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Improving the Morningstar Rating for Stocks

A company's quality will now be better reflected in its stars.

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 (ACF) will have to fall further below its fair value estimate than a low-risk stock like Wrigley (WWY).

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 (G)) are fairly predictable, so we rate them as "wide" moat companies, while companies with no competitive advantages (e.g., DaimlerChrysler (DCX) or Lucent (LU)) by definition have no economic moats. Most large-cap companies fall in between and get a "narrow" moat rating.