At Morningstar, we believe buying shares of superior businesses and allowing them to compound over time is the surest way to create wealth in the stock market. The long-term fundamentals of businesses, such as cash flow, competition, economic cycles, and stewardship, are our primary focus because history has shown that market sentiment is fleeting, momentum can quickly reverse, and the herd is sometimes a dangerous crowd. Occasionally, this approach causes our recommendations to appear out of step, but willingness to be contrarian is an important source of outperformance and a benefit of Morningstar's independence. The brief definitions that follow help illustrate our methodology. Extensive methodology documents are available on our website.
Morningstar Research Process for Company Analysis
The economic moat concept is a cornerstone of Morningstar's investment philosophy and is used to distinguish high-quality companies. An economic moat is a structural feature that allows a firm to sustain excess returns over a long period of time. Without a moat, profits are more susceptible to competition. Companies with a narrow moat are likely to achieve normalised excess returns beyond 10 years, while wide-moat companies are likely to sustain excess returns beyond 20 years. The longer a firm generates economic profits, the higher its intrinsic value. We believe low-quality, no-moat companies will see their returns gravitate toward the firm's cost of capital more quickly than companies with moats. We have identified five sources of economic moats: intangible assets, switching costs, network effect, cost advantage, and efficient scale.
Fair Value Estimate
Our fair value estimate is primarily based on Morningstar's proprietary three-stage discounted cash-flow model. We also use a variety of supplementary fundamental methods to triangulate a company's worth such as sum-of-the-parts, multiples, and yields, among others. We're looking well beyond next quarter to determine the cash-generating ability of a company's assets because history has shown that the market price of a security will migrate towards the firm's intrinsic value over time. Economic moats are not only an important sorting mechanism for quality in our framework, but the designation directly contributes to our estimate of a company's intrinsic value through sustained excess returns on invested capital.
The Morningstar Uncertainty Rating demonstrates our assessment of a firm's cash-flow predictability, or valuation risk. From this rating, we determine appropriate margins of safety: The higher the uncertainty, the wider the margin of safety around our fair value estimate before our recommendations are triggered.
Our uncertainty ratings are low, medium, high, very high, and extreme. With each uncertainty rating is a corresponding set of price to fair value ratios that drive our recommendations: Lower price/fair values (<1.0) lead to positive recommendations while higher price/fair values (>1.0) lead to negative recommendations. Our price/fair values have proven highly predictive of future stock returns. In very rare cases, the fair value estimate for a firm is so unpredictable that a margin of safety cannot be properly estimated. For these firms, we use a rating of extreme, which indicates that nearly all investors should avoid speculating on that company's shares. Risk and volatility-averse investors should generally avoid very high and extreme uncertainty companies.
Our recommendations are based on the current share price relative to Morningstar's Fair Value Estimate after adjusting for an appropriate margin of safety. These recommendations are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, tax situation, time horizon, income needs, and complete investment portfolio, among other factors.
Depending on the portfolio strategy employed, the ratings below can indicate different actions for different investors. For example, income investors might be best served holding a fairly valued investment with a reliable dividend stream instead of rotating into a Buy recommendation with questionable income characteristics. Nonetheless, our recommendations serve as valuable starting points for equity portfolio strategies.
Recommendations displayed in Morningstar's Australian equity research products are Buy, Accumulate, Hold, Reduce and Sell.
Buy (significantly undervalued): Our Buy recommendations indicate we believe appreciation beyond a fair risk-adjusted return (the company's cost of equity) is highly likely over a multi-year timeframe. Scenario analysis developed by our analysts indicates the current market price represents an excessively pessimistic outlook, limiting downside risk and maximising upside potential. This rating encourages investors to consider an overweight position in the security relative to the appropriate benchmark, provided the risk is appropriate.
Accumulate (modestly undervalued): Our Accumulate recommendation indicates we believe appreciation beyond a fair risk-adjusted return is likely. This rating encourages investors to own the firm's shares, possibly overweight relative to the appropriate benchmark after fully considering the security's fit with their targeted portfolio and more attractively priced alternatives, such as our Buy recommendations.
Hold (fairly valued): Our Hold recommendation indicates we believe investors are likely to receive a fair risk-adjusted return. Concentrated portfolios might consider exiting these positions completely in favour of more attractively priced alternatives, pending the availability of less expensive alternatives for a given strategy.
