Morning Star Equity Research Process Methodology

Equity Research Process and Quality Control
Morningstar Report December

Morningstar, Inc. All rights reserved. The information in this document is the property of Morningstar, Inc. Reproduction or transcription by any means, in whole or in part, without the prior written consent of Morningstar, Inc., is prohibited.
Introduction
To ensure the quality of Morningstars equity research, we have developed a rigorous system of checks and balances. Each of the following elements plays an important role, and we discuss each in depth below.
3 3 3 3 3 3 3 Department Structure Standardized Morningstar Valuation Model Research Workow Quality Control Analyst Performance Appraisals Analyst Backgrounds Hiring Process
2 December 2003
2003 Morningstar, Inc. All rights reserved. The information in this document is the property of Morningstar, Inc. Reproduction or transcription by any means, in whole or in part, without the prior written consent of Morningstar, Inc., is prohibited.
Department Structure
As Morningstar has built up its equity staff over the past several years, weve focused on building a team of industry specialists. Reporting to the Director of Stock Analysis are currently ve Associate Directors, each of whom heads up a team of ve to eight analysts working in closely related elds. The Associate Directors review the work of the analysts under them, and grant nal approval for publication of all Analyst Reports. This structure allows the analysts on each team to both specialize in a particular industry and learn from others covering companies in related elds. Under the Associate Director in charge of nancials, for example, are individual analysts specializing in insurance, regional banks, asset managers, brokerages, and life insurance. The Associate Directors work with the Director of Stock Analysis to formulate reasonable industry and sector forecasts that feed into our valuation models. We dont want our hardware analyst forecasting 10% long-term growth in personalcomputer demand, for example, if our software analyst is forecasting 15%. The Associate Directors are then responsible for ensuring that our analysts are consistent in the way they incorporate industry or macroeconomic trends such as housing starts, technology demand, or interest-rate movements.
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Industy Specialization
(Note: Some industries may have more than 1 analyst devoted to them.)
Director of Stock Analysis
Associate Director Basic Materials/Utilities
Associate Director Financials
Associate Director Consumer Goods
Associate Director Technology
Associate Director Healthcare
Oil and Gas
Specialty Finance
Media
Semiconduc
Pharmaceuticals
Oil and Gas Services
Asset Managers
Retail
Telcommunica
Biotechnology
Utilities
Banks
Specialty Retail
Software
Medical Devices
Transportation
Insurance - Property/Casualty
Restaurants
Business Serv
Health Services
REITs
Beverages
Hardwar
Brokerages
Regional Banks
Life Insurance Insurance Brokers
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Standardized Morningstar Valuation Model
All analysts use the same internally developed discounted cash ow model. (We have created variations on the model for industries such as banks and insurance.) This helps ensure consistency across the department, and makes it easier for Associate Directors and the Director of Stock Analysis to perform quality checks. If each analyst used a different model, each manager would need to learn that model in order to determine if the fair value estimate truly made sense. Checks and balances are built into the model to help prevent logical errors. For example, an analyst cannot forecast an earnings growth rate that isnt consistent with the companys return on capital and its investment rate. Also, we always assume a company cannot earn above-average returns on capital forever; eventually those returns will regress back to the cost of capital. The model also provides the analyst with long-term trends in a wide variety of ratios that alert the analyst to unrealistic assumptions. Finally, long-term trends such as the rate of decay of returns on capital (as they regress to the companys cost of capital) are standard across models.
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Research Workow
Whenever an analyst writes a new Analyst Report, the Associate Director who manages the analyst reviews the work. Only when the Associate Director is satised will the work be submitted for a nal edit by our copyediting staff. Each analyst takes the following steps:
1. Perform Background Research 3 3 3 3 3 3 Examine the rms nancial statements and lings Contact the rms management and investment-relations personnel Contact competitors, suppliers, and distributors Attend trade shows where these constituents congregate Visit the company Read related trade publications
2. Produce the Analyst Report 3 Determine the Economic Moat rating (wide, narrow, or none) and Business Risk rating (below average, average, or above average). Submit these to the Investment Policy Committee for approval. Build a discounted cash ow model, which leads to the creation of a fair value estimate of the stock. Write an Analyst Report explaining assumptions and key factors that inuenced the projection of future cash ows. The report also includes a detailed discussion of the rms competitive position, business strategy, and bull and bear view points on the stock.
3 3
3. Submit the Report for Review 3 3 An Associate Director or the Model Auditor reviews the valuation model An Associate Director reviews the Analyst Report and gives edits back to the analyst. This process repeats until the Associate Director signs off on the report. Our copyediting staff reviews the Analyst Report and publishes it.
