Improving the Morningstar Rating for Stocks

In The Intelligent Investor, value investor Benjamin Graham wrote, "To distill the secret of sound investment into three words, we venture the motto, Margin of Safety." With those three words in mind, we've decided to make some changes to our Morningstar Rating for stocks.

Why? Well, all companies are not created equal--and neither are all stocks. Some are riskier than others, of course. So we've changed the way we calculate our star ratings to better include risk in the equation. Previously, any stock selling more than 30% below its fair value estimate was rated with 5 stars. From now on, however, we'll be risk-adjusting the star rating. To get a 5-star rating now, a risky stock like Americredit  will have to fall further below its fair value estimate than a low-risk stock like Wrigley .

We've also made another change by incorporating the size of a company's economic moat into our calculation. "Economic moat" is a term used by Warren Buffett to describe the predictability of a company's future profits. Companies with big competitive advantages in mature industries (e.g., Pfizer (PFE) or Gillette ) are fairly predictable, so we rate them as "wide" moat companies, while companies with no competitive advantages (e.g., DaimlerChrysler  or Lucent ) by definition have no economic moats. Most large-cap companies fall in between and get a "narrow" moat rating.

A New Way of Seeing Stars
As a result of these changes, the hurdle a stock has to clear before it qualifies as a 5-star holding depends on its risk and moat. The higher the risk, and the weaker the moat, the higher the hurdle.

Practically speaking, the changes will have the following effects:

1. A company's quality will be better reflected in its star rating.
   With the changes, high-quality companies will be rewarded because a smaller discount to their fair value estimates will be required for them to be rated with 5 stars. A wide-moat/low-risk stock need only be 20% below our fair value estimate to receive 5 stars. 
    
   By the same token, we think requiring a larger margin of safety for a risky stock than for a nonrisky one is prudent. So, we've incorporated that idea into our calculation. Now a high-risk/no-moat stock will require a 60% discount to reach 5-star status--a much larger margin of safety than a wide-moat/low-risk stock would require. Additionally, stocks with no moats will become 1-star holdings more easily. After all, these types of stocks aren't long-term keepers; they're short-term valuation plays--stocks Buffett calls "cigar butts" because they may have only one puff left in them. If one of these stocks is 10% overvalued, we'll rate it with 1 star.
    
2. There will be fewer 5-star stocks.
   Because of these changes, there will be fewer 5-star stocks than under our previous methodology, and the quality of our typical 5-star stock will be higher. We think readers would rather have a few really good picks--only our very best ideas--than a longer list of 5-star stocks we aren't as confident in.

No-Moat/High-Risk Stocks
Some stocks will be affected more than others under this new star-rating methodology. As previously mentioned, stocks with no economic moats and high risk ratings will experience the most significant changes.

To illustrate, consider these 10 high-risk stocks, with their old and new star ratings:

High-Risk Stocks
Company	Size of Moat	Fair Value ( $ )	*Price ( $ )	Old Star Rating	New Star Rating
Nextel	None	12.00	7.44
EchoStar Comm	None	27.00	17.51
Tyco	None	28.00	15.75
Advanced Micro Devices (AMD)	None	7.00	6.25
El Paso	Narrow	21.00	12.20
Check Point Software  (CHKP)	Narrow	23.00	15.53
Apple Computer (AAPL)	None	20.00	14.72
Genzyme	Narrow	35.00	21.42
Goodyear Tire & Rubber (GT)	None	26.00	10.59
ICOS	None	48.00	21.99
*Prices as of 09-22-02.

Wide-Moat Stocks
The changes also will award a higher star rating to some wide-moat stocks. Stocks with this moat rating are the highest quality companies we cover--the type of stocks we'd feel comfortable buying and holding on to for long periods of time. Because their earnings and cash flows are more predictable, they require less margin of safety to earn a 5-star status.

Here are some of the wide-moat stocks that will get a higher rating as a result of the changes:

Wide-Moat Stocks
Company	Risk Rating	Fair Value ( $ )	*Price ( $ )	Old Star Rating	New Star Rating
Eli Lilly (LLY)	Low	70.00	55.63
PepsiCo (PEP)	Low	48.00	37.50
UPS (UPS)	Low	55.00	62.80
Berkshire Hathaway (BRK.B)	Low	3,015.00	2,400.00
American Express (AXP)	Low	43.00	31.22
American Intl Group (AIG)	Medium	80.00	56.23
Gentex (GNTX)	Medium	35.00	27.91
Blackrock (BLK)	Low	53.00	41.99
Bank of New York (BK)	Medium	39.00	28.65
Freddie Mac (FRE)	Low	78.00	58.24
*Prices as of 09-22-02.

All 10 of these companies have big competitive advantages in their respective industries and a relatively high degree of earnings predictability. In 10 years, they will still exist in one form or another--something I can't predict about the stocks on the no-moat/high-risk list, at least not with any degree of confidence.

Fair Value Estimates Unchanged
It's worth noting one more important aspect of the new star ratings: They won't affect our fair value estimates. If a stock had a fair value estimate of $50 before the changes, it still has a fair value estimate of $50 today. As before, only two things can cause us to change a stock's fair value estimate:

1. We change our estimate of a company's future cash flows.
    
2. We change our estimate of the appropriate discount rate. (Discount rate is determined by a company's business risk, the risk-free rate, and the general riskiness of stocks versus Treasury bonds.)

We think these stock star-rating changes are a big improvement over our previous "one size fits all" methodology. Visit The Morningstar Rating for Stocks page to see a complete list of all the stocks we cover and their new star ratings.