Morningstar's Investing Tool: Finding the Next Super Star

by: SA Editors

This article is part of a regular series in which we interview our Tool Providers - the folks that develop the amazing stock-market Tools in Seeking Alpha's new Investing Tools platform.

Please use the comment stream below to share your own experiences with the featured Tool. And feel free to suggest to the developers any improvements or changes you'd like to see (or write a review!).

This week, we interviewed Melissa Chlopecki of Morningstar - whose Investing Tool, Morningstar Analyst Research, provides investors with "concise, actionable analysis" on over 2,000 stocks and ETFs.

Editor's note: Morningstar and our Investing Tools team are offering a 30% discount for anyone who signs up for the Morningstar Investing Tool during the coming week. Use discount code Morningstar30off.

And now, the interview:

Morningstar's Investment Tool on Seeking Alpha is a gateway to Morningstar's well-known stock and ETF Analyst Reports. How many stocks do you currently cover? Any plans to expand?

We currently cover more than 1,700 companies and 350 ETFs. We expect our stock coverage to remain around this number in 2011. We are continuing to add regular coverage of newly-launched ETFs, including recently launched funds such as Direxion Airline Shares (NYSE:FLYX), ETFS Physical White Metals Basket Shares (NYSEARCA:WITE), and Rydex MSCI Emerging Market Equal Weight ETF (NYSEARCA:EWEM).

Explain Morningstar's "star" rating system. Is it completely algorithmic, or are there subjective components?

Our stock star rating system is based on three factors: 1) The stock's fair value estimate derived from the analyst's discounted cash flow model. 2) The fair value uncertainty rating assigned by the analyst. And 3) the stock price. We recommend that investors purchase stocks at a discount to their fair value. As such, the star rating is based on the difference between the fair value estimate and the current market price, with five stars indicating "consider buy," one star "consider sell," and 3 stars "hold." As the stock price falls, assuming no change to the analyst's fair value estimate, the star rating increases. The uncertainty rating is baked into the star rating, with higher uncertainty ratings requiring a larger discount to fair value before the stock can attain a 5-star rating.

So I opened up the latest report on Knight Transportation (NYSE:KNX), and I see it receives three stars. Could you break that down for me?

That means we think the stock is fairly valued. It is trading around $20 and our fair value estimate is $22, so it is trading at less than a 10% discount to our fair value estimate, which we consider fairly valued.

The body of the report consists of five sections: Thesis, Valuation, Risk, Management & Stewardship, and Overview. Is the Thesis section where you explain why Knight receives three stars?

No. The Thesis section helps investors understand the fundamental dynamics driving the business itself. This is where we analyze the business's profit drivers, industry dynamics, risks, and any competitive advantages enjoyed by the firm. The valuation section is where we explain the assumptions behind our fair value estimate for the stock. As explained above, the fair value estimate in relation to the current market price drives the star rating. A solid business can have a low star rating if the stock is overvalued compared with our fair value estimate. Likewise, a weaker company can attain a high star rating if the stock is trading far below our fair value estimate.

For Valuation, you have KNX at $22 - a small premium to Wednesday's close of $19.38. Does this refer to Knight's current fair valuation, or can it be extrapolated into the future? What are the implications of this for an investor who's considering initiating a position in KNX? What about for someone who's been in the stock for a while, and wants to know if the time has come to move on?

Our fair value estimate refers to the present value of the firm's future cash flows, based on our estimates. Morningstar analysts forecast and discount a firm's future cash flows in their fair value calculation, so it includes forward-looking projections in arriving at a current value for the shares. The fair value estimate is not static. In theory, it would increase over time by the cost of equity, assuming nothing else changed in our assumptions. So given that Knight is fairly valued today, according to our current estimates, investors who took a position now may expect a fair return from the stock equal to its cost of equity, but no added return due to undervaluation.

In the Risk section of the report, you list off some key industry risks: an economic downturn; a shortage of truck drivers; cutthroat pricing. None of these risks is specific to KNX. Is this always the case, or is it just that your analysts identified no company-specific risks? If so, could you give us an example of a stock with company-specific risks?

We include the risks we think are most pertinent to a given situation. In this case, we think these general risks are the most important ones the firm faces. For a risk analysis that includes company-specific risks, see Dish Network (NASDAQ:DISH), which discusses competition-related lawsuits that the company faces.

I love the Bulls Say/Bears Say section, which summarizes the bullish and bearish cases for a stock. Could you tell us a little more about this section?

In this section, we try to capture the key tenets of both sides of the debate around a given stock.

Your Management & Stewardship section seems to focus on the motivations and entrenchment of management (is this a family run company? is the CEO also the chairman? etc.) but stops short of qualitatively judging management performance. Why?

We use our stewardship grade for that. Morningstar stock analysts assign a Stewardship Grade to each of the companies in Morningstar's coverage universe. We evaluate the demonstrated commitment to shareholders of each company's board and management team. Our assessment is divided into three general areas:

  1. Transparency. Morningstar analysts evaluate a company's accounting practices and financial disclosure, aiming to identify firms that provide investors with insufficient or potentially misleading information. Analysts review whether a company has instituted major changes in accounting procedures, overused "one-time" charges, or applied aggressive accounting methods, among other practices.
  2. Shareholder Friendliness. This category assesses the power of shareholders relative to management, evaluates the firm's share-class structure and assignment of CEO and board chair roles, and notes the existence of any takeover defenses or related-party transactions.
  3. Incentives, Ownership, and Overall Stewardship. This area focuses on whether management's incentives are aligned with shareholders' interests. Morningstar analysts penalize those firms that change management goals midstream, issue too many options, overcompensate executives, or have low levels of equity ownership.

Morningstar stock analysts base the Stewardship Grades on public filings, previous management actions, conversations with company officials, and their own expertise. We assign the grades on an absolute scale - not on a curve or on an industry-peer basis. Therefore, if a company engages in practices that the Morningstar analysts think do not reflect good stewardship of investors' capital, it will receive a poor grade regardless of how other firms may have scored.

Our Stewardship Grades can be interpreted as follows:

  • A means "Excellent"
  • B means "Good"
  • C means "Fair"
  • D means "Poor"
  • F means "Very Poor"

For a small number of companies we cover, sufficient data to assign a complete grade was unavailable. These firms will receive a designation of "NA," indicating that the rating is not applicable.

Is there a way to use Morningstar's SA Investment Tool to surface new investment ideas - or is it primarily a tool to read up about stocks you've already identified?

The information in Morningstar App will help you do both, research new investing opportunities and help you evaluate your current holdings. Investors have all of our latest thinking on investments at their fingertips, so as they start to search out new ideas and come across companies of interest, they can use the Investment Tool to get our unbiased perspective on a potential opportunity.

Can you give us some examples of cases where clients using Morningstar were able to make superior investment decisions because of something they read?

We have a very large list of recommendations where this would be the case, and/or could provide some aggregate performance data. Our investment ideas are intended to work out over a three-year time horizon; here are a few that have worked out well:

  • Compass Minerals (NYSE:CMP)
  • Genzyme (GENZ)
  • KLA-Tencor (NASDAQ:KLAC)

Thanks Melissa!

Have any thoughts, suggestions, or comments for Melissa and her team? Tell them, and other SA readers, what you think in the comment stream.