Our 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, with the results made transparent to investors through our newsletters. As experts in our stock rating methodology, they have keen insight on how to best use our equity research to achieve outsized returns. In addition, Morningstar created the Wide Moat Focus 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 in practice, each with slightly different goals, from income generation, to total return and low turnover. The performance of these investable strategies in 2010 was mixed, but year-to-date, and trailing 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 five-year period, these returns line up as we would hope except for our 1-stars. During the financial 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 effect on our 1-star bucket's performance. This increased influence, combined with some of our 1-stars returning from the brink of destruction, lead to outsized returns in the 1-star portfolio.

For additional information 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 positive or negative returns that we did not predict.

Do Moats Matter?
We don't believe simply picking wide-moat stocks without regard for valuation will lead to outperformance. However, moats clearly make a substantial 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- 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 4th quarter, we believed the market was trading at a 1% discount to our fair value estimate. The rally that continued in the 4th quarter has brought the median stock in our universe to a 6% premium over fair value, as you can see with our market valuation graph. Fortunately, while the market may be slightly overvalued, there are still some strong opportunities in individual stocks. As a starting point, the financial services and health care sectors look particularly undervalued, while consumer cyclical, real estate and technology look a bit expensive. In addition, there are plenty of wide-moat bargains to be found, as nearly 21% of our 184 wide-moat stocks are trading at a price that is at least a 15% discount to our fair value estimate.