How our stock star ratings have performed

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. One of the questions we get the most frequently is how are our [Morningstar Ratings for stocks] performing. I am here today with vice president of global equity and credit research Heather Brilliant who will help answer that question and see how our star ratings have done throughout 2012.

Heather, thanks for joining me.

Heather Brilliant: Thanks for having me, Jeremy.

Glaser: I know we don't like to focus too much on short-term performance. But the first part of this year has really been kind of a crazy ride, and I think it would be worth taking a look at how the star ratings have performed and how they have guided investors. For someone who is going in and buying those 5-star-rated stocks, how have they done so far?

Brilliant: In the first quarter of 2012, which is really the scope of what we'd like to discuss today, the 5-star stocks have outperformed the market overall. They were up about 16% in the first quarter versus a market [that was] up about 12%-12.5%. That’s really great, and we’re really excited to see that. But as you mentioned, we try not to anchor too much on short-term performance because when we are looking at the companies that we cover, we’re really looking at a three-year time horizon over which we expect the stock price to converge to our fair value estimates.

Glaser: One of the things I know that the analysts spend a lot of time thinking about is competitive advantages and assigning a moat rating. Have we seen performance really differ a lot depending on wide-moat stocks versus narrow-moat stocks versus no-moat stocks?

Brilliant: Yes. There has been a tremendous difference over time. Over the long run you see wide-moat stocks outperform, and really if you look at wide-moat names that are trading at a meaningful discount to fair value, the cheapest wide-moat equities, there is tremendous outperformance over a longer period of time. In fact, it's something to the tune of 700 basis points annually during the last five years.

Another thing we saw in the first quarter specifically is that wide-moat stocks, generally speaking, underperformed the market. The reason for that is because wide-moat names are considered to be higher-quality companies, and we really saw what I would call a junk rally in the first quarter. So we saw the higher-uncertainty companies outperform low-uncertainty companies actually by a margin of 1,200 basis points, which is a huge outperformance for the high-uncertainty companies. The same holds true on the moat side, where narrow and no-moat companies meaningfully outperformed wide-moat companies.

However, if you look at the Wide Moat Focus Index which we use to show the performance of the 20 cheapest wide-moat stocks rebalanced quarterly, the important thing about that index is that we take valuation into consideration, too. And if you just look at the performance of the cheapest wide-moat stocks, the outperformance is meaningful. If you ignore valuation, moat does not tell you enough in the short term, but if you also take into consideration that valuation, it makes a huge difference.

Glaser: What about sector [performance]? Were there some areas of the market that really helped drive that outperformance and other areas where maybe it lagged a bit?

Brilliant: Yes. In the first quarter, the sectors where we had 5-star stocks that outperformed the market were in consumer cyclical and also in technology. I would point out though those areas are both also some of the top performers in the 1-star stock bin. So, the 1-star stocks also performed very well in the first quarter, even better than 5-star stocks. You see that a lot when we see junk rallies, as well, but those sectors also were the highest-rallying regardless of star rating.

Glaser: If the 1-star names are performing so well, does that mean a contrarian strategy--to basically just buy a bunch of 1-star stocks--makes sense in a long-term portfolio?

Brilliant: We don't think that makes sense in the long term. [Stocks with ratings of 1 star] can certainly outperform over a short-term period. For example, if you look over the first quarter, we saw 1-star stocks outperform 5-star stocks by about 100 basis points, but if you look over a longer-term time period, take a trailing three-year range, we saw 1-star names meaningfully underperform 5-star stocks by about 2,600 basis points. That's the kind of trend we see over the long term. We strongly encourage people to really focus on the underlying valuation when you're picking stocks.

Glaser: Then what's the best way to use the star rating? Are there any strategies that have been particularly successful during the last few years?

Brilliant: Yes. We track a portfolio around our research where we look at every stock that's in 5-star territory, and we buy it when it's at 5 stars and sell it when it's at 3 stars. If you followed our research that way, so buying everything when it’s a buy and selling it as soon as it becomes a hold, then during the last three years, we have seen the returns annualized about 34%-35% for this strategy, 34.7% to be precise. That compares with a market return during that period of about 23%.

That's really meaningful, more than 1,000 basis points of outperformance. That's the kind of trend we see over time. We really think that the system works, and while we certainly have periods where our performance is not great, over the long run, we feel like we have a really solid philosophy that works really well for investors.

Glaser: Heather, thanks for the update. We're looking forward to hearing the second-quarter numbers when they come out.

Brilliant: Thanks, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser.