Stock Star Rating Report Card

At Morningstar, we espouse the benefits of transparency in the investing world. For that reason, we do our best to provide an honest picture of our stock rating performance every quarter. We do so not only so you can judge the value of our research, but so that you can use the performance information to hone your own investment strategies.

How Did Our Investable Strategies Perform?
Morningstar's strategists manage several equity portfolios through our newsletters. As experts in our stock rating methodology, they have keen insight into how to best apply our equity research to achieve outsized returns. In addition, Morningstar created the Wide Moat FocusSM Index, which rebalances to hold the 20 cheapest wide-moat stocks every quarter. The portfolios and our Wide Moat Focus Index are replicable strategies, and they represent easy and efficient ways to put our research into practice, each with slightly different goals, from income generation to total return and low turnover. The performance of these investable strategies in the third quarter of 2010 was mixed. However, year-to-date, and trailing 1-, 3-, and 5-year returns for our investable strategies have all beaten the S&P 500.


How Did Our Rating System Perform?
Although our investable strategies represent efficient real-world application of Morningstar research, we find it illustrative to examine our rating system comprehensively. Our average star rating buckets show the returns of hypothetical portfolios that rebalance all of the stocks with a given rating on a daily basis to equal weights. Because of this frequent rebalancing, it is spurious to compare these buckets to the S&P 500. It suffices to simply expect 5- and 4-star buckets to outperform the 2- and 1-star buckets over time. Over the trailing 5-year period, these returns line up as we would hope, except for our 1-stars. During the crisis, we believed the market to be significantly undervalued, and as a result had few 1-star stocks. This allowed each individual 1-star stock to have a greater impact on our 1-star bucket's performance.


For additional details about our performance, we look to our median return buckets. These buckets chain weight the median returning stock with each rating from each day in a given time period. Although our median buckets are in no way replicable, they illustrate the performance of our buckets without the effect of outliers. Since these buckets line up better than our average buckets, we can say that while we get most stocks right, our covered stocks sometimes have large irregular returns that we did not predict.


Do Moats Matter?
We don't believe that simply picking wide-moat stocks with disregard for valuation will lead to outperformance. However, moats clearly make a very large difference when combined with valuation. Since wide-moat companies have more predictable cash flow streams, it stands to reason that our discounted cash flow, or DCF, valuations would be more accurate on wide-moat companies. As shown below, our average star buckets line up much better when eliminating all of the narrow-moat and no-moat stocks. You can have a higher conviction in our valuations for wide-moat stocks, since empirically they tend to work out more than our valuations on narrow- and no-moat stocks.


Conclusion
At the beginning of the third quarter, we believed the market was trading at a 6% discount to our fair value estimate. September's rally has brought it right back up to fair value. In fact, you can click here to go directly to our market valuation graph.

Fortunately, while the market may be fairly valued, there are still some strong opportunities in individual stocks. As a starting point, the business services, health care and financial services sectors look particularly undervalued, while software, hardware and media look a bit expensive. In addition, there are plenty of wide-moat bargains to be found, as nearly 38% of our 172 wide-moat stocks are trading at a price that is at least a 15% discount to our fair value estimate.