Shedding Light on our Uncertainty Rating

Morningstar's fair value uncertainty rating is essential to the margin of safety concept that is at the core of our investment philosophy. A single-point fair value estimate is falsely precise in that the countless assumptions that go into the calculation of that single number are not certainties, but rather best guesses within a range of possible outcomes. Our fair value uncertainty rating is meant to describe our uncertainty about these underlying assumptions. It also determines, in combination with our fair value estimate, the Consider Buying and Consider Selling prices that delimit our 5- and 1-star ratings.

How are fair value uncertainty ratings determined?
Each company in our coverage universe is assigned an uncertainty rating, ranging from low to extreme, at the discretion of our stock analysts. The rating is based on the dispersion of possible fair values resulting from the range of possible cash flows the company may achieve in the future. Potential bankruptcies, lawsuits, and government interference are all examples of events that can increase the uncertainty corresponding to our fair value estimate. (More information on the methodology behind our fair value uncertainty ratings can be found here.)

What are the characteristics of stocks within each fair value uncertainty rating?
Our fair value uncertainty rating is forward-looking and fundamentally based. It is not surprising to find a correlation between uncertainty and several and other Morningstar ratings because, after all, small, financially unhealthy, and poorly managed companies all face greater uncertainty. The data below also show that extreme uncertainty stocks appear cheaper than their peers, as would need to be the case to justify the risks inherent in such an investment decision.

Characteristics of Stocks by Uncertainty Rating
	Median Cost of Equity	Median Price/Fair Value Ratio	Median Market Cap ($ mil)	Median Financial Health Grade	Median Stewardship
Low	9.5%	0.73	18,951	A	B
Medium	10.5%	0.70	5,025	B	C
High	11.0%	0.67	1,642	C	C
Very High	12.0%	0.69	593	C	C
Extreme	12.5%	0.46	351	D	D
Data from Morningstar as of 2-23-09.

Does the fair value uncertainty rating predict volatility?
While our fair value uncertainty rating is not meant to predict the future volatility of a company's stock price, we have found correlation between the two. Stocks may have greater fair value uncertainty due to large amounts of financial leverage, operating leverage, or any number of underlying business factors including litigation, the discretionary nature of its products, or customer concentration. Each of these underlying fundamental issues can breed greed and fear among market participants, and thus inflate the volatility of returns. We measured the returns of every stock in each band over the time period from April 30, 2008 (one month after we began using the extreme rating), through Jan. 30, 2009. The median and standard deviation of these returns are shown below.

Median Return and Standard Deviation of Stocks by Uncertainty Rating
	Median Return	Standard Deviation of Returns
Low	-25%	21%
Medium	-41%	24%
High	-52%	30%
Very High	-62%	35%
Extreme	-71%	39%
Data from Morningstar based on returns between 4-30-08 and 1-30-09.

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