Morningstar's 2006 Contrarian Portfolio

Contrarian investment strategies posit that attractive returns are earned by investing in stocks that are out of favor with most investors. A few years ago, we decided to test this theory, and started analyzing Morningstar's Web site traffic to compare the returns from stocks that are popular with our subscribers with those that are unpopular. Although we believe that investing in the stocks that are most popular with Morningstar's audience offers a good shot of achieving returns that outperform the market, our research indicates that even higher returns seem more likely in less-popular, or "contrarian," stocks.

At Morningstar, we can directly measure a stock's popularity--or lack thereof--with our subscribers. Using our Web site data, we can count unique page views for each stock we cover, and then create a page rank that measures the stock's popularity with our clients. We define a page view as one client clicking on the Analyst Report for a stock once. This yields a direct, and unique, measure of "popularity." For example, in 2005,  Microsoft (MSFT) was our most-viewed Analyst Report (with a page rank of 1), while  Monolithic Power Systems  (page rank 8,006) was least popular. By creating an ordinal ranking of the stocks we cover using our page ranks, we can easily identify the most "contrarian" stocks we cover.

We continue to acknowledge that our methodology isn't perfect. Our 5-star stocks are the most popular, so they generate more page views, and thus higher page rankings. What's more, well-known stocks tend to get more page views regardless of value or market activity. Our page-rank data is also a partial measure of our subscribers' interests, which tend to lean heavily toward undervalued stocks in general. Finally, we can't prove that Morningstar's subscribers are a representative sample of the financial markets. However, we think the data are reliable enough to prove useful, and any strategy that helps investors uncover good businesses that they can buy with an attractive margin of safety has merit.

To get started, let's review the 10 most popular stocks among Morningstar subscribers in 2003, 2004, and 2005:

2003's Most Popular Stocks
	Rank	2003 Return ( % )	2004 Return ( % )	2005 Return ( % )
Pfizer (PFE)	1	17.76	-22.31	-10.45
Wal-Mart Stores (WMT)	2	5.73	0.51	-10.26
Microsoft (MSFT)	3	6.81	8.95	-0.94
General Electric (GE)	4	30.75	20.68	-1.48
Home Depot (HD)	5	49.42	21.47	-4.35
Altria Group (MO)	6	42.74	18.38	27.30
Johnson & Johnson (JNJ)	7	-2.11	25.17	-3.22
Cisco Systems (CSCO)	8	84.96	-20.26	-11.39
General Dynamics (GD)	9	15.97	17.40	10.53
First Data	10	16.28	3.72	1.72
Avg (equally weighted)	6	26.83	7.37	-0.25
S&P 500		28.69	10.88	4.83
Outperformance		-1.86	-3.51	-5.08

2004's Most Popular Stocks
	Rank		2004 Return ( % )	2005 Return ( % )
Pfizer (PFE)	1		-22.31	-10.45
Microsoft (MSFT)	2		8.95	-0.94
Wal-Mart Stores (WMT)	3		0.51	-10.26
General Electric (GE)	4		20.68	-1.48
Merck (MRK)	5		-27.76	3.70
Coca-Cola (KO)	6		-16.12	-0.50
Johnson & Johnson (JNJ)	7		25.17	-3.22
Anheuser-Busch (BUD)	8		-1.95	-13.29
Home Depot (HD)	9		21.47	-4.35
Berkshire Hathaway B (BRK.B)	10		4.30	-0.02
Avg (equally weighted)	6		1.29	-4.08
S&P 500			10.88	4.83
Outperformance			-9.59	-8.91

2005's Most Popular Stocks
	Rank			2005 Return ( % )
Microsoft (MSFT)	1			-0.94
Pfizer (PFE)	2			-10.45
Wal-Mart Stores (WMT)	3			-10.26
Berkshire Hathaway B (BRK.B)	4			-0.02
Coca-Cola (KO)	5			-0.50
Johnson & Johnson (JNJ)	6			-3.22
Anheuser-Busch (BUD)	7			-13.29
General Electric (GE)	8			-1.48
ExxonMobil (XOM)	9			11.80
Dell	10			-28.93
Avg (equally weighted)	6			-5.73
S&P 500				4.83
Outperformance				-10.56

