Morningstar Equity Research

Introduction to Morningstar and Our Equity Research

Morningstar is one of the most recognised and trusted names in the global investment industry, serving financial advisers, asset management firms, retirement plan providers, retirement plans, and individual investors around the world. Our investors first approach has led to a strong reputation for independence and objectivity, as our interests are well aligned with those of our clients.

In Australia and New Zealand, Morningstar helps individual, adviser, and institutional investors achieve their long-term investment goals by providing insightful, differentiated, independent, and actionable equity research, as well as portfolio management services.

Morningstar has more than 100 equity analysts globally, covering over 1,500 stocks, making us one of the largest independent research teams in the world. A team of 17 analysts and strategists based in Australia cover nearly 200 Australian and New Zealand stocks.

Morningstar's analysts apply a consistent, rigorous, and proven global methodology which focuses on long-term fundamental valuation, competitive advantages (economic moats), risk, financial health, and capital allocation. Each equity research analyst covers 15 to 20 companies and research is reviewed on an ongoing basis (and at least quarterly) to ensure our investment ideas are relevant. Local analysts exchange insights with global sector teams in the United States, Europe, and Asia resulting in an enriched product and ensuring global consistency. Site visits and frequent interaction with company management and other industry participants foster deeper analytical insight.

Morningstar's equity research independence means we do not offer issuer-paid coverage. In other words, we do not receive commissions for providing research in Australasia and we do not charge companies to be covered; instead our investor clients pay a subscription fee for ongoing service. We take an investors first approach to choosing coverage companies, detailed later in this report.

Equity Research Coverage

Documentation detailing Morningstar's coverage and coverage changes is reviewed and updated quarterly then published on our corporate and product websites. Morningstar's equity coverage is based on our assessment of a security's investment attractiveness, including a strong bias to companies with economic moats. This approach aligns with our position of independence and, we believe, puts investors first.

Australian Equity Coverage Guidelines

• Nearly all companies in the S&P/ASX 100 Index.
• Companies in the S&P/ASX 200 Index which are deemed to have an economic moat and/or cash flow which is at least reasonably predictable (generally not possessing "extreme" uncertainty in our framework). As a rough guide, Morningstar aims to cover at least 80% of S&P/ASX 200 Index companies (equating to approximately 95% of the index by market capitalisation). Companies in this index which are not covered by Morningstar are usually unattractive for most portfolios, in our opinion.
• Up to 30 ex-S&P/ASX 200 stocks are selected on Morningstar's judgment of the security's investment merit – with a very strong bias toward high-quality companies (those with moats).

New Zealand Equity Coverage Guidelines

• The majority of the NZX20 Index.
• Up to 10 ex-NZX20 Index stocks selected on our judgment of the security's investment merit.

Guidelines for Temporary Coverage

• From time to time, Morningstar’s equity research team will be impacted by staff turnover. This may necessitate the cessation coverage for some companies. Morningstar aims to minimise the impact of the coverage disruptions by limiting the interruption to companies typically outside S&P/ASX 100.
• For companies material to the overall market and where continuous coverage is deemed a priority, that is, usually firms within the S&P/ASX 100, coverage will transition to a temporary analyst until the replacement analyst is recruited and reinitiates in their own name.
• Barring unforeseen circumstances, we intend for any transitional coverage to be undertaken by the most senior members of the equity research team, namely the three directors.
• For stocks where coverage temporarily pauses, we aim to resume coverage as the new hire initiates on their list. Stocks will be reinitiated under the new analyst’s name on a regular basis until the entire list is complete. This process usually takes approximately 18 months from start to finish.
• Where better opportunities exist, stock coverage may permanently cease with an analyst departure to accommodate initiation of the new, higher-quality stock in future. Permanent coverage drops will typically sit outside the S&P/ASX 200 index while the additions will usually sit inside the index.
• Similarly for the New Zealand market, potential permanent drops are likely to fall outside the NZX20 Index and initiations on firms included in the NZX20 index.

