A look at the stock star rating in an anxious market.
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By Pat Dorsey, CFA | 04-27-05 | 06:00 AM | Email Article

During a recent taping of a business show on which I appear each week, I took some heat for making positive comments about the market’s little slide over the past several weeks. Some folks seemed to think it was odd that I would welcome having more investment opportunities, but I suppose it all depends on your perspective. If you're a net investor with a long time horizon, lower stock prices are a wonderful thing, because they allow you to buy streams of future cash flows for less capital. If you're a net seller--or a trader with a short time horizon--lower share prices are not as welcome.

Needless to say, at Morningstar we generally take the perspective that lower share prices are an opportunity to be welcomed, not a disaster to be feared. We continue to believe that the simple process of valuing stocks as small pieces of a business, and waiting to recommend them until the market presents the shares at a compelling price, is the most sensible way to invest. So far, it’s also produced solid long-term returns. Here’s our latest performance review, with returns through the end of 2005’s first quarter.

The First Quarter of 2005
As before, we're measuring ourselves by creating a hypothetical portfolio that buys 5-star stocks, sells them if they hit 1 star, and hangs on to them otherwise. Returns are calculated using internal rate of return, which takes into account the flow of money into and out of our hypothetical portfolio. Because the star rating is an absolute measure, rather than a relative one, the number of 5-star stocks can vary quite a bit over time. Using internal rate of return accounts for the fact that our 5-star portfolio will have different amounts of money invested at different times.

Here's how our "buy at 5, sell at 1" portfolio has done:

 S&P 500 Compared to "Buy at 5, Sell at 1" Strategy
 
Since inception*
2005**
2004  2003 2002 2001*
Buy at 5, Sell at 1 10.5% -3.3% 24.4% 36.0% -22.5% 27.2%
Buy-and-Hold Indexes  
S&P 500 1.3% -2.1% 10.9% 28.7% -22.1% -3.8%
S&P 500, equal-weighted 7.8% -0.9% 16.9% 38.7% -19.4% -2.2%
Cash-Flow-Matched Indexes  
S&P 500 5.2% -2.0% 14.4% 26.2% -16.2% 8.9%
S&P 500, equal-weighted 10.9% -2.1% 21.3% 37.3% -13.3% 11.9%
* Morningstar Rating for stocks launched 8/6/01
** Through 3/31/05

Since inception, we're still doing quite well relative to the S&P 500--which we regard as the “default option” for most investors--and we're also still outperforming the equal-weighted S&P 500, though not by as much. For the first quarter of 2005, we're slightly behind both indexes, and I'll talk more about why a little later in this review.

Cash-Flow-Matched Benchmarks
Of course, a key feature of the Morningstar Rating for stocks is that the number of 5-star stocks can and does vary with the general level of the market, so our "buy at 5, sell at 1" portfolio puts more money to work when we have more 5-star stocks, which is generally when the market is down. (Over the past year, for example, the number of 5-star stocks has varied from a high of about 8% of our coverage universe in mid-August 2004 to just 31, or 2% of our universe, at the end of 2004.)

As you might guess, some portion of our outperformance has stemmed from simply putting more money into the market when stocks are relatively cheap, and taking more out when it's dear. So, we’ve constructed another set of benchmarks based on the traditional and the equal-weighted S&P indexes, which buy and sell units of the index at the same time that the Buy5/Sell1 portfolio makes transactions. In other words, these benchmarks have the same "buying low and selling high" advantage over a buy-and-hold index as does the Buy5/Sell1 portfolio. This is a tougher test, and since inception, we’ve managed to best the cash-flow-matched S&P 500 that’s weighted by market cap (the traditional S&P 500), but we’re lagging the cash-flow-matched, equal-weighted S&P 500 by a small margin.

Moat and Risk
After I posted the last performance review, a number of readers asked for an update on how stocks in different economic moat and risk categories have performed. (We assign an economic moat rating to every company we follow, which is our judgment of the strength of the firm's competitive position and ability to earn excess economic returns in the future.) I'm happy to provide it.

 Stock Performance in the Buy at 5, Sell at 1 Strategy, by Moat and Risk
 Moat
Since inception*
2005**
2004  2003 2002 2001*
None 1.4% -1.9% 34.9% 42.3% -32.2% 23.6%
Narrow 14.2% -3.4% 27.5% 40.9% -19.1% 33.6%
Wide 14.9% -3.6% 18.2% 28.1% -1.1% 20.4%
Risk Level Since inception* 2005** 2004  2003 2002 2001*
Above Average 11.2% -9.5% 55.1% 51.2% -23.4% 35.4%
Average 8.7% -2.4% 26.6% 36.3% -26.5% 26.3%
Below Average 14.9% -3.1% 17.2% 32.4% -4.5% 21.5%
* Morningstar Rating for stocks launched 8/6/01
** Through 3/31/05

The patterns here are similar to what they were about six months ago when I last presented an analysis of our performance broken down by moat and risk. Broadly speaking, we've done better at recommending stocks with some degree of an economic moat (wide or narrow) and stocks with relatively less business risk than we have with their lower-quality, higher-risk peers.

