Morningstar Rating for Stocks Performance Update

With the first half of 2005 in the rearview mirror, it's time for another review of how the stock star rating is doing. I'm happy to report that after lagging a bit in the first quarter, we've now pulled ahead of most of our benchmarks.

The First Half of 2005
As a reminder, we measure our performance by creating a hypothetical portfolio that buys 5-star stocks, sells them if they hit 1 star, and holds them otherwise. Returns are calculated using internal rate of return, which takes into account the flow of money into and out of our hypothetical portfolio. Because the Morningstar rating is an absolute measure, rather than a relative one, the number of 5-star stocks can vary quite a bit over time. Using internal rate of return accounts for the fact that our 5-star portfolio will have different amounts of money invested at different times.

S&P 500 Compared to Buy at 5, Sell at 1 Strategy
	Since inception*	2005**	2004	2003	2002	2001
Buy at 5, Sell at 1	10.9%	0.7%	24.4%	36%	-22.5%	27.2%
Buy-and-Hold Indexes
S&P 500	1.5%	-0.8%	10.9%	28.7%	-22.1%	-3.8%
S&P 500, equal-weighted	7.7%	-0.6%	16.9%	38.7%	-19.4%	-2.2%
Cash-Flow-Matched Indexes
S&P 500	5.3%	-0.1%	14.4%	26.2%	-16.2%	8.9%
S&P 500, equal-weighted	11.1%	1.5%	21.3%	37.3%	-13.3%	11.9%
* Morningstar Rating for stocks launched 8/6/01 ** Through 6/30/05

For the first half of 2005, and since inception, we're doing well relative to the buy-and-hold indexes, which means we're adding value over a passive "default" investing strategy. Moreover, the margins of outperformance are substantial against both buy-and-hold indexes.

Of course, we also look at our performance relative to cash-flow-matched indexes, which buy and sell units of the S&P 500 at the same time that the Buy 5/Sell 1 portfolio makes transactions. These benchmarks are a tougher hurdle, since they have the same "buying low and selling high" advantage as the Buy 5/Sell 1 portfolio. We're besting the cash-flow-matched S&P 500 that's weighted by market capitalization (the traditional S&P 500), so far in 2005 and since inception. However, the cash-flow-matched, equal-weighted S&P 500 has been a tough bogy--we're essentially neck and neck with it since inception, and we're lagging it a bit so far in 2005.

Digging Deeper
There are a couple of reasons for this, I think. Looking at year-to-date performance, we've been rather bearish on most energy and utility stocks for some time, while those sectors--which comprise about 12% of the S&P 500--were the only two portions of the S&P 500 to be up substantially during the first half of 2005. I'm not terribly concerned about this at the moment, since I think our contrarian stance on energy is well-grounded, and we're just temporarily out of step with the market.

Looking at our since-inception performance, we're essentially neck and neck with the cash-flow-matched, equal weighted S&P 500 index, and I think one reason for this is simply that we made some bad stock calls early on that are still weighing down our since-inception results. The good news is that we've learned from our mistakes, as the following table of trailing three-year returns--starting on July 1, 2002--shows quite clearly.

Trailing Three-Year Returns (%)
Buy at 5, Sell at 1	18.3
Buy-and-Hold Indexes
S&P 500	9.3
S&P 500, equal-weighted	15.0
Cash-Flow-Matched Indexes
S&P 500	11.1
S&P 500, equal-weighted	16.7

As you can see, we've done quite well relative to all of our benchmarks--even the tough ones--over the past three years. This doesn't excuse the bad calls we made in early 2002, but it does indicate that we've gotten better at weeding out undervalued stocks from troubled companies that just get into more trouble.

Additional Metrics
In my last performance update, I provided an analysis of how 5-star stocks in different moat and risk categories have fared. Although many readers requested this--and I was happy to provide it--I'm going to wait until a later performance review to give another update, since the results have not changed very much since last quarter. A number of readers have also requested to see results from star-rating strategies that sell 5-star stocks sooner--"Buy at 5, Sell at 3," for example. We've run some preliminary tests on these, which seem to indicate that alternate strategies like Buy 5/Sell 3 do produce higher returns, but at the expense of much higher turnover (as you might expect). Whether or not the added returns are worth the extra costs is unclear at this point, but I hope to provide some more specific information on alternative strategies in a performance review later this year.

Now on to the good stuff--which of our stock calls have added value and which have subtracted it?

The Good, the Bad, and the Ugly
Here's a list of our best- and worst-performing 5-star stocks over the past year:

The Past Year's 5-Star Winners and Losers
Best		Worst
Stock	Return*		Stock	Return*
Toll Brothers (TOL)	102%		Eyetech Pharmaceuticals	-47%
Chicago Mercantile Exchange (CME)	79%		Exact Sciences (EXAS)	-45%
National Semiconductor	73%		Doral Financial	-31%
Taro Pharmaceutical	68%		Kemet	-31%
Pathmark Stores	58%		LIN TV	-19%
Amer. Power Conversion	58%		eSpeed	-19%
Pacer International	53%		DeVry (DV)	-18%
Fair Isaac (FIC)	52%		Allied Waste	-18%
Alkermes (ALKS)	51%		Solectron	-18%
WMS Industries	49%		Pep Boys	-14%
* From date of purchase--first 5-star rating--until 6/30/05 or 1-star rating.