Equity Research Methodology

We believe that a company’s intrinsic worth results from the future cash flows it can generate. The Morningstar Rating for stocks identifies stocks trading at a discount or premium to their intrinsic worth—or fair value estimate, in Morningstar terminology. Five-star stocks sell for the biggest risk- adjusted discount to their fair values, whereas 1-star stocks trade at premiums to their intrinsic worth. Four key components drive the Morningstar rating: our assessment of the firm's economic moat; our estimate of the stock's fair value; our uncertainty around that fair value estimate; and the current market price. This process ultimately culminates in our single-point star rating. Underlying this rating is a fundamentally focused methodology and a robust, standardised set of procedures and core valuation tools used by Morningstar's equity analysts, including our Capital Allocation rating. In this document, we provide a detailed overview of how the Morningstar Rating for Stocks is derived, and also outline the analytical work that feeds into our coverage of stocks.

Morningstar’s Economic Moat™ Rating

The concept of an economic moat plays a vital role not only in our qualitative assessment of a firm's long-term investment potential, but also in the actual calculation of our fair value estimates. An economic moat is a structural feature that allows a firm to sustain excess profits over a long period of time. We define excess profits as returns on invested capital, or ROICs, above our estimate of a firm's cost of capital, or weighted average cost of capital, or WACC. Without a moat, profits are more susceptible to competition. The assumptions that we make about a firm's economic moat play a vital role in determining the how quickly any excess profits are eroded—a topic we will explore in the next section.

Companies with a narrow moat are those we believe are more likely than not to achieve normalised excess returns for at least the next 10 years. Wide-moat companies are those in which we have very high confidence that excess returns will remain for 10 years, with excess returns more likely than not to remain for at least 20 years. The longer a firm generates economic profits, the higher its intrinsic value. We believe low-quality no-moat companies will see their normalised 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.

When considering a company's moat, we also assess if there is a substantial threat of value destruction, stemming from risks related to ESG, industry disruption, financial health, or other idiosyncratic issues. In this context, a risk is considered potentially value destructive if its occurrence would eliminate a firm's economic profit on a cumulative or midcycle basis. If we deem the probability of occurrence sufficiently high, we will rate the firm no-moat.

To gauge the sustainability of excess profits, analysts perform ongoing assessments of what we call the moat trend. A firm's moat trend is positive in cases where we think its sources of competitive advantage are growing stronger; stable where we don't anticipate changes to competitive advantages over the next several years; or negative when we see signs of deterioration.

Morningstar's moat rating is central to our investment philosophy. It encapsulates our thinking on business competition, influences our valuation process, and is used prominently in many of the products and services Morningstar provides. As such, moat ratings for all initiations and any proposed changes must go through the global moat committee, which comprises senior members of Morningstar's equity research department.

Determining Fair Value

At the heart of our valuation system is a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Analysts create custom industry and company assumptions to feed income statement, balance sheet, and capital investment assumptions into our globally standardised, proprietary discounted cash flow, or DCF, modeling templates. We use scenario analysis, in-depth competitive advantage analysis, and a variety of other analytical tools to augment this process.

We believe this bottom-up long-term, fundamentally based approach offers advantages over other valuation techniques. Multiyear cash-flow forecasts with a focus on key inputs allows for illustrative scenario analysis. It also helps us to identify potential future trends, and presents an opportunity to closely analyse returns on invested capital – all critical tenets to our economic moat framework and uncertainty ratings. Furthermore, it focuses analyst efforts on long-term business drivers, whichhave the greatest valuation impact, rather than short-term market noise of little importance.

We think analysing valuation through discounted cash flows presents a better lens for viewing cyclical companies, high-growth firms, businesses with finite lives (such as miners or oil and gas producers), or companies expected to generate negative earnings over the next few years. That said, we think multiples can be important cross-checks for our DCF-based fair value estimates. We acknowledge DCF models offer their own challenges (including complexity of inputs, false precision and the possibility of missing short-term market-price movements), but we believe these negatives on balance are mitigated by deep analysis and our long-term approach.

