Introducing star ratings to Morningstar Australasia equity research

Adam Fleck | 27/04/2017

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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.

This report appeared on www.morningstar.com.au 2017 Morningstar Australasia Pty Limited

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