4. Ongoing Review 3 The analyst updates each Analyst Report at least quarterly. For higher-prole companies, reports are updated at least every six weeks. When news happens, the analyst publishes a Stock Analyst Note on the company. The analyst participates in conference calls, analyzes earnings releases, and updates the fair value estimate or writes a Stock Analyst Note as events warrant.
3 3
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Analyst Research Flow Chart
Background Research Conducted by Analyst
Research Conclusions Developed by Analyst
Evaluations Associate Director and Model Auditor Investment Policy Committee Moat Analysis Business Risk Analysis Future Cash Flows Discounted Cash Flow Model Fair Value Estimate Future Cash Flows Discounted Cash Flow Model Fair Value Estimate
Release
Management Interview Investment Relations Conference Calls Competitors Interview Suppliers Interview Distributors Interview Customers Interview Financial Statements Industry Tradeshows Trade Publications
Moat Analysis Business Risk Analysis Future Cash Flows Discounted Cash Flow Model Fair Value Estimate
Moat Analysis Business Risk Analysis Future Cash Flows Discounted Cash Flow Model Fair Value Estimate
Analyst Report
D R A F T
Analyst Report
D R A F T
Analyst Report
D R A F T
Analyst Report
Morningstar analysts engage in a fundamentally driven, iterative research process. The analysts conduct extensive backround research on their rms and industries, and use this research to evaluate the size of each company's economic moat and level of business risk, to project future cash ows, and to build a discounted cash ow model. The model generates a fair value estimate for each company. An Associate Director of Stock Research and the Model Auditor review the analysts' assessments of the rms' future cash ows, their DCF models, and the resulting fair value estimates. The Investment Policy Committee also challenges the analysts to defend their research conclusions. At any point in the process, analysts may be asked to make revisions to their inputs or estimates. When the Associate Directors, Model Auditor, and IPC have signed off on the research, the reports are released.
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Example: Analyst Research of Biogen-IDEC By Jill Kiersky, Associate Director of Stock Analysis
When I rst picked up coverage of IDEC Pharmaceuticals in March 2002, I was prepared to analyze another overpriced, underdeveloped biotechnology company. It didn't take long after navigating IDEC's web site, reading through 10Ks and proxy statements, listening to archived quarterly conference calls, and talking to doctors and nurses before I sensed that IDEC wasn't just a struggling biotech. I dug deeper to nd that it was among the few protable biotechnology rms to work its way along the drug development value chain. It had nearly all the components necessary to be a star within the industry. My rst task was to determine how IDEC had achieved its success (and whether the company could repeat it). I examined IDEC's alliances with other rms and visited chief operating officer Bill Rohn to learn how the rm executed on that strategy. He answered questions such as why the company chose to build its manufacturing facilities before it had enough product to utilize the capacity, and how the company attracts and retains talent. I toured the facilities and spoke with key executives to learn about the rm's approach to research and development. Gaining condence that IDEC's strategy was well planned and executed, I assessed the company's economic moat. Without the vast dollars in free cash ow (as a percentage of sales IDEC was exceptionally strong) that more-mature rms Genentech and Amgen were bringing in, could IDEC sustain a consistent (and high) return on its invested capital? For answers, I looked to the demand for IDEC's products. IDEC's leading drug, Rituxan, didnt face any direct competition. I spoke with several physicians and a nurse, who expressed enthusiasm for the drug's benets (which study results conrm). The consensus seemed to be that the drugs benets far outweighed possible side effects such as nausea. Furthermore, several additional indications for the drug were showing positive signs in clinical trials. With IDEC's concrete product demand, manufacturing capacity, and strong scientic capabilities, Morningstars Investment Policy Committee (IPC) signed off on the wide-moat rating I submitted for IDEC.
2 December 2003
Next I developed a discounted cash ow model to calculate an intrinsic value for the rm. As with most drug-development companies Morningstar covers, I used a probability-based sales model for top-line sales growth. The biggest questions included: how many years would it be before IDEC begins earning big-pharmalike margins; what discount rate should I use, and should future cash ows (when the company is presumably more stable and less risky than it is today) be discounted at the same rate or a lower rate; and how long will IDEC earn returns in excess of its cost of capital? To answer the last question, I turned to the economic moat. As a wide-moat rm, IDEC's strong excess returns should fade to its cost of capital over a 20-year period (the standard time period used for Morningstar's wide-moat stocks). For some inputs, I assumed similar biotech industry standards that we use for mature drug-development rms. After discussions with the IPC, I settled on my model inputs and fair value estimate-one that indicated that although the company held promise, the stock was still overvalued. A few months later, news hit that reimbursement for the rm's newest drug, Zevalin, would be lower than expected. Along with the broader marketwise decline in biotech stock prices, this bad news, which I had already factored into my fair value estimate through lower sales assumptions, sent the stock price tumbling. The stock soon hit ve stars, and I was called to meet with Morningstar's IPC. After a pat on the back for realizing the