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Stock Strategist

Top Performers in Morningstar's Four Stock Portfolios

We look at the stocks with the best 2006 performance in each portfolio.

For those of you who don't know, Morningstar runs four stock model portfolios that appear in our newsletters, StockInvestor, DividendInvestor, and GrowthInvestor. The portfolios rely on the research produced by our team of 95 stock analysts--their fair value estimates, moat ratings, company visits, etc.--allowing our portfolio managers to whittle down our 1,800-stock coverage universe to a shortlist of the most attractive stocks.

Below we take a look at the stock in each portfolio that has posted the best return so far in 2006. The purpose isn't to toot our own horn--we have our share of losers, and our investment horizon is far longer than nine and a half months. But each of these stocks illustrates a nice lesson.

Hare Portfolio
Best 2006 Performer:  CarMax (KMX)
2006 Return: 45.0%
Current Morningstar Rating: 4 Stars
It's wonderful to see one of your stocks up 45%. It's even better when it's your largest holding. CarMax was 14% of the Hare Portfolio at the end of August, and it's been the biggest position in the portfolio since we purchased the stock in early 2004. We were beginning to think the stock would never leave 5-star territory, but in September of this year it finally appreciated enough to shed a star. The lesson here is that if you love a company's fundamentals, don't be afraid to a) make it a big position, and b) add to your holdings when the stock is weak.

Paul Larson, who runs the Hare Portfolio, is in no hurry to sell the position as long as the fundamentals remain strong. And at $40, it's still well below our fair value estimate of $49. According to analyst John Novak's latest Analyst Report: "Our fair value estimate is $49 per share. Sales growth continues to significantly outpace the automobile dealership industry. With only 0.6% share of transactions and plenty of markets left to pursue, we project new store growth of 17% for the next five years. CarMax posted a lease-adjusted return on invested capital of 12% in fiscal 2004 and 10% in fiscal 2005, and we expect these returns will climb with increased scale, brand strength, and cost improvements."

Tortoise Portfolio
Best 2006 Performer:  Merck (MRK)
2006 Return: 33.6%
Current Morningstar Rating: 3 Stars
Merck has been a holding in the Tortoise Portfolio since November 2003--well before the Vioxx scare. We held on as the stock fell to a low of $25, and it's now back above $40. Paul Larson summarized the situation in an alert to StockInvestor subscribers in August: "How you view the success of our ownership of Merck depends on your point of view. Though there is only a small paper profit at this point (our cost basis is $38.42 per share), I am going to put Merck in the 'win' column for the moment, because it could have been much worse. Remember, we first bought the shares in 2003, about a year before the whole Vioxx mess came to light. Moreover, we held through some very dark days for the company when every headline was negative and scores of aggressive litigants targeted the firm for a big payday. At one point, the stock had lost almost half of its value while in the Tortoise. But now that Merck is up more than 50% from its 2005 lows, I view not cutting bait in those dark days as a difficult but correct decision."

Growth Portfolio
Best 2006 Performer:  Tempur-Pedic (TPX)
2006 Return: 52.7%
Current Morningstar Rating: 3 Stars
This one has been a wild ride. We originally bought the stock in July 2005 at $17 per share, at a time when our fair value estimate was $23. The stock continued to fall after we purchased it, getting as low as $9 per share. The company's growth in mattress sales slowed down sharply--much more sharply than either we or the market expected. We trimmed our fair value estimate (and downgraded the company's moat rating), but the stock still looked too cheap to sell.

Good thing we held on. The stock is back up to $17. As analyst Anthony Chukumba relayed in a  recent note, Tempur-Pedic's sales growth picked up considerably in the second quarter after two quarters of single-digit sales growth. With the stock currently at 3 stars and with a moat rating of "none," it's questionable how much longer Tempur-Pedic will remain in the Growth Portfolio. But as this experience illustrates, even if one's thesis about a company doesn't play out according to script, sometimes a stock is simply too cheap to dump.

Dividend Portfolio
Best 2006 Performer:  Suburban Propane (SPH)
2006 Return: 33.8%
Current Morningstar Rating: 3 Stars
We bought this little propane supplier in November 2005 at $25 per share. It has since risen to $33 per share and gone from 5 stars to 3.

Unlike Merck and Tempur-Pedic, where new information caused us to think long and hard about whether to hold on, Suburban Propane has made it easy to remain shareholders. Josh Peters, who manages the Dividend Portfolio, had this to say in an e-mail alert sent to DividendInvestor subscribers in late August. It's worth quoting at length because it nicely encapsulates our thinking on selling.

"With a gain like this, there's a natural temptation to lock it in by selling. It appears that a major Wall Street brokerage firm did just that on Wednesday, reducing its rating from outperform to market perform--a move that clipped more than 5% off the share price. With the units relatively close to our fair value estimate, we no longer consider Suburban a buy either.

"Yet my bias remains strongly toward holding our Suburban units over the long term. The speed of Suburban's earnings recovery, while both pleasing and unexpected, doesn't mean that its distribution growth potential has diminished. We should be able to count on our current distribution rate of $2.65 (for a yield of 7.9%) plus 3%-4% annual growth for many years to come, putting our long-run return from here at around 11.5%. This remains true even after our 40% return thus far.

"Selling, on the other hand, means (1) paying steep short-term capital gains taxes on our profit thus far, (2) finding a suitable replacement with a similar total return prospect, and (3) replacing the large margin of safety we continue to have for our original investment with a similar discount elsewhere.

"Consider the hit we'd take if we sold at $33.55. Our short-term capital gain would be $1,241 (our original cost was $3,971), so at a hypothetical federal and state tax rate of 31%, we'd hand $385 of our gain back to the government. We'd never have an opportunity to earn income on that portion of our gain again.

"Second, to make up for the tax bite, we'd have to replace the 11.5% we expect out of Suburban from here (note: we get to earn this return on our original investment, our unrealized gain, and the taxes we'd otherwise have to pay) with an investment returning a full percentage point higher (12.5%). If I knew of a similarly attractive stock offering a 12.5% return, you can bet I'd be recommending it already.

"Finally, a new stock would have to offer a margin of safety at least as large as the one we've already got with Suburban. Remember, we've only got $3,971 invested in the units--that's what our margin of safety is protecting. The likelihood of an eventual loss in Suburban is much lower now than when we bought the units, not only because the market price has increased, but also because the company's fundamentals have improved and we've learned more about the business. Buying something new and unproven resets the clock, offsetting our locked-in gain from Suburban with a greater probability of loss elsewhere�.

"�we didn't buy Suburban to take a gain at the first opportunity; we bought it to hold indefinitely. Dividends (and partnership distributions) take time to provide a return, but they also take the pressure off the investor--I don't need to time the stock, with one finger always on the sell button. I find it much easier to collect steady income at our enormous yield on our cost and watch that income continue to grow than to try and time this or any other stock.

"So even if Suburban is no longer a buy, the best advice seems to be, 'Don't just do something, stand there!'"

Haywood Kelly, CFA has a position in the following securities mentioned above: KMX. Find out about Morningstar’s editorial policies.