Morningstar Guide to Share Investing

Introduction

As a young child growing up, I was lucky to receive each birthday a small number of shares from my parents. They would choose companies that sold products to which I could relate and would then use my investments to teach me what it really meant to be a share investor.

Whenever we walked by the Chase Manhattan bank headquarters in New York City, for instance, I would be told that I owned part of the building. Similarly, if I bought a pair of Nike shoes I would subsequently be informed that a small part of what I had paid for them would come back to me in the form of a dividend. Over time, I understood what it meant to be a shareholder. These childhood lessons had a profound impact on how I’ve viewed investing ever since.

There is a gulf between knowing the definition of something and having a deep understanding of a concept. So it goes with investing. Consider a share, for instance. Is it merely a virtual piece of paper whose price fluctuates according to a president’s tweets, or the whims of corporate chieftains and self-interested financial institutions? Or does it represent a stake in the future cash flows generated by a business selling goods and services? And when you buy a share, what are you actually putting your money towards? Are you placing a bet or making an investment?

At Morningstar we passionately believe that making better investment decisions can transform lives. Central to this belief is clearly defining what you are buying when you purchase a share. It isn’t a virtual piece of paper that is traded for short-term profits. Buying a share means becoming an owner of a business.

We believe that adopting an ownership mentality drives behaviour that will lead to better investment returns. An ownership mentality means thinking long term and ignoring market volatility. It means focusing on the underlying reasons that allow a business to generate future cash flows instead of playing the short-term earnings estimate beat / miss / match game.

We’ve designed this guide for investors who seek to use the share market to build long-term financial security. We hope you find it helpful.

Happy investing,

Mark LaMonica

What are you buying when you purchase a share?

As the name suggests, purchasing a share of a company makes you a partial owner of the business. That means that you own a portion of everything that the company has or does. This may take the form of tangible assets such as factories, equipment, real estate, cash and securities. Or intangible assets such as patents, trademarks, copyrights and brand names. A well as assets, buying a share also means that you “own” a portion of any liabilities a company may have. This may take the form of debt and other obligations a company has, including payments to suppliers, wages and taxes. 

You can find the full guide on Morningstar Investor, that goes through the mentality you should have when purchasing stocks.

What is the stock market?

Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years—Warren Buffett

Distinguishing between what you buy and where you buy it is crucial. Since buying a share makes you a partial owner of a company, the stock market is simply a means to purchase and sell shares. It is a marketplace that connects buyers and sellers.

At Morningstar we advocate a long-term investing approach. Taking a patient, long-term view helps us ride out the market’s ups and downs and seize on the opportunities when they arise. We know that investors often overemphasise the importance of recent events, rushing into hot stocks when they’re overpriced and fleeing from market downturns. We fight this common error by focusing on long-term lessons and long-term performance.

Access the full guide to understand one of the main attractions to stock investing.

How do you identify great companies to buy?

If you want to be a successful long-term investor it doesn’t get much easier than simply buying shares in great businesses and holding them for a long time. So, what is a great business? At Morningstar we believe a great business is one that has a long-term competitive advantage, which allows it to fend off competitors while investing capital at a high rate of return. The long-term competitive advantage of a business is called an economic moat. Just as moats were dug around medieval castles to keep enemies at bay, economic moats protect the high returns on capital enjoyed by the world’s best companies. A company with an economic moat is quite rare because any time a profitable product or service is developed other firms respond by trying to produce a similar version, or even improving on the original version. Some companies are able to withstand the relentless competition of the marketplace and these are the wealth-compounding machines that an investor wants to find and own.

