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By Pat Dorsey, CFA | 07-31-08 | 12:00 PM | Email Article

At the end of May, the "Buy at 5 Stars, Sell at 1 Star" portfolio was about flat for the year, compared with a 4% loss for the S&P 500 Index. Unfortunately, the quarter didn't end in May, and June was a brutal month for our benchmark portfolios. As a result, our performance so far this year roughly parallels the market's. That's an improvement over last year's subpar performance, but it's still weaker than the results we would like to be delivering.

Our trailing returns show weak recent results dragged down by our poor 2007 showing, but balanced by respectable longer-term numbers. Because we employ the same fundamental research process today that we did when we began rating stocks in 2001, I am confident that our current slump is temporary, and I think the improvements we've recently made to that process should hasten a turnaround.

So, what's been the trouble recently? Although we overhauled our take on the financials sector earlier this year, becoming much more cautious on many of the weaker franchises, equity prices have still unraveled with surprising speed. As a result, our list of the worst-performing stocks over the past year is overwhelmingly populated with financial-services companies.

 Calendar-Year Returns
 Summary
Buy at 5,
Sell at 1
Buy at 5,
Sell at FV
Buy at 5,
Sell at 3
S&P 500

S&P 500
Eq-Weight

2008
-11.7%
-11.4%
-10.1%
-11.9% -10.9%
2007
-4.5%
-8.4%
-8.7%
5.5% 1.5%
2006
17.4%
20.2%
23.3%
15.8% 19.0%
2005
7.6%
9.4%
9.2%
4.9% 7.4%
2004
21.4%
26.8%
32.8%
10.9% 17.1%
2003
42.3%
47.2%
44.3%
28.7% 44.8%
2002
-32.8%
-37.0%
-36.8%
-22.1% -16.2%
2001*
2.0%
3.9%
5.0%
-11.9% -1.2%
Data from Abacus Analytics, through 06-30-08. * Morningstar began rating stocks on 08-06-01.

 Trailing-Period Returns
 
Buy at 5,
Sell at 1
Buy at 5,
Sell at FV
Buy at 5,
Sell at 3
S&P 500

S&P 500
Eq-Weight

Trailing 1-Year
-21.7%
-23.5%
-23.4%
-13.1% -16.8%
Trailing 2-Year
-1.7%
-2.7%
-1.3%
2.4% 0.4%
Trailing 3-Year
2.1%
1.8%
3.0%
4.4% 4.1%
Trailing 4-Year
5.0%
5.4%
6.7%
4.9% 5.7%
Trailing 5-Year
8.7%
10.2%
11.8%
7.6% 9.9%
Since Inception
3.4%
3.6%
4.5%
2.6% 6.0%
Data from Abacus Analytics, through 06-30-08.

Some of this unraveling has been due to what I would call fundamental weakness--loan losses coming on higher than expectations--but at least some portion is due to a crisis of confidence. This crisis became severe enough that even conservative, well-capitalized lenders like  M&T Bank  and  U.S. Bancorp  were changing hands at single-digit multiples of below-trend earnings as investors fled the sector, before the big bounce in financials a few weeks ago.

We continue to monitor the incoming data, and we revise our fair value estimates as necessary. But we also continue to believe that many--although certainly not all--financial-services companies are undervalued, with share prices that discount an unreasonably pessimistic view of the future. At the moment, about a quarter of the companies we cover in this sector are rated 5 stars.

On the plus side, a number of our top-rated energy and materials stocks have done well over the past year, even relative to the tail winds coming out of these sectors. After spending most of 2007 at about the same price, three of our favorite midsize exploration and production companies-- Whiting Petroleum ,  Southwestern Energy , and  Cimarex --all moved sharply upward in the past nine months, posting gains ranging from 80% to 160%. Our patience was likewise rewarded with  Energy Conversion Devices , which makes solar panels and batteries for hybrid cars--it has tripled from our 5-star price. Longtime favorites  Compass Minerals  and  Monsanto  also continued to post excellent operational results, and their share prices have followed suit.

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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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