While most of these stocks are certainly popular, their returns aren't consistently attractive. The 2003 stocks delivered positive returns in 2003 and 2004, but they have lagged the returns of the S&P 500 in each of the last three years. The 2004 stocks underperformed the S&P 500 by about 9 percentage points over the last two years. And 2005's most popular stocks were even worse, lagging the S&P 500 by more than 10 percentage points, with only  ExxonMobil (XOM) generating a positive return.

Let's review the returns of Morningstar's 10 least popular stocks for each of the last three years. If our "contrarian" theory has merit, these should be higher.

2003's Least Popular Stocks
	Rank	2003 Return ( % )	2004 Return ( % )	2005 Return ( % )
Neiman Marcus	1,907	76.60	34.57	**
Gabelli Asset Manage (GBL)	1,645	32.56	26.50	-8.86
Knight Ridder	1,467	24.48	-11.83	-3.30
Navistar	1,403	97.00	-8.17	-34.92
Citizens Comm	1,288	17.73	34.09	-4.06
Getty Images	1,265	64.09	37.34	29.66
Sealed Air (SEE)	1,251	45.15	-1.61	5.44
VISX	1,210	141.65	11.75	1.60
Barra	1,201	**	**	**
Bausch & Lomb	1,199	46.11	25.30	6.14
Avg (equally weighted)	1,384	54.54	14.79	-0.83
S&P 500		28.69	10.88	4.83
Outperformance		25.85	3.91	-5.66
** Was acquired, data unavailable

2004's Least Popular Stocks
	Rank		2004 Return ( % )	2005 Return ( % )
Equity Lifestyle Prop (ELS)	6,393		20.88	24.76
Pemstar	6,377		-44.99	-18.23
WebMethods	6,324		-20.77	6.93
Tim Hella ADR**	6,278		45.09	**
Distribucion y Serv ADR	5,816		-11.12	7.75
Molex	5,732		-13.66	-12.91
Marsh A	5,667		8.57	-17.88
Kindred Healthcare	5,630		15.24	-13.99
United National Group A	5,494		5.38	-1.40
Com. Brasileira de Dist. (CBD)	5,445		2.76	29.80
Avg (equally weighted)	5,916		0.74	0.48
S&P 500			10.88	4.83
Outperformance			-10.14	-4.35
** Was acquired, data unavailable

2005's Least Popular Stocks
	Rank			2005 Return ( % )
Monolithic Power	8,006			61.18
Calpine	7,437			-94.67
Charles Schwab (SCHW)	7,373			22.57
Tasty Baking	6,830			-4.82
MSC.Software	6,807			62.37
Cadence Design Systems (CDNS)	6,631			22.52
Stewart Enterprises	6,577			-21.53
National Interstate	6,574			23.15
Petroleum Geo-Serv ADR (PGS)	6,125			49.78
Gramercy Capital	5,765			17.84
Avg (equally weighted)	6,813			13.84
S&P 500				4.83
Outperformance				9.01

And for the most part, they are. The returns on our least popular 2003 stocks more than doubled the returns of the most popular stocks in 2003 and 2004, and were in line with the returns of the most popular stocks in 2005. The returns from 2004's least popular stocks lagged the S&P 500, but handsomely beat the return of the most popular stocks last year. And for 2005, the returns on the least popular stocks bested the returns of the most popular stocks by almost 20 percentage points. One aside is important at this point--note the average page rank of these stocks. For the 2003 stocks it was 1,384; for the 2004 stocks, 5,916; and for the 2005 stocks it was 6,813. In other words, on average during 2005, there were more than 6,800 stocks that were more popular among Morningstar's subscribers, so we're definitely in contrarian territory. (Morningstar covers only about 1,900 stocks, so the other rankings reflect page views for stocks we don't cover).

>> Click here for Part 2 of the article and Morningstar's Contrarian Portfolio.