Morningstar Rating for Stocks Performance Update

During the first quarter of 2006, our top-rated stocks continued to perform well. Year to date through March 31, our "Buy at 5 Stars, Sell at 1 Star" portfolio had risen by 7.4%, well ahead of the S&P 500's 4.2% return and somewhat ahead of the 6.7% return of the equal-weighted S&P 500.

I'm pleased that we're ahead of the equal-weighted S&P 500 so far this year, since this index is more analogous to the Buy at 5, Sell at 1 portfolio--both invest an equal dollar amount into each holding, regardless of market cap. Moreover, our performance since inception relative to this tough benchmark continues to improve. Six months ago, the Buy at 5, Sell at 1 portfolio trailed the equal-weighted S&P 500 by 1.7 percentage points, but we've now cut that lead to just under 1 percentage point. We continue to handily outperform the standard S&P 500 that's weighted by market cap, as you can see in the following table.

Buy at 5, Sell at 1 Strategy
	Since Inception*	Trailing 3-year	Trailing 1-Year
Buy at 5, Sell at 1 (time-weighted)	8.6%	26.4%	20.1%
Buy at 5, Sell at 1 (dollar-weighted)	13.3%	26.4%	20.9%
S&P 500 (cap-weighted)	3.4%	17.3%	11.8%
S&P 500 (equal-weighted)	9.5%	25.7%	17.7%
Data as of 03-31-06 *The Morningstar Rating for stocks launched on 08-06-01.

As a reminder for first-time readers of our quarterly performance review, we measure the performance of the star rating 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 explanation of the difference between time-weighted and dollar-weighted returns, as well as how we measure our performance, see our October 2005 performance review.)

In this performance review, I'd like to show you some data about the performance of stocks with different economic moat ratings, as well a breakdown of the current Buy at 5, Sell at 1 portfolio's composition. Before I do, however, I'd like to reiterate a point that I made in the  January 2006 performance review, which is that the difference between the dollar-weighted and time-weighted returns of our benchmark portfolio will vary the most over longer periods that include both bull and bear markets.

Moreover, it's highly likely that our dollar-weighted returns will always exceed the time-weighted returns over these longer periods, because we're almost certain to have more 5-star stocks during bear markets when stocks are relatively cheap. As I've pointed out before, this is vastly different than what you'll see from most mutual funds, for which dollar-weighted returns are very frequently much lower than time-weighted returns. Why? Because most fund investors chase short-term performance and thus do an awful job of timing the market. (For more on dollar-weighted versus time-weighted returns in mutual funds, you might want to read an article we recently published, Six Reasons to Not Take Returns at Face Value.)

Digging into Returns by Moat
I thought readers would be interested in seeing how the Buy at 5, Sell at 1 portfolio has done when broken down by our various economic moat ratings. Here's the data:

Buy at 5, Sell at 1 Strategy by Moat
	Since Inception*	Trailing 3-year	Trailing 1-Year
Wide	13.8%	22.0%	17.6%
Narrow	10.9%	27.3%	20.2%
None	9.6%	33.2%	28.0%
Data as of 03-31-06 *The Morningstar Rating for stocks launched on 08-06-01.

In sum, our 5-star, wide-moat stocks have outperformed our narrow-moat and no-moat picks since inception, but the lower-quality firms are whomping the wide-moat stocks over the past one and three years. The reason for this is pretty simple: Our wide-moat, 5-star stocks held up much better during the bear market. For example, in 2002 when the S&P 500 was down by more than 20%, our wide-moat, 5-star stocks declined in value by about 13% in aggregate, while our narrow-moat stocks dropped by more than 20%, and our no-moat stocks plunged by more than 30%.

This shouldn't be too surprising--wide-moat stocks are generally larger, more resilient companies, so they hold up better during down markets, even though they're less likely to scream upward when the overall market is doing well. It also highlights a theme that I've written about before, which is the strong outperformance of riskier, lower-quality companies over the past few years as risk premiums have declined to their lowest levels in years. Sooner or later, I think this trend will reverse, the last will become first, and our wide-moat, 5-star stocks will post better returns than their narrow- and no-moat counterparts.

