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Stock Strategist

Stock Star Rating Performance Update

The star rating continues to do well, though the second quarter was rough.

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We lost some ground during the second quarter of 2006, but the performance of our top-rated stocks continues to be solid. More importantly, we added a large number of new 5-star stocks to our benchmark portfolio during the market's swoon, and any opportunity to buy companies at bargain prices is a welcome one, in my opinion.

Year to date through June 30, our "Buy at 5 Stars, Sell at 1 Star" portfolio is up 3%, which is slightly ahead of the S&P 500's 2.4% gain, but behind the 4.5% return of the equal-weighted S&P 500. We lost a fair amount of ground against both benchmarks during the second quarter, partially due to some missed calls, but largely due to our higher weighting in small-cap and foreign stocks. About one third of stocks in the current 5-1 portfolio are small caps or foreign stocks, while the S&P 500 contains no foreign stocks, and only a tiny number of small caps. These types of companies gave the 5-1 portfolio a boost versus the S&P 500 over the past few years, but their poor performance in the second quarter caused the 5-1 to give back some ground.

 Buy at 5, Sell at 1 Strategy
Since Inception* Trailing
3-year
Trailing
1-Year
Buy at 5, Sell at 1
(time-weighted)
5.1% 15.9% 11.0%
Buy at 5, Sell at 1
(dollar-weighted)
11.0% 15.3% 11.2%
S&P 500 (cap-weighted) 2.9% 11.1% 8.3%
S&P 500 (equal-weighted) 8.6% 16.9% 12.2%
Data as of 06-30-06
*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.)

Another View of Our Performance
If you're familiar with our star-rating system, you're likely aware that the number of 5-star stocks can vary quite a bit depending on how many attractive opportunities the market is offering at any point in time. So, you can separate our rating performance into two questions: Did we tell investors to buy stocks at the right time (regardless of which stocks we recommended), and did we tell people to buy the right set of stocks?

We can answer the first question (market timing) by looking at the difference between the time-weighted return of the S&P 500--the return that a buy-and-hold investor would have received from owning the index--and the dollar-weighted return that would have been achieved if an investor had timed purchases and sales to mirror the cash inflows and outflows of the 5-1 portfolio. As you can see in the table below, simply buying when the market was cheap (lots of 5-star stocks) and selling when it was dear (fewer 5 stars) would have increased an investor's return since the star rating's inception from 2.9% annually to 6.4% annually.

The answer to the second question (security selection) comes from comparing the dollar-weighted S&P 500 return to the dollar-weighted return of the 5-1 portfolio. Since the cash inflows and outflows are identical, the return differential comes from the different portfolio compositions. As the table shows, the superior performance of the stocks in the 5-1 portfolio relative to the S&P 500 would have increased an investor's return from 6.4% annually to 11%.

 Buy at 5, Sell at 1 Strategy (Dollar-Weighted)
Since Inception* Trailing
3-year
Trailing
1-Year
S&P 500 2.9% 11.1% 8.3%
S&P 500 (dollar-weighted) 6.4% 10.7% 8.6%
Buy at 5, Sell at 1
(dollar-weighted)
11.0% 15.3% 11.2%
Data as of 06-30-06
*The Morningstar Rating for stocks launched on 08-06-01.

Different Ways to Use the Star Rating
When we first began assessing our performance some years ago, we picked the 5-1 strategy as our benchmark because it's simple--you buy what's cheapest and sell what's most dear. Buying at 5 and selling at 1 also emphasizes a longer holding period, which minimizes turnover and so keeps transaction costs and taxes to a minimum.

However, one size does not necessarily fit all, and the increasing use of self-directed retirement accounts means that many investors have a tax-deferred account as their primary investment vehicle. Moreover, it's perfectly reasonable philosophically to sell a stock at or near fair value--equivalent to our 3-star rating--rather than waiting for it to become significantly overvalued. In fact, one could argue that lower-quality "cigar butt" companies, which are unlikely to increase their intrinsic value over time, are best sold at or near fair value, while only the very best companies merit holding through periods of overvaluation.

So, we constructed two additional hypothetical portfolios based on buying at 5 stars, and selling at either 3 stars, or at fair value. The returns since inception have been materially higher than the buy at 5, sell at 1 strategy, but of course, portfolio turnover is also much higher. Since inception, a buy at 5, sell at fair value strategy would have generated 6.1% average annual returns, while a buy at 5, sell at 3 strategy would have returned 5.6% annually. While these results are meaningfully higher than the 5.1% annual return of the buy at 5, sell at 1 strategy, you don't get something for nothing. The average holding period of a stock in the buy at 5, sell at 1 portfolio is about three years, which declines to one year for the buy at 5, sell at fair value strategy, and further declines to about six months for the buy at 5, sell at 3 approach. Note that these results are not adjusted for taxes or transaction costs, which will certainly have a higher effect on the higher-turnover approaches.

I'll write more about these other ways of using the star rating in future performance updates--including results that are adjusted for transaction costs and taxes--but since many readers have written in asking for this data, I thought I should provide you with some preliminary results. At this point, I'd say that whether you sell 5-star stocks at 3 stars, fair value, or 1 star depends on your sensitivity to taxes, your tolerance for higher turnover, and the quality of the 5-star holding.

Winners and Losers
It's always worth reviewing individual hits and misses. For this performance update, I've chosen to show the best-performing stocks that we've sold from the 5-1 portfolio in the past few months (regardless of their holding period), and the worst-performing 5-star picks from the past year. Think of these as some of our best calls on which the book was recently closed, and recent 5-star picks that have stumbled, but on which the jury is still out.

