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A new way to identify quality companies

Christine St Anne  |  05 Aug 2014Text size  Decrease  Increase  |  

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Christine St Anne is Morningstar's online editor. Follow her on Twitter @MstarChristine 

 

The recent article titled How to avoid a bad stock followed the recent launch of the Morningstar Stewardship Rating methodology. This article takes a closer look at how this methodology is applied to some Australian examples.

Morningstar's Stewardship Ratings for Australian stocks give individual investors the ability to screen and monitor the quality of capital-allocation decisions by management teams and helps them manage portfolios of high-quality investments.

This Stewardship Rating section can now be found in individual company research reports.

"Investors can get a better understanding of the governance behind the companies they invest in, by digging into the quality of the organisation and looking at the track record of management rather than relying on what the company is telling them," Morningstar strategist and head of Asia-Pacific operations Gareth James says.

The Morningstar Stewardship Rating methodology focuses on a company's capital-allocation decisions and specific factors such as financial leverage, investment strategy, investment timing and valuation, dividend and share buyback policies, execution, compensation, related party transactions and accounting practices.

For example, do investments and acquisitions support the company's competitive advantages and core businesses in its investment strategy? Importantly, what is the cost of acquisitions and major investments?

When it comes to dividend and share buyback policies, has the company struck the right balance between internal investment opportunities and returning cash to shareholders?

Morningstar analysts are also keen to evaluate how well a management team has played the hand it has been dealt.

Many acquisitions made by companies translate into poor returns for investors. However, rather than using hindsight as the primary guide in evaluating a management team's capital-allocation skills, Morningstar analysts put themselves in management's shoes at the time the decision was made.

For example, when a company looks to buy a business, Morningstar asks: What other options did management have at the time? How did the timing of the decision fall in the industry's cycle? What were the prevailing industry multiples at the time the acquisition/divestment was announced?

Just as an investor can take all the right steps in evaluating a stock only to have the market fall or have another unforeseen event lead to poor short-term results, it's helpful to learn more about the thought process behind a company's decision to acquire another company, start a joint venture, invest in growth capital expenditures, or repurchase stock.

Realising that luck will come and go, Morningstar analysts want to determine the thoroughness of management's investment evaluation process and if recent successes and failures have altered that process.

This, Morningstar believes, will tell more about the quality of the firm's general capital-allocation decisions than what short-term results might suggest.

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