Morningstar is getting a lot more style-conscious. We have just rolled out a brand new methodology for calculating the Morningstar Equity Style Box for stocks, funds and portfolios. By using a wide range of growth and valuation measures, and by adding style-based analysis of non-North American stocks, the style-box improvements incorporate much more of the information on which fund managers base their stock-selection decisions.
This, in turn, makes the Morningstar Style Box a more accurate measure of a fund's equity style, and therefore a more useful tool for portfolio construction. Investors will be able to size up the style characteristics of their entire portfolios, including any foreign stocks or funds.
The style box still looks the same. It continues to use our classic three-by-three grid, with market-capitalization shown on the vertical axis and investment style shown horizontally. Also, it continues to use a holdings-based approach, where style attributes are determined at the security level and then aggregated to the level of funds and portfolios.
The new methodology, however, recognizes that most fund managers look at a company's growth prospects separately from its valuations. The previous style-box calculations for Canadian and U.S. equity funds relied on just two valuation factors -- price-earnings (P/E) ratios and price-to-book (P/B) ratios -- to categorize funds as value, blend or growth.
In the past, stocks have essentially been placed in the growth camp by default. The assumption was that the absence of value characteristics implied growth attributes. For the most part, this assumption was a reasonable one, since investors will generally pay a higher than average multiple for current earnings if they expect rapid earnings growth.
But P/E ratios don't necessarily offer insight into a company's expected growth rate. Factoring in growth rates directly -- as Morningstar's new methodology does -- leads to more accurate classifications of manager styles.
In all, Morningstar's new equity style boxes are based on 10 factors -- five times as many as before. The 10 factors are split evenly between valuation and growth criteria. They include both historical and forward-looking measures.
Using all of these factors means more stability and reliability for equity style assignments. Because different factors go in and out of fashion, we're better positioned with the new 10-factor methodology to reflect what's driving performance. For instance, earnings- and sales-growth rates told most of the performance story in 1998 and 1999, but price-earnings and price-to-cash-flow swung back into favour in the more price-conscious post-2000 period.
By combining both forward-looking and historical measures, the new style-box methodology is less susceptible to changes in the economic cycle. For instance, if you buy an automaker at the bottom of the market cycle, you may be paying a steep price relative to trailing earnings. Yet forward earnings and price/sales figures might reveal that you're actually buying at a very cheap price if the company rebounds to historical norms.
Not only will we do a better job of measuring style, but we're casting a much wider net geographically in order to capture the style of all equities held in a portfolio. The equity style box now applies to all equity markets.
This improvement directly addresses one of the limitations of our old style-box model, which was able to analyze manager style only for stocks in Canada and the U.S. Furthermore, we weren't able to report on the overall style of an equity fund if it held stocks from both Canada and the U.S. Domestic equity funds did not have foreign securities factored into their Canadian equity style-box calculations.
By contrast, the new and improved 10-factor model allows us to categorize stocks from around the world, and enables us to analyze multi-country portfolios. With our new methodology, if a fund holds any stocks -- no matter how few or how many and no matter from what countries -- our new style box will specify the equity style of that fund.
The Morningstar Equity Style Box can provide extremely valuable assistance for building and monitoring a fund portfolio. It enables you to know what types of stocks your funds really own and how they invest, which is sometimes quite different from what their names and marketing materials suggest. By using the style box to find out what types of stocks or bonds a fund actually owns, you can build a portfolio that represents a wide variety of securities, and therefore be better prepared when one sector of the market, is out of favour -- or so in favour that it becomes dangerously overpriced.
For more details on how we calculate our new 10-factor equity style box, click here.
