Introducing the Morningstar Capital Allocation Rating

-- | 14/12/2020

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Mark LaMonica: So, I'm here with Matt Hodge. We're talking about the Morningstar Capital Allocation Rating, which is replacing the Stewardship Rating. So, Matt, what has changed?

Mathew Hodge: Basically, we've taken a fresh look at our Capital Allocation Rating and we've decided to focus on three key things, which are balance sheet, investment, and shareholder distributions, and those are the three things that management has control over and they are the three things that management can spend money on.

LaMonica: And we'll get into those, but why the change?

Hodge: We really wanted to focus in on the key things that are inputs for total shareholder returns. So, if a company invests well, that's obviously going to be important to their earnings growth, and that's going to reflect over time in the total shareholder return. If it's a more passive business, we really care about: Are they returning the right amount of money to shareholders through the distribution? So, we wanted to focus on those things. And obviously, if you're investing or you're returning money, you obviously want to have a strong balance sheet as well. So, that's an important contributor and can be an important factor in total shareholder returns as well, particularly in downside scenarios.

LaMonica: All right. So, we talked about why this is important to investors. We've outlined that we are changing the name of this rating. What are the actual ratings that investors should expect to see?

Hodge: So, as with the Stewardship Rating, with the Capital Allocation Rating, the names of the actual ratings will be the same. We're going to have Poor, Standard, and Exemplary ratings. What does that mean, right? Exemplary is where we're calling out a company for performing really well, or we've got an expectation that they're going to continue to do that in the future, and that might be on the investment front if they are a growth company or it might be on the distribution front if they're a more mature firm that should be focused on returning cash to shareholders.

Likewise, on the Poor side, we want to call out if the company is running an excessively geared balance sheet and taking too much risk with shareholder value. We'd also want to call out if they're investing poorly, investing in the wrong things at the wrong price, or if they're just not sending the right share of that cash back to shareholders, and to be Poor it would have to be substantially less than we would expect, or some combination of all of those three things.

LaMonica: Let's talk about balance sheet as the first element. So, why should we care about the balance sheet?

Hodge: Well, you want a company to run a sustainable balance sheet that puts them in a position to invest when they need to, invest in the right things, and also, if it's a more distribution-focused business, that they're distributing funds to shareholders in a sustainable way. If firms run overly aggressive balance sheets, we can see that in downturns like we've just had with COVID and before then with the GFC that they do run the risk of having material shareholders' value destruction via equity issuances at the wrong time. So, that's something we want to be cognisant of. On the flip side, it's also possible for a balance sheet to be undergeared, which means that the company is not minimising its cost of capital. So, we want to take those factors into account.

LaMonica: And decisions that companies make on capital allocation, one, is obviously to invest in the business. Tell me a little bit about that.

Hodge: Yeah. It's particularly important when you have a growth business, say, it's technology or a biotech or something like that, where you've got a growth franchise and you're investing and you're investing at an attractive rate of return, we really care about, A) are they investing in the right things, like is the strategy right? Are they doing so at the right price? And is management able to execute? And those are the three things we use when we assess investment. For growth-orientated companies, it is the key driver of total shareholder returns.

LaMonica: And then, on the flip side, obviously, companies can make decisions to return capital to shareholders. So, talk a little bit about that. What are you looking for there?

Hodge: Yeah. So, for mature firms and industries or industries that tend to be more kind of passive assets, so like REITs or infrastructure, paying a dividend or making returns to shareholders is an important part of the total shareholder return, particularly if it's a mature business, it's not really growing much anymore. We want to see that that cash flow is being returned to shareholders, particularly if the other options are running an excessively lazy balance sheet or investing in new projects that destroy value. If they're not earning their cost of capital and they're not supporting the strategy, then that money is better off being returned to shareholders, either through dividends or buybacks.

LaMonica: All right. So, we've got these three different elements. So, how do you bring those together into this rating?

Hodge: We have a pretty simple flow chart that walks through how we should think about all of those things. So, we rate each of the three items separately, and then we bring together those kinds of sub-assessments, if you like, for the overall Capital Allocation Rating. And we may have situations where we have some pluses and some minuses, or we have one big plus and some other so-so. In those cases, what we really care about is, like I said, if it's a growth company, we really care about our opinion on investment. If it's more of a passive mature company, then we're likely to care more about: Are the shareholder distributions appropriate? So, it depends what kind of company it is as to how we weigh all of those things.

LaMonica: Great. Well, Matt, thank you very much. It's great to hear about the new rating.

Hodge: Thanks Mark.

This report appeared on www.morningstar.com.au 2022 Morningstar Australasia Pty Limited

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