How the Stock Star Rating Is Performing

With 2004 in the rearview mirror, I thought I'd share another Morningstar Rating for stocks performance review with you. Our results continue to be positive, which makes this a pleasant review to write.

As before, we're measuring ourselves by creating a hypothetical portfolio that buys 5-star stocks, sells them if they hit 1 star, and hangs on to 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 star rating is an absolute measure, rather than a relative one, the number of 5-star stocks can vary quite a bit over time. That means our 5-star portfolio will have different amounts of money invested at different times: more money when the market is cheap and we have lots of 5-star stocks, and less money when the market is expensive.

Here's how our "buy at five, sell at one" portfolio has done.

Buy at Five, Sell at One Portfolio Vs. the S&P 500
Portfolio	Inception	2004	2003	2002	2001*
Buy5/Sell1	12.77%	24.38%	36.01%	-22.50%	27.19%
S&P 500	1.99%	10.85%	28.69%	-22.10%	-3.80%
S&P 500, equal-weighted	8.68%	16.90%	40.97%	-18.18%	-1.59%
* Star rating launched 8/6/01

We've continued to do quite well versus the market, though we're not as far ahead of an equal-weighted S&P index as we are relative to the traditional, capitalization-weighted S&P 500 index. As I discussed in the last performance review, this reflects the poor relative performance of large caps over the past few years.  Mega-cap stocks have lagged the average stock recently, which means that an equal-weighted portfolio has had a natural advantage over one that weights bigger stocks more heavily. But even an apples-to-apples comparison of our equal-weighted Buy5/Sell1 portfolio versus the equal-weighted S&P 500 shows us coming out ahead by a decent margin.

Another Viewpoint
Of course, the returns for both of these benchmarks--the traditional S&P 500 and the equal-weighted S&P 500--are buy-and-hold returns from the beginning of 2004 until the end of the year. A key feature of our star rating system is that the number of 5-star stocks can and does vary with the general level of the market, so our Buy5/Sell1 portfolio puts more money to work when we have more 5-star stocks, which is generally when the market is down. (In 2004, the number of 5-star stocks varied from a high of 114, or 8% of our coverage universe, in mid-August to just 31, or 2% of our universe, at the end of the year.)

Buy at Five, Sell at One Portfolio Vs.Cash-Flow Matched Benchmarks
Portfolio	Inception	2004	2003	2002	2001*
Buy5/Sell1	12.77%	24.38%	36.01%	-22.50%	27.19%
S&P 500 (cash-flow matched)	6.47%	14.38%	26.22%	-16.17%	8.90%
S&P 500, equal-weighted (cash-flow matched)	12.68%	21.31%	32.27%	-13.27%	11.90%
* Star rating launched 8/6/01

As you might guess, some portion of our outperformance has stemmed from simply putting more money into the market when stocks are relatively cheap, and taking more out when it's dear. This kind of discipline--waiting for the right pitch, in Buffett's words--will get you a long way in the investing world. However, our goal is not just to tell people when stocks are cheap or dear, but to also succeed at selecting individual stocks that will do well over the long haul.

To measure whether we're doing this or not, we constructed another set of benchmarks based on the traditional and the equal-weighted S&P indexes, which buy and sell units of the index at the same time that the Buy5/Sell1 portfolio makes transactions. In other words, these benchmarks have the same "buying low and selling high" advantage over a buy-and-hold index as does the Buy5/Sell1 portfolio. Lagging these benchmarks would mean that we're good at valuing stocks in aggregate, but that we'd need to work on our recommendations of specific securities.

As you can see, we're measuring up to even this tough test, though the margin of outperformance is smaller. The fact that the returns of the Buy5/Sell1 portfolio have outstripped cash-flow weighted benchmarks means that we're adding value with our stock picks--they tend to do better than the indexes, even when bought at the same time.

Digging Deeper
Speaking of stock picks, no performance review would be complete without looking at some specific highlights and lowlights. Financials, health care, and technology dominated our 15 top-performing recommendations in 2004:

Top Recommendations for 2004
Chicago Mercantile Exchange (CME)	108.74%
Garmin (GRMN)	92.78%
Biogen IDEC (BIIB)	80.32%
Jones Lang LaSalle (JLL)	75.80%
Toll Brothers (TOL)	74.58%
Taro Pharmaceutical	68.35%
Nuveen Investment	66.09%
Alkermes (ALKS)	58.14%
EMC	56.86%
DoubleClick	53.75%
Fair Isaac (FIC)	53.03%
WMS Industries	50.81%
National Semiconductor	49.76%
iPayment	48.00%
Argosy Gaming	46.86%

These are all great examples of our approach to investing--value the business, and then wait for the market to offer up the shares at an attractive price.  Fair Isaac  (FIC), for example, is a wonderful business with midteens returns on capital, and which converts 25% of sales to free cash flow. In mid-July of last year, it got whacked 25% in a single day when it warned that it would miss earnings. We thought this was an overreaction, held our fair value steady, and the stock has done quite well since. Technology giant  EMC  is another example of how patience pays off. We raised our fair value from $10 to $13 per share at the start of 2004, when the shares were selling for about $15. By midyear, they'd slid below our $10 "consider buy" price, and have rebounded nicely. Our fair value didn't change--but the market's mood did.

Of course, we blew some calls as well, and those also merit some discussion. Aside from three drug stocks, our 15 worst calls from 2004 didn't share many common traits--except that I wish there were fewer of them.

Worst Recommendations of 2004
Netflix (NFLX)	-56.13%
Alliance Gaming (AGI)	-54.08%
Krispy Kreme	-52.18%
Level 3 Communications	-39.57%
DeVry (DV)	-30.25%
Merck (MRK)	-29.07%
AVX	-23.96%
Pfizer (PFE)	-22.79%
Odyssey HealthCare	-22.07%
Learning Tree (LTRE)	-19.85%
99 Cents Only Stores	-18.79%
Eli Lilly (LLY)	-18.60%
Interpublic Group (IPG)	-13.66%
Amvescap (AVZ)	-13.14%
Exact Sciences (EXAS)	-12.36%

I discussed three of our bigger misses-- Netflix (NFLX),  Krispy Kreme , and  Level 3 --in the past performance review, so I'll look at a couple of others here.  Alliance (AGI) has been the number-two player in the very profitable slot-machine industry, and we thought that it could hold off industry titan  International Game Tech    as well as  WMS Industries  , which was rebounding from a software glitch that essentially took it out of the market for a time. We were wrong; both firms appear to be eating Alliance for lunch, and our fair value has been slashed from $31 per share to $8. Lesson: Always look over your shoulder, and never underestimate a hungry competitor. For  99 Cents Only , we underestimated the challenges that the firm would face expanding outside of its core California market and have whacked our fair value estimate almost in half. Lesson: Retail is a tough business, and what works in one part of the country may not work elsewhere.

Conclusion
Although there's always room for improvement, I think we're still doing well overall. Even when benchmarked against a portfolio with the same "buy low and sell high" advantage, the Buy5/Sell1 portfolio posted better numbers, which means that our stock picks overall are adding value for investors. Look for our next performance update in mid-April after the first quarter is done.