Investing in the 21st century

Morningstar’s fundamental analysis

Morningstar, a global investment and research firm, has been publishing estimates of listed company values for decades. Since 2001, they have published star ratings for each company based on the discount or premium of share price to their estimate of fair value. In a recent study, Analyzing the Performance of Our Stock Recommendations, Morningstar reviewed the past two decades of their ratings to assess whether the system delivered positive results.

Morningstar’s rating scale is from 5 to 1 stars:

• 5 most undervalued
• 4 undervalued
• 3 fair value
• 2 overvalued
• 1 most overvalued

The period after 2001 was rocky for sharemarkets. It included the recovery from the 2000 “tech wreck”, the Global Financial Crisis, and then the recovery from the GFC. China emerged from nowhere at the start of the period to become the top contributor to world GDP growth, year in, year out. Would normal valuation techniques stand up to extreme volatility and the emergence of a new leading world economy?

Morningstar study results

Morningstar’s study revealed that investing in a portfolio of the 5-star or cheapest stocks can potentially add 4% to total returns. Equally, investing in a portfolio of the 1-star or most expensive stocks can detract about 4% per annum. Share investment and portfolio management based on valuations can work (i.e. share price discounts to estimated fundamental fair value). The 5 and 1 ratings, most undervalued and most overvalued, worked significantly more strongly than ratings 4 and 2.

Fundamental analysis may not work as well for commodity stocks

Fundamental valuation investing was found to work less well for commodity stocks: energy producers, miners including gold, and other natural resource and basic materials producers. These industries may be more driven by commodity price cycles and fluctuations than any return to fair value in individual stock prices.

When an investor attempts to assess a company’s value, revenue and profit margins play a crucial role. However, these elements are very volatile for commodity companies, and the companies have no control over their selling prices. Whereas in non-commodity sectors (such as packaged consumer goods, industrial manufacturing and technology) different firms have different products and they can manage their prices to a larger degree.

Is fundamental investing useful for all investors?

So what does this apparent success of fundamental investing mean for other investors? Traders, momentum followers and income investors are less likely to be focused primarily on fundamental valuations, as they form more of a growth discipline. But this doesn’t mean that fundamental analysis is irrelevant for these kinds of investors.

Even if you’re following a trading or income approach, most investors would rather be trading or holding better value stocks to support their primary strategy. Focusing on undervalued companies may provide a better platform to manage your risk and trade profitably (assuming you’re trading stocks from the long side). And the opposite is also true. Income investors often aim for capital stability as well as income - and holding undervalued companies for their dividend yields should help them achieve that.

Diversification is still important

Morningstar’s self-assessment was carried out across hundreds of stocks in many industries. So if you want to successfully follow a fundamental approach, you may still need to diversify sufficiently across a number of companies in a range of industries.

Another thing to note is that Morningstar’s star ratings require companies with greater risk or “uncertainty” to have greater discounts to estimated fair value (in order to justify one of the undervalued ratings). This is another good portfolio management discipline for most investors.

Fundamental analysis holds its place

So perhaps it does turn out that fundamental analysis and value investing can survive and prosper in the 21st century. It could be used as an effective way to enhance other essential portfolio disciplines, like matching stocks to suit your individual objectives, and maintaining sufficient diversification.

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