We seek undervalued stocks with a medium to long-term investment time horizon.

Companies that make the best investments tend to be those able to grow earnings per share year after year and which are able grow at rates above the average of the market. Earnings growth supports a solid and growing dividend stream which is the essence of shareholder return.

In searching for the best businesses in the market, we want to see an ability to turn revenue into profits and a record of strong returns to equity. The ability to generate strong free cash flow is critical as this is where the funds come from to pay dividends or to invest in new growth areas. The greatest free cash flow generators will have strong margins, good controls over working capital and limited requirement for capital expenditure. The best businesses will also have robust balance sheets including a not onerous level of debt. We believe in strong, experienced and disciplined management.

Recommendations

Our qualitative recommendations are simple and easy to understand:

- Buy: Suitable for purchase now

- Accumulate: Undervalued but there is time to purchase

- Hold: Appropriately priced, neither buy nor sell

- Reduce: Sell part holding

- Sell: Sell all holdings now

- Avoid: Not investment grade

Morningstar's recommendations are anchored on each analyst's estimate of a company's fair value, which is what the analyst thinks the business is worth on a per share basis. Our analysts arrive at this value by forecasting how much excess cash - or 'free cash flow'- the firm will generate in the future, and then adjusting that total for both timing and risk. Cash generated next year is worth more than cash generated several years down the road, and cash from a stable business is worth more than cash from a cyclical or uncertain business. Stocks trading at meaningful discounts to our fair value estimates will receive positive recommendations. For high quality businesses, we require a smaller discount than we do for mediocre ones, for a simple reason: we have more confidence in our cash flow forecasts for strong companies, and therefore in our fair value calculations. The future is inherently uncertain, and that uncertainty is greater for some companies than it is for others. If a stock's market price is significantly above our fair value, it will receive a negative recommendation, no matter how wonderful we think the business is. Even the best company is a poor investment if an investor overpays for its shares.

Each stock is given a recommendation of Buy, Accumulate, Hold, Reduce or Sell based on share price discount or premium to fair value. We also use Avoid for stocks that are not investment grade. Under Review is occasionally used where the analyst required additional time to revise the recommendation. It is ordinarily used for a few days only.

The recommendation trigger guide appears at the top of each report, demonstrating the triggers at which the recommendation may change should prices move and there is no change in business fundamentals. Recommendation trigger prices are set on a discount/ premium to fair value based on estimation of required returns for each level of business risk. Required returns are higher for higher risk stocks and the Hold range is wider given the greater margin of safety applied.

Estimating Fair Value

We value shares as pieces of a business. Fair value is based on projection of the company's cash flows. Discounted cash flow methodology is cross-checked by earnings multiples or other valuation methods. Separate proprietary Morningstar model templates are used for industrial companies, REITs, banks and insurers.

Valuation models comprise three stages. The sum of the cash flows from all three stages is discounted to present value using a weighted average cost of capital (WACC).

- Stage One is the five to 10-year explicit forecast period where analysts make numerous detailed assumptions including those on revenue, profit margins, changes to working capital and capital spending.

- Stage Two - during this period, return on invested capital (ROIC) will decline (or rise) to the cost of capital and the perpetual growth rate will fall (or rise) to the perpetual growth rate of around 3%. The length of this stage depends on the company's Economic Moat. It takes 20 years for ROIC to fade to WACC for Wide Moat firms and 10 years for Narrow Moats.

- Stage Three is a perpetuity where the residual value of the firm is calculated with the assumption that ROIC = WACC.

Economic Moats

The term "economic moat" was popularised by Warren Buffett and is used to describe companies with sustainable competitive advantages. Just as moats protected castles from invaders in medieval times, economic moats protect the company's earnings from competition. Moat companies have exclusive assets or skills that help them stay ahead of the competition and thereby survive the hard times and flourish in the good. Moats allow firms to generate excess economic returns for an extended period. The key is the sustainability of high returns. Many companies can generate strong returns over the short-term, say two or three years. Without a moat, their returns may be competed away as other companies move in to take a share of the high returns available.

