The mutual fund rater extends its domain. That's good news for individual investors. By David Landis, Contributing Editor July 31, 2008 Although he founded a company that has become almost synonymous with mutual fund analysis, Joe Mansueto, Morningstar's chief executive, is at heart a stocks guy. He began his career as a stock analyst at Harris Associates, which runs the Oakmark mutual funds. At Morningstar's headquarters, in Chicago, he works in an unassuming cubicle surrounded by the cubicles of the company's growing corps of stock analysts.So the fact that Morningstar has more than four times as many U.S.-stock analysts (102) as fund analysts (25) and rates more U.S.-listed stocks (about 2,100) than funds (about 1,800) on its five-star scale is hardly out of character. As far as Mansueto is concerned, stock research is a natural extension of the firm's mutual fund franchise. "What is a stock fund but a collection of stocks?" he asks. "To understand funds, you really need to know stocks." Sponsored Content True enough, but Morningstar's stock-research business is far more than just an in-house resource for its fund analysts. It is one of the nation's largest independent stock-research operations, with a scope that rivals that of long-established competitors Standard & Poor's (1,800 stocks covered) and ValueLine (1,700). Morningstar quickly became a player in stock research after the serv ice began in 2001 by applying to stocks the formula that has made its fund research so successful: a sober, long-term outlook, easy-to-digest reports, and the trademark star ratings. But it was also lucky enough to be in the right place at the right time. In 2003, a dozen of Wall Street's biggest brokerage firms agreed to spend about $450 million to buy research from independent suppliers, such as Morningstar, to settle charges that they manipulated their own research and deceived investors during the tech-stock bubble of the late 1990s. When the settlement money began flowing in 2004, Morningstar won contracts to supply research to six of the 12 firms. At the time, Morningstar had about 25 analysts on staff and planned to add 50 more over five years. Instead, the staff tripled in one year. Advertisement Growing customer base Those contracts, worth $21 million annually (about 5% of Morningstar's 2007 total revenues of $435 million), probably won't be renewed when the five-year settlement ends in mid 2009. But Morningstar has already made the most of the opportunity. Its customer base for research has grown to include 182,000 premium Web-site clients (who pay $159 annually), more than 100,000 subscribers to four stock newsletters ($95 to $149 annually), a wide network of financial advisers, and about 30 so-called buy-side research outfits. The buy-side customers, a collection of hedge-fund and mutual fund firms of all sizes, are potentially the most lucrative. They pay premium prices so that their portfolio managers can call at any time to pick the brains of Morningstar's analysts -- a perk not available to individual subscribers. Research has traditionally been a "soft dollar" business, a service that Wall Street brokerages provided at no explicit cost in exchange for a customer's stock-trading business. So the fact that Morningstar, which has no stock-trading business, can earn hard cash for its research is a tribute to its effectiveness. It's also a testament to the investment philosophy laid down by Mansueto, whose approach is based on his experience at Harris Associates as well as on the teachings of Warren Buffett. Buffett is frequently cited on the company's Web site and in research reports, and Morningstar recently sent two dozen research staffers to Omaha to sit in on the annual meeting of Buffett's company, Berkshire Hathaway. Although Morningstar's approach to stocks closely resembles traditional value investing, Morningstar's research director, Pat Dorsey, resists the label. He points to Morningstar's long-term support of stocks with high price-earnings ratios, such as Expeditors International and Fastenal (see Stocks Buffett Would Love), as proof the company can't be stuffed into that pigeonhole. "Buffett's quote is that growth is a component of value -- sometimes a positive, sometimes a negative," says Dorsey, who dropped out of a doctoral program in political science at Northwestern University to help launch Morningstar's first stock newsletter in 1998. "That's kind of how we look at the world." Advertisement Morningstar analysts examine two key elements in a stock: the relationship between a company's share price and its fair value (as they've determined it), and the degree to which a company's business has a long-term competitive edge, or a "moat," as Buffett likes to call it. To determine fair value, analysts start with free cash flow (earnings plus depreciation and other noncash charges, minus capital expenditures). They project free-cash estimates far into the future, then calculate the lump-sum value of that cash in today's dollars. For a company with a wide moat, profit projections tend to be more optimistic, leading to a higher determination of fair value than for a company without one. Analysts also pay close attention to risk. They grade stocks on a five-point "uncertainty" scale and insist on a much higher discount before recommending a stock with a cloudy outlook. For example, at a mid-June share price of $28, Microsoft (symbol MSFT) traded at just 20% below Morningstar's fair-value estimate of $35, yet the stock merits a top, five-star rating because there's little doubt about Microsoft's future profitability. In contrast, mortgage insurer PMI Group (PMI), at $5, traded at a whopping 62% discount to Morningstar's $13 fair-value estimate, yet the stock rates only three stars because of the turmoil in its industry. How well does this system work? It helped Morningstar's analysts get in early on winners such as MasterCard (MA). With the stock in the $40s, Morningstar