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Introducing Morningstar's New Stewardship Rating for Stocks

Our new rating system gets right to the heart of the matter: evaluating whether management teams are good stewards of shareholder capital.

Heather Brilliant, CFA,Elizabeth Collins, CFA, 05/01/2012

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 EGO and for Kinross Gold KGC on the basis of capital allocation decisions illustrates the focus of our new rating methodology. Gold is a commodified industry. Mines deplete, which means a constant need for reinvestment. For these reasons, management decisions have a big impact on a company's advantages and performance relative to fellow industry players. We award Eldorado an exemplary rating because of the company's history of wise and attractively priced investments that have resulted in an enviable portfolio of high-quality, low-cost gold mines. Meanwhile, we rate Kinross' managers as poor stewards of shareholder capital. The company has a history of value-destructive acquisitions, and its operating and capital costs are increasing at a concerning rate.

Ford Motor Co F provides a good example of how our stewardship assessment is changing with the new methodology. In the past, we gave Ford a D stewardship grade from our grading scale of A, B, C, D, and F. Under our previous methodology that focused on particular corporate governance practices, we penalized the company for having two share classes. Under the new methodology, which places a much greater emphasis on strategic decisions, investments, and other actions that concretely affect shareholder value, Ford management's wise moves partially offset the concern of the dual share-class structure, and we award the firm a standard rating. Alan Mulally joined Ford in 2006 as CEO, and the changes he implemented allowed the company not only to survive the global financial crisis, but also to thrive as a highly profitable automaker. In particular, Mulally's financing moves in 2006 helped Ford weather the downturn without any taxpayer-funded bailout money. Mulally's product moves mean Ford started turning out more cars people want. Mulally also implemented significant manufacturing efficiencies and product quality improvements.

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.

Heather Brilliant, CFA, is the vice president of Global Equity and Credit Research at Morningstar.

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