Applying the same valuation framework across our entire global coverage facilitates comparison of investment opportunities across industries and geographies on an apples-to-apples basis.

Combining our analysts’ financial forecasts with the moat rating helps us determine how long returns on invested capital are likely to exceed the firm’s cost of capital. Returns for firms with wide economic moat ratings are assumed to fade to the estimated cost of capital over a longer period than the returns of narrow-moat firms. We expect both to fade slower than no-moat firms. This increases our estimate of the intrinsic value of narrow- and particularly wide-moat firms.

As a result of this methodology, our model is divided into three distinct stages. Here is how the system works in practice for operating companies:

Stage I: Explicit Forecast

In the first stage, which can last five to 10 years, analysts make full financial statement forecasts, including items such as revenue, profit margins, tax rates, changes in working-capital accounts, and capital spending. Based on these projections, we calculate earnings before interest, after taxes, or EBI, and the net new investment, or NNI, to derive our annual free cash flow forecast. 

Stage II: Fade

We define the second stage of our model as the period it will takethe company’s return on new invested capital—the return on capital of the next dollar invested (“RONIC”)—to decline (or rise) to its cost of capital. During the Stage II period, we use a formula to approximate cash flows in lieu of explicitly modeling the income statement, balance sheet, and cash flow statement as we do in Stage I.

The length of the second stage depends on the strength of the company’s economic moat. We forecast this period to last anywhere from one year (for companies with no economic moat) to 10–15 years or more (for wide-moat companies). During this period, cash flows are forecast using four assumptions: an average growth rate for EBI over the period, a normalised investment rate, average return on new invested capital, or RONIC, and the number of years until perpetuity, when excess returns cease. The investment rate and return on new invested capital decline until a perpetuity value is calculated. In the case of firms that do not earn their cost of capital, we assume marginal ROICs rise to the firm’s cost of capital (usually attributable to less reinvestment), and we may truncate the second stage.

Stage III: Perpetuity

Once a company’s marginal ROIC hits its cost of capital, we calculate a continuing value,using a standard perpetuity formula. At perpetuity, we assume that any growth or decline in revenue is an NPV= 0 proposition. Stated differently, in the perpetuity period, we assume that any growth or decline or investment in the business neither creates nor destroys value and that any new investment provides a return in line with estimated WACC.

Discount Rates

Because a dollar earned today is worth more than a dollar earned tomorrow, we discount our projections of cash flows in stages I, II, and III to arrive at a total present value of expected future cash flows.

Because we are modeling free cash flow to the firm—representing cash available to provide a return to all capital providers—we discount future cash flows using the WACC, which is a weighted average of the costs of equity, debt, and preferred stock (and any other funding sources), using expected future proportionate long-term, market-value weights. For mainly financial companies, we use a fee cash flow to equity model and discount free cash flows by the company's cost of equity.

Cost of Equity

A company’s cost of equity, or COE, represents the average, annualised, nominal total return expected by shareholders. For most companies, COE is the dominant factor in the company’s WACC and therefore holds sizable influence in the valuation process. However, in contrast to fixed-rate forms of capital, the COE is not a contractual return. It cannot be observed directly, and considerable controversy persists in theoretical finance as to how the COE is best estimated.

Morningstar’s process for estimating COE is inspired and informed by the logic of the capital asset pricing model, or CAPM, even as we take a largely qualitative and forward-looking approach. Our goal is to provide reasonable distinctions between the risk characteristics and expected returns of different companies while minimising the effects of recency bias, false precision, and market noise.