Moat Ratings of Wide, Narrow or None are displayed on the front page of Morningstar's research reports with the sources of the moat explained within the analyst note and Investment Thesis section. The vast majority of firms have no moat. Companies with a Moat Rating of Wide will be, on our assessment, able to generate excess returns for 20 years or more. Narrow Moat companies should generate excess returns for up to 10-15 years. The Moat Rating is just one of the ingredients used in determining a company's fair value, though it is obviously an important one. Companies with no moat can make good investments, at the right price, but the very best long-term investments are in Wide Moat firms bought when they are undervalued. Morningstar's model portfolios are heavily weighted to moat companies and each of the Morningstar Best Businesses has a moat.

Sources of competitive advantage

Innovation and time
Companies that repeatedly design better products or more efficient production methods are better able to stay ahead of the competition. Being the first significant company in a market can provide a near-monopoly status and high margins. Some risks are involved due to the uncertainty of success and requirement for investment in research & development (R&D) along with production, marketing and distribution so that ideas are brought to reality. Hearing implant manufacturer Cochlear (COH) is an example of a moat company benefiting from first-mover advantage. There is a strong emphasis on innovation deriving from Professor Graeme Clark's mid-1960s research at Melbourne University. Some 15-20% of sales are invested in R&D, enabling development of highly functional and reliable implantable hearing devices. The reputation for high quality makes the devices the first choice for surgeons selecting products for their patients.

Scale advantages
Low costs stem from greater scale of operations or more efficient use of capacity. The advantage of a sustainable low cost structure is the ability to undercut rivals and/or increase margins. Woolworths' (WOW) scale allows efficiency gains from organic growth in supermarket retailing, rollout of new and refurbished stores and constant margin pressure on suppliers.

Intangible assets
- Product differentiation and brand strength can provide advantages through the ability to divide a market into distinct groups of buyers with different needs and provide products or services that will be popular to those groups. Dominating a sub-market allows a company to become a quasi-monopoly, allowing them to charge higher prices. Clothing manufacturer Billabong (BBG) derives a moat through its ability to develop a variety of brands that are popular in various sub-markets, along with a strong distribution network. Brand strength provides pricing power. The Billabong brand has a long history and would-be imitators find its popularity difficult to match.

- Intellectual property rights (patents, trademarks, copyrights, government approvals) can place the company is a quasi-monopoly position. Investors should be wary that favouritism can be fickle.

- A unique company culture could create an environment where generation of excess returns on capital becomes a habit. Industrial conglomerate Wesfarmers (WES) has long been regarded as a strong manager of what are basically unrelated businesses.

High customer switching costs
High customer switching costs increase customer stickiness and make life harder for aspiring market entrants. Upfront costs of training or implementation can often be paid back with high renewals. Toll Holdings' (TOL) transport infrastructure is highly integrated into clients' operations, making it near untenable for them to consider alternatives. Via the sophisticated IT linking of an extensive network of transport and storage assets, TOL has become an essential component of many customers' supply chains. Its services significantly lower clients' working capital needs.

The network effect
Locking out competitors can also help create a moat. The network effect is powerful because it allows growth to feed itself. Every time someone starts using a network, it makes even more sense for another person to also join the network. Companies that are the first or one of the first to create a standard in an emerging industry can sometimes create monopolies. The launch of a new generation telephone system is a good example of this. Australian Stock Exchange (ASX) has benefited in this regard. More liquidity means greater ease of trading and narrower buy-sell spreads, which increase returns for traders and investors.

Business Risk

Business Risk ratings of Low, Medium, High or Speculative are determined by the analyst's assessment of diversity of revenue sources, cyclicality of revenues, the firm's fixed-cost structure, financial leverage and contingent events. A greater margin of safety is used to buy high business risk companies through a higher discount rate and greater required discount to fair value before buying the stock.

Pricing Risk

Pricing risk reflects the premium or discount implied in the current price of the shares. Many growth stocks trade on high earnings multiples giving them high pricing risk though they may have low business risk.

Investors should consider their risk tolerance before investing in the share market. Many investors will decide to have only low risk stocks in their portfolio though others will accept higher risk levels in order to pursue higher returns.