The Cream of the Crop in Our Coverage Universe
 
Firms with 5-star stocks, low risk, wide moats, and great stewardship. 
 
by Parvathy Krishnan, CFA | 02-10-06 | 06:00 AM | E-mail Article | Print Article | Permissions/Reprints 
 
So what are our criteria for recommending stocks? At Morningstar, we are disciples of the long-term value-oriented approach championed by great investors like Warren Buffett, Peter Lynch, and Bill Ruane. We therefore recommend stocks of high-quality, well-managed companies trading at attractive valuations. So when are valuations considered attractive and how do we identify high-quality, well-managed companies? There are simple objective measures that can be used to answer both these questions.

Stocks are valued attractively when they are trading at prices below their intrinsic values. Stocks become cheap for many reasons; Pat Dorsey, our director of stock analysis, has commented on this subject before. Stocks trading far enough below our estimate of their intrinsic values get a 5-star Morningstar Rating for stocks.

How do we identify good companies? Given that the primary goal of all companies is to make profits and thus increase wealth, we think high-quality companies have three defining characteristics. First, they have demonstrated an ability to consistently earn profits above their cost of capital. We therefore like companies that sport returns on invested capital (ROICs) above their weighted average cost of capital (WACC). See my colleague Elizabeth Collins' comments on why ROIC is our favorite measure of profitability.

As Elizabeth points out, ROICs are not usually reported, and it is therefore difficult to screen for companies with high ROICs. But we have a good alternative at Morningstar. We believe that companies that have earned ROICs higher than their WACCs consistently over a period of time have that "special something" that allows them to keep competitors at bay, pass on cost increases to customers, and thus maintain their high profitability. We call that special something an economic moat. Companies have built moats of various levels around their business, and many have none. The wider the moat, the safer the company's profits.

The second important characteristic of a good company is a low risk profile. Revenues, profits, and cash flow at such companies are not overly volatile and are in fact less volatile than the general market itself. These below-average-risk companies earn our low risk rating.

The third characteristic is management quality. Given that management is largely responsible for a company's performance and capital allocation decisions, a good management team can raise a company to great heights and a poor management team can do the opposite. At Morningstar, our measure of management quality is the company's Stewardship Grade. Needless to say, a company earning a Stewardship Grade of "A" has better management policies than a company that has earned a lesser grade.