Speaking of good returns, I would be remiss if I did not mention a few of the wide-moat stocks that contributed more than their share to our star rating's performance.  Moody's (MCO) has more than tripled since its shares hit 5 stars in late 2002 amid worries that rising rates and increased competition would hurt the firm's prospects. We thought those worries were overblown, and it turns out that they were. (We also owned Moody's in the real-money Tortoise Portfolio of our StockInvestor newsletter.)

A couple of timely asset-manager picks have also helped-- AllianceBernstein (AB) has run from $25 to more than $65 since the stock hit 5 stars in mid-2002, and  BlackRock (BLK) almost tripled from the time of its initial 5-star rating in late 2002 until it hit 1 star in late 2005. AllianceBernstein got cheap because the market assumed that the bear market in equities would last forever (we took a more measured view), and BlackRock was undervalued because the market pigeonholed it as a niche bond manager, whereas we thought that the firm had lots of potential to increase its market share in fixed-income money management.

Finally, very astute readers have likely noticed that the since-inception returns of all three moat groups are higher than the 8.6% aggregate return of the Buy at 5, Sell at 1 portfolio since inception. This isn't a typo, I promise. It's because the returns in the table above don't include a relatively small group of companies that entered and left the Buy at 5, Sell at 1 portfolio before we started assigning economic moat ratings in mid-2002. By and large, these were pretty poor picks, so they drag down the aggregate performance. If I had to retroactively assign them moats, I'd say that the majority are no-moat companies--but that may just be 20-20 hindsight.

What Does the Buy at 5, Sell at 1 Portfolio Look Like?
I took a look at all of the current positions in the Buy at 5, Sell at 1 portfolio--stocks that were rated 5 stars in the past, but which have not yet reached 1 star--to see what the composition of the portfolio looks like today. The table below slices the portfolio in various ways, and I've listed the composition of our entire 1,700-plus stock coverage universe for comparison.

Buy at 5, Sell at 1 Portfolio Breakdown
		Buy at 5, Sell at 1	Coverage Universe
Moat
	Wide	27%	9%
	Narrow	54%	48%
	None	18%	43%
Risk
	Below Avg	26%	9%
	Average	62%	54%
	Above Avg	11%	33%
	Speculative	1%	4%
Size
	Large Cap	39%	32%
	Mid-Cap	39%	41%
	Small Cap	21%	27%
Domicile
	Domestic	89%	83%
	Foreign	11%	17%
Data as of 03-31-06

As you can see, the most striking characteristic of the current Buy at 5, Sell at 1 portfolio is that it's much more heavily weighted in higher-quality, lower-risk companies. Over one fourth of the stocks in the portfolio have either wide moats or below-average risk, whereas only 10% of the stocks we cover have one of those two designations. Conversely, more than 40% of our coverage universe is rated no-moat, and one third of the stocks we cover are rated as having above-average risk--but only about 20% of the Buy at 5, Sell at 1 portfolio is no-moat, and just about 10% is high risk. In terms of size, the Buy at 5, Sell at 1 portfolio is a bit skewed toward large caps relative to our coverage universe, but not by all that much.

The higher proportion of lower-risk, higher-quality stocks in the Buy at 5, Sell at 1 portfolio isn't the result of some grand top-down decision. Instead, it's simply the outcome of looking at each company individually on its own merits. Most investors have been chasing riskier, lower-quality companies over the past couple of years, which means that the share prices of these firms have been bid up, and so there are relatively few of them in our Buy at 5, Sell at 1 portfolio. By contrast, high-quality firms with less risk have been left on the sidelines, which is why we've found so many wide-moat bargains.

Look for the next performance update in mid-July after the second quarter is over.