Since the third quarter of 2004, when I last posted these numbers, our performance on no-moat stocks has improved markedly, and the spread between the performance of narrow- and wide-moat stocks has narrowed, largely due to an improvement in the performance of our narrow-moat recommendations. Looking at risk categories, our performance on average and above-average risk stocks has improved, while the performance of our below-average risk stocks has remained steady.

To me, there are three big takeaways from these results. First, we're not kidding when we slap the "above-average" risk tag on a stock. These babies can really move when the market is doing well, as it did in 2003 and 2004, but they also fall the hardest when Wall Street takes a tumble. Second, we've done extremely well at recommending stocks with less risk and with some kind of competitive advantage (narrow and wide economic moats). These are the kind of stocks we like the most, and the ones we think should comprise the bulk of anyone's portfolio. Third, though we may not think they're good long-term holdings, we nonetheless need to get better at recommending no-moat stocks. Our performance in this area has improved quite a bit over the past six months, but it's something I'd like to see get even better.

Some Specifics
So what worked and what didn't in the first quarter? On the positive side, the list was led by  Panera Bread  (+40%), which we recommended last year during the height of the Atkins frenzy;  Closure Medical  (+37%), which we initially recommended at about $20 last summer and hung tight when it plunged to the low teens last fall after an earnings warning; and video-game firm  THQ  (+30%), which hit 5 stars after a well-timed fair value estimate increase in late January--just before it released financial results that were above Wall Street’s forecasts. Other standouts were  Office Depot  (+28%),  American Power Conversion  (+23%), and  Intuit  (+16%).

Looking over these and other top performers, I don't see any industry or macroeconomic themes. Most were just good old-fashioned examples of ignoring short-term market noise, focusing on long-term business prospects, and recommending stocks trading for less than their intrinsic value.

On the flip side, the market’s poor mood in the first quarter took its toll on many of our recommendations. Some of these, like  DST Systems  (-11%) or  CDW 
(-15%) were longstanding recommendations that simply pulled back more than the market. Both DST and CDW are still up about 50% from their original 5-star prices, and we still have positive opinions on both stocks.  InterActiveCorp  and  International Game Technology  were similar stories--both were down about 20% in the first quarter, but we continue to believe that both companies are substantially undervalued.

After coming in near the top of our 2004 performance list,  Biogen IDEC  led the laggards in the first quarter of 2005, tanking almost 50% after a recently approved multiple sclerosis drug was withdrawn from the market. Given that this drug accounted for a relatively small percentage of the company’s income, we felt the market had overreacted, and we lowered our fair value estimate by a much smaller amount. Nonetheless, the plunge in the stock's price was painful and hurt our performance in the first quarter. (Full disclosure: I shared in the portfolio's pain on this one, since I own some shares of Biogen IDEC.)

Other laggards were  Triton PCS  (-35%),  Lear  (-27%), and  eSpeed 
(-26%). On Triton, we underestimated the hit that the wireless carrier would take from losing profitable roaming revenue; the Big Three’s troubles hurt auto-parts firm Lear, despite its strong position in the industry; and bond exchange eSpeed has been losing market share, leading us to cut our fair value estimate by a decent amount. As with the good calls, there were no real industry themes among our misses--our mistakes were mainly on stock-specific issues.

Conclusion
Although we lagged our benchmarks by a bit in the first quarter, I think we're continuing to add value for people who follow our philosophy. Our performance on no-moat stocks has improved somewhat, but can still get better; that's an area on which we'll continue to focus. What won't change is our fundamental philosophy and our disciplined approach to recommending stocks. Look for our next performance update in late July after the second quarter is done.

Etc.
For most people, the arrival of spring (which we're still awaiting here in Chicago) means baseball, barbecues, and other leisurely pursuits. For investors, however, spring means just one thing--the annual “Woodstock for capitalists” in Omaha, Neb., at the annual meeting of  Berkshire Hathaway . Myself and about 40 of my colleagues from the equity analysis group at Morningstar will be attending--say hello if you see us!

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Pat Dorsey, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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