Does an 'F' Mean Sell?

Based on some of the reaction we had to our last stewardship-focused article, we figured it might be a good idea to review some of the objectives we originally had in mind when we started providing stock Stewardship Grades for the firms we cover--especially as these tenets have changed little over the years. We also wanted to make it clear to investors that a Stewardship Grade in and of itself should not be viewed as a recommendation to buy or sell a company's stock, but rather should be seen as yet another useful tool to use when making investment decisions. In this article, we'll review what we believe are some of the more critical factors to juggle when making the decision whether or not to pull the trigger.

Two of Morningstar's Key Metrics: Moats and Risk
We believe there are a multitude of different factors that investors should consider before putting their hard-earned money into any stock. Even though price is probably the biggest single piece of data that most investors consider, at Morningstar we also like to focus on economic moats, which we believe can provide firms with periods of above-average profitability--especially if the firm's moat is wide enough to keep competitors at bay for an extended period of time. Based on our assessment of a myriad of different factors--from the industry in which a firm competes to the competitive advantages it holds over its peers--we assign firms a wide, narrow, or no economic moat rating.

Although we believe that one of the key tenets to producing superior long-term returns is finding companies that are capable of staying one step ahead of their competitors, it is also likely that the market (having recognized the strength and sustainability of a firm's competitive advantages) has already incorporated much of this into the price its stock. So forming an investment strategy based solely on purchasing wide-moat firms is likely to prove tenuous on its own--that is, unless the discount to the company's fair value estimate is sufficient enough to warrant purchasing the shares today.

In addition to economic moats, we also look at the potential business risks tied to the firms we cover. Even though the size of a company's moat does play a role in our determination of its risk, we look at many other factors as well: the cyclicality of the firm's business, the makeup of its balance sheet, the sustainability of its cash flows, and any sort of event-driven risks (such as acquisitions and divestitures and/or litigation) that could reduce the precision of our cash-flow estimates. Ultimately, we're trying to gauge the confidence we have in our estimates, given the firm's business and our belief in management's ability to handle unforeseen events that could affect the firm's cash flows longer term.

Much like our economic moats, we rank a company's level of business risk into one of four groups--below-average, average, above-average, or speculative. The margin of safety we demand before recommending any of the stocks we cover is directly tied to our assessment of the business risk of the companies they represent. As such, firms with below-average risk will require smaller discounts to our fair value estimates of their stocks before reaching a Consider Buying (or, 5-star) price than would companies with average or above-average risk ratings. This is mainly because companies that have been more consistent operators over time tend to have more predictable cash flows longer term, providing us with a lot more confidence in the assumptions we're making in our valuation models. The margin of safety, in effect, provides investors with a cushion should our estimates of the company's future prospects prove to be somewhat more ambitious than the final reported results.

Looking Beyond Moats and Risk
Taken together, our assessment of a firm's economic moat and its business risk should allow investors to separate the wheat from the chaff and hone in on some fairly solid long-term investments. But the investigation should never stop there, as there are plenty of other factors that should be considered before becoming an owner of any company's stock. Aside from learning as much as possible about the business and industry in which a company operates, we also actively encourage investors to look closely at the management teams running the firm. This is an idea that stems from the writings of Philip Fisher, author of Common Stocks and Uncommon Profits, who believed that investors should be wary of an enterprise and its shares--regardless of how good a company might look from a financial or competitive position--when there are serious doubts about management's "sense of trusteeship for shareholders."

When we first rolled out our Stewardship Grades several years ago, our original intent was to provide investors with a measure of the commitment we felt that the boards and management teams at the companies we graded had toward their shareholders. Unlike the scores provided by so many of the other governance rating services, we don't focus on how well a company might be performing relative to its peers (or some other benchmark), but instead pay close attention to how well a company's management team and its board of directors regard their own shareholders, and assign grades based upon our observations.

Should a company engage in activities that run contrary to what we believe are essential practices for its managers to be good stewards of investors' capital, then the firm receives a poor grade--regardless of how other firms in its industry (or benchmark) score. We do this because we want to award grades based on how companies are actually treating their shareholders, rather than giving credit to firms with poor stewardship that may just happen to be the best of a bad bunch. As such, companies with a strong track record of putting their shareholders first have tended to score well, while those that have treated shareholders poorly have ended up at the other end of the spectrum.

What's the Value of Stewardship Grades?
With our Stewardship Grades awarded on an absolute scale from A (Excellent) to F (Very Poor), it would certainly be easy to limit your investment choices to only those firms that have received grades at the upper end of the scale. While it is likely that many of these firms are well-managed, the idea of investing in only A-rated and B-rated firms might prove as tenuous as investing in only wide-moat firms without regard to valuation. After all, as you can see from the table below, a strategy based on investing in only those firms with good or excellent Stewardship Grades would eliminate more than 50% of the 1,764 companies we currently have graded.

Stewardship Grade Breakdown
Grade	Number of Companies	Percentage of Total
A ("Excellent")	91	5%
B ("Good")	733	42%
C ("Fair")	711	40%
D ("Poor")	200	11%
F ("Very Poor")	29	2%
Total Number of Graded Firms: 1,764

We think that the key focus should not be on the ranking itself but what the designation implies for investors longer term. When a company has a wide moat around its business, we can generally assume that it has attributes that give it a huge leg-up over its competitors, allowing it to generate above-average results for a sustained period of time. When a company earns a Stewardship Grade that is higher than a grade of C, then we can generally assume that the management team and board of directors at that particular company have been doing an above-average job of looking after shareholders' interests. In either case, though, we still think it is also important to know more about the particular attributes that allow these firms to separate themselves from the rest of the pack.

There are several ways of digging deeper into a firm's economic moat. For example, does the company have dominant market share, or does it enjoy economies of scale in areas like manufacturing, sales, and/or marketing, which makes it difficult for its competitors to catch up? Has the firm built a wide moat around its business because it is the low-cost producer in the industry? Does it enjoy other significant competitive advantages, such as patents, copyrights, or government licenses that protect its products or markets? And realizing that moats will ebb and flow as industries and markets change, it is important to ask these types of questions from time to time rather than assume that a firm's moat is unassailable.

In that same light, we would also want to know more about the conditions that have allowed some firms to receive Stewardship Grades above the group average, as well as the attributes that led firms to have failing grades. As we highlighted in our last article,  "Five Stocks that Deserve an F," there are times when specific conditions (such as large levels of family ownership and/or concentrated voting power, along with the existence of related-party transactions) can combine to produce a failing Stewardship Grade, even though each individual factor on its own may not be enough to lower a company's rating to a below-average level.

Even though we realize that our Stewardship Grades are often times viewed as a quick take on our impression of a firm's management team, board of directors, and its commitment to shareholders, we actively encourage investors to dig deeper into the different drivers behind the grades and determine whether or not the conditions that exist at any given firm are ones they'd be willing to live with longer term. After all, it is not out of the realm of possibilities for a company with a poor track record of corporate activity to still turn out to be a decent investment. Ultimately, though, we continue to believe that in the long run it is those companies that treat all shareholders with respect that tend to produce less headaches and heartaches for their shareholders.