stock wasn't worth the high price it was getting when I rst picked up coverage, the committee wondered if I had been conservative enough in my estimates. I explained that while my earnings estimates didn't differ dramatically from those of other analysts, our valuation approaches were night and day. Most analysts seemed to base their ratings on a price-toearnings (P/E) multiple based on 2004 or 2005 earnings estimates. I felt this logic was awed because the multiple was arbitrarily based on that of other rms in this uncertain biotech market, as was the year the analysts were choosing as a basis for their earnings denominator. Instead, Morningstar's discounted cash ow model takes into consideration the rm's wide economic moat and the fact that IDEC's best years would be several years away, likely not next year or the year after. Because I felt IDEC's moat warrants excess returns fading over an extended period, our model forecasts
2 December 2003
operating earnings and cash ow over a similar period. As a result, we give IDEC credit for more cash ow than a traditional P/E does, particularly when the earnings are so uncertain. In June 2003, IDEC announced its merger with Biogen, and after deeper analysis, my opinion became even more contrarian to the market's negative view. In evaluating the merger, I rst needed to decide whether Biogen's weaker business would dilute IDEC's wide-moat status. Having covered Biogen, I was initially skeptical. IDEC was growing more rapidly and momentum had picked up, while Biogen's only marketed product was losing market share. I was afraid that IDEC's innovation would become lost in Biogen's seemingly less adept research capabilities. I was also wary of the new company's bi-coastal management team. Due to the risks associated with the merger, I sought (and was granted) approval from the IPC to raise my business risk rating from average to above average. Again, I asked COO Rohn some tough questions: Why would a rm as innovative as IDEC want to partner with less-savvy Biogen? Who would really make the tough decisions for the combined rm, and how much control would IDEC executives truly retain? Would he and the other top minds move from California to Massachusetts to the new headquarters? I also dug deeper into each rm's technology and capabilities. Biogen specialized in autoimmune disorders and was dabbling in oncology. IDEC specialized in oncology and had a foothold in autoimmune therapies. Together, each rm had something the other wanted-scientic and manufacturing success in the other rm's niche. A prior research collaboration proved the rms already work well together. Although Morningstar analysts are typically skeptical of mergers and acquisitions, I began to warm to the idea of this particular union. Next, I analyzed the SEC lings, which helped in building my discounted cash ow model for the combined rm. I lowered my expected long-term earnings growth rate--the combined rm's sales and earnings growth will be slower than IDEC alone--and raised my discount rate to account for the risks mentioned above. The combined-rm model shows that free cash ow per share dramatically improves. That's because the company won't have to invest as much as each rm would on its own, so return on capital gets better. The fair value estimate according to my combined-rm model increased from $49 to $52. I concluded
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that, if executed well, the merger could be a good thing for both Biogen and IDEC shareholders. Morningstars IPC was skeptical of my positive opinion. Biogen's sales are nearly three times those of IDEC, so how could Biogen's narrow economic moat not dilute IDEC's wide moat? How much inuence could IDECs California-based management team exert on Biogens Massachusetts-based team? Since I was among the few analysts who liked the merger, the IPC was curious how and why my assumptions differed from peers on the Street (again, the wide moat and valuation approach were the leading differentiators). The higher fair value estimate, along with the rationale for my conclusions and diagrams of the pros and cons, was enough for the IPC to agree with the resulting wide-moat, ve-star rating. Given the strong clinical support and demand for Biogen IDEC's products, the evidence convinces me that the market hasn't been giving either rm enough credit. Since the merger closed in November, Biogen IDEC shares have run up 14% and now receive Morningstar's four-star rating.
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Quality Control
In addition to the ongoing review of each analysts work by the Associate Directors, weve instituted several additional checks on quality.
Daily Review of Stocks
To ensure the quality of research across the department, the Investment Policy Committee (IPC) meets daily with one or more analysts. The committee reviews the analysts recommendation and fair value, asks questions to determine whether the analyst can back up his argument, and either agrees or requests revisions. The committee is made up of, among others, Morningstars Chief of Securities Analysis, Director of Stock Analysis, and Equity Strategist. We feel that this stringent review process raises the quality of our stock coverage and ensures that each analyst sticks to our framework of valuing and analyzing stocks.
Review of Fair Value Estimate Changes
Associate Directors sign off on all fair value changes for their teams. The IPC also reviews most large changes to fair-value estimates.
Review of Rating Changes
The Director of Stock Analysis reviews a list of proposed Morningstar Rating changes daily. The IPC reviews all stocks that reach 5 stars. The analyst must receive the green light in such cases before the 5-star rating can be published.
Review of Proposed Changes to Economic Moat and Business Risk