We use a building block approach to derive COE estimates for individual companies: 

Cost of Equity = Market Average Real Return Expectation (6.5%–7.0% based on what we observe as a mean-reverting real return of the S&P 500 over long rolling time horizons— this is not a forecast, but rather what we believe shapes investor expectations)

+ Inflation Expectation (2.0%–2.5% based principally on stable 10- to 30-year inflation expectations derived from TIPS spreads as well as actual CPI over the last decade)

+/- Country Risk Premium (for non-USD reporting firms; this will reflect differentials in inflation and real risk-free rate expectations outside the U.S. as well as political risks)

+/- Systematic Risk Premium (four categories; ranges from -1.5% to +4.5%)

Importantly, because the fair value estimate reflects the present value of expected future cash flows, it should rise by the company’s estimated cost of equity (net of the shareholder return allocated to dividends) over time, all else equal. 

Cost of Debt

In estimating the cost of debt, we use a similar building-block approach as our cost of equity. We use the same assumed risk-free rate and level of inflation, while layering on a corporate credit spread, which varies according to the company’s credit risk. We also adjust for the tax benefit of the deductibility of interest expenses. Once we have these inputs, we weight them in terms of the implied value of each as a proportion of total estimated enterprise value to come up with our overall WACC estimate.

A significant percentage of our coverage includes firms domiciled outside the United States, and there are those that call the U.S. home but have considerable non-U.S. operations. Depending on the systematic risk of a country relative to the U.S., we may incorporate a country risk premium into our discount rate. Some characteristics that we consider are differences in local real risk free rate, expected inflation, financial disclosure, and other specific operating-market differences that could cause equivalent businesses to be more or less risky in one national economy versus another. In assigning country risk premia, we have developed a set of country-specific standardised scores that are reviewed at least once annually.

Hidden Assets/Liabilities

Once we have an estimated present value of expected future cash flows, we must also consider any other items that affect value not specifically included within our cash-flow projections. We refer to these special items as hidden assets and hidden liabilities, and they might include items that occur frequently across our coverage, such as the estimated value of outstanding option grants or underfunded/overfunded pensions, or items that tend to be very company-specific in nature, such as minority ownership positions in other companies, underutilised land or other balance sheet assets that could be sold without changing the cash-flow prospects of the business, or an expected future litigation settlement. It is impractical to list all the possible hidden assets and liabilities we find across our coverage, but we think about these hidden assets and liabilities as anything that affects value that is handled outside of our cash-flow forecasts.

The Uncertainty Rating

Morningstar’s Uncertainty Rating captures a range of likely potential intrinsic values for a company and uses it to assign the margin of safety required before investing, which in turn explicitly drives our stock star rating system. The Uncertainty Rating represents the analysts’ ability to bound the estimated value of the shares in a company around the Fair Value Estimate, based on the characteristics of the business underlying the stock, including operating and financial leverage, sales sensitivity to the overall economy, product concentration, pricing power, exposure to material ESG risks, and other company-specific factors.

Analysts consider at least two scenarios in addition to their base case: a bull case and a bear case. Assumptions are chosen such that the analyst believes there is a 25% probability that the company will perform better than the bull case, and a 25% probability that the company will perform worse than the bear case. The distance between the bull and bear cases is an important indicator of the uncertainty underlying the fair value estimate. In cases where there is less than a 25% probability of an event, but where the event could result in a material decline in value, analysts may adjust the uncertainty rating to reflect the increased risk. Analysts may also make a fair value adjustment to reflect the impact of this event. Our recommended margin of safety—the discount to fair value demanded before we’d recommend buying or selling the stock widens as our uncertainty of the estimated value of the equity increases. The more uncertain we are about the estimated value of the equity, the greater the discount we require relative to our estimate of the value of the firm before we would recommend the purchase of the shares. In addition, the uncertainty rating provides guidance in portfolio construction based on risk tolerance.

Our uncertainty ratings are low, medium, high, very high, and extreme. With each uncertainty rating is a corresponding set of price/fair value ratios we use to assign star ratings, as shown in Exhibit 5.

