Morningstar's Stock Star Rating Report Card

Our performance record has been mixed during the first six months of 2010. Although our 5-star stocks underperformed both our coverage universe and the S&P 500, our 1-star stocks had far more negative returns. In addition, low-quality stocks--as measured by our uncertainty and moat ratings--continued to outperform high-quality stocks.

Star Ratings
To construct our average star rating portfolio returns, we calculate the equal weighted average returns of all stocks with a given rating on a daily basis. We then take the geometric average of those daily returns over the relevant time period. Our average star returns show that 1-star stocks had enormous returns over the last year, lifting all of their trailing period returns. Excluding 1-star stocks, the returns line up roughly as we would hope, with 5-star stocks outperforming lower rated stocks. In addition, the 1-star outperformance trend seems to have reversed itself in 2010.

In addition to the equal weighted portfolios shown above, we construct hypothetical return series based on the median returns of each star rating. While these median return series are in no way investable--no one can know which stock will have the median return before the return is earned--they do remove the effect of outliers, yielding another data point about our performance. On the whole, these numbers show that our median 5-star stock significantly outperforms our median 1-star stock over all trailing time periods.

Highlighting some individual stock calls can add context to our star rating performance. Our five best 5-star calls during the second quarter of 2010 are below. While these calls all came from different sectors, most had high Uncertainty ratings, and no Economic Moat.

Star Rating Performance by Moat
In addition to star ratings, we think our economic moat rating is a valuable tool in the investment decision-making process. By itself, the moat rating is value-agnostic. This means we do not believe that it speaks in any way to the discount or premium the company is trading at to its fair value. In other words, we do not claim the moat rating will predict excess returns. However, in combination with the star rating, we have found that the moat rating enhances the performance of our measured strategies. Although quality stocks in general have underperformed the market in 2010, our Buy at 5-star, Sell at Fair Value portfolio--with wide moat stocks only--has almost doubled the annualized return of its full universe counterpart since inception.

Quality vs. Junk
In general, the higher the uncertainty and the smaller a company's moat, the better its performance has been during the first six months of 2010. Much of this outperformance was earned in the first quarter, as low-quality stocks were rebounding from their overly depressed 2009 lows due to investors' increased willingness to take on risk. We think this trend will continue to slow, now that investor risk-taking has reached more normalized levels.

Investable Strategies
While most of the strategies mentioned above are helpful for the purpose of monitoring our performance, their transaction costs would prohibit anyone from following them with real money. For that reason, we also offer more investable strategies based on our stock research. These strategies include our Tortoise and Hare portfolios (available through Morningstar's StockInvestor newsletter), our Dividend Builder and Dividend Harvest portfolios (available through Morningstar's Dividend Investor newsletter), and our Wide Moat Focus Index, which rebalances quarterly to track our twenty cheapest wide-moat stocks. Each of these real, investable portfolios has beaten the S&P 500 since inception, and all but the Wide Moat Focus continued their winning streaks in the second quarter of 2010.

Where Are We Now?
We believe the market as a whole is close to fairly valued. Fortunately, for the diligent investor, there are still opportunities to pick up undervalued stocks in certain sectors. A quick look at our price-to-fair value ratios by sector shows that the median stocks in only the software, hardware, media, and consumer goods sectors are overvalued.