New Style Box Captures the Whole Picture

Morningstar is getting style conscious. In a few days, we’ll roll out a brand new methodology for calculating the Morningstar style box for mutual funds. It will still use the classic nine-box grid, but the inputs will be different. The goal is to do a better job of capturing fund managers’ strategies.

The new methodology will incorporate 10 factors in the style-box calculation rather than just two--for the first time we’ll incorporate growth measures as well as valuations. The new factors are: price/projected earnings, price/book, price/sales, price/cash flow, dividend yield, long-term projected earnings growth, historical earnings growth, sales growth, cash-flow growth, and book-value growth. Though the changes will be subtle, this represents a vast improvement on the old style box. We’ll provide more details when we introduce the new methodology to the site, but in the meantime I’ll highlight a few key improvements.

The Value of Growth
By using five growth measures, we’ll finally capture the other half of a stock’s picture. Most fund managers look at a company’s growth prospects as well as its valuations. A typical growth manager is looking for rapid growth. If they find that growth in a company with modest valuations, so much the better. However, our old style box might have placed such a stock in blend or value.

For example, Janus Mercury (JAMRX) has consistently held tech stocks and generally mapped to growth. However, recent shrinking valuations and manager Warren Lammert’s move into some financials has nudged the fund into the value column. When we add in growth measures, though, we see that Lammert is still pursuing stocks with above-average growth rates--he’s just doing so using stocks with lower valuations.

Greater Breadth
We’re casting a much wider net in order to capture the variety in the stock market. For example, cable and media stocks trade on price/cash flow rather than price/earnings, but the old box didn’t capture that. While price/book matters for financials, most investors give it little heed in other industries. A couple of years ago, JDS Uniphase (JDSU) landed in the value region of the style box because it had a low P/B and no P/E, though clearly it was as growthy as anything around.

Just as different industries trade on different measures, different managers pay attention to different factors. Many growth managers emphasize price/forward earnings and earnings-growth rates, while some value managers like Mario Gabelli and Wally Weitz focus on cash flow. Thus, we’ll do a better job of measuring a wider variety of stocks and funds.

Consistency
Because different factors go in and out of fashion, we’ll be better positioned with the new 10-variable methodology to reflect the factors that are driving performance. For instance, earnings- and sales-growth rates told most of the performance story in 1998 and 1999, but now P/E and price/cash flow are in favor as investors have discovered price risk.

In addition, by mixing in both forward and historical measures, the new style box methodology will be less susceptible to changes in the economic cycle. For instance, if you buy a semiconductor maker or an automaker at the bottom, you may be paying a steep price relative to trailing earnings, yet forward earnings and price/sales figures might reveal that you’re actually buying at a very cheap price if the company rebounds to historical norms.

Conclusion
You’ll find our new style box provides a more accurate snapshot of what a manager is doing. We’d love to hear your comments or questions as we roll out the new methodology. My e-mail address is russel_kinnel@morningstar.com.

This article originally appeared March 25, 2002.