Equity Research Process and Quality Controlcorporate.morningstar.com/us/.../MorningstarEquityResearchProcess... · Equity Research Process and Quality Control ... To ensure the quality

Equity Research Process andQuality 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.

© 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.

Equity Research Process and Quality Control | 2 December 2003

2

Introduction

To ensure the quality of Morningstar’s equity research, we have developed arigorous system of checks and balances. Each of the following elements plays animportant role, and we discuss each in depth below.

3 Department Structure

3 Standardized Morningstar Valuation Model

3 Research Workflow

3 Quality Control

3 Analyst Performance Appraisals

3 Analyst Backgrounds

3 Hiring Process



3

Department Structure

As Morningstar has built up its equity staff over the past several years, we’vefocused on building a team of industry specialists.

Reporting to the Director of Stock Analysis are currently five Associate Directors,each of whom heads up a team of five to eight analysts working in closely relatedfields. The Associate Directors review the work of the analysts under them, andgrant final approval for publication of all Analyst Reports.

This structure allows the analysts on each team to both specialize in a particularindustry and learn from others covering companies in related fields. Under theAssociate Director in charge of financials, for example, are individual analystsspecializing in insurance, regional banks, asset managers, brokerages, and lifeinsurance.

The Associate Directors work with the Director of Stock Analysis to formulatereasonable industry and sector forecasts that feed into our valuation models. Wedon’t want our hardware analyst forecasting 10% long-term growth in personal-computer demand, for example, if our software analyst is forecasting 15%. TheAssociate Directors are then responsible for ensuring that our analysts areconsistent in the way they incorporate industry or macroeconomic trends such ashousing 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.)

Oil and Gas

Oil and Gas Services

Utilities

Associate DirectorBasic Materials/Utilities

Specialty Finance

Asset Managers

Banks

Insurance - Property/Casualty

REITs

Brokerages

Regional Banks

Life InsuranceInsurance Brokers

Associate DirectorFinancials

Media

Retail

Specialty Retail

Restaurants

Beverages

Associate DirectorConsumer Goods

Semiconduc

Telcommunica

Software

Business Serv

Hardwar

Associate DirectorTechnology

Pharmaceuticals

Biotechnology

Medical Devices

Health Services

Associate DirectorHealthcare

Director of Stock Analysis

Transportation



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All analysts use the same internally developed discounted cash flow model. (Wehave created variations on the model for industries such as banks and insurance.)This helps ensure consistency across the department, and makes it easier forAssociate Directors and the Director of Stock Analysis to perform quality checks.If each analyst used a different model, each manager would need to learn thatmodel 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. Forexample, an analyst cannot forecast an earnings growth rate that isn’t consistentwith the company’s return on capital and its investment rate. Also, we alwaysassume a company cannot earn above-average returns on capital forever; eventuallythose returns will regress back to the cost of capital. The model also provides theanalyst with long-term trends in a wide variety of ratios that alert the analyst tounrealistic assumptions. Finally, long-term trends such as the rate of decay ofreturns on capital (as they regress to the company’s cost of capital) are standardacross models.

Standardized Morningstar Valuation Model



6

Research Workflow

Whenever an analyst writes a new Analyst Report, the Associate Director whomanages the analyst reviews the work. Only when the Associate Director issatisfied will the work be submitted for a final edit by our copyediting staff.

Each analyst takes the following steps:

1. Perform Background Research

3 Examine the firm’s financial statements and filings

3 Contact the firm’s management and investment-relations personnel

3 Contact competitors, suppliers, and distributors

3 Attend trade shows where these constituents congregate

3 Visit the company

3 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.