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By Jeremy Glaser | 05-08-2012 10:00 AM

Insights From the 'Best on the Street'

Hear industry outlooks and best ideas from the 12 Morningstar analysts named by The Wall Street Journal among the "Best on the Street."

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Jeremy Glaser: For Morningstar, I’m Jeremy Glaser. Twelve Morningstar equity analysts were recently named among the Best on the Street in the annual Wall Street Journal survey, with one analyst winning in two industries Morningstar was the most honored firm this year. We sat down with several of these winners to get their best ideas, but first we talk to Morningstar's global director of equity research, Heather Brilliant, for her insights on our research methodology.

Heather, thanks for joining me.

Heather Brilliant: Thanks for having me, Jeremy.

Glaser: Let's talk about the research process that won all these awards. Can you walk us through how Morningstar analysts value companies?

Brilliant: Sure. So there are a couple of elements that I think are really instrumental to our process. The first is that we analyze the economic moat of any company that we cover, so we are really looking for businesses with sustainable competitive advantages. Second is that we analyze the valuation by building a discounted cash flow model on each of the companies that we cover. So we put a lot of time into customizing the key assumptions that determine what are driving the revenue and earnings growth of a given company, and then we put that into an overall model that's really consistent across all of our companies. So we can compare and look at a company in the consumer sector and see how that compares with a company in the technology sector, for example, and it gives us, I think, a better overall picture of how companies are doing.

Glaser: So how do you reach that [Morningstar Rating for stocks] then? How do you know when it's time to buy, when it’s time to sell, or when you should just hold shares?

Brilliant: Essentially we're looking for companies that are trading at a premium or a discount to their intrinsic value. So we use that discounted cash flow model to estimate the intrinsic value, and then from there we look at where the stock price is trading relative to that. So a company that's trading meaningfully below its intrinsic value and below the required margin of safety that we would wait for would be a 5-star stock, and one trading meaningfully above would be a 1-star stock.

Glaser: When you look across the entire equity universe, where do you see valuations right now?

Brilliant: Overall, we think stocks are fairly valued. We see them trading almost exactly at fair value at this point across our entire universe. We see the biggest opportunities in basic materials and energy, and we think that some of the more defensive sectors are the most overvalued at this point.

Glaser: You said that correlations are starting to decline a little bit. Is that a trend that you see continuing, and why does that make stock-picking that much more important?

Brilliant: We have seen some signs that it’s continuing. I mean, we’re looking at correlation data in a couple of different ways. We have started to see that the correlation between industries has not really decreased, but the correlation between global markets has really started to come down. And interestingly, tech has really decoupled from the rest of the sectors out there, in large part because Apple is really the key driver in tech right now, so that's had a big effect.

Sometimes when correlations are really high, everything trades in conjunction with each other. So it doesn't matter if you pick a great stock or find something that's really undervalued, it's going to move just in line with the general market. That's really frustrating when you're a stock-picker, because then you don't see the work you do on the individual names actually play out in an idea that works or doesn't. As long as you are calling the market right, you are getting your ideas right. So now that we are starting to see the market matter less and the stock ideas matter more, we expect our process will continue to do very well.

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