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Stock Strategist

Morningstar Rating for Stocks: Change to Uncertainty Bands

Given current conditions, we're widening our star-rating cut-offs.

Starting on Friday, Oct. 10, we have changed the uncertainty bands across our coverage universe. We use these uncertainty bands to determine what star ratings each stock should receive.

We're making the change to reflect the extraordinary volatility in the markets, which is a result, in part at least, of the increased uncertainty surrounding most of the businesses we cover. For any company, we consider its fair value to be the mid-point in a range of possible fair values. To help us get a handle on that range, we do scenario analysis on individual companies, stress-testing our valuation models under a variety of assumptions. We then assign that company an Uncertainty Rating based on this assessment. Given the current credit environment, it's clear to us that the range of plausible outcomes has widened across broad swaths of our coverage list. We thus feel it prudent to increase the uncertainty bands for all companies.

The result of the change will be a somewhat higher hurdle for stocks to hit 5 star or 1 star. So, for example, we now require a Medium uncertainty stock to trade at 70% of its fair value before awarding it 5 stars (see image below), as opposed to 75% before. For a Very High uncertainty stock, the discount widens to 40% of fair value from 55%.

Practically speaking, the change will mean fewer ratings changes than we would have had otherwise. It will also mean fewer 5 star and 1 star stocks. Given the extraordinary number of 5-star stocks we currently have, we hope this provides our subscribers a somewhat more manageable list of our best ideas. We will still have a large number of 5-star stocks, which we think is perfectly natural. After all, the S&P 500 is a much more attractive investment at 900 than it was at 1,500.

We don't expect to change our uncertainty cut-offs frequently, but we will periodically revisit them and make adjustments accordingly.