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Familiarity Can Breed Bad Investment Decisions

Use this screen to ensure local companies are solid investments and not behavioral-finance traps.

Mike Taggart, 10/27/2009

When considering stocks to invest in, many investors gravitate toward well-known companies. Whether blue-chip stocks, longtime favorites, or companies that are often in the news, there seems to be something inherently comfortable about investing in a well-known stock. However, this comfort can be at best superficial and at worst catastrophic to portfolio performance. The reason behind the comfort is what's known as the illusion of knowledge.

Most of us know someone who has won a bet on a sporting event after basing his decision on nothing more than the teams' colors. This goes against our intuition. How can such a basis for decision-making beat out other bettors who are well-schooled and more knowledgeable about the sport? It's not simply luck. It's that our intuition can fool us. The illusion of knowledge tells us that having more information about something, like a stock or a publicly traded company, will increase our predictive accuracy about future events. Studies have shown, however, that more information can actually decrease predictive accuracy and, simultaneously, increase our confidence. In other words, I think I know more about something than I actually do, so I believe that I can more accurately predict future events around this subject and I am extremely confident in my belief.

How does this fallacy appear in investing? One example could be placing stocks of local companies in client portfolios. After all, they are local companies. We read about them in the local press daily. We know people, maybe even executives, who work at the firm. Maybe a client works there or has friends or family who do. We seemingly know how well the firm is performing by collecting information from the newspapers or from social encounters. Such methods of collecting information for an investment can lead to anecdotal bias. (We collect a few anecdotes about a firm and extrapolate that evidence onto a broader frame, not understanding the missing pieces of our knowledge.)

At Morningstar, we provide equity research coverage on about 2,000 companies. As stock analysts, we are not immune to behavioral finance issues. In fact, we deal with them everyday. Our awareness, however, has led us to certain processes in our routines to ensure that we are not succumbing to biases. Performing scenario analysis on every stock we cover, for example, forces us to take a broad view of likely outcomes. And while we do speak with company management teams, we curb the anecdotal bias by corroborating data against regulatory filings and other management teams' comments within the same industry. Battling our own behavioral biases is tough work, but we guard against it vigilantly.

So how can advisors ensure that local firms within their clients' portfolios are actually solid investments and not traps fraught with behavioral-finance risk? One way is to screen for local companies to see how they stack up. (This screen can be done in Morningstar Advisor Workstation.)

State of Domicile = Illinois

For this issue's screen, we first home in on companies that are based in our state of Illinois. Morningstar's screeners allows you to screen for any state and many countries. In August, our screen resulted in 272 publicly traded companies that are based in Illinois. These firms range in size from global pharmaceutical behemoth Abbott Laboratories ABT to micro-cap Svi Media SVIA, which trades for a penny on the Pink Sheets. Already we can see that not all local firms are created equal.

And Economic Moat = Narrow

It's important to focus on companies that have durable competitive advantages. If an investment is intended to be in a client's portfolio for the long term, it is critical that the underlying economic earnings capacity of the company also can endure for several years. This filter also begins to get us away from our illusion of knowledge to an actual basis of reality. Judging from several sources and benchmarking against other firms in the stock universe, a narrow- or wide-moat designation implicitly states that a firm is creating economic profits and can be expected to do so for many years. Applying this filter further limits our screen to 47 companies.

And Morningstar Stewardship Grade <= C

We want to know how the firm is being run and for whom. No executive we meet in a social setting is going to willingly state that he is reaping the rewards of economic profit at the expense of shareholders. This grade is determined based on the legal setup of the firm and on how the firm is administered (including executive compensation). It's a good way to see if the local darling is truly set up to reward shareholders.

And Financial Health Grade >= C

Next, we want to know how close the firm is to financial distress. Is it highly levered or does it have obligations that it will have difficulty meeting? Or is it fiscally sound and likely to sail through a rough economic patch (like the one we are now in)? Morningstar's financial health grade is designed to ferret out the answer to such questions. Again, this screen is meant to get us some truly useful knowledge that we won't likely get from our own personal sources.

At any point in this screen, we can stop to see how existing stocks in our portfolios are stacking up and where they are falling short. Perhaps we'll find some companies that, upon further reflection, are not suitable for an investor's profile. This screen can also help us find the few local companies that are gems and suitable for investment at the current market price.

And Morningstar Rating for Stocks = 5 Stars

After we apply this final criterion to our screen, three companies remain. It's remarkable that out of our 272 Illinois-firm universe, only 1% meet all of our requirements for investing today. That, in itself, shows the fallacy that the illusion of knowledge can lead to.

These three passing companies are highlighted below.

Abbott Laboratories ABT
Senior analyst Damien Conover, CFA, lays out the reasons Abbott can create economic profits year after year: "On the foundation of a wide lineup of patent-protected drugs, a leading diagnostics business, a strong nutritional division, and an emerging vascular group, Abbott has dug a wide moat. We expect these operating lines will continue to generate strong returns and drive growth."

Arthur J. Gallagher AJG
Insurance broker Arthur J. Gallagher faces tough industry competition. However, senior analyst Bill Bergman believes that "Gallagher has built a narrow moat by specializing in more than 20 niches, such as shopping centers, universities, public entities, construction contractors, and sports teams. Niche markets can provide relatively high brokerage profitability, but the whole is more than the sum of the parts. Customers increasingly view Gallagher as a valuable solution because it provides efficient one-stop access to a range of insurance coverage and to experts in a variety of risk-management services."

Exelon Corp. EXC
Exelon is the only utility in Morningstar's coverage universe that carries a wide economic moat rating. Senior analyst Travis Miller explains why: "In an era of concerns about global warming and rising fossil fuel prices, Exelon maintains an enviable position as the largest nuclear plant operator in the United States. Its ability to produce low-cost, carbon-free electricity should produce substantial, sustainable, and growing shareholder value for many years, regardless of what path power prices take."

Mike Taggart, CFA, is a senior equity analyst with Morningstar.

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