Stewardship Goes Back to the Fundamentals

A history of value-accretive acquisitions, optimal financial leverage, ideal dividend and share buyback policies, and investments that enhance competitive advantages—these are the marks of exemplary stewards of shareholder capital.

Certain corporate practices, such as poison pills and staggered boards, are easily visible and garner much attention in governance analysis circles. Unfortunately, focusing on governance practices tends to poorly predict a firm’s ability to generate improving returns on invested capital and shareholder returns. Instead, fundamental investors should conduct a more thorough analysis of manage- ment stewardship of shareholder capital.

Morningstar equity analysts’ focus on competitive advantages and credit analysis puts them in a unique position to assess this type of stewardship.

The Need for a Change
In June 2011, Morningstar equity analysts began an in-depth review of the methodology of the Stewardship Grades for stocks. The purpose of the Stewardship Grades had always been to identify how well management teams are acting on shareholders’ behalf. In our review, however, we determined that the 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. The thinking was that corporate-governance practices can be good indicators of actual stewardship of shareholder capital. But we found that good corporate governance is not a foolproof predictor of good capital-allocation decision-making and the creation of shareholder value. A change to the stewardship methodology was needed. For the past year, Morningstar analysts have worked to create a much more holistic methodology for rating stewardship of shareholder capital.

Analysts have always had the subjective leeway to place a greater emphasis on capital-allocation decisions and a lower emphasis on corporate-governance practices; now, it’s more explicitly incorporated into the methodology. There are many examples of Morningstar awarding a company with traditionally frowned-upon corporate- governance practices a favorable Stewardship Rating because of excellent capital-allocation decisions, and vice versa.

Focus on Capital Allocation
Under the new 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. Instead of giving letter grades, analysts will assign companies one of three Stewardship Ratings: Exemplary, Standard, and Poor. Analysts judge steward- ship from an equity holder’s perspective, not a debt holder’s. Ratings will be determined on an absolute basis. Companies will be judged not against peers within their industry, but against ideal stewardship of shareholder capital. Some industries may have a disproportionate share of companies with Exemplary or Poor ratings. Most companies will receive a Standard rating, and this should be considered the default rating in the absence of evidence that a management team has been exceptionally strong or weak in its capital-allocation decisions.

Because the new methodology is more comprehensive and doesn’t hone in on particular governance practices, the new rating methodology will be applicable globally, whereas the old methodology was relevant only in the United States and Canada.

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 (poor) Stewardship Grade. Under our previous methodology that focused on corporate governance practices, we penalized the company for having two share classes.