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Stock Strategist

Introducing Morningstar's New Stewardship Rating for Stocks

Our new rating system gets right to the heart of the matter: evaluating whether management teams are good stewards of shareholder capital.

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Today we are launching a new stewardship rating system, the Morningstar Stewardship Rating for Stocks. We will be making the transition from our previous stewardship grade system, which was derived from a somewhat more quantitative measurement of corporate governance practices, to one that focuses more heavily on the quality and depth of a company's management and board of directors in their roles as stewards of investor capital.

The new system will require our analysts to assign one of three Stewardship Ratings--exemplary, standard, or poor--based on their assessments of how each firm stacks up in regards to capital allocation decisions and stewardship of shareholder capital. We believe our stock analysts have a unique advantage in assessing and communicating a rating of this nature, given our focus on economic moats and credit quality, and expect it to be applicable for all companies, regardless of domicile, which is something that was not fully attainable with our old system.

Why the Change?
In June 2011, we initiated a project to take a fresh look at the best ways to evaluate corporate stewardship and answer the question we have been aiming to answer with our stewardship evaluation all along: Are the management teams of the companies we cover good stewards of capital for shareholders? As we look to answer that question for each of the companies we cover, we feel we are in a particularly good position to evaluate whether management is doing a good job looking after shareholder interests, given all the time and effort we put into analyzing the competitive advantages of these businesses and their capital allocation decisions.

The review process that began in mid-2011 determined that our former methodology was focusing too much on particular corporate governance practices instead of actual capital allocation decisions that lead to the creation or destruction of value for shareholders. Morningstar's equity analysts have always had the subjective leeway to place greater emphasis on capital allocation decisions and less emphasis on corporate governance practices; now it's more explicitly incorporated in our methodology. There are many examples of Morningstar awarding a company with traditionally frowned-upon corporate governance practices a favorable stewardship grade because of excellent capital allocation decisions, and vice versa.

New Focus: Capital Allocation
Our new system allows us to get right to the heart of the matter, evaluating whether management teams are good stewards of shareholder capital, rather than indirectly trying to assess management by evaluating all the individual control mechanisms that could (but may not necessarily) affect capital allocation and shareholder returns. Under the new, more holistic methodology, Morningstar equity analysts assess companies on items such as: financial leverage, investment strategy, investment timing and valuation, dividend and share buyback policies, execution, compensation, related-party transactions, and accounting practices. Since the new methodology is more holistic and doesn't home in on particular governance practices, it will be applicable globally, whereas the previous methodology was relevant only in the United States and Canada.

The contrast between our new Stewardship Ratings for Eldorado Gold (EGO) and for Kinross Gold (KGC) on the basis of capital allocation decisions illustrates the focus of our new rating methodology. Gold is a commodified industry. Mines deplete, which means a constant need for reinvestment. For these reasons, management decisions have a big impact on a company's advantages and performance relative to fellow industry players. We award Eldorado an exemplary rating because of the company's history of wise and attractively priced investments that have resulted in an enviable portfolio of high-quality, low-cost gold mines. Meanwhile, we rate Kinross' managers as poor stewards of shareholder capital. The company has a history of value-destructive acquisitions, and its operating and capital costs are increasing at a concerning rate.

Ford Motor Co (F) provides a good example of how our stewardship assessment is changing with the new methodology. In the past, we gave Ford a D stewardship grade from our grading scale of A, B, C, D, and F. Under our previous methodology that focused on particular corporate governance practices, we penalized the company for having two share classes. Under the new methodology, which places a much greater emphasis on strategic decisions, investments, and other actions that concretely affect shareholder value, Ford management's wise moves partially offset the concern of the dual share-class structure, and we award the firm a standard rating. Alan Mulally joined Ford in 2006 as CEO, and the changes he implemented allowed the company not only to survive the global financial crisis, but also to thrive as a highly profitable automaker. In particular, Mulally's financing moves in 2006 helped Ford weather the downturn without any taxpayer-funded bailout money. Mulally's product moves mean Ford started turning out more cars people want. Mulally also implemented significant manufacturing efficiencies and product quality improvements.

As the Ford example demonstrates, our new methodology focuses on how well a management team acts on behalf of shareholders. We are increasing our focus on empirical evidence and behaviors, and reducing our focus on the corporate governance structures that, while intended to ensure management acts in the best interests of shareholders, are no substitute for observing the actual facts.

As has always been the case with our stewardship methodology, this system looks at the absolute stewardship of the firms we cover. We don't look at how well a company has performed relative to others within its own industry or against a benchmark. Instead, we focus on the crucial elements that we believe impact how a company's management team and board of directors regard their shareholders. If a management team does not exhibit behavior consistent with that of a good steward of investors' capital, then it will receive a poor grade regardless of how other firms in its industry or country of origin have scored. We do this because we want to assign ratings based on how companies are actually treating their shareholders, rather than give credit to firms with poor stewardship that may just happen to be the best of a bad bunch.

New Methodology Specifics
Under the new stewardship methodology, analysts will assign each company one of three ratings--exemplary, standard, or poor--based on their assessments of how well a management team protects shareholder interests, including evaluating items such as: financial leverage, investment strategy, investment timing and valuation, dividend and share buyback policies, execution, compensation, related-party transactions, and accounting practices. The default rating for all companies will be standard, with firms receiving this rating in the absence of extraordinarily good or extraordinarily bad management and/or capital allocation decision-making. We anticipate most companies will receive a standard rating.

As part of the transition, our previous stewardship grades--denoted as A, B, C, D, or F--will be replaced with one of the three new ratings--exemplary, standard, or poor--with the rating for companies that have not yet been addressed by an analyst denoted as N/A. We feel it would be inappropriate to have an automatic translation of the current letter grades into the new rating labels because the two systems are measuring two different things, with the previous system focused more heavily on corporate governance issues and the new system weighted more heavily toward management quality and stewardship of shareholder capital. As demonstrated by the Ford example above, it is possible that a company that rated poorly in our previous system actually would be an exemplary capital allocator, and vice versa. We also note that our analyst team will be assessing capital allocation decisions from an equityholder's perspective.

Investment Strategy
Given Morningstar's focus on competitive dynamics, analysts pay close attention to a company's investment strategies. A key question for all companies is: Has the firm strayed from its core competencies in the pursuit of growth? A company with exemplary stewardship will be one that has made investments and acquisitions that support its competitive advantages and core businesses. Moreover, exemplary firms will divest underperforming or noncore businesses.

Home Depot (HD) illustrates a company that has done right for shareholders by divesting noncore assets. In our view, Home Depot's stewardship of shareholder capital is exemplary. Chairman and CEO Frank Blake is responsible for Home Depot's aggressive strategic about-face, trimming the company's portfolio of businesses down to focus solely on the traditional orange box Home Depot stores. Before Blake's tenure at the helm, the firm was highly criticized for its empire-building mentality.

Investment Valuation and Financial Leverage
Unfortunately, investments that make sense from a strategic perspective still can destroy shareholder value if the price paid is too high. Therefore, in addition to the strategic angle, analysts consider the price of acquisitions and the cost of major investments. A company's strategy with regard to financial leverage can have a big impact on shareholder returns, uncertainty, and volatility. We look unfavorably on cyclical, capital-intensive companies that carry a high debt load. Likewise, mature, stable companies with minimal reinvestment needs that sport too little debt are clearly not doing everything to maximize shareholder value.

We view stewardship at basic materials companies such as Vulcan Materials (VMC), Alpha Natural Resources (ANR),and Arch Coal (ACI)--which leveraged up to purchase peers during peak industry conditions--unfavorably, as shareholders suffered the negative consequences of too much financial leverage and excessive purchase prices.

Dividend and Share Buyback Policies
Dividends and share repurchases are used to return cash to shareholders. Just like with financial leverage, a Morningstar analyst is like Goldilocks, looking for an ideal amount of returning cash to shareholders that's neither too little nor too much for a particular company. A company with many opportunities to invest cash at high rates of return within the business or even with acquisition opportunities should probably deemphasize dividends and share repurchases. Meanwhile, a mature company with minimal profitable investment opportunities should look to return cash to shareholders.

