How to Use Morningstar Ratings to Find Quality Stocks
A guide to understanding Morningstar analyst-driven stock ratings and how they work together.
Question: How does the stock star rating work?
Answer: To fully understand the star rating and how you might use it as a consider-buying gauge, it might help to get a brief background on how a few analyst-driven Morningstar ratings are determined and how they work together.
The Star Rating
Let's start with the star rating, whose official name is the Morningstar Rating for stocks. This is calculated by comparing a stock's current market price with Morningstar's estimate of the stock's fair value. The bigger the discount, the higher the star rating. Our rating system also factors in an uncertainty adjustment (known as the fair value uncertainty rating--more on that below) so that it's more difficult for a company to earn a 5-star rating the less confident we are in the precision of our fair value estimate.
Fair Value Uncertainty
When Morningstar equity analysts assign a fair value estimate to a stock, it's a single dollar-value estimate. But in actuality, our analysts predict of a range of outcomes or scenarios for each company when determining its fair value estimate. Our uncertainty rating follows the principals of a confidence interval, surrounding our fair value estimate. Essentially, a low fair value uncertainty rating means that the analyst thinks he or she can more tightly bound the fair value of a company because he or she can estimate its future cash flows with a greater degree of confidence. In determining this rating, our analysts score companies based on sales predictability, operating leverage, financial leverage, and exposure to contingent events (for example, a biotech company's success or failure may hinge on whether a single drug is approved or not).
(Note: This rating is sometimes referred to in shorthand as the "uncertainty rating," which may lead some people to assume the measure is intended to predict the future volatility of the stock's price. Although that is not the intent of the rating, some of the elements that go into determining the fair value uncertainty rating, such as leverage and risk of events such as litigation, could arguably result in a more volatile stock price.)
To illustrate how the rating works, let's look at two companies: The first, McCormick & Company (MKC), the market leader in seasoning and spices, is a good example of a company that earns a "low" fair value uncertainty rating. While the company does have to contend with price fluctuations in the commodity market for the raw materials that make up the spices, McCormick generates relatively stable cash flows and has a manageable debt load; therefore, Morningstar senior equity analyst Erin Lash feels there is a low degree of uncertainty around McCormick's fair value estimate. Further, Lash explains that McCormick's dominance in its category is marked by a unique feature: its private-label presence. "The firm is the largest producer of private-label spices and seasonings in North America, and as such, the pricing threats many consumer-product firms face are limited for McCormick, ensuring that no other company gains enough scale to significantly affect the pricing of the firm's branded offerings. In addition, we think that by offering these lower-priced products, McCormick enhances its relationship with retailers."
At the other extreme is Arch Coal (ACI), one of a handful of companies in Morningstar's stock coverage universe receiving an "extreme" fair value uncertainty rating. Many of the uncertainties that Arch faces are shared by most, if not all, coal producers; these risks include a fall in coal prices, competition from substitute fuels such as natural gas, environmental regulations, both global and domestic economic performance, and weather. But what pushes Arch Coal further toward extreme uncertainty is very high leverage, said Morningstar equity analyst Kristoffer Inton. "In our base case, we think Arch's debt is so large that it overshadows the enterprise value of the company, leading to no equity value. In fact, our fair value only reflects option value for the 'bull case' scenario. Since the value purely relies on an upside case, it seems pretty extreme to us," Inton said.
The idea of an economic moat (a term originally coined by Warren Buffett) refers to how likely a company is to keep competitors at bay for an extended period. One of the keys to finding superior long-term investments is buying companies that will be able to stay one step ahead of their competitors, and it's this characteristic--think of it as the strength and sustainability of a firm's competitive advantage--that Morningstar is trying to capture with the economic moat rating. A company that has generated capital higher than its cost of capital for many years probably has a moat, especially if its returns on capital have been rising or are fairly stable. Here are some things that can give companies economic moats:
Putting It All Together
The proprietary Morningstar ratings mentioned above can help you narrow your focus to find high-quality stocks that have a good chance of outperforming peers. In addition, the more comprehensive Stock Analyst Reports can provide valuable research that can help you make your investment decision. But after a six-year bull market, bargains are scarce. I used the Premium Stock Screener to search our entire coverage universe of stocks for those rated 5 stars, along with a fair value uncertainty rating of "low," and a wide economic moat rating. Out of more than 950 stocks we rate, there are only two in our coverage universe that currently meet these stringent criteria--energy firms Exxon Mobil (XOM) and Plains GP Holdings LP (PAGP).
Dropping the 5-star criterion yields a list of 37 stocks, however. (Premium Members can click here to see the results of the screen.) Though most of these stocks are not screaming buys at this point, our Portfolio Manager tool makes it easy to set up a watchlist for stocks that pique your interest. Just click here, select New Watch List, enter the tickers, save, and you're done. (The share number, purchase price, and commission fields can be left blank.) You can customize your watchlist alerts to tell you about price swings or, if you're a Premium Member, you can be alerted whenever a new fair value estimate or Analyst Report is published.
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Karen Wallace does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.