gave the credit-card company a five-star rating in May 2006, not long after it went public. In mid June, MasterCard traded at $296. More recently, Morningstar last fall reiterated its bullish outlook for Cimarex Energy (XEC) after a weak third quarter for natural-gas prices. The shares were trading in the mid $30s then. They were at $69 in mid June. Advertisement On the other hand, the system did not prevent Morningstar from underestimating the collateral damage from the subprime-mortgage meltdown. Although the analysts weren't terribly bullish on financial stocks before things started to fall apart a year or so ago, they, like many others, didn't anticipate the massive losses in banks' securities portfolios. They were also prematurely bullish last year on stocks of homebuilders and were overly optimistic about the outlook for retailers and restaurants. Determining how Morningstar's calls stack up against those of other research outfits is difficult. Morningstar doesn't provide data to consultants who compile independent rankings of stock-research performance because, Dorsey says, those rankings are short-term-oriented and aimed at traders and other professional investors. To his credit, Dorsey publishes a quarterly warts-and-all critique of his analysts' performance on Morningstar's Web site, including a running tally of how their picks have collectively performed against Standard & Poor's 500-stock index. Despite a disappointing 2007, an equally weighted portfolio of Morningstar's five-star-rated stocks, held until their ratings fell to one star, would have returned an annualized 15% over the past five years through March 31. That's an average of nearly four percentage points per year better than the return of the S&P 500. Those numbers were better, however, before last year, when the portfolio of Morningstar picks lost 5%, trailing the S&P 500 by ten points. While the results are important, most individual investors are just looking for sound advice in language they can understand. By that standard, Morningstar's reports, with their clearly spelled-out investing theses and best- and worst-case scenarios for each stock, are succeeding. "I'm not a professional trader, so I look for resources I understand to help me with my homework," says subscriber Pamela Terracciano, a nonpracticing attorney in Briarcliff Manor, N.Y., who uses Morningstar research to help manage her retirement portfolio and her husband's. "If I read something in a report that poses a question about a company, I know it's a question I need to answer before investing." Advertisement Some 80% of premium Web-site subscribers say they sign up for the fund information, but about half of those who renew cite the stock research as a reason, says Catherine Odelbo, Morningstar's president of individual business. "A lot of people come for funds, but they stay for stocks." And even though services for individual investors are a shrinking part of Morningstar's overall business (its fast-growing institutional business accounted for more than half of revenues and two-thirds of operating profits last year), individuals remain an important strategic audience. "We believe wide acceptance of the company by retail investors is what drives a large portion of its business," says Marvin Loh, an analyst for investment bank WR Hambrecht. That's good news for ordinary investors, who have always been a low priority for high-profile Wall Street analysts. If Morningstar's stock-research operation continues to succeed, perhaps it will send a message to Wall Street about the way things ought to be done. A sampling of morningstar's current calls Five-star companies UnitedHealth (symbol UNH): The health insurer is a narrow-moat business, which is Morningstar's way of saying it has a moderate competitive advantage -- in this case because of its enormous size ($75 billion in annual revenue). But what really makes the stock a buy is its low price. At $33 in mid June, it traded at a 45% discount to analyst Matthew Coffina's $60 estimate of UnitedHealth's fair value. Sanofi-Aventis (SNY): A robust pipeline of new, patented drugs earns this French pharmaceutical firm a wide-moat rating. The new drugs should offset losses from those that have lost patent protection, such as allergy treatment Allegra, says analyst Damien Conover. He pegs Sanofi's fair value at $50. It traded recently at $35. Central North Airport Group (OMAB): Morningstar calls this U.S.-listed Mexican airport operator an undiscovered growth company with a wide moat thanks to its regional monopoly. Low-cost airlines are driving an increase in air traffic that should result in double-digit revenue growth over the next five years, says analyst Adam Fleck. At $20, Grupo Aeroportuario del Centro Norte, as it is known in Spanish, trades well below Fleck's $31 estimate of fair value. One-star companies Amazon.com (AMZN): The online retailer earns a wide-moat rating for its innovative business. But analyst Joseph Beaulieu says the stock's $81 price tag makes sense only if you believe that Amazon's profit margins can keep growing steadily in today's uncertain environment for consumer spending (he doesn't). Beaulieu's fair-value estimate for the shares is $45. Bucyrus International (BUCY): This no-moat maker of mining equipment has been a big beneficiary of rising commodity prices. But analyst Joel Bloomer says mining firms -- Bucyrus's customers -- may be the more profitable play. At $75, the shares trade for more than twice Bloomer's $33 estimate of Bucyrus's fair value. MEMC Electronic Materials (WFR): The semiconductor industry is cyclical, and chips are commodities. So, in Morningstar's view, MEMC (a member of the Kiplinger Green 25) has no moat around its business, despite its role as a chip supplier to solar-panel makers. Analyst Andy Ng expects new chip supplies to flood the market and drag down prices. His fair-value estimate is $20, less than one-third of MEMC's recent price of $65.