Three Steps to Better Stock Investing

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.

This week on Morningstar.com, we're looking at 5 Days to Become a Better Investor. I'm here today with Heather Brilliant. She's the head of global credit and equity research for Morningstar, for a look at individual stock selection.

Heather, thanks for joining me.

Heather Brilliant: Thanks for having me, Jeremy.

Glaser: So, I know that when you dive into buying individual stocks, it can be kind of overwhelming. You have all of these SEC filings and all this information that can be difficult to sort out the wheat from the chaff.

Can you talk to us a little bit about Morningstar's approach into selecting individual stocks? What's a good place to start?

Brilliant: We really look at three main factors when we're trying to figure out which stocks would make an attractive investment. The first is economic moat or sustainable competitive advantage. This is really a screen or a tool to be able to make sure that you're buying the highest-quality businesses that you can.

Now, some might say, "Oh, that's kind of obvious. Of course you should buy something like a McDonald's or a Coke." But the second element that we really bring into it is the importance of valuation and making sure that the stocks you're buying are trading at a reasonable discount to what we think they're worth, or what you think they're worth as that investor.

And finally, we always look for a margin of safety. So, if you think a given company is worth $50 a share, you might not be willing to pay $50 a share. You might want to pay maybe a 20% discount before you'd be willing to buy it.

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Glaser: So, let's start by looking at economic moat. I know, this is a coinage that Warren Buffett likes to talk about, and a lot of other very successful investors.

How do you assess if a company truly has competitive advantages that are going to be sustained over a long period of time?

Brilliant: Well, at Morningstar, we have a team of analysts looking very closely at the competitive advantage and the competitive landscape of every company that we cover. And so we actually have a Moat Committee that evaluates the economic moat rating we assign to every company, and we're basically looking for four main things:

We're looking for companies who either have a network effect, which is a business whose value increases as the number of users increase. Or we're looking for some type of cost advantage. We might be looking for customer switching costs. Or finally we could be looking for intangible assets, which would include things like patents or government licenses.

So, I think it's really important to understand that it's not just a matter of looking at a company and reading through its filings. The moat analysis is actually a really in-depth process that we apply consistently across all of our coverage.

Glaser: Now, let's take a look at valuation, then. I think we'd all like to buy $1 for $0.50.

How do you make sure that you're really getting a true value and not just entering into a value trap?

Brilliant: I think if you start with companies that have a sustainable competitive advantage or have an economic moat, I think you are less likely to fall into the value trap category, because you are not just necessarily chasing cigar butts or ... picking up dimes lying on the street as people like to say. But you're really trying to buy a high-quality business at a discount to what you think it's worth.

So when we look at valuation, we use a discounted cash-flow model, but we also look at multiples to make sure we're understanding how the market is thinking about the stock and what it would take to see the stock be revalued.

Glaser: So when we are thinking about valuation, you are really evaluating the business as a whole because you are becoming an owner and not worrying about what the next guy is going to pay for it?

Brilliant: Exactly.

Glaser: And then if we are thinking about that margin of safety that you talked about--we all get things wrong and you might be a little bit too optimistic. For some companies, are you going to demand more margin of safety if you are more uncertain? How exactly does that process work?

Brilliant: Absolutely. So, in order to capture the margin of safety that we'd look for before investing in a company, we assign an uncertainty rating to each company that we cover. And so for a low uncertainty rating stock, we might be willing to buy it at, say, a 20% discount to what we think it's worth. But for a company that has high or very high uncertainty, it's very hard for us to estimate the value of that company. We think it's hard for any investor to estimate, and so the stock price is likely to be a lot more volatile and the prospect of future returns could be very different depending on the scenario that plays out. And so in that case we'd look for a much greater discount, more like a 50% discount, before we would buy.

Glaser: So it sounds like that by taking a looking at the competitive positioning or the moat, making sure you are getting a good valuation, and that you have an understanding that there is going to be some uncertainty around it, can really put you on the track to being a better stock investor.

Brilliant: Yes, we think that's a recipe for success.

Glaser: Heather thanks so much for talking with me today.

Brilliant: Thanks for having me Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser.