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Stock Strategist

Stock Star Rating Performance Update--Page 2

Here's how we're doing so far in 2007.

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In past performance reports, I've looked at our best and worst individual stock calls. For this report, I'd like to examine our recent performance from a top-down perspective, looking at which sectors helped and hurt our returns relative to the broad market. The table below shows how much of the 16.6% return of the equal-weighted S&P 500 Index over the past year was contributed by each of the 12 Morningstar sectors, and how much each sector contributed to the 12.5% return of the Buy at 5, Sell at 1 portfolio.

 Contributions to Returns, 9-30-06 through 9-30-07
Sector Buy at 5,
Sell at 1
S&P 500
Eq-Weight
Business Services 2.2% 0.8%
Consumer Goods 1.3% 1.38%
Consumer Services -1.3% 0.6%
Energy 1.8% 3.8%
Financials -0.8% 0.5%
Hardware 1.5% 2.4%
Health Care 1.6% 1.2%
Industrial Materials 3.9% 3.5%
Media 0.5% 0.3%
Software 0.7% 0.4%
Telecom 1.4% 0.9%
Utilities 0.2% 0.7%
Total 12.5% 16.6%

This table may be a bit confusing, so let me give you a couple of specific examples. On the plus side, the business-services sector helped our performance, because it contributed about 2.2 percentage points to the return of the Buy at 5, Sell at 1 portfolio, while this sector overall contributed less than 1 percentage point to the return of the S&P 500. By contrast, the financial-services sector hurt our performance by a bit less than a percentage point, whereas the financial sector overall helped the performance of the S&P 500 by about half a percentage point.

Going further down the table, the industrial-materials sector contributed almost 4 percentage points to the return of the Buy at 5, Sell at 1 portfolio, which is great. But because that sector did very well over the past year--contributing about 3.5 percentage points to the S&P 500's return--we have take into account that fact that our picks in that sector were riding a rising tide.

By contrast, our measured stance on energy hindered our performance. Although the energy sector contributed almost 2 percentage points to the performance of the Buy at 5, Sell at 1 portfolio (good), the sector contributed about twice that return--almost 4 percentage points--to the S&P 500 (not so good). So, the upshot is that while we had some solid energy picks that made money for investors, we also had some missed opportunities in the sector. The hardware sector within the Buy at 5, Sell at 1 portfolio turned in similar performance, in that it did well, but the sector overall contributed even more to the market's return.

Big picture, the business-services sector helped our performance the most, followed by smaller--but still very much positive--contributions from telecommunications, health care, industrial materials, and software. Business services is a bit of a grab-bag sector, but one in which we often find misvalued stocks. In the past year, we've had three doubles in this sector, ranging from a small-cap Spanish company that makes monitoring systems for pipelines ( Telvent (TLVT)), a credit-card network ( MasterCard (MA)), and a fast-growing company that does back-end processing for telecom carriers ( Synchronoss (SNCR)). We've also had one triple--digital-mapping firm  NAVTEQ (NVT), which just happens to be headquartered right across the street from Morningstar in Chicago. Our only major blowup in this sector over the past year was digital-image purveyor  Getty Images (GYI), which got whacked by almost half.

On the negative side, the consumer-services sector (which houses all of the homebuilders) and financials hurt our absolute returns the most, with energy, hardware, and utilities dragging down our relative performance. Out of curiosity, I separated out all of the stocks directly tied to the housing market--homebuilders, mortgage insurance firms, large mortgage lenders, and so forth--to see their effect on the performance of the Buy at 5, Sell at 1 portfolio, and overall, those stocks subtracted almost 5 percentage points from the portfolio's return. In other words, the Buy at 5, Sell at 1 portfolio would have been up more than 17% during the past year had we just thrown every housing-related stock into the "too-hard" bucket.

Of course, that's not what we did. Hindsight is 20/20, but it's clear that we misjudged how ugly things could get in housing, and we didn't anticipate the further shock to demand caused by credit drying up in late summer. For homebuilders in particular, we were on the right track with our "preparedness" analysis this past April, but we erred substantially by not heeding our own advice. We should have been faster to put on our credit-analyst hats and focus on balance sheets (particularly of the less "prepared" builders), rather than consistently looking at them all as going concerns. Our mistakes with regard to the mortgage lenders and guarantors were somewhat different, but stemmed from the same source--the bottom of the trough looks like it will be much lower than we'd initially anticipated.

Conclusion
Thanks for reading our latest performance update. We think it's important to regularly update you on what we're doing right, as well as where we think we can improve. As always, feel free to send me an e-mail with any questions or comments, and look for our next performance update in January of the new year.

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

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