Step 1: Geographic zones: Each stock in a portfolio is grouped into one of seven geographic zones. The seven zones are: Canada, the United States, Latin America, Europe, Japan, Asia ex-Japan and Australia/New Zealand. This helps to ensure that the size and style assignments are relevant to local investors everywhere, including in Canada.
Step 2: Market capitalization: Within each of the geographic zones, we determine whether a security is small-cap, mid-cap or large-cap. The market-cap thresholds are based on the cumulative value of all the stocks within a given zone, rather than a market index.
Companies whose capitalizations are within the largest 70% of their style zone are considered large caps. Those whose market caps are in the next 20% are considered mid-caps, and the rest are considered small caps. Individual stocks are then assigned size scores that typically range from minus 100 (micro-cap) to 400 (giant-cap) based on where they fall in the size spectrum. This lets us differentiate between, for instance, big mid-caps and mid-caps verging on small-cap territory.
Step 3: Investment style characteristics: Stocks are compared only to other comparable stocks, but that principle includes size as well as geography. For example, the style of a Canadian mid-cap stock is assessed relative only to other Canadian mid-cap stocks.
Each stock is given both a value score between zero and 100 and a growth score between zero and 100, based on how it stacks up according to the five growth and five value factors. We then subtract a stock's value score from its growth score, with the result ranging anywhere from minus 100 to 100. If the result is strongly negative, the stock's style is value; if it is strongly positive, the stock is a growth stock; and if the stock's scores for value and growth are similar in strength, then the stock is considered a core stock.
Our five value factors and their relative weightings are:
- Price-to-projected earnings (50% of value score)
- Price-to-book (12.5% of value score)
- Price-to-sales (12.5%)
- Price-to-cash flow (12.5%)
- Dividend yield (12.5%)
In the past we used trailing net earnings in our P/E calculations, but now we use projected operating profits -- the industry standard. Because money managers look ahead rather than behind, the forward-looking measure is a better indicator of what drives a stock's price.
Meanwhile, our five growth measures are:
- Long-term projected earnings growth (50%)
- Historical earnings growth (12.5%)
- Sales growth (12.5%)
- Cash-flow growth (12.5%)
- Book-value growth (12.5%)
As with the value score, half of the growth score is based on one forward-looking measure and the other half of the score is derived from four historical factors.
Step 4: Asset-weighted scores: As always, securities that consume a larger position within a given portfolio will hold more sway in determining a fund's aggregate size and investment style than will smaller positions. We weight each stock's size score and its overall style score based on the percentage of the portfolio that the stock represents. Then, we use the portfolio's weighted score to determine a fund's placement in the style box.
Step 5: Putting it all together: Funds that devote most of their assets to stocks with strong growth characteristics will land in the growth column of our style box, while those with a higher concentration of value stocks will land in our value column. Funds that hold both growth and value stocks, or those that focus mainly on core stocks (securities where neither growth nor value is dominant) will land in the blend column.
Similarly, funds that invest mainly in large companies will end up in the top or large-cap row of the style box, while those that own holdings mainly in small companies will show up in the bottom or small-cap row. Funds that own mainly medium-sized companies, or a mixture of companies of all sizes, will reside in the middle or mid-cap row of the style box.
For more information, download Fact Sheet: The Morningstar Equity Style Box.
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