Morningstar's Four Stock Portfolios: Performance Update

It's been a tough year for growth stocks. Through the end of July, there has been a difference of more than 15% between the performance of growth and value as defined by Morningstar. The Morningstar Growth Index has lost 4% year to date, versus an 11% gain for the Morningstar Value Index.

You see the discrepancy quite clearly when you examine the 2006 performance of our four stock portfolios: the Tortoise, Hare, Dividend, and Growth portfolios. Only the Dividend Portfolio--thanks to its holdings in high-yielding stocks of quality companies--has beaten the Morningstar U.S. Market Index's return of 3.4% (although the Tortoise is close). But the Hare and especially the Growth portfolios have lost ground this year.

Performance Drivers
As Morningstar subscribers know, we've been cool to most stocks in the two sectors that have performed best in 2006: energy and utilities. (We think that we'll eventually look like geniuses, but "eventually" is taking a while to get here.) That said, four of the Dividend Portfolio's holdings reside in the energy sector, which has helped the portfolio's 2006 performance. But the Hare and Growth portfolios have almost no exposure to those two sectors. Instead, they have hefty positions in some of the worst-performing sectors so far this year--hardware, software, and consumer services.

Given that we run concentrated portfolios--about 20 stocks per portfolio, with top positions often topping 10%--our performance can, and often does, depart substantially from what our sector or style exposure might otherwise suggest. Let's talk a little about the individual stocks that have contributed to our year-to-date performance.

Dividend: Up 8.5%
Seventeen of the 20 stocks in the portfolio at the beginning of the year have appreciated this year. Large gains from Suburban Propane Partners (SPH) (up 34%) and Diageo (DEO) (up 23%) have helped 2006 returns.

Tortoise: Up 2.5%
No holding is down more than 20%, but one of the top holdings--title insurer First American (FAF)--has suffered in the real-estate slowdown, losing 18% this year. On the plus side, Merck (MRK) has rebounded nicely (up 32% this year), and the portfolio has also had large gains from General Dynamics (GD) and J.P. Morgan Chase (JPM).

Hare: Down 2.6%
 CarMax (KMX), the portfolio's biggest position, is up 24% this year. But five holdings have lost more than 20%, including eBay (EBAY) and Dell .

Growth: Down 9.9%
Whereas the Hare focuses on wide-moat companies, the Growth Portfolio focuses on what we call emerging-moat companies, which tend to be smaller and more volatile. Holdings International Game Technology  and Tempur-Pedic (TPX) have each notched 26% gains in 2006, but four holdings have fallen more than 30% this year:  Educate , Expedia (EXPE), Blue Nile , and Avid Technology .

How We're Positioned Today
For each of the four portfolios, the underlying portfolio-building principles are exactly the same, and can be summarized as follows:

� Buy stocks at a healthy margin of safety.
� Don't dilute good ideas with mediocre ones.
� Keep an eagle eye on trading costs.

Because of this discipline, we're actually happy to see growth stocks take a beating. It provides more opportunities to deploy capital. Paul Larson, who manages the Hare Portfolio, has doubled down on Dell Computer and eBay so far this year. (StockInvestor subscribers recently participated in a conference call to hear more about our latest thinking on Dell.) And Toan Tran pointed out in a recent issue of GrowthInvestor that 18 stocks on his Emerging Moat watch list--the main source of ideas for the Growth Portfolio--had tripped into 5-star territory, including Zebra Technologies (ZBRA), Given Imaging , and Nasdaq (NDAQ).

So going forward, we're quite excited about our growth-oriented portfolios. As you can see from the table below, they currently sport the highest average star ratings. (These are weighted by each stock's weighting in the portfolio, and exclude cash.) The top holding of the Growth Portfolio, International Game Technology, sports only 3 stars because it has appreciated to $38 from $29 since we purchased it. But the weighted-average star rating of the portfolio is 4.5. Thirteen of the portfolio's 18 holdings are rated 5 stars. As for the Hare, 13 of its 20 holdings are rated 5 stars.

Morningstar Portfolio Statistics
	Tortoise	Hare	Dividend	Growth
# of Holdings	23	20	20	18
Avg. Star Rating (excluding cash)	4.1	4.5	4.1	4.5
Top Holding	TransCanada (TRP)	Carmax (KMX)	Wells Fargo (WFC)	Intl. Game Technology
Top Holding (%)	7.7%	14.2%	6.8%	10.1%
Forward P/E	16.3	18.1	14.3	20.7
Price/Book	2.8	3.3	2.8	2.6
ROA	8.5%	11.2%	7.1%	10.2%
ROE	31.6%	26.1%	21.2%	21.4%
Dividend Yield	2.2%	1.3%	4.3%	0.6%
Median Market Cap (mil.)	$36,691.8	$10,773.2	$12,257.9	$4,193.2
Data as of 7-31-06