Our Best and Worst Stock Calls

It's time for another review of the Morningstar Rating for stocks. Since this is the fourth time we've reviewed the performance of the star rating, I'll skip a detailed discussion of how the star rating works and how we measure performance. (If you want a refresher, click here.) In a nutshell, 5-star stocks trade far enough below our fair value estimate to make them worth buying, and 1-star stocks trade far enough above our fair value estimates that we don't think they're worth the risk. To measure the aggregate performance of the star rating, we created a hypothetical portfolio that buys 5-star stocks, sells them if they reach 1 star, and hangs on to them otherwise.

Since we launched the star rating in August 2001, this portfolio would have lost 1.6%, compared with a 20.0% loss for the S&P 500. Year-to-date, the "buy 5, sell 1" portfolio has gained 12.7%, compared with a 6.7% gain for the S&P 500. The "comparable market return"--which we calculate by buying and selling  S&P 500 SPDRs (SPY) at the same time any 5-star stock is bought or 1-star stock is sold--was -4.6% since inception and +7.1% year-to-date.

So, the star rating is still doing a solid job of identifying when stocks are cheap, and it seems to be improving at picking out which stocks are cheap. In calendar 2002, for example, the "comparable market" portfolio edged out the star rating by about a percentage point, but year-to-date in 2003, the star rating is beating the comparable market return by a bit over 5 percentage points, which means our 5-star stocks are doing a better job at outperforming the market. I think much of the improvement is due to the changes in the star rating that we implemented last fall, which required a larger margin of safety for lower-quality companies, and a smaller one for very high-quality firms.

That's it for the aggregate numbers, but of course they don't tell the whole story. Let's look at some of the most recent highlights (and lowlights) from our coverage universe.

What We Got Right...
One of the best things about a bear market--well, maybe the only good thing--is that you get a lot of opportunities to buy great companies at reasonable prices, and the star rating has identified plenty of those over the past several months. Bond-rating service  Moody's (MCO) hit 5 stars last December at about $42 as investors fretted over the potential for increased competition, but we stuck to our $52 fair value, and things worked out just fine--the stock has since appreciated about 25%. Topnotch insurance firm  Progressive (PGR) has risen over 50% since hitting 5 stars in early January, and credit-reporting giant  Equifax (EFX) has also done very well (up 30%) since it dipped into 5-star territory during the pre-war sell-off this past March. These are all wonderful wide-moat companies that should deliver solid returns for years to come, and I'm glad the star rating flagged them as undervalued at such reasonable prices.

We also managed to continue nailing some overvalued stocks. For example, we flagged  Intuit (INTU) as looking too expensive back in March when it traded for around $50, right before the company warned it would miss earnings and subsequently tanked 25% in a single day. Looking back further, we've had a fair value estimate of between $9 and $11 on  Charles Schwab (SCH) since November 2001, when the shares traded hands for about $15. Since the stock is currently quoted at around $9, I'd say we got that one right. Around the same time, we posted a fair value estimate of $13 on biotech  Millennium Pharmaceuticals , even though the stock was trading for $30. The shares have gone straight south ever since, hitting a low of under $7 earlier this year before a recent big rebound brought it back close to our fair value estimate.

...and Wrong
Of course, we've made some mistakes as well. We thought  General Dynamics (GD) looked cheap at $80 back in January, but troubles in its Gulfstream division dragged the stock all the way down to $50 by early March. Though the shares have since recovered nicely to $65--and we still think they're substantially undervalued--we were definitely early on this one. We also misjudged  Automatic Data Processing (ADP), which hit 5 stars at $41 in January when our fair value estimate was $54. Since then, the stock price has fallen by eight bucks to $33, but we cut our fair value estimate by 10 bucks to $44 to reflect lower interest rates and more conservative margin assumptions.

Going back further, it's clear that we were wrong to recommend insurance giant  Aegon (AEG) in June 2002 at about $21--a combination of bond defaults, record-low interest rates, opaque accounting, and asset writedowns have since cut the stock in half. (Interestingly, the shares had already been cut in half when we started recommending the stock last year. Just goes to show that cheap stocks can keep getting cheaper.)

Finally, I should mention our mixed track record on subprime lender  Americredit , which we first highlighted as a "deeply undervalued, high-risk stock" back in September 2002, when the shares were trading at about $7. At the time, we thought the stock was worth $25. But early in 2003, Americredit imploded spectacularly, eventually plunging all the way to $2, and we slashed our fair value estimate from $25 to its current $8 level. Since the shares have skyrocketed from $2 back to $8 over the past two months, anyone who averaged down on their initial investment has probably done pretty well--but there's no question we got the initial call wrong. The lesson here is that insisting on a huge margin of safety for high-risk stocks definitely can mitigate the damage done to your portfolio by a blowup.

Moving Along
As the market has roared upward over the past few months, the percentage of 5-star stocks in our universe has dwindled as well, which is exactly what I would expect when share prices move up faster than underlying fundamentals improve. In mid-October, almost 30% of the stocks we covered had 4- or 5- star ratings. By mid-March, that percentage shrank to 16%, and it now stands at just 9%. On the flip side, the percentage of stocks rated 1 or 2 stars has increased from 20% to almost 40% over the same time frame.

Our current star-rating distribution implies that stocks are not cheap--it's been quite some time since we had so few 5-star stocks in our coverage universe. That's not to say the market can't keep rising from here, but it does suggest that there's little margin of safety built into the market right now.