The actual price/fair value cutoffs are determined using a combination of a) empirical data from the historical performance of our uncertainty rating, and b) option pricing theory based on the implied volatility of stocks with commonly agreed-upon uncertainty characteristics. Our empirical data show that appropriate 1-star and 5-star prices fall approximately at the midpoint between a log-normal relationship and a symmetrical relationship. A log-normal relationship would mean that a stock would post the same return between the 5-star price and the fair value as it would between the fair value and the 1-star price, while a symmetrical relationship would mean that the same percentage discount to a stock price for a 5-star rating would be assigned as a premium to the stock price for a 1-star rating. For low-, medium-, high-, and very-high-uncertainty stocks we formally assign our 1- star prices as the midpoint between the symmetrical and the log-normal relationship. We then round these prices to fair value relationships to the nearest 5 percentage points for simplicity. For extreme uncertainty stocks we assign the 1-star price using the log-normal relationship only.

Typically, a significant portion of an extreme uncertainty company’s capital structure is composed of debt. Using the lognormal relationship to set the 1-star price accounts for the fact that a small improvement in the forecast for free cash flows will have a large upside impact to the equity value for any highly-indebted company.

Generating the Morningstar Recommendation/Star Rating

Once we determine the fair value estimate of a stock, we compare it with the stock’s current market price on a daily basis, and the star rating is automatically re-calculated at the market close on every day the market is open.

Our analysts keep close tabs on the companies they follow, and, based on thorough and ongoing analysis, raise or lower their fair value estimates as warranted. Furthermore, we would expect our fair value estimates to generally rise over time, due to the time value of money. Specifically, barring major changes to analyst assumptions, we would expect our fair value estimates to increase at the level of our estimate of a firm’s cost of equity (net of shareholder returns attributed to dividends) each year. So, for a stock that pays no dividends with a $100 fair value estimate today and an estimated 10% cost of equity, we would expect our fair value estimate to rise to $110 in 12 months, all else equal.

It is also worth noting there is no predefined star rating distribution. The percentage of five star stocks can fluctuate daily, so the star ratings, in the aggregate, can serve as a gauge of the broader market’s valuation. When there are many 5-star stocks, the stock market as a whole is more likely undervalued, in our opinion, than when very few companies garner our highest rating.

We expect that if our base-case assumptions are true, the market price will converge on our fair value estimate over time, generally within three years (although it is impossible to predict the exact time frame in which market prices may adjust). If a stock is bought at exactly our fair value estimate today, we would expect total returns for the next three years in line with our assumed cost of equity, or COE, absent a material change in business prospects relative to our base-case expectations. A stock price lower than our fair value estimate means we think there is a higher probability than not investors should expect returns at a greater rate than COE over a three-year period. Conversely, a price above our fair value estimate implies lower-than-COE expected returns. If the price/fair value estimate ratio is sufficiently high, we believe investors should expect negative absolute returns.

Our star ratings 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.

★★★★★: We believe appreciation beyond a fair risk-adjusted return is highly likely over a multiyear time frame. Scenario analysis developed by our analysts indicates that 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.

★★★★: Appreciation beyond a fair risk-adjusted return is likely, in our opinion. This rating encourages investors to own the firm’s shares, possibly overweight relative to the appropriate benchmark after fully considering more attractively priced alternatives, such as our Buy recommendations.

★★★: Indicates that we believe investors are likely to receive a fair risk-adjusted return (approximately cost of equity). Concentrated portfolios might consider exiting these positions if more attractively priced alternatives are available.

★★: We believe investors are likely to receive a less than fair risk-adjusted return and should consider directing their capital elsewhere. Securities with this recommendation should generally be underweight, assuming less expensive alternatives are available for the portfolio strategy being employed.

★: Our analysis suggests a high probability of undesirable risk-adjusted returns from the current market price over a multiyear time frame. We think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss. This rating encourages investors to strongly consider exiting portfolio positions in the security.

