How to use Morningstar Ratings to find quality stocks

Let's start with the star rating, whose official name is the Morningstar Rating for stocks. This is calculated by comparing a stock's current market price with Morningstar's estimate of the stock's fair value. The bigger the discount, the higher the star rating. Our rating system also factors in an uncertainty adjustment (known as the fair value uncertainty rating--more on that below) so that it's more difficult for a company to earn a 5-star rating the less confident we are in the precision of our fair value estimate.

Fair value uncertainty

When Morningstar equity analysts assign a fair value estimate to a stock, it's a single dollar-value estimate. But in actuality, our analysts predict a range of outcomes or scenarios for each company when determining its fair value estimate. Our uncertainty rating follows the principles of a confidence interval surrounding our fair value estimate. Essentially, a low fair value uncertainty rating means that the analyst thinks he or she can more tightly gauge the fair value of a company because he or she can estimate its future cash flows with a greater degree of confidence. In determining this rating, our analysts score companies based on sales predictability, operating leverage, financial leverage and exposure to contingent events (for example, a biotech company's success or failure may hinge on whether a single drug is approved or not).

This rating is sometimes referred to in shorthand as the "uncertainty rating," which may lead some people to assume the measure is intended to predict the future volatility of the stock's price. Although that is not the intent of the rating, some of the elements that go into determining the fair value uncertainty rating, such as leverage and risk of events such as litigation, could arguably result in a more volatile stock price.

To illustrate how the rating works, let's look at two companies: The first,  McCormick & Company (MKC), the market leader in seasoning and spices, is a good example of a company that earns a "low" fair value uncertainty rating. While the company does have to contend with price fluctuations in the commodity market for the raw materials that make up the spices, McCormick generates relatively stable cash flows and has a manageable debt load; therefore, Morningstar senior equity analyst Erin Lash feels there is a low degree of uncertainty around McCormick's fair value estimate. Further, Lash explains that McCormick's dominance in its category is marked by a unique feature: its private-label presence. "The firm is the largest producer of private-label spices and seasonings in North America, and as such, the pricing threats many consumer-product firms face are limited for McCormick, ensuring that no other company gains enough scale to significantly affect the pricing of the firm's branded offerings. In addition, we think that by offering these lower-priced products, McCormick enhances its relationship with retailers."

At the other extreme is  Peabody Energy (BTU), one of a handful of companies in Morningstar's stock coverage universe receiving an "extreme" fair value uncertainty rating. Many of the uncertainties that Peabody faces are shared by most, if not all, coal producers; these risks include a fall in coal prices, competition from substitute fuels such as natural gas, environmental regulations, both global and domestic economic performance, and weather. But what pushes Peabody further toward extreme uncertainty is very high leverage, said Morningstar equity analyst Kristoffer Inton. He writes that his fair value estimate of US$3.50 "reflects a 25% probability weighting of our bull-case fair value estimate of US$14 per share, as our base- and bear-case assumptions point to zero equity value," Inton said.

Economic moat

The idea of an economic moat (a term originally coined by Warren Buffett) refers to how likely a company is to keep competitors at bay for an extended period. One of the keys to finding superior long-term investments is buying companies that will be able to stay one step ahead of their competitors, and it's this characteristic--think of it as the strength and sustainability of a firm's competitive advantage--that Morningstar is trying to capture with the economic moat rating. A company that has generated capital higher than its cost of capital for many years probably has a moat, especially if its returns on capital have been rising or are fairly stable. Here are some things that can give companies economic moats:

• Network effect: Lots of people are using the service. That, in turn, makes the service more valuable to the people who use it. For some illustrations of companies that have network effects, think  eBay (EBAY) (lots of buyers and sellers in the same virtual marketplace) or Facebook (FB) (lots of friends and family in one "place").
• Intangible assets: Patents, brands, regulatory licenses and other intangible assets can prevent competitors from duplicating a company's products, or allow the company to charge a significant price premium. Think  Pfizer (PFE) (which, until its patent expiration in 2011, owned the patent on cholesterol-lowering drug Lipitor, one of the best-selling drugs of all time with billions of dollars in annual sales), or  Altria Group (MO), with millions of loyal Marlboro customers. (Marlboro has been the largest cigarette brand in the United States for 35 years and represented more than 44% of U.S. cigarette sales in 2015.)
• Cost advantage: Firms with a structural cost advantage can either undercut competitors on price while earning similar margins, or they can charge market-level prices while earning relatively high margins. A classic example of this is  Wal-Mart Stores (WMT): Through its operating efficiencies and massive scale, the retailing behemoth is able to offer products at some of the lowest costs anywhere. Another example operating in a smaller market is  Compass Minerals International (CMP), which produces rock salt for use in road and highway de-icing. The major reason for its cost advantage: Compass owns the world's largest active rock-salt mine in Goderich, Ontario, whose thicker seams allow for more efficient mining operations. In addition, the mine is located on Lake Huron, giving Compass easy access to snowy markets located along the Great Lakes.
• Switching costs: When it would be too expensive or troublesome to stop using a company's products, the company often has pricing power. For example,  Automatic Data Processing's (ADP) long-term contracts and the difficulty inherent in switching outsourced human resources processes to another provider allow ADP to lock clients into its services. Another example is  Oracle (ORCL), which provides databases and other IT solutions to businesses. Companies are extremely sensitive to the cost and risk of switching out their database technology, which results in a wide moat for Oracle.
• Efficient scale: When a niche market is effectively served by one or a small handful of companies, efficient scale may be present. To illustrate this one, consider  Kinder Morgan (KMI) and  Williams Companies (WMB), whose pipeline infrastructure assets would be cost-prohibitive and difficult, if not impossible, for a competitor to replicate.

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