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Stock Strategist

A New Pick for The Ultimate Stock-Picker's Portfolio

Our latest position from the ideas of some of the best investment minds around.

The time has come to unveil the newest position in The Morningstar Ultimate Stock-Picker's Portfolio. It comes right off my newly updated 5-star stock watch list based on our group of 20 investment mangers' latest filings. Before revealing the newest stock, though, I wanted to comment a bit on my methodology.

Methodology Update
The idea behind this portfolio is to utilize the quarterly holdings data from a group of investment managers with attractive long-term track records as an initial screen for a universe of potential investment opportunities. By then comparing this universe with Morningstar's stock coverage and proprietary investment metrics, I can identify those stocks that are both commonly held by at least a few of my group of 20, and that we at Morningstar believe are presently priced to offer potential investors pleasing long-term returns.

What differentiates this approach from others is that it does not just replicate these managers' positions by simply buying when they do, and then selling when they do, but rather, it identifies a group of stocks that various investors--including our analysts at Morningstar--have independently researched and found to be attractively priced. Given that different investors have different methods of researching stocks that, at times, can take them down significantly different paths, I believe it is a very powerful indicator when these paths converge on a common investment conclusion. As a result, we at Morningstar can offer you a truly unique model portfolio that focuses solely on best ideas. To date, it appears that this approach has merit, as our model portfolio has delivered very pleasing performance since its inception last year.

Over time I expect this model portfolio to hold between 10 and 15 names, with the buy and sell decisions driven by the Morningstar Rating for stocks. For example, the portfolio will buy stocks when they are rated 5 stars, and sell stocks when they reach fair value, which, under our rating system, is 3 stars. Why this strategy? I believe that investors can boost their long-term returns by opportunistically recycling capital from lower-return opportunities--think 3 stars--into higher-expected-return investment ideas--think 5 stars--over time.

At Morningstar, we can calculate an annual expected return on a stock over a three-year investment horizon, which gives us a unique quantitative metric to determine the highest expected return opportunities available at any one time. Thinking about how this relates to our star ratings, when a stock is rated 3 stars (fairly valued), it means that the stock's intrinsic value will likely grow by its cost of equity assumption each year. However, when a stock is rated 5 stars, that security is priced to offer investors an excess return (alpha) over its cost of equity assumption. And to generate alpha (profit) for your overall portfolio, you need to be invested in those ideas that offer the potential for excess profits.

There is another very powerful component of this model portfolio. Not only can we benefit from the insights in manager shareholder letters and public commentary, but with 100 equity analysts covering almost 2,000 stocks, we at Morningstar can offer real time assessments of a particular company held in the portfolio or on our watch list. A case in point is the model portfolio's position in homebuilder  Pulte Homes (PHM), which came under moderate pressure amid the recent meltdown in the subprime lending area. Those of you who subscribed to my free e-mail alerts already know that I sat down with Morningstar analyst Eric Landry to discuss the homebuilding industry in general, as well as his take on Pulte. After speaking with Eric, I became more comfortable with the model portfolio's position in Pulte, which has somewhat limited downside risk, in my opinion, and is priced to offer potential investors a still-pleasing long-term return. Even better, I was able to quickly communicate this to readers in an e-mail alert. (I encourage you to sign up for my free alerts if you haven't already.)

New Position and Watch List
After analyzing the group of 20 investment managers' Dec. 31 holdings, and assessing the relative attractiveness of each name by comparing it with Morningstar's star ratings and expected return metrics, I decided to make a couple of transactions to the model portfolio. On Monday March 26, I replaced the portfolio's position in  IAC/InterActiveCorp (IACI), which is rated 3 stars and climbed about 40% during its holding period, with a new position:  American Express (AXP).

My analysis indicated that the following positions were the most common holdings of the group of 20 managers. You'll note that all of these companies are rated as having either a wide or narrow moat by Morningstar analysts, and that the model portfolio holds all of the most commonly held positions that are rated 5 stars, except for one.

