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By Pat Dorsey, CFA | 10-21-05 | 06:00 AM | Email Article

As 2005 draws to a close, our performance continues to be solid all around, with some bright spots and a few areas for further improvement. Our contrarian stance on large-cap and energy stocks has weighed on our results recently, but we're still confident that those calls will work out in the end.

Time and Dollars
As always, we measure our performance by creating a hypothetical portfolio that buys stocks with 5-star Morningstar Ratings, sells them if they are rated 1 star, and holds them otherwise. We have been reporting our performance using internal rate of return--also called a "dollar-weighted return," which takes into account the flow of money in and out of our hypothetical portfolio. The number of 5-star stocks can vary quite a bit over time, and internal rate of return accounts for the fact that the portfolio will have different amounts of money invested at different times.

Starting with this performance update, we will also be reporting time-weighted returns, which are more directly comparable to buy-and-hold index returns. You can think of the time-weighted results as being unaffected by the number of 5-star stocks at any point in time, while the dollar-weighted return numbers incorporate the star rating's implicit message to invest more money in the market when there are more attractive opportunities--5-star stocks--available. (For example, the market's recent downdraft has yielded about 115 5-star stocks, more than twice the number we had just a couple of months ago.)

Finally, as a reminder we show both the market-cap weighted version of the S&P 500 and an equal-weighted version as benchmarks. The cap-weighted flavor is more commonly used by passive investors, but the equal-weighted version is more analogous to our Buy at 5/Sell at 1 portfolio, which invests an equal dollar amount in each stock regardless of its market cap. Even this index is not the best for our coverage universe, since we cover many small-cap stocks and almost 300 foreign companies, so we're working on constructing an equal-weighted index of all the stocks we cover. We hope to begin reporting this index when we post the next quarterly performance update in early January.

 Buy at 5, Sell at 1 Strategy
Since Inception
Trailing
3-Year
Trailing
1-Year
Buy at 5, Sell at 1 (time-weighted)
6.6%
25.1%
17.0%
Buy at 5, Sell at 1 (dollar-weighted)
11.2%
26.1%
17.4%
S&P 500 (cap-weighted)
2.3%
16.7%
11.9%
S&P 500 (equal-weighted)
8.3
24.7%
18.4%
Data as of 09-30-05

You can think about the difference between time- and dollar-weighted returns like this: The time-weighted returns are what we'd report if the Buy at 5/Sell at 1 portfolio were a mutual fund, whereas the dollar-weighted returns show how investors would actually have fared had they invested an equal amount of money into each of our 5-star stocks.

Since inception, our dollar-weighted returns are higher because the number of 5-star stocks jumped dramatically when the market sold off after 9/11--so putting more money to work would have been a smart thing to do and would have increased your returns. The dollar-weighted and time-weighted returns are much more similar over the past one year and three years because the market hasn't been very volatile over those time frames. Late 2002 was essentially the bottom of the bear market, and the past year has not seen a lot of huge moves up or down in the broad market.

The contrarian nature of the Morningstar Rating for stocks means that we'll always have more "buys" when the market sells off, so expect the dollar-weighted returns to outstrip the time-weighted returns over longer time frames that include bull and bear markets. It's worth noting that for most mutual funds, dollar-weighted returns are lower than time-weighted returns, because investors generally do an awful job of timing by chasing hot funds with strong short-term returns.

Overall, we're beating the S&P 500 over all trailing periods on both a time-weighted and a dollar-weighted basis, which means that we're continuing to add value over a passive approach that indexes the market and weights large caps more heavily (as almost all indexes do). The equal-weighted S&P 500 continues to be a tough bogy, partially due to the dearth of energy and utility stocks in the Buy at 5/Sell at 1 portfolio and partially due to some missed opportunities on our part elsewhere in the market.

