Introducing star ratings to Morningstar Australasia equity research

Adam Fleck  |  27/04/2017Text size  Decrease  Increase  |  

Adam Fleck: We're making a change to our recommendation system away from the buy to sell ratings to our 5-Star Rating system. Importantly though, our system remains forward-looking and based on our analysts' opinion of valuation. It's ultimately still the price to fair value estimate combined with the uncertainty ratio that drives our 5-Star Ratings.

I think it's important to note that a 3-Star Rating, which we previously referred to as a hold, still conveys our opinion that investors are likely to receive a fair rate of return, roughly the cost of equity.

It also means a 5-Star Rating means our analysts think there is a high likelihood that the returns of the company over the next several years will outpace that required rate of return.

Whereas a 1-Star Rating, which we used to call a sell, means that analysts think there is a high likelihood that investors will not enjoy a fair rate of return. That doesn't mean that the company is a poor-quality company. We just don't think the investment opportunity is pricing in a margin of safety at this point.

We're making this change to acknowledge the fact that our investors may use our valuation opinion in conjunction with some of our other ratings. For instance, an investor who is looking for high-quality companies trading at a discount, may seek out wide moat firms with 5-Star ratings. Our current buy, sell or hold recommendation doesn't account for this flexibility in making that decision for investors.

Ultimately, we're approaching our research process the same way as we were before. We seek to answer two questions. Is this company a quality company as measured by our economic moat rating? And is this investment opportunity of the stock a high-quality stock as measured by the price-to-fair value ratio?

Nothing about that is going to change. Our 5-Star Rating will remain forward-looking just like our buy, sell or hold recommendations did.

Nothing about this change will alter how we view the moat rating or our fair value estimate. The economic moat rating remains our confidence in a company's ability to sustain its return on invested capital as driven by its competitive advantage.

That won't change at all nor will our fair value estimate. Our fair value estimate is based on the future cash flows of a company discounted back to today.

What that means, of course, is that our fair value estimate should go up slightly over time as stocks rise with their cost of equity. While we compare the current market price to our fair value estimate to ultimately arrive at our Star Rating, the process behind the estimation of that valuation is not going to change.

All of Morningstar's products will reflect this Star Rating change that includes Morningstar.com.au, Advisor Research Center, Your Money Weekly as well as our Email Distribution System. Ultimately, investors will see our Star Rating instead of our word-based buy to sell rating, but our economic moat, our fair value estimate and importantly, the research that underlies those assumptions will remain exactly the same.

We are aiming to make this change by the end of 2017 sometime in the fourth quarter. We continue to offer our help and communication around this change, but it will ultimately be a change in all of our products.

Video Archive...

Why the time is right to invest in India
25/05/2017  Indian stocks rallied after the appointment of Narendra Modi as Prime Minister--but then subsequently fell. UK-based investment manager Jonathan Schiessl says now is the time to buy.
When should you pay active fund fees?
23/05/2017  When is it worth paying higher fund fees for active fund management? The single most important factor effecting a fund's relative performance is its price.
Budget 2017: bank levy a potential 4pc hit to big five profits, dividends
10/05/2017  If unable to pass on costs associated with the new levy proposed in the Budget, bank profits and dividends could dive 4 to 5 per cent, in a significant hit to shareholders and customers.
Why PIMCO Australian Bond is a Gold-rated strategy
10/05/2017  Tim Wong explains why PIMCO Australian Bond is Morningstar's most highly rated fixed-interest strategy in this market.
2 leisure stocks weather Cyclone Debbie, Dreamworld fallout
02/05/2017  These two companies with large theme park operations have faced significant challenges in recent times. Morningstar senior equity analyst Brian Han explains how they've fared.
Schroders stays hot on commodities, cooler on tech and defensives
01/05/2017  Long-term investors in Australian shares will continue to find value, but the time for risk-taking on more speculative plays has passed, says Martin Conlon, Schroders’ head of Australian equities
Introducing star ratings to Morningstar Australasia equity research
27/04/2017  What investors can expect from Morningstar's roll-out of its star rating methodology across Australian and New Zealand stocks, as explained by the regional director of equity research, Adam Fleck.
French elections: Macron versus Le Pen
26/04/2017  Following the first round of the French Presidential elections, the 7 May vote is now between Emmanuel Macron and Marine Le Pen. What does it mean for investors?
How climate change will impact your portfolio
20/04/2017  Ignore climate change at your portfolio's peril, says Jeremy Grantham, founder of asset manager GMO.
How dwindling resources will push up commodity prices
13/04/2017  Jeremy Grantham, renowned investor and founder of GMO, explains how a growing population is putting a strain on global resources.
How retirement spending affects withdrawal rates
10/04/2017  Data shows that the withdrawal rate gets higher as spending decreases in retirement, says Michael Kitces, a US-based financial planning expert.
What lies ahead for mining and materials
10/04/2017  Iron ore, coal, lithium, and uranium: some end-markets will rise and others will fall behind, says Morningstar commodities and resources analyst David Wang.
The evolution of multi-asset investing
07/04/2017  More difficult market conditions in a rising interest rate environment highlight the value of active management across your portfolio, says Simon Doyle, Schroders' head of fixed income and multi-asset.
When is the right time to buy stocks?
29/03/2017  Davis' Associates Chris Davis says the best time to invest is when you have the money, and to ignore market "noise".
How misinterpreting risk impacts financial returns
28/03/2017  Dr Gerd Gigerenzer says fund providers need to invest in education so that savers are better equipped to deal with risk--and can make better financial decisions.
Are European stocks overvalued?
27/03/2017  Isabel Levy of French asset manager Metropole Gestion explains how she uses fundamental industrial analysis to avoid value traps and identify the fair value of European equities.
Which funds are worth paying for?
23/03/2017  High active share funds--that is, those managers who take off-benchmark bets--outperform those which are low active share. So, ban closet trackers from your portfolio.
Bond market wobbles no cause for panic
21/03/2017  Australian bonds see only a slight tremor in response to the Fed's rate rise, says John Likos, Morningstar's senior credit analyst, who also provides insights on the new, and anticipated, hybrids from Australian banks.
ESG: Essential steps for successful long-term investing
21/03/2017  Want sustainable long-term returns? Morningstar UK reveals the essential components and the fund providers who are getting it right.
Few values left in global stock market
20/03/2017  Morningstar's directors of equity research think investors need to be cautious in the market today and offer some of their best investment ideas.