Capital Allocation

While not directly impacting our Star Rating, our Capital Allocation Rating represents our assessment of the quality of management’s capital allocation, with particular emphasis on the firm’s balance sheet, investments, and shareholder distributions. Analysts consider companies’ investment strategy and execution, balance sheet management, as well as dividend and share buyback policies. Corporate governance factors are only considered if they are likely to materially impact our view of the management of either the balance sheet, investment, or shareholder distributions. Analysts assign one of three ratings: "Exemplary", "Standard", or "Poor". Analysts judge Capital Allocation from an equity holder’s perspective. Ratings are determined on a forward looking and absolute basis. The Standard rating is most common as most managers will exhibit neither exceptionally strong nor poor capital allocation.

For a company's balance sheet, we consider the current position and how it is likely to evolve, whether a firm has reasonable or excessive leverage, and if a company will generate sufficient cash flow to make meaningful improvement if necessary. For investment, we consider if a firm is likely to invest to fortify or enhance its competitive position in future, and if it is likely to do so at the right price—that is, generating attractive rates of return above the estimated cost of capital. We also consider execution and if material mis-steps or successes are likely. For shareholder distributions, we consider if future dividends and/or share buybacks are likely of the appropriate size and form. Cash should be distributed to shareholders unless better uses exist and the opportunity cost of foregoing investment or strengthening the balance sheet is considered.

Capital Allocation analysis published prior to Dec. 9, 2020, was determined using a different process. Beyond investment strategy, financial leverage, and dividend and share buyback policies, analysts also considered execution, compensation, related party transactions, and accounting practices in the rating.

Distribution of Recommendations

Our spread of recommendations as at Feb. 11, 2022 is displayed in Exhibit 6. Our recommendations are based on a long-term fundamental view and rigorous, consistently-applied methodology, so the proportion of positive relative to negative recommendations will often ebb and flow in negative correlation to moves in the market. Exhibit 7 demonstrates how our recommendations have helped clients generate wealth in the past few years. Most recently, we had many ★★★★★ and ★★★★ recommendations as the market declined in early 2020. Many of these recommendations later became ★★★, ★★, and then ★ as the market rallied through the year.

Research Publications

Morningstar publishes a range of exceptional research material to support adviser and investor conversations and decisions, including:

▶ Comprehensive Company Report

Includes a summary of our in-depth analysis on the company's strategic positioning and competitive advantages, risks, financial health, proprietary Morningstar datapoints (fair value estimate, fair value uncertainty, moat, and capital allocation) and financial forecasts. These also include analyst notes containing analysis of key corporate events and changes to key assumptions, estimates and/or datapoints.

▶ Timely Corporate Event Analysis
Analysis of, and advice on, events that require shareholder action such as capital raisings, mergers, takeovers, demergers, off-market buybacks, and spin-offs.

▶ Equity Pre-IPO Reports
A detailed report on companies due to list on the ASX for which a prospectus has been released to the market and which we intend to initiate full coverage on.

▶ Thematic Reports
Special reports containing in-depth analysis on a company, sector, or industry where we have identified an actionable investment opportunity.

▶ Best Stock Ideas
A monthly publication containing our high conviction equity investment opportunities across a broad range of sectors and currently trading at attractive prices.

Morningstar Australia/New Zealand Equity Research Team (as at March 2022)

Team Qualifications, Tenure, Industry Experience

The average industry experience of the Australian and New Zealand analyst team is more than 19 years and about 9 years average tenure with Morningstar. Morningstar is an employer of choice where high-quality research is awarded above all else, and this reflects in a cohort of long-serving analysts. Profiles of the Australian and New Zealand analyst team members are provided in the Appendix.

Profiles of Australian and New Zealand Equity Analyst Team

About Morningstar

Morningstar, Inc. is a leading provider of independent investment research in North America, Europe, Australia, and Asia. The Company offers an extensive line of products and services for individual investors, financial advisors, asset managers and owners, retirement plan providers and sponsors, and institutional investors in the debt and private capital markets.

Morningstar provides data and research insights on a wide range of investment offerings, including managed investment products, publicly listed companies, private capital markets, debt securities, and real-time global market data. Morningstar also offers investment management services through its investment advisory subsidiaries, with approximately $265 billion in assets under advisement and management as of Dec. 31, 2021. The Company has operations in 29 countries.