 The Past Year's 5-Star Winners and Losers
Company
Risk/Moat
Return
Chicago Mercantile Exchange 
Average/Wide
95.7%
King Pharmaceuticals 
Above Avg./Narrow
84.4%
Amylin Pharmaceuticals 
Above Avg./None
78.7%
AirTran Holdings 
Above Avg./Narrow
68.8%
Gerdau ADR 
Above Avg./Narrow
64.4%
HCC Insurance Holdings 
Average/Narrow
54.0%
Posco ADR 
Average/Narrow
53.9%
Resources Global Professionals 
Average/Narrow
50.7%
Robert Half International 
Below Avg./Narrow
47.5%
Priority Healthcare 
Average/Narrow
46.8%
Company
Risk/Moat
Return
Doral Financial 
Above Avg./Narrow
-43.9%
Cost Plus World Market 
Average/None
-33.6%
Tempur-Pedic International 
Average/Narrow
-32.1%
Eyetech Pharmaceuticals 
Above Avg./None
-24.4%
Boston Scientific 
Average/Wide
-24.4%
Diebold 
Below Avg./Narrow
-23.3%
New Century Financial 
Above Avg./None
-21.0%
LIN TV 
Above Avg./Narrow
-20.4%
Expedia 
Average/Narrow
-16.9%
Family Dollar Stores 
Average/None
-16.7%
Data as of 09-30-05

  
I'll start with the bad news, on the second table. Three stocks on this list-- Doral,  Eyetech, and  LIN--make repeat appearances from our second-quarter update. Mortgage stocks as a group have been pounded over the past few months, which has weighed on Doral, and the company also postponed filing its restated financials longer than it had initially estimated. This is a risky stock, no doubt about it, and we've certainly been wrong on it so far. Still, we think the value outweighs the risks right now, and that the company's cash flows are unaffected by the current accounting flap.

Eyetech cratered after a competitor released strong clinical results that dampened future prospects for a key drug, but the shares bounced back nicely after a juicy buyout offer. Still, this one belongs in the loss column, because the buyout price was below where we had initially recommended the stock.

Finally, a couple of words about two of our other big misses so far over the past year are in order.  Cost Plus has faced a very tough market for home furnishings--close competitor  Pier 1  has also taken it on the chin over the past several months--but we also misjudged the speed of the company's turnaround, an issue that has been exacerbated by its lengthy search for a new CEO.  Tempur-Pedic is a slightly different story. After stellar results early in the year, sales have slowed quite a bit, and the stock has been whacked on concerns that competitors are gaining share from the firm. We think that the sales slowdown has more to do with consumers trading down to less-expensive Tempur-Pedic mattresses than the vicious competition posited by some; we also think that the current share price assumes a much more dire scenario than will ultimately come to pass.

On the "winners" side of the table above,  the Merc makes a repeat appearance, having almost doubled from the 5-star price it hit in mid-April when the market was fretting about competition from a merged Archipelago/NYSE. We're sorry to see it go after hitting our 1-star price just a few days before the end of the quarter, but it's just too pricey right now.

The Merc is followed by a pair of timely pharmaceutical picks. Diabetes-drug developer  Amylin hit 5 stars in early June after trickling lower for most of the year, and strong sales of two recently approved products sent the shares soaring almost 80% to our 1-star price in just a few months' time.  King Pharmaceuticals was beaten up earlier this year when a proposed merger was called off, and just got too cheap to pass up--we think the firm faces some tough hurdles, but the sub-$10 price offered by Mr. Market in spring discounted these and more.

Also on our top-10 list for the trailing year are three stocks from smokestack industries-- AirTran,  Gerdau, and  Posco. If you had asked a couple of years ago whether we'd be pounding the table on airlines and steel stocks, you might have gotten a funny look. However, all three firms have earned narrow moat ratings by doing exactly what firms selling commodity goods or services should do--relentlessly focusing on low costs. Only industry titan  Southwest  has lower costs than AirTran, while Gerdau has access to low-cost hydroelectric power, and Posco benefits from technologically advanced mills and close proximity to China. It just goes to show that great investments can be found in every corner of the market.

Conclusion
Thanks for taking the time to read this latest performance update. It's somewhat longer than past updates, but readers have e-mailed and asked for more information and more discussion of our results, which we're happy to provide. In the future, look for an index of all the stocks we cover as well as sector-by-sector breakdowns of the star rating's performance, and a discussion of the Buy at 5, Sell at 3 strategy. (Many of you have e-mailed about the latter, and we haven't forgotten.)

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Pat Dorsey, CFA has a position in the following securities mentioned above: EXPE EXPE Find out about Morningstar's editorial policies.
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