How do you choose your stocks? Most of us look at commonly used financial ratios like the price-to-book (P/B) ratio, the price-to-earnings (P/E) ratio, or the price-to-sales (P/S) ratio to see if a stock is cheap or expensive. Makes sense. Knowing if the price is right is important because buying a stock at the wrong time is always a bad decision.
Besides price, at Morningstar we focus on the quality of the business, or its competitive advantage – we call it the “Morningstar Economic Moat” – which is the company’s ability to hold off competitors. and remain profitable for many years to come. Awesome, right?
No matter how “great” a company is, buying a good company at the wrong price is also a bad decision. That’s why our best investment ideas are stocks with an economic moat that Also trade at a discount to our estimates of fair value.
There is also a third aspect that investors should consider when buying a stock, and that is how managers are able to increase shareholder returns through proper capital allocation. At Morningstar, we judge a company’s asset allocation through a rating called ‘Morningstar Stewardship Rating.’
Why Stewardship Matters
But why are these aspects so important?
“The first thing we need to do is understand what type of business we are investing in, because our judgment can be very different when it comes to a growth or value stock. When you have a growing business , such as a technology or biotechnology company, it is important to see the rate of return on its investments and to answer the questions: is it investing in the right things, is it doing it at the right price, is management capable to execute? For companies in more mature sectors like infrastructure or banking, shareholder return will be driven by dividends or buybacks,” says Mathew Hodge, director of equity research for Morningstar.
Either way, both strategies need to be executed sustainably.
“That’s why we also focus on the balance sheet. If a company is too aggressive in buying new assets or if it pays too much for its shares or distributes dividends to shareholders in an unsustainable way, it could be very risky in the event of a downturn or scandal that could significantly reduce revenue,” says Hodge.
How to read reviews
Thanks to the Morningstar Stewardship Rating, companies can obtain an Exemplary, Standard or Poor rating, based on an assessment of three aspects: balance sheet, investments and shareholder distribution. Analysts judge stewardship from the perspective of an equity owner. Grades are determined on an absolute basis. Companies are not judged against their peers within their sector, but against an ideal management of shareholder capital. Most companies will receive a standard rating, and this should be taken as the default rating in the absence of evidence that a management team has made exceptionally strong or poor capital allocation decisions. Here’s how the other two work:
Exemplary: A company is rated “Exemplary” if it has demonstrated excellent business stewardship practices.
Poor: A company gets a “poor” rating if it takes too much risk with shareholder value. That could mean he’s investing badly, investing in the wrong things at the wrong price, or simply not returning the right share of that money to shareholders.
How it works
The reason our analysts pay attention to capital allocation is because of equity returns. If we look at all the companies covered by Morningstar, we can see a significant difference between the 10-year annualized returns of companies with exemplary capital allocation and those with poor ratings. In the first case, 50% of the companies recorded a return higher than 14.6%, in the second case, half of the group obtained returns lower than 1.6%.
Be careful, however. Just because a company has an economic moat doesn’t mean it has an exemplary capital allocation rating. Even if it’s true that more companies with an economic moat also have management making the right decisions about how to allocate capital, we Also have Wide Moat businesses with a mediocre rating. And Bayer is one of them.
“The company spends significantly less on R&D than the industry average. This explains why he showed low productivity with poor execution in developing his pipeline. Also on the acquisitions side, Bayer performed poorly. Monsanto’s largest recent acquisition diversified cash flow and looked like a reasonable acquisition at the time, but mismanagement and misunderstanding of glyphosate risk made the deal more problematic and strained the balance sheet and likely took capital out of needed R&D investments. , says Damien Conover, director of equity strategy for Morningstar.
Ryanair, on the other hand, is an example of a value company without a moat but with an exemplary capital allocation. “Its balance sheet is managed conservatively compared to its industry peers. Debt levels are kept low and the group often operates with a net cash balance. This gives the business the financial freedom to act opportunistically and have the cash to operate in a downturn. The group pays no dividends and uses share buybacks to return excess capital to shareholders,” said Joachim Kotze, equity analyst for Morningstar.
In summary, before buying a stock, don’t just look at valuations. Understand if it has a sustainable competitive advantage and read all you can about the company, what it has done in the past and what it plans to do in the years to come. The company’s annual report is a good starting point, where you will find all the information you need to assess the quality of its capital allocation.