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Rekenthaler Report

A Guide to the Best (and Worst) Investors' Ideas

Viewing stocks through Morningstar's Ownership Lens.

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Investment Copycats

Cheating is the most natural investment strategy. Why bother with your own research, when the smartest person in the room has already done the work?

Unfortunately for those who would ride for free, imitating successful investors is the sincerest form of flattery, but it is not the simplest. Duplicating the holdings of a single portfolio manager places every investment egg into a lone basket. That seems unwise. In contrast, borrowing from several managers fixes that problem, but doing so introduces a new concern: choice. Because investors cannot realistically buy all those managers' selections, they must winnow the field.

In the 1980s, several mutual funds crashed on that very rock. They marketed themselves as offering "Great Ideas"--stocks identified from the filings of the era's leading money managers, such as Berkshire Hathaway's (BRK.A) Warren Buffett, Loews Corporation's (L) Larry Tisch, and Carl Icahn. Clever concept; bad execution. When narrowing down the great ideas to create conveniently sized portfolios, those who ran such funds imposed their own views. At that task, they failed.

They could have taken another path. Rather than arbitrarily track certain investment managers, regarded by them as "stars," and then choose selected stocks from those managers, those who ran the Great Ideas funds could have implemented a fully objective procedure that would have removed themselves completely from the outcome. Had they done so, their portfolios would have held the stocks that were most favored by the top portfolio managers. Period.

An Automated Approach

Such is the spirit behind the recently published report, "Morningstar Ownership Lens: Ownership Alpha for Stock Selection." Written by Morningstar's Kathryn Wing and Neelotpal Shukla, the paper outlines a rigorous approach for ranking stocks based on the quality of that stock's investors. The result is a score called "Ownership Alpha."

(Note: The current report is a sequel to 2019's "Morningstar Ownership Lens: An Introduction." However, as the previous publication took a somewhat different angle, it will not be further discussed in this column.)

Unlike the Great Ideas funds, which evaluated only a small subset of available securities, Ownership Alphas are awarded to every eligible stock. What's more, the scores incorporate the views of every active mutual fund portfolio manager. The Ownership Alpha scores therefore run the gamut. Some are very high, indicating that the stock is largely held by top managers, while others are unusually low, because those equities are mostly owned by unsuccessful investors.

Here are the basic details of the Ownership Alpha calculation:

1) The investment universe consists of all actively run U.S. diversified equity funds (save for those that were eliminated owing to data unavailability).

2) The quality of each fund is measured by its trailing three-year performance, as scored by its Carhart four-factor alpha. (Carhart alphas are risk-adjusted measures that attempt to account for investment factors that might have helped or hindered the fund's performance, such as company size or stock-price momentum.)

3) The larger the weighting that a stock occupies within a fund, as determined the percentage of assets that it commands, the more influence that stock has on the Ownership Alpha.

That is merely a sketch of the methodology; the paper provides the full details. The important thing to recognize is that Ownership Alpha scores are awarded to stocks, but they are governed entirely by fund results. The better the funds that hold a stock have performed, the higher that stock's Ownership Alpha score will be.

History's Judgment

The Ownership Alpha is a neat idea, but its utility would be limited without evidence of its results. Fortunately, the authors possessed the data to assess the accuracy of its predictions. They began by sorting stocks into quintiles. Each three months, they created a top Ownership Alpha quintile, which consisted of those stocks that had the highest Ownership Alpha scores; then a second Ownership Alpha quintile, and so forth until they reached a bottom Ownership Alpha quintile. They then calculated the returns for each quintile over the next quarter. Stringing those quarters together provided the long-term returns for each of the five quintiles.

The results were mostly supportive. For the first six years of the test, which began in 2013, returns for the four highest Ownership Alpha quintiles converged. That, one must confess, wasn't a great validation of the measure's forecasting power. However, the lowest Ownership Alpha quintile did trail the other four quintiles throughout the period, so the score did help with identifying stocks to be avoided.

Then, starting in 2019, the performances among the quintiles sharply diverged. By March 2021, when the study concluded, the top Ownership Alpha quintile had turned an initial equal-weighted $1,000 investment into nearly $2,500, as opposed to $2,300 for the second quintile, $1,800 for the middle quintile, $1,700 for the fourth quintile, and $1,500 for the bottom quintile. That's how predictive measures are supposed to work!

The authors then ran several additional tests, each of which reconfirmed the initial impression. For the admittedly limited period of 2013 through 2021, a stock's Ownership Alpha score was positively correlated with future returns.

Looking Forward

At this stage, Ownership Alpha is merely a research idea. No Morningstar product currently carries the data point. However, it seems that will soon change. The authors have recommended that the Ownership Alpha scores be used in Morningstar's Risk Model, which is offered to Morningstar's professional clients.

Eventually, I hope, the Ownership Alpha scores will appear on Morningstar.com's pages for all to see. Not that I would recommend that they be used as the sole investment determinant, as with the Great Ideas funds. But they could be a deciding factor for equity investors who find themselves on the fence about a transaction. All things being equal, it's better to be in good company when making a trade, than to emulate the decisions of the fund industry's also-rans.

John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

John Rekenthaler does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.