Five-Star Stocks a Top-Down Approach Would Miss

Many money managers and other investors screen for stocks by using a "top-down" approach. Investors who use this approach will usually start by evaluating the short-term economic outlook. They will typically look at GDP growth across countries, interest rate direction, consumer confidence, exchange rates, and various leading indicators. In a country as big as the U.S., investors might also conduct an analysis of regions or states. As a result of this analysis, investors will avoid places where the economic outlook is negative.

Next, the top-down investor might try to identify the sectors or industries that are expected to outperform based on the economic analysis. At this stage they might ask these questions:

1. Which industry will outperform in a rising interest rate environment?
2. Which industry is a sure bet when consumer confidence is on the rise?
3. Which industry will be a better investment when commodity prices fall?

Finally, top-down investors screen for individual stocks only after choosing the sector or industry they think will do well given their economic forecast.

Our View
Though the "top-down" approach makes sense in theory--why not put your money where the economy works in your favor?--we at Morningstar think that it comes with a price. First, forecasting the direction of the economy is extremely difficult. You only have to turn on the TV or read the business section of any newspaper to get several substantially different opinions on the direction of the economy. Study after study show that even the experts can't predict anything as complex as interest rates, exchange rates, or economic growth. Second, positive economic forecasts usually draw many investors, and stock prices inflate to unjustified levels as a result. Finally, avoiding certain geographic areas or industries with a negative economic outlook might result in passing up a company with a positive outlook that is selling below its fair value.

At Morningstar we believe that a stock should be purchased at a price below the fair value of the underlying business. That does not mean that we ignore short-term economic trends when we make our recommendations. On the contrary: We always try to incorporate all relevant economic factors. Whether we want to or not, we have to forecast oil prices to value an oil producer, gold prices to value a gold miner, and housing starts to value a homebuilder. We lay out those assumptions in our Analyst Reports so readers know what we base our fair value estimates on. If we think the economic outlook is negative, it will certainly affect our fair value estimate. However, we will never pass up an industry, a sector, or a geographic area just because the economic outlook is negative. We're bottom-up investors, not top-down investors. And if our fair value estimate is lower than the current stock price, we will recommend that investors avoid a company even if the economy is working in the firm's favor. We would never consider economic forecasts in and of themselves to be a reason to buy or avoid a stock.

This is why several companies that now sport 5-star Morningstar Ratings for stocks probably will not show up on a typical "top-down" stock screen. Take for example Oak Hill Financial  and Park National (PRK), two Ohio-based banks that currently trade below our estimates of their fair value. Investing in Ohio's economy? A "top-down" stock screen will probably tell you that there are better states than Ohio in which to put your money. Take Nevada or Arizona, for example: The economies of both are expected to grow at a significantly higher rate than Ohio's economy.

Another example is  Lennar (LEN), one of the largest homebuilding companies in the U.S. A "top-down" analysis would probably suggest staying away from the real-estate sector in the near future as housing prices cool and housing inventory builds. We, however, view Lennar as a solid builder that currently sells well below our estimate of its fair value and, therefore, qualifies as a good long-term investment. Of course, we've factored in a rough period for the housing market in arriving at our fair value estimate.

Another segment of the market that may rank low on a "top-down" stock screen these days is title insurance, whose fortunes ebb and flow with the real-estate market. Nevertheless, we see opportunities in this segment. First American (FAF), a leading title insurance company, can be currently bought at a price significantly below our estimate of its fair value.

Attractive Prices, Unfavorable Conditions
Company	Rating	Comments
Oak Hill Financial		Operates in a sluggish economy
Park National (PRK)		Operates in a sluggish economy
Lennar (LEN)		Operates in the real estate market
First American (FAF)		Exposed to the real estate market
Rating as of 07-18-06

Choosing stocks based on economic forecasts comes with a price that we think investors should not pay. At Morningstar, we prefer to focus on the long-term prospects of each company and the price investors can buy it for. That way we hope to avoid overpaying for companies operating in favorable economic environments or passing up companies that operate under tougher conditions but sell below fair value.