We believe there are five major sources of competitive advantage, or economic moat:

1. Intangible assets: These can include brands, patents, or government licenses that explicitly keep competitors at bay. This can be seen in pharmaceutical companies with patent protection or with consumer brands that have long-standing and well-regarded brands.
2. Cost advantage: Firms that can provide goods and services at lower costs have significant advantages over rivals as they can either undercut their rivals on price or sell at the same price and earn a higher profit margin. Generally, moats based on cost advantage are due to economies of scale. Economies of scale is defined as the cost advantages that companies obtain due to the scale of their operations with the cost to produce a product or service going down as output increases.
3. Switching costs: Switching costs refer the inconveniences or expenses associated with a customer switching from one product to another. Banks can be good examples as it is time-consuming to switch bank accounts once you have set up direct deposits and payments.
4. Network effect: The network effect occurs when the value of a particular good or service increases as more people use the good or service. Social media sites are perhaps the best example as a low number of members provides less of a benefit to a user than a high number of members.
5. Efficient scale: Efficient scale applies to companies that serve limited markets where there are a small number of competitors. Potential competitors are discouraged from entering the market based on the small opportunity. An example can be a pharmaceutical company that produces drugs for diseases that only affect small patient populations.

Morningstar analysts assign a moat rating to select companies in our coverage universe. You can find the moat rating in the Morningstar Analysis section of our quote pages and a full description of the rationale for assigning a moat rating in the analyst notes section.

Find our Morningstar Analysis and the full Guide to Share Investing on Morningstar Investor.

Valuation: value versus price

“The stock market is filled with individuals who know the price of everything, but the value of nothing.”—Phillip Fisher

It is easy to figure out the price of almost anything. A central tenet of the modern economy is price discoverability. In simple terms that means that in order to encourage commerce the price of goods and services must be widely known. This tenet also applies to liquid financial assets such as stocks or bonds. A quick trip to the internet is all it takes to find out the price of any liquid security. That is the magic of market liquidity. 

As, Ben Graham, the so-called father of value investing once famously said: “In the short run, the market is a voting machine, but in the long run, it is a weighing machine.” Simply put, Graham is saying the price and the value of an equity may deviate significantly over the short term but eventually they will intersect. That is why we are so focused on intrinsic value at Morningstar and why we include our valuation estimate within each of our research reports.

The full guide on Morningstar Investor covers the below topics in depth, including the ways to value a stock to understand whether it is an opportunity.

How do you value a stock?

There are countless ways to value a stock. At Morningstar we have a very specific approach which we will go through in detail in the next section. 

How does Morningstar value a stock?

At Morningstar we believe in fundamental equity analysis. A fundamental research approach means gaining a deep understanding of each investment. At its core, a fundamental investing approach means focusing on the future earnings of an investment and not its prospective price change. Our focus on fundamental research means we don’t fall victim to convincing stories to support the merits of an investment.

We believe that there is both an art and a science to valuing stocks. An art in deeply understanding the company, the product, the customers and the competitive landscape, and a science in being able to marry those understandings with the financial statements. The output from this analysis is a fair value estimate of the share. We don’t care what the stock market says the share is worth. We care what the underlying company is worth because we think in the long term that will be reflected in the share price. Ultimately, Morningstar analysts believe a company's intrinsic worth is linked to the future cash flows it can generate.

Uncovering a company's fair value

Forecasting is hard. But a good analyst who has spent years getting to know an industry well, can use informed assumptions and technical analysis to successfully predict a company's future revenue and growth prospects.

Morningstar analysts use a valuation method known as a discounted cash flow, or DCF. The key behind a DCF model is relatively simple: a stock's worth is equal to the present value of all its estimated future cash flows, minus an appropriate discount rate. 

In the full Guide to Share Investing we walk through each of the steps of how we calculate the fair value of A2 Milk as an example. Read it on Morningstar Investor.

Resources to help you identify shares to purchase

Our equity analysts provide fundamental qualitative research on over 1500 global shares. Each share in our coverage universe receives three distinct ratings:

• An Equity star rating that provides a risk adjusted comparison of our fair value calculation with the current market price of the share
• A Moat rating that assesses the sustainable competitive advantage of the company
• A stewardship rating which assesses management’s ability to allocate resources to generate positive returns for shareholders

You can access our research by entering the company name or the ticker into the search bar located at the top left-hand corner of any page on our website.