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Stock Strategist

Morningstar Rating for Stocks Performance Update

We examine the stars and come up with some interesting results.

In 2005, the stock star rating continued to deliver very respectable performance. We're still ahead of the S&P 500 over all trailing periods on both a time-weighted and a dollar-weighted basis.

Even better, we're gaining significant ground on the equal-weighted S&P 500, which is more analogous to our Buy at 5, Sell at 1 portfolio because both invest an equal dollar amount in each holding regardless of market cap. The equal-weighted S&P has been a tough bogy so far, and I'm pleased that on a time-weighted basis we've widened our lead over the trailing three-year period, and improved our relative performance since inception.

Here are the numbers:

 Buy at 5, Sell at 1 Strategy
Since Inception* Trailing
3-year
Trailing
1-Year
Buy at 5, Sell at 1
(time-weighted)
7.3% 22.0% 8.0%
Buy at 5, Sell at 1
(dollar-weighted)
11.9% 21.1% 9.5%
S&P 500 (cap-weighted) 2.6% 14.4% 4.9%
S&P 500 (equal-weighted) 8.5% 21.2% 8.1%
Data as of 12-30-05
*The Morningstar Rating for stocks launched on 08-06-01.

Briefly, we measure our performance by creating a hypothetical portfolio that buys stocks with a 5-star Morningstar Rating when they're first rated 5 stars, sells them if they are rated 1 star, and holds them otherwise. We report both time-weighted returns--which are unaffected by the number of 5-star stocks at any particular time, and which are directly comparable to index returns--and dollar-weighted returns, which incorporate the star rating's implicit message to invest more money in the market when there are more attractive opportunities available. (For a detailed recap of the difference between time-weighted and dollar-weighted returns, as well as how we measure our performance, see our October 2005 performance review.)

Before moving on to a discussion of individual stock calls, it's worth pointing out that although our dollar-weighted returns are significantly higher than our time-weighted returns since inception, the difference is much smaller over the trailing one- and three-year timeframes. The reason for this is simple--the past three years have not been at all volatile, whereas the 2001-2002 timeframe incorporates the most recent bear market.

The dollar-weighted approach will add the most value over longer periods that include both bull and bear markets. I'll repeat here a point I've made before, which is that this stands in stark contrast to most mutual funds, for which dollar-weighted returns are much lower than time-weighted returns because most investors do an awful job of timing by chasing strong short-term returns. We designed the star rating specifically to counteract this self-destructive-- but very common--tendency. 

What Worked and What Didn't?
I thought it might be interesting in this performance review to take a slightly longer-term view of our best and worst stock calls. In the table below, you'll see our five best and five worst calls made in each of the three past calendar years. (Note that the returns are cumulative from the date that the stock was first rated 5 stars until the present, until it was rated 1 star, or until the rating was removed.) I've discussed many of these stocks individually in past performance columns, so I'll focus here on broader themes.

 Best and Worst Calls: 2003-2005

                                                                   2003

Buy Date

Portfolio Status Gain/Loss Moat/Risk
Alcon  01-06-03

Sold at 1 star, 09-05

258% Wide/Below Average
Progressive (PGR) 01-16-03 Sold at 1 star, 10-05 145% Wide/Average
Student Loan  02-07-03

Holding--3 stars

141% Narrow/Below Average
Chicago Merc. Ex. (CME) 11-18-03 Sold at 1 star, 09-04 130% Wide/Average
Circuit City  02-06-03 Sold at 1 star, 09-03 125% None/Average
Triad Guaranty (TGIC) 11-14-03 Holding--5 stars -7% Narrow/Below Average
Time Warner  02-04-03 Rating removed, 02-03 -8% Narrow/Above Average
Wal-Mart (WMT) 12-03-03 Holding--5 stars -9% Wide/Below Average
CarMax (KMX) 10-15-03 Holding--5 stars -14% Narrow/Average
Reynolds American  03-18-03 Sold at 1 star, 09-03 -16% Narrow/Average

                                                                   2004

Buy Date

Portfolio Status Gain/Loss Moat/Risk
Omnicare  07-26-04 Sold at 1 star, 12-05 112% Narrow/Average
Cemex (CX) 06-09-04 Holding--3 stars 108% Narrow/Average
Toll Brothers (TOL) 07-08-04 Sold at 1 star, 02-05 102% Narrow/Average
Alkermes (ALKS) 08-06-04 Sold at 1 star, 08-05 98% None/Above Average
Garmin (GRMN) 05-06-04 Sold at 1 star, 11-05 93% Narrow/Average
Lear (LEA) 05-20-04 Holding--5 stars -46% Narrow/Average
Krispy Kreme  05-12-04 Rating removed, 10-04 -51% Narrow/Average
Alliance Gaming (AGI) 05-07-04 Sold at 1 star, 11-04 -54% Narrow/Average
Netflix (NFLX) 07-16-04 Sold at 1 star, 10-04 -56% Narrow/Average
Level 3 Comm.  02-04-04 Sold at 1 star, 02-05 -64% None/Above Average

                                                                   2005

Buy Date

Portfolio Status  Gain/Loss  Moat/Risk
King Pharma.  03-29-05

Holding--3 stars

103% Narrow/Above Average
AirTran Holdings  01-24-05

Sold at 1 star, 10-05

99% Narrow/Above Average
Chicago Merc. Ex. (CME) 04-15-05 Sold at 1 star, 09-05 96% Wide/Average
Gerdau (GGB) 04-15-05 Sold at 1 star, 12-05 86% Narrow/Above Average
Amylin  06-03-05 Sold at 1 star, 08-05 79% None/Above Average
Kinetic Concepts  10-11-05 Holding--4 stars -23% Narrow/Average
Pier One  08-26-05

Holding--5 stars

-32% None/Average
Tempur-Pedic (TPX) 07-25-05 Holding--5 stars -34% Narrow/Average
Cost Pl Wld Mkt  01-10-05 Holding--3 stars -37% None/Average
Doral Financial  03-21-05 Holding--4 stars -54% Narrow/Above Average
Morningstar data

One theme that emerges is the value of opportunism. Many of our best performers were rated 5 stars--meaning they offered an adequate margin of safety to our fair value estimate at the time--for relatively brief periods.  Alcon ,  Progressive (PGR),  AirTran , and  Amylin  were all rated 5 stars for less than a week, and  Garmin (GRMN) was rated 5 stars for only about two weeks. When good opportunities arise, you have to be willing and able to take advantage of them quickly. Many great investors talk about the importance of being decisive and of always having some cash available for unexpected opportunities, and many of our best calls reflect this advice.

Another theme is the importance of not "anchoring" on past stock performance. Shares of  Cemex (CX), for example, had almost doubled in the year prior to our initiation of coverage in mid-2004--but they still looked inexpensive to us, so we posted a fair value estimate significantly higher than the stock price, and launched coverage with a 5-star rating. Then, after another year had passed and a further 50% run in the stock, we took a second look at the company and raised our fair value estimate to $61 from $42. Just because a stock has gone up doesn't mean it's no longer attractive.

Of course, the converse is also true, and stocks that have been hammered can continue to decline. Some of our worst calls have occurred when we underestimated the rate at which firms' intrinsic values were shrinking. When a price decline is accompanied by a quick contraction in business value, your margin of safety can actually get smaller over time, and I think the allure of low valuation has sometimes tempted us to recommend stocks in this category that have subsequently performed poorly.


Conclusion
As always, thanks for taking the time to read our latest performance update. Look for the next one to be posted after the first quarter, in early April.

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