Reduce (modestly overvalued): Our Reduce recommendation indicates we believe investors are likely to receive a less than fair risk-adjusted return and should consider directing their capital elsewhere. Securities with a Reduce recommendation should generally be underweight and exited completely in most strategies, if less expensive alternatives with similar risk characteristics are available.
Sell (significantly overvalued): Our Sell recommendation indicates we believe there is a high probability of undesirable risk-adjusted returns from the current market price over a multi-year timeframe. Scenario analysis by our analysts indicates the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to substantial loss. This rating encourages investors to strongly consider exiting portfolio positions in the security in nearly all strategies.
The principal objective of the Morningstar Income Equities Model Portfolio is to create a reliable, above-market income yield with moderate long-term capital growth through investment in listed Australian and New Zealand equity securities. The Morningstar Income Equities Model Portfolio is an actively managed, concentrated portfolio, constructed with a tax-effective income focus.
The Portfolio targets a grossed-up dividend yield at least equal to the one-year bank deposit rate, and which grows at least in line with CPI. The portfolio also aims to outperform the S&P/ASX 200 Accumulation Index over the longer term.
Investment strategy and approach
The Morningstar Income Equities Portfolio focuses on companies we expect to generate above-average and sustainable dividend yields over the medium to long term. It embodies the principles central to Morningstar's investment philosophy, namely a focus on long term fundamental value with a strong bias toward businesses with sustainable competitive advantages (economic moats) and predictable cash flows.
Our structured and rigorous investment decision-making process boosts the quality and transparency of our portfolio strategy, limiting the risk of behavioural errors, such as emotion-driven decisions. We believe market sentiment - which drives much of the short-term movements in share prices - is fleeting and often a great source of mispriced securities. Deviation between market prices and the fair values developed by our analysts are prime opportunities for our strategies (and clients) to outperform.
In-depth analysis from Morningstar's large and global securities research team is the key source of our portfolio ideas and allows us to comfortably implement high conviction positions. From our 100-plus global equity and credit research team, Morningstar generates detailed opinions on about 1,800 companies globally, including around 230 in Australia & New Zealand. This team is grouped into global sectors and deeply focused on differentiated research on dynamic competitive forces, growth prospects and valuations. Analyst-derived fair value estimates, economic moat ratings and uncertainty ratings are at the core of our portfolio process.
Portfolio weights are based more on conviction than relative benchmark weights. Greater weights are given to above-average sustainable yield producing companies trading at larger discounts to our fair value estimates, and we strongly prefer economic moats and lower uncertainty to protect against downside risk and maximize upside potential. Weightings to industries are monitored to ensure reasonable diversification, but we prefer to stick to high conviction ideas than hug an index. Our strong bias to high quality firms trading with a sufficient margin of safety reduces portfolio risk, somewhat offset by the relatively high concentration of typically 15-20 stocks (the mandated range being 10-20). The overall portfolio is regularly assessed for various risks including cyclical versus defensive exposures, industry concentrations, market cap, liquidity, cash holdings and other factors.
Prior to each transaction, proposed positions are reviewed thoroughly by Morningstar's Investment Strategy Committee in light of alternative opportunities and the portfolio's mandate. This step leverages the committee's extensive and diverse investment experience and helps to ensure optimal portfolio outcomes.
Asset allocation ranges
|Weight to any GICS Industry Gp||0%||35%|
This feature highlights one of the most compelling investment ideas across our coverage universe. The best idea is chosen from the Morningstar Best Stock Ideas Special Report that we publish monthly. We'll typically choose high quality firms with an economic moat, lower risk, and trading at an attractive price at the time of publication. Our intention is for these best ideas to be actionable in most investor portfolios and produce excess returns in the long-term. The "Role in Portfolio" graphic provides a starting point for portfolio application but investors must consider their individual investment objectives.
Role in Portfolio graphic
This feature highlights an attractively priced, high quality investment idea from Morningstar's global team of 100+ equity and credit analysts covering around 1,800 stocks. We will typically choose large cap companies with economic moats and limited risk. Our intention is for these ideas to be actionable for most investors seeking international exposure and to produce excess returns in the long term. The "Role in Portfolio" graphic provides a starting point for portfolio application but investors must consider their individual investment objectives.