moat designation for their competitive advantages: Abbott Labs ABT, Anheuser-Busch, Berkshire Hathaway, Boston Scientific BSX, Coca-Cola KO, Diageo DEO, Johnson & Johnson JNJ, Wal-Mart WMT, Microsoft MSFT and Washington Post WPO.

John Coumarianos is an analyst with Morningstar.

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