Morningstar Ratings

Fair value estimate: is a stock a deal or overpriced?

The fair value estimate is an analyst’s projection of a stock’s true, long-term value. A stock earns a higher star rating if it’s trading below what Morningstar analysts think it’s worth. If a stock looks overpriced to analysts, it earns fewer stars.

With the Uncertainty Rating, Morningstar builds in a margin of safety. The more uncertain the estimate, the greater the discount investors want before buying. Uncertainty ratings range from low to extreme.

Analysts review factors like:

• Operating and financial leverage.
• Sales sensitivity to the overall economy.
• Product concentration.
• Pricing power.
• Exposure to material ESG risks.
• Company-specific factors.

Economic moats: holding off the competition

An economic moat measures a firm’s durable competitive advantage. If analysts expect a company will fend off competitors for 20 years, it receives a wide moat rating. A 10-year advantage earns a narrow moat. Firms with a short-lived or no competitive advantage get no moat.

Analysts must pitch wide-moat recommendations to an expert committee, composed of senior Morningstar equity researchers. They also award a positive, stable, or negative rating based on the trending direction of the moat.

Economic moats come from five sources:

• Switching costs—money, effort, or time—can dissuade customers from jumping to a competitor.
• The network effect is when a good or service becomes more valuable as more people use it.
• Intangible assets like patents, regulatory licenses, and brand identity can prevent competitors from copying products.
• A company with a cost advantage can produce goods or services at a lower cost, undercutting the competition or boosting profitability.
• Efficient scale benefits companies in a niche market that only supports a few competitors.

Assess capital allocation

The Capital Allocation Rating assesses where and how leadership uses excess profits. Do they return it to shareholders through dividends? Do they pay down their debt? Do they invest in product development?

Companies can receive a poor, standard, or exemplary rating.

The Morningstar rating for funds

Introduced in 1985, the Morningstar Rating^TM for funds, often called the star rating, compares funds against their peers to inform investment decision-making. It’s an at-a-glance look at a fund’s risk-adjusted performance over the past three years.

The star rating shines a light on fees that can erode the ultimate returns on an investment. One trade-off: the rating only reflects historical returns, which don’t guarantee future performance.

The Morningstar Rating for funds follows a bell-curve distribution. The top 10% of funds in a category receive a 5-star rating. The next 22.5% receive a 4-star rating.

Estimate future performance with Morningstar Medalist Ratings

The Morningstar Medalist Rating simplifies how wealth and asset managers search for, select, and monitor investments. It offers one forward-looking assessment through a market cycle of at least five years.

The rating reflects an analyst’s conviction that a fund will outperform peers on a risk-adjusted basis. It includes three positive ratings—Gold, Silver, and Bronze.

• Gold-rated funds rank in the top 15% of their category with expected positive net-of-fee alpha.
• Silver-rated funds rank in the next 35% of products with expected positive alpha.
• Bronze funds in the bottom 50% of products that are predicted to have positive alpha.
• Neutral funds are expected to deliver zero or less than zero alpha.
• Negative funds, the worst designation, are ranked in the bottom 70% of the category’s products with subzero alpha.

The Medalist Rating combines humans and algorithms to expand Morningstar coverage. Algorithms replicate analyst findings using past rating decisions and the data behind them. The model continues to pick clearly over-and underperforming funds.

3 Pillars of Morningstar Manager Research

Morningstar’s more than 100 analysts operate globally with an added layer of local expertise. Independent research empowers asset and wealth managers with a forward-looking perspective on how investments might act in different market environments.

Researchers analyze Morningstar data and fund documents and, when possible, conduct face-to-face interviews with the fund management team.

The People pillar analyzes the person who manages a fund. Analysts look at factors like:

• Length of tenure.
• Qualified analysts.
• Relevant investment experience.
• Succession planning and team stability.

2. The Process pillar reflects how well managers execute their investment strategy over time. Analysts assess factors like:

• Investment philosophy behind a strategy.
• Investment research.
• Systematic and repeatable elements of a process.
• Approach to risk management.
• Manager decision-making.
• Loyalty to the strategy, especially when it’s out of favor.

3. The Parent pillar reviews the stewardship quality of a firm. Analysts look for qualities like:

• Recruitment and retention of talent.
• Quality of product lineup.
• Detailed preparation.
• Alignment of interests with investors.
• Regulatory compliance.