 Best-Performing 5-Star Picks That Were Recently Sold
 

Bought

Sold Moat Annualized
Return* (%)
Cumulative
Return (%)
AllianceBernstein (AB) 07-23-02 04-19-06 Wide 39 246
Manpower (MAN) 09-20-01 04-05-06 Narrow 22 148
Asyst Technologies (ASYT) 04-26-05 02-01-06 None 117 117
NYSE Group (NYX) 10-19-05 03-08-06 Narrow 114 114
TTM Technologies (TTMI) 08-10-05 02-14-06 None 101 101
GrafTech Intl (GTI) 05-10-05 01-25-06 None 98 98
Steel Dynamics (STLD) 08-23-04 04-04-06 Narrow 52 97
UBS AG (UBS) 08-06-04 05-08-06 Wide 47 96
Terex (TEX) 04-15-05 02-01-06 None 95 95
Group 1 Automotive (GPI) 05-03-04 05-02-06 Narrow 36 85
* Periods longer than one year are annualized.

Starting with the good news, one theme you'll notice in the table above is that many of the 10 winning positions that recently hit 1 star are in some way cyclical--tied to the fluctuations of the economy, the financial markets, or commodity prices. Staffing firm  Manpower (MAN) benefits from the demand for labor brought about by a robust economy; the recent commodity boom has benefited  Steel Dynamics (STLD); and  UBS (UBS), the  NYSE (NYX), and  AllianceBernstein (AB) are all joined at the hip to the animal spirits of the financial markets.

The lesson here is simple: If you can buy when everyone else is selling, you'll generally make a lot of money. Economies, markets, and commodity prices don't go down forever, but stocks can get priced as if they do. As we've seen more recently, the reverse is also true, of course.

You'll also notice the importance of patience. The bulk of AllianceBernstein's cumulative return has come in the past year, and  Group 1 (GPI) treaded water for almost 18 months before shooting up in the first half of this year. Good things often come to those who wait.

 Worst-Performing 5-Star Picks from the Past Year
 

Bought

FV Change
Since 5 Stars (%) 
Return*
(%)
Hovnanian (HOV) 01-18-06 No Change -41
Educate (EEEE) 10-11-05 -17 -41
NeoPharm (NEOL) 11-02-05 -28 -38
Journal Register (JRC) 01-19-06 -16 -38
Expedia (EXPE) 08-09-05 -21 -37
Ryland Group (RYL) 02-02-06 -10 -37
Tuesday Morning (TUES) 12-27-05 No Change -35
Beazer Homes (BZH) 02-01-06 Under Review -34
Mills (MLS) 11-11-05 No Change -30
Dell (DELL) 09-02-05 -15 -30
* Through 06-30-06

Now, on to some of our less-than-brilliant picks (so far). Homebuilders have certainly hurt our performance recently, as slowing home sales have caused investors to leave the industry for dead. We think, however, that most homebuilders are in far better shape during this downturn than they were the last time the real estate market hit the skids, thanks to better balance sheets and the practice of optioning raw land rather than buying it outright. Many of these stocks are currently trading close to (or below) book value, implying that either the land on their books is worth much less than the purchase price, or that the company itself will create no economic value. We think these are unlikely outcomes and that these stocks are quite cheap at current prices.

The two stocks on which we've been "most wrong" so far--measuring wrongness by the change in our fair value estimate since our initial 5-star rating--are a study in contrasts.  NeoPharm (NEOL) is a tiny, high-risk biotech with almost no current sales that has all of its hopes (and our valuation) pinned on the future approval of three drugs. If the drugs do well in trials and get approved, the stock's worth a lot more than the current price. If they don't, it's likely heading much further south.

 Expedia (EXPE), by contrast, generates almost half a billion dollars in normalized free cash flow, which is equivalent to about a quarter of revenue and 10% of the firm's market capitalization. There is no problem making money here--the difficulty has been growth, as competition has heated up more than we originally anticipated. Since we think the current stock price assumes GDP-level growth and no margin expansion--a very unlikely scenario, in our opinion--we're maintaining our 5-star rating.

Conclusion
It's interesting to see how quickly things can change. In the first quarter, the lower-quality companies in the 5-1 portfolio--those without economic moats--returned a whopping 12.3%, followed by narrow moat stocks at 8.1%, and wide-moat stocks at 3.8%. Although the second-quarter's sell-off hurt all three groups, the lower-quality firms bore the brunt. No-moat stocks lost 6.7% in the second quarter, while narrow moats were down only 4%, and wide moats lost just 2%.

I think the long-awaited resurgence of higher-quality stocks may finally be at hand, but then I've been making the argument that quality is cheap since late 2004. So, my timing may have been off a little. Nonetheless, I'm sticking to my guns--high-quality companies are cheaper now than they have been in many, many years, and I'd strongly advocate taking a long hard look at some of the many  wide-moat stocks that are currently trading at solid discounts to their intrinsic values. (For more on why you should buy quality now, check out this article.)

As always, thanks for taking the time to read our latest performance update. Look for our next one in mid-October, when the leaves are turning and the books close on the third quarter.

Correction
Some of the data in the first table of this article and in the ninth paragraph was corrected on Feb. 15, 2007. For details of the correction, please click here.

Pat Dorsey has a position in the following securities mentioned above: EXPE. Find out about Morningstar’s editorial policies.

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