The Year in Stocks: The Rally Continues

Stocks are ending 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 6.4% for the year through Dec. 21, putting on 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  and  Dow Jones , and airline and auto-parts bankruptcies. Difficulties at these businesses meant good news for rivals such as  Toyota (TM),  Google (GOOG), and  Genentech . 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 . Notable spin-offs included  Expedia (EXPE) (from  InterActiveCorp (IACI)) and CBS (from  Viacom ). 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 , home improvement retailers  Home Depot (HD) and Kingfisher PLC, computer-printer maker  Lexmark , and industrial conglomerate  Tyco . Analyst Dreyfus Neenan views Berkshire as a bargain currently.
 
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  suffered a fourth-quarter swoon, but still tacked on healthy gains for the year. None remains in 5-star territory.

Surveying the Sectors
Energy surged for the second straight year, leading all sectors and posting a 34.6% gain through Dec. 21. However, the sector has stumbled so far in the fourth quarter, shedding about 5% for the trailing 13 weeks through Dec. 21. Many of the larger exploration and production companies faltered toward the end of the year. In the fourth quarter, ConocoPhillips lost 17%, and  ExxonMobil (XOM) lost 8%, though they posted YTD gains of 34% and 19%, 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 thinks "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  and  TC Pipelines , when they briefly descended into 5-star territory.
 
Utilities finished as the second-best sector of the year, putting up a 15.3% gain through Dec. 21. 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 .
 
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 (as of Dec. 21), 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 currently. Other online businesses enjoying strong performance include online advertising agency and consultant  aQuantive  and provider of online educational content  Blackboard . Both of these stocks are currently trading above their fair values, according to our analysts.
 
Paper companies such as  Domtar  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  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.

Morningstar Portfolio Performance
Our method of investing in high-quality businesses at margins of safety below our fair value estimates helped the Morningstar StockInvestor portfolios. The Tortoise Portfolio rose 11.6% through the end of November, beating the S&P 500 Index. Title insurer  First American (FAF) and natural-gas pipeline  TransCanada (TRP) led the charge. The Hare Portfolio, containing faster-growing and higher-risk stocks, was up 11.3% through the end of November, also beating the S&P. Payroll processor  Paychex (PAYX) powered the portfolio.  Chicago Mercantile Exchange (CME) contributed mightily until StockInvestor editor Paul Larson sold it for valuation reasons. Both portfolios have beaten the S&P 500 Index handily since their inception on June 18, 2001, with the Tortoise Portfolio posting nearly 12% average annual returns and the Hare Portfolio posting 5.7% average annual returns, versus 2.4% for the index.

We also introduced two new newsletters/portfolios in 2005: Morningstar DividendInvestor and Morningstar GrowthInvestor run by equity-income strategist Josh Peters and equities strategist Mike Trigg, respectively. The Dividend Portfolio began on Jan. 10, 2005, and returned 1.4% through Nov. 11, 2005. It was hampered by a large cash stake and underperformance in banks  Fifth Third (FITB) and  National City (NCC). The Growth Portfolio began on May 19, 2005, and returned 5% through Dec. 13. Cash and underperformance in  Tempur-Pedic (TPX) and  Kinetic Concepts  hurt the portfolio.

Uncovering Value
Although the market was up, high energy prices, interest rate increases, and a flat yield curve (often signaling an economic slowdown) restrained stocks for most of 2005. The Market Valuation Graph 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). To learn more about these stocks and other opportunities in the market, start a 14-day, free Premium Membership trial.