Our View of the U.S. Market Entering 2006

IMA figures show that only 4.2% of the assets in unit trusts and OEICs sold to UK investors were in offerings specializing in North American securities at the close of 2005. However, the importance of the U.S. stock market in a global context is undeniable. The total capitalization of the U.S. market is roughly 45% to 50% of global market capitalization, and UK stocks tend to be highly correlated with their U.S. counterparts. With that in mind, we’ll take a closer look at where the U.S market stood at the beginning of 2006, and where it might be headed in the year to come.

As an astute investor, whenever you read the words "Economists predict that ..." you know to skip to the next article. Predicting anything as complex as the economy, whether one focuses on interest rates, the stock market, or next month's inflation figure, is an exercise in futility. And the more confidence an expert has in her macro prediction, the less credence you should put in it. Experts in any field tend to exhibit more confidence than the facts--or their own track records--justify.

So how can Morningstar have a view of the U.S. stock market? What we mean by "view" isn't a prediction of what the market will return in 2006. We don't know. Instead, we refer to our opinion on the valuation of individual stocks--as embedded in our fair value estimates. Our analysts estimate these fair values one stock at a time, but we can roll these fair values up to form a picture of the overall valuation of the U.S. market. Morningstar's U.S. team covers 1,700 stocks, so we think we have a pretty good idea of how the market, and various sectors of the market, are currently valued.

Where We Stand Today
We entered 2006 with 83 5-star stocks, which as a percentage of our coverage universe is 5%. As a refresher, 5-star stocks are those we consider attractive buying opportunities because they trade at a significant discount to our estimate of fair value--or our estimate of what a rational investor would pay for the company's future cash flows.*

In itself, having 5% of the universe rated 5 star is neither optimistic nor pessimistic. We can compare that figure with historical levels, though, to put it in perspective. Although that 5% is higher than at the beginning of 2005, when the percentage was just 2%, we've hovered right around 5% for much of the past year. This reflects the low volatility (and low returns) of the overall market. The S&P 500 finished 2005 up 4.8%, and didn't take too many detours to get there.

Star Rating Distribution
Date	1 Star (%)	2 Stars (%)	3 Stars (%)	4 Stars (%)	5 Stars (%)
09/30/04	26	12	43	14	5
12/31/04	37	15	40	6	2
03/31/05	27	11	45	12	4
06/30/05	27	11	45	12	4
09/30/05	27	10	45	13	5
12/30/05	26	11	46	12	5
Data as of 12-31-05

The last time I wrote about our star-rating distribution was in October, in order to point out a sudden surge in the number of 5-star stocks. As it turned out, the article appeared right as we reached our peak of 5-star stocks for the year--8% of our coverage universe. On Oct. 27, our research suggested that the median stock in the market was undervalued. The median price/fair value ratio of our coverage universe hit 0.99. (A ratio of 1.00 means we think the median stock trades right at fair value; a number below 1.00 means the median stock is undervalued.) Since then, the market has turned up, the aggregate price/fair value ratio has risen, and the number of 5-star stocks has correspondingly dropped.

At the start of 2006, the median stock was 5% overvalued according to our research. But while price is important, it isn’t everything. At Morningstar, we're big proponents of investing in companies with sustainable, long-term competitive advantages, which act as a wide economic "moat," protecting companies against invasion by the competition. Wide-moat firms typically reside in attractive, profitable industries and are characterized by predictable earnings streams, returns on capital higher than their cost of capital, and long-term staying power.

Given that, it’s well worth noting that many wide-moat companies were attractively valued entering 2006. Indeed, since October, the median price/fair value ratio of wide-moat stocks hasn't budged from 0.93. Instead, the valuations of lower-quality narrow and no-moat companies have risen sharply. (You can see all this graphically in our Market Valuation Graph.)

Price/Fair Value by Moat Rating
	Median Price/Fair Value	52-Week High/Low	All-Time High/Low
Morningstar Coverage Universe	1.05	1.12 - 0.99	1.14 - 0.78
Wide Moat	0.93	0.99 - 0.91	1.06 - 0.81
Narrow Moat	1.01	1.09 - 0.97	1.11 - 0.79
No Moat	1.15	1.23 - 1.07	1.27 - 0.75
Data as of 12-31-05

This suggests to us that some of the best opportunities for long-term investors are staring them right in the face: high-quality companies with deep competitive advantages. Among our 157 wide-moat companies, for example, 11 traded within 5% of their 52-week low at the start of the year. Our Tortoise Portfolio, which invests in wide-moat blue-chips and which we feature in Morningstar StockInvestor, has money invested in 21 stocks, five of which are wide-moat, 5-star stocks: Berkshire Hathaway, Wal-Mart Stores, Anheuser-Busch, Coca-Cola, Johnson & Johnson, and J.P. Morgan.

This doesn't mean that we predict wide-moat stocks will rise in 2006 and that no-moat stocks will fall. Even if our fair value estimates were 100% accurate, we wouldn't be able to predict when the value would be recognized in the market price. As I pointed out in my earlier piece, since we launched our rating system in 2001, the low point of the median price/fair value ratio was 0.78. That's 26% below current levels. And wide-moat stocks have been as low as 0.81 before, so there's no floor at 0.93 to keep them from falling. Prices can deviate significantly from our fair value estimates either because those estimates are off or (we hope) because the market swings up and down more violently than do underlying business values.

5-Star Stocks by Sector
Just as we steer clear of market forecasts, we also shun sector forecasts. But again, we can say something intelligent about relative sector valuations and which sectors we think are most under- or overvalued.

The below table breaks out the 83 5-star stocks into their respective sectors, and shows what percentage of each sector falls into the 5-star category. Consumer services boasts the largest percentage of 5-star stocks; these include Wal-Mart, Apollo Group, Educate, and Expedia. Media, consumer goods, and software also house a good share of bargains, in our opinion.

5-Star Stocks by Sector
Sector	# of 5-Star Stocks	% of Sector
Software	4	7.3%
Hardware	4	2.5%
Telecom	2	3.3%
Media	6	9.4%
Health care	7	4.0%
Consumer services	20	11.5%
Business services	3	2.1%
Financial services	17	5.4%
Consumer goods	9	7.6%
Industrial materials	8	3.8%
Energy	2	1.6%
Utilities	1	1.2%
Data as of 12-31-05

At the other end of the spectrum are energy and utilities. These were the best-performing sectors in 2005, and the prices have run ahead of value, in our opinion. Based on reasonable assumptions about energy prices--we assume energy prices spike up and down, but over time revert to their long-term trend--there's very little to like in the oil or natural-gas industries right now. At the start of the year, only two energy firms and one utility merited a 5-star rating.

Happy Hunting This Year
Whether the U.S. stock market will be up 20% or down 20% in 2006 is anyone's guess. But we can say that the median stock out there didn't appear all that attractive from our bottom-up perspective at the start of the year, being about 5% too expensive. Fortunately, though, investors don't have to buy the median stock. They can cherry-pick the attractively priced stocks that exist in almost any market, no matter how expensive the averages. Right now we think there are many good opportunities among wide-moat stocks and in several different sectors of the economy. The more time an investor spends worrying about the market, the less time there is for what truly separates the good investors from the bad: the careful analysis of individual securities.

*Morningstar’s star-rating for U.S. stocks is distinct from its star-rating for mutual funds. The former is assigned by stock analysts based on their assessment of a company’s fair market value. The latter is determined by a quantitative assessment of a fund’s historical risk-adjusted total returns.