 Most Commonly Held Names


No. of Fund
Wal-Mart (WMT) Wide 11 Yes
Tyco  Narrow 9 Yes
American Int'l Group (AIG) Narrow 9 No
Comcast (CMCSA)  Wide 9 No
Berkshire Hathaway (BRK.B) Wide 8 Yes
General Electric (GE) Wide 8 No
Johnson & Johnson (JNJ) Wide 8 Yes
American Express (AXP) Wide 7 New
ConocoPhillips (COP) Narrow 7 No
Coca-Cola (KO) Wide 7 No
Time Warner  Wide 7 Yes
* As of 12-31-06
** As of 03-16-07

As such, American Express was selected because it was held by the most investment managers, is rated 5 stars by Morningstar, and offers a solid three-year annual expected return from the watch list table below, which to me indicates that the likelihood of American Express earning excess returns is greater than that of some of the other names on the watch list.

 Portfolio Watch List
Company No. of Fund
Cost of Equity**

3-Year Ann
Exp Ret**

American Express (AXP) 7 81.71% 10.0% 17.66%
Microsoft  (MSFT) 6 83.00% 9.0% 15.98%
White Mountains  (WTM) 4 70.13% 11.0% 24.94%
Western Union  (WU) 4 70.72% 10.0% 23.47%
Bank of America  (BAC) 4 76.96% 10.0% 20.04%
Medtronic  (MDT) 4 77.86% 9.0% 18.48%
Marsh & McLen (MMC) 3 66.22% 10.5% 26.77%
eBay  (EBAY) 3 67.80% 10.0% 25.22%
Apollo Group   3 70.58% 10.0% 23.54%
Yum Brands  (YUM) 3 72.25% 9.5% 22.03%
Symantec  (SYMC) 3 76.57% 10.5% 20.79%
United Tech  (UTX) 3 85.14% 9.00% 15.00%
* Fund holdings data as of 12-31-06
** Morningstar data as of 03-26-07

In a recent article, we provided our take on American Express: "This firm has by far the best business model out of any of the card-based businesses in our coverage universe. Given that the firm is now a pure play card firm, it's poised to take advantage of the long-term secular trend of consumer payments moving away from cash and checks more toward card-based and other forms of electronic payments. Although all card firms share in this secular growth trend, American Express' superior business model has the best economics--most revenue per dollar spent on its cards--and the best demographics--highest spending per cardholder--which allows for a virtuous cycle of merchants wanting to accept Amex cards to capture high spenders and high spenders wanting Amex cards for the industry-leading rewards that the firm is able to offer, given its financial strength."

Consistent with our positive outlook, Chris Davis and Ken Feinberg, the new managers of the  Clipper Fund (CFIMX), recently commented in their fourth-quarter shareholder letter that "�some of the highest quality companies that we know--companies with strong balance sheets, global leadership, durable brands, and relatively reliable growth prospects---are trading at virtually no premium to second-tier alternatives�With this idea in mind, Clipper has built positions in companies like American Express,  Wal-Mart (WMT),  Harley-Davidson (HOG),  Microsoft (MSFT), and  News. Corp  without paying premium prices." Perhaps an even greater vote of confidence in the management of American Express was given by legendary investor Warren Buffett in his annual letter to shareholders, where he remarked, "There are many giant-company managers whom I greatly admire; Ken Chenault of American Express, Jeff Immelt of  General Electric (GE) and Dick Kovacevich of  Wells Fargo (WFC) come quickly to mind." While I take comfort from these comments, I'm even more encouraged by Morningstar's 5-star rating and $70 fair value estimate, as they indicate that shares in American Express are still priced attractively enough to offer pleasing long-term returns to the model portfolio.

Some of you may have noticed that the expected return for American Express was lower than that of some other companies on the watch list. When I think about differentiating between 5-star stocks on our watch list, I first tend to look for the number of funds that hold a particular name, and then secondly rank the stocks by our analysts' three-year annual expected return. I will note, though, that if a stock offers a very high expected annual return, it could possibly leapfrog some of the other names on the watch list if the number of funds holding it is somewhat similar.

>> Click here for Page 2 and the full portfolio holdings

Justin Fuller has a position in the following securities mentioned above: AXP, APOL, MSFT, PHM, MDT, EBAY, WU, GE. Find out about Morningstar’s editorial policies.