The IPC approves all changes to economic moat or business risk ratings. These two measures inuence several aspects of our valuation model and overall Morningstar Rating for Stocks.
Quarterly Review of Individual Stock Calls
Its crucial that we analyze our best and worst stock calls on an ongoing basis. The IPC reviews each analysts stock recommendations each quarter and gives feedback to the Associate Directors.
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Model Auditor
A model auditor reviews valuation models across the staff. The auditor checks the internal consistency of each analysts model, makes sure there are no unrealistic assumptions built into the model, and ensures analysts properly incorporate department-wide enhancements.
Review of Changes to the Valuation Model
Whenever a change to the valuation model is proposed, the IPC reviews the change. For any major enhancement, Morningstars quantitative research staff also reviews the change and tests for bugs.
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Analyst Performance Appraisals
Analysts receive feedback from an Associate Director on every Analyst Report they produce. We believe its also important for analysts to receive regular formal feedback on their performance. We do this in two ways: 1. Analysts receive monthly scores based on the quantity and quality of their work. The Director of Stock Analysis compiles and distributes these scores. Associate Directors conduct quarterly performance reviews for the analysts on their teams, with feedback from the Director of Stock Analysis. (The Director of Stock Analysis in turn reviews the Associate Directors.) These reviews include: A written summary of the analysts work, progress toward past goals and future goals. Any feedback from the Investment Policy Committee on the analysts work. The analysts performance in each of the following categories: Knowledge of companies Ability to create insightful investment theses Ability to defend fair value estimates Writing
2.
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Analyst Backgrounds
What kind of analyst does Morningstar look for? We look for the intellectually curious individual with a passion for investing. We place a high value on analysts who think independently and therefore wont parrot the consensus. (Otherwise, why have an analyst staff?) We also stress verbal and written communication skills: An analyst must be able to communicate effectively to our customers, who are mainly individual investors. That means clear, concise prose with little of the jargon so common in investment reports. Our analysts come from a wide variety of backgrounds. Many have previous experience as equity analysts. Several have years of industry experience that gives them hands-on knowledge of various business models. Many have advanced academic degrees outside of the nance area. All of them have a passion for investing. Two thirds of the equity analysts have an MBA, a CFA, or other advanced academic degree. On average they have between three and ve years of tenure at Morningstar and an average of six years of experience in the nancial services industry. Associate Directors and members of the Investment Policy Committee have an average of 10 years of equity research experience. We have 13 CFAs on the equity staff, as well as 17 MBAs.
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Hiring Process
The equity analyst hiring process at Morningstar is quite rigorous. We ask each applicant to submit a resume, cover letter, and writing sample. Then, the applicant takes a 2 1/2 hour writing test asking them to analyze a data set about a ctitious company and decide whether the company would make a good investment. At least two senior analysts or Associate Directors review each set of application materials, including the writing test. We judge each applicant on analytical ability, argument presentation, and writing skills. If the writing test passes muster, we invite the applicant to a rst round of interviews with two or three Associate Directors. If those directors approve the applicant for the next round, they must act as advocates for the applicant, and explain to the Director of Stock Analysis and the Chief of Securities Analysis why they think the applicant would make a good analyst. If we invite the applicant back for a second round of interviews, the applicant meets with the Director of Stock Analysis, the Chief of Securities Analysis, the President of Securities Research and Retail Business Unit, and the departments Director of Human Resources. Each second-round applicant also interviews with Morningstars CEO. Everyone who has met the applicant then expresses his view on the candidate, and the group comes to a consensus about whether the candidate should be hired.
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Equity Research Process and Quality Control

Morningstar Report December

Equity Research Process and Quality Control

Equity Research Process and Quality Control

Associate Director Basic Materials/Utilities

Associate Director Financials

Associate Director Consumer Goods

Associate Director Technology

Associate Director Healthcare

Oil and Gas

Oil and Gas Services

Life Insurance Insurance Brokers

Equity Research Process and Quality Control

Standardized Morningstar Valuation Model

Equity Research Process and Quality Control

Equity Research Process and Quality Control

Analyst Research Flow Chart

Background Research Conducted by Analyst

Research Conclusions Developed by Analyst

Equity Research Process and Quality Control

Equity Research Process and Quality Control

Equity Research Process and Quality Control

Equity Research Process and Quality Control

Equity Research Process and Quality Control

Analyst Performance Appraisals

Equity Research Process and Quality Control

Equity Research Process and Quality Control

Equity Research Process and Quality Control

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