Execution
A robust portfolio of attractive operating assets and skilled human capital, assembled with favorable valuations, can't create shareholder value if a company has frequent operational and executional missteps. Industrial accidents, customer service problems, or product recalls can depress operational results and destroy shareholder value. Conversely, praiseworthy execution can lead to a company significantly outperforming its peers on operational metrics and shareholder value creation.

For example, we award Chubb Corp (CB) an exemplary Stewardship Rating. Chairman and CEO John Finnegan has been at the helm of Chubb since 2002 and, along with the rest of his management team, has done an exemplary job in his stewardship of shareholders' capital. Prior to his tenure, Chubb consistently was losing money on underwriting, a trend that was sharply reversed by the decisions and policies implemented by current management. Chubb refocused on the most profitable and moaty businesses. Furthermore, it is now a much more disciplined company in terms of underwriting margins. While on the surface level it seems obvious that insurers should consistently strive for profitable underwriting, there are many pressures that cause companies to cut prices, especially during the competitive periods in soft pricing markets. Chubb largely has managed to avoid these temptations, a testament to management's quality. Chubb is now among the most profitable underwriters of the insurance companies we cover.

Compensation
In most cases, a company's compensation practices will not materially affect our Stewardship Rating. However, egregious compensation can keep an otherwise admirable management team from earning our exemplary rating. In certain cases where compensation is especially outrageous, where a material amount of value is being directed to managers at the expense of owners, companies can receive a poor rating on the basis of egregious compensation.

We look unfavorably on Gamco Investors' (GBL) stewardship, in part because we take issue with CEO Mario Gabelli's outsized pay package. Aside from collecting an annual "management fee" equivalent to 10% of the firm's pretax profits each year, he also takes home pay for his role as a portfolio manager. This netted Gabelli more than $60 million in annual compensation last year, equivalent to 19% of Gamco's total revenue in 2011. Although Gabelli's total pay package last year was down from the more than $70 million that he collected in 2007, it is inching its way back in that direction, and he remains (by just about every measure) the highest-paid CEO among the publicly traded asset managers that we cover.

Ownership Structure
Morningstar analysts take note of a company's ownership structure: Is it family owned and controlled? Does the government have a controlling stake or a golden share? Is it majority owned by another company? These structures reduce the power of minority shareholders, but in many cases we don't consider them cause for concern by themselves, especially when the controlling shareholders' economic interests are significantly aligned with minority shareholders'. However, when the ownership structure has led to value-destructive capital allocation decisions, we certainly take this into consideration when assigning Stewardship Ratings.

For example, we give Cablevision (CVC) a poor Stewardship Rating. The Dolan family's tight-gripped control over the company is entrenched by a long-standing dual share-class structure, which gives the Dolan clan 70% of the voting power while retaining only a 21% economic interest. This control gave managers the leeway to issue a $10-per-share special dividend in 2006. The company funded this dividend with borrowed money, adding $3 billion in debt to the company's balance sheet, hurting the company's financial health. We estimate that the dividend funneled as much as $650 million into the Dolan family coffers. Because the Dolans stood to benefit the most from the dividend, we think capital allocation decisions have been made in the family's best interests, to the detriment of new would-be shareholders.

Other considerations include related-party transactions, accounting practices, management backgrounds, and issues concerning health, safety, and the environment (HSE) where relevant. Since Morningstar analysts are assessing stewardship from a shareholder--not a stakeholder--perspective, the default stance on a company's HSE practices is agnostic. However, if a company's HSE track record has had a demonstrated impact on operational performance or shareholder value, then we take that into consideration in our assessment of stewardship of shareholder capital.

Ratings under the new methodology are now available on more than 250 companies, with supporting written analysis in the Management & Stewardship section of the company reports. Analysts will roll out the methodology to the remainder of Morningstar's coverage universe throughout 2012. Stewardship grades assigned under the previous system will be removed from company reports, as the old grades aren't translatable into the ratings assigned under the new methodology. Premium Members can access the Stewardship Ratings in the Analyst Research section of stock reports.

Heather Brilliant has a position in the following securities mentioned above: F. Find out about Morningstar’s editorial policies.