Assessing ESG risk

Morningstar ratings visualize ESG risk in a consistent, common language.

The ESG Risk Assessment describes a company’s exposure to material ESG issues and how well they manage that risk. Unlike the star rating, the ESG Risk Assessment represents an absolute number you can compare across industries.

Morningstar Sustainalytics considers 20 material sustainability indicators that shape its total risk assessments. Reports also flag a company’s top three material ESG issues.

The Sustainability Rating for funds rolls up the ESG risks of underlying holdings. The 1-5 globe rating assesses how well companies in a portfolio manage ESG risk relative to their peers. A 1-globe rating represents high ESG risk; a 5-globe rating represents low ESG risk.

Controversy level

Corporate scandals can damage a firm’s reputation, trigger legal penalties, or inspire consumer boycotts. Controversies ratings can support investment decisions and help stakeholders manage reputational risks.

Sustainalytics assesses how controversies are likely to evolve over the next 12 to 24 months. Analysts monitor more than 700,000 daily news stories to flag ESG-related incidents. Our framework considers:

• Severity of incidents.
• Corporate accountability.
• If incidents form a pattern of corporate misconduct.

Carbon Metrics

As global climate action ramps up, carbon risk metrics indicate an investment’s exposure to carbon related risks such as future regulation or price pressures.

The Morningstar® Portfolio Carbon Risk Score™ measures the risk that companies face from the transition to a low-carbon economy. For funds and portfolios, the score reflects the weighted average of the underlying holdings.

Morningstar® Portfolio Fossil Fuel Involvement™ assesses how exposed a company is to the fossil fuel industry, from extraction to distribution.

To earn the Morningstar® Low Carbon Designation™, companies need low carbon and fossil-fuel exposure.

What is the ESG Commitment Level?

The ESG Commitment Level assesses the ESG resources and expertise in a firm or strategy. It’s a way to gauge the truthfulness of sustainability marketing claims. The rating follows a four-point scale: Leader, Advanced, Basic, and Low.

The level offers a stamp of authenticity from an independent source that clients can trust.

To earn the leader designation, asset management firms must incorporate ESG principles into their investment programs to the greatest extent relative to peers. The assessment reviews a firm’s:

• Firm’s history of ESG investing.
• ESG policies.
• Company culture.
• Level and consistency of integrating ESG processes.
• Reporting on ESG metrics for its funds.
• Stewardship activities.

ESG Impact Metrics

As companies operate, their actions affect the world around them—these are known as externalities. These include greenhouse gas emissions, treatment of workers, community interactions, and more. Some investors want to understand what real-world outcomes result from their investments.

Impact metrics measure the environmental and social consequences of business activities, both positive and negative.

The Morningstar Sustainalytics ESG Impact Framework creates a common way to talk about issues that matter to investors. It offers consistent, meaningful assessments of company-level impact. Portfolio-level impact metrics can look across underlying holdings in a fund to assess the total footprint.

The ESG Impact Framework aligns with the internationally accepted UN Sustainable Development Goals. It simplifies the 17 SDGs into a handful of relevant themes:

• Basic Needs
• Human Development
• Climate Action
• Resource Security
• Healthy Ecosystems

Impact metrics fall into two buckets.

Operational metrics measure the impact of business activities. How much water does a company pull from its watershed? How often are workers injured on the job?

Sustainable activities metrics reflect the percentage of a company’s revenue that comes from business activities with a positive environmental or social impact. A car manufacturer could mitigate climate change by producing electric vehicles, or a pharmaceutical company could research cures for neglected diseases.

Credit ratings measure a borrower’s capacity to repay a debt. With thorough due diligence, analysts assess the likelihood of company, entity, or government defaulting on a loan. Credit ratings can affect the interest rates an entity must pay on a loan.

DBRS Morningstar rates more than 5,000 credit issuers and 60,000 securities worldwide.

Credit ratings range from AAA (low credit risk) to a C (increased credit risk). At each level except the highest, AAA, (high) represents the top performers and (low) the bottom. DBRS credit ratings help investors compare types of debt across asset classes.

Researchers specialize in four main sectors, each with their own methodology:

• Corporate finance.
• Financial institutions.
• Governments.
• Structured finance.