Our new rating system gets right to the heart of the matter: evaluating whether management teams are good stewards of shareholder capital.
Today we are launching a new stewardship rating system, the Morningstar Stewardship Rating for Stocks. We will be making the transition from our previous stewardship grade system, which was derived from a somewhat more quantitative measurement of corporate governance practices, to one that focuses more heavily on the quality and depth of a company's management and board of directors in their roles as stewards of investor capital.
The new system will require our analysts to assign one of three Stewardship Ratings--exemplary, standard, or poor--based on their assessments of how each firm stacks up in regards to capital allocation decisions and stewardship of shareholder capital. We believe our stock analysts have a unique advantage in assessing and communicating a rating of this nature, given our focus on economic moats and credit quality, and expect it to be applicable for all companies, regardless of domicile, which is something that was not fully attainable with our old system.
Why the Change?
In June 2011, we initiated a project to take a fresh look at the best ways to evaluate corporate stewardship and answer the question we have been aiming to answer with our stewardship evaluation all along: Are the management teams of the companies we cover good stewards of capital for shareholders? As we look to answer that question for each of the companies we cover, we feel we are in a particularly good position to evaluate whether management is doing a good job looking after shareholder interests, given all the time and effort we put into analyzing the competitive advantages of these businesses and their capital allocation decisions.
The review process that began in mid-2011 determined that our former methodology was focusing too much on particular corporate governance practices instead of actual capital allocation decisions that lead to the creation or destruction of value for shareholders. Morningstar's equity analysts have always had the subjective leeway to place greater emphasis on capital allocation decisions and less emphasis on corporate governance practices; now it's more explicitly incorporated in our methodology. There are many examples of Morningstar awarding a company with traditionally frowned-upon corporate governance practices a favorable stewardship grade because of excellent capital allocation decisions, and vice versa.
New Focus: Capital Allocation
Our new system allows us to get right to the heart of the matter, evaluating whether management teams are good stewards of shareholder capital, rather than indirectly trying to assess management by evaluating all the individual control mechanisms that could (but may not necessarily) affect capital allocation and shareholder returns. Under the new, more holistic methodology, Morningstar equity analysts assess companies on items such as: financial leverage, investment strategy, investment timing and valuation, dividend and share buyback policies, execution, compensation, related-party transactions, and accounting practices. Since the new methodology is more holistic and doesn't home in on particular governance practices, it will be applicable globally, whereas the previous methodology was relevant only in the United States and Canada.
The contrast between our new Stewardship Ratings for Eldorado Gold
Ford Motor Co
As the Ford example demonstrates, our new methodology focuses on how well a management team acts on behalf of shareholders. We are increasing our focus on empirical evidence and behaviors, and reducing our focus on the corporate governance structures that, while intended to ensure management acts in the best interests of shareholders, are no substitute for observing the actual facts.