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Stock Strategist

Stock Star Rating Performance Update

Here's how we did in the first quarter of 2008.

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So far, 2008 is not progressing as well as I would like, but it's an improvement over 2007. While our poor returns from last year continue to weigh on our trailing performance, we were ahead of the market by a decent margin during the first quarter, so we regained a small amount of mojo during the first three months of 2008.

Our trailing results are below, and the story here remains the same as it was when I last updated you on our performance: Respectable long-term results dragged down by a number of bad calls over the past year or so. Given that we underperformed the S&P 500 Index in 2007 by almost 10 percentage points, it will take some time to regain lost ground. We are, of course, working hard to accomplish this.

So far this year, we've been helped by some of the same stocks that hurt us in 2007. For example, most of the homebuilding stocks posted tremendous gains in the first quarter, and while many still trade below their original 5-star prices, the sharp rally did help our performance. We also got a boost from our relatively positive stance on consumer-oriented companies coming into the year, with stocks like  P.F. Chang's China Bistro (PFCB),  Perry Ellis (PERY), and  Gymboree (GYMB) all jumping more than 25% in the quarter. (You wouldn't know it from the headlines, but consumer discretionary was one of the better-performing sectors of the market during the first quarter.)

 Calendar-Year Trailing Returns
 Summary Buy at 5,
Sell at 1
Buy at 5,
Sell at FV
Buy at 5,
Sell at 3
S&P 500

S&P 500
Eq-Weight

2008 -7.54% -7.14% -6.76% -9.44% -8.60%
2007 -4.46% -8.40% -8.74% 5.49% 1.53%
2006 17.42% 20.15% 23.27% 15.79% 19.04%
2005 7.57% 9.38% 9.15% 4.91% 7.37%
2004 21.35% 26.75% 32.76% 10.88% 17.13%
2003 42.27% 47.15% 44.32% 28.69% 44.75%
2002 -32.75% -37.04% -36.83% -22.10% -16.15%
2001* 1.99% 3.86% -5.03% -11.89% -1.22%
Data from Abacus Analytics, through 3-31-08. * Morningstar began rating stocks on 08-06-01.

Large gains from some of our favorite energy names, such as  Cimarex (XEC),  XTO Energy (XTO), and  EOG Resources (EOG), also helped us out in the first quarter. Although the gains posted by these stocks were generally in response to company-specific news about production or reserves, the energy sector's positive tail wind certainly didn't hurt.

 Time-Weighted Returns
  Buy at 5,
Sell at 1
Buy at 5,
Sell at FV
Buy at 5,
Sell at 3
S&P 500

S&P 500
Eq-Weight

Trailing 1-Year -12.27% -14.65% -14.94% -5.07% -9.74%
Trailing 2-Year -1.54% -2.45% -1.33% 3.03% 0.57%
Trailing 3-Year 4.86% 4.66% 5.59% 5.85% 5.89%
Trailing 4-Year 6.59% 7.18% 8.33% 6.06% 6.94%
Trailing 5-Year 14.96% 17.06% 18.08% 11.32% 14.91%
Since Inception 4.24% 4.52% 5.28% 3.12% 6.62%
Data from Abacus Analytics. Data through 3-31-08.

Finally, our lukewarm stance on technology stocks at the start of the year helped us out as that sector rolled over in a big way. It's worth noting that we've definitely been finding more values in this area as prices have come down, however--the percentage of the Buy at 5, Sell at 1 portfolio in tech moved from about 11.5% at the start of 2008 to just under 15% at the end of the first quarter.

On the downside, we were hurt by some stock-specific calls-- Moneygram (MGI) and  Borders (BGP) both got crushed in the first quarter, for different reasons--as well as by the continuing implosion in the financial services sector. The financial guarantors, along with a number of the weaker lenders such as  National City (NCC) and  CIT (CIT), were some of the main culprits in dragging down our performance. Overall, financial services stocks were the largest detractors from our first-quarter performance.

We spent a great deal of time during the first quarter reassessing our stance on financial companies. While we still think there are a lot of attractively priced stocks in the sector, we're focusing on companies with solid balance sheets, enduring franchises, or (better yet) both. We've become much more cautious on companies that look cheap, but which have weak business models or weak balance sheets, because it has become abundantly clear that the credit bubble led to a high-water mark of profits in the sector that's unlikely to be reached again any time soon.

Our Process
Stepping back to look at the bigger picture, we have been applying some of the lessons learned from the bursting of the credit bubble to improving our research process more generally. For example, we're spending more time on scenario analysis. Although we've long modeled different scenarios for a subset of the companies we cover--such as those with potentially high but uncertain growth prospects--we're applying this analytical tool to more and more companies across our coverage universe.

Doing this has two benefits. First, we should have more accurate fair values, because we're now weighting a number of possible future outcomes, rather than choosing a single most likely path. Second, and equally important, scenario analysis forces us to consider the possibility of divergent outcomes before they come to pass, which should help us avoid the mental trap of anchoring on one specific set of future events. Generally speaking, if you've mapped out a few different potential outcomes in advance, you're more likely to change your opinion based on marginal information that indicates one of those outcomes is now more or less likely, rather than stubbornly sticking with the only scenario you imagined as the most likely outcome.

We're also spending more time focusing on our variant perceptions for the outliers in our coverage universe. In other words, we're looking very carefully at the companies that we think are extremely over- or undervalued, and we're pushing hard to ensure that we have a solid rationale for having a radically different opinion than the market. The intuition here is fairly simple--the further away your opinion is from the market price, the more confident you need to be that the market is wrong and you are right.

Conclusion
I'll conclude by addressing a question that has arisen quite frequently over the past month: Have we hit bottom? Was the fear that permeated the market in mid-March during the  Bear Stearns (BSC) crisis as bad as things will get? Frankly, I have no idea--though I'll note that a much smarter investor than I has all but said that the worst is yet to come for the economy. However, it's worth bearing in mind one very important fact: The stock market is a discounting mechanism, which means that, on balance, it looks forward rather than backward. The financial media, by contrast, tends to look backward rather than forward, and this tendency is magnified when it reports on economic statistics that are lagging indicators of where the economy has been recently.

So, the headlines--and probably the economic news--will remain negative for some time after equities begin to look forward and price in an improving earnings environment. Has that happened already? I don't know. What I do know is that the principles of sound investing haven't changed, which means that patient accumulation of undervalued securities still makes a lot of sense over the long haul. It may be boring, but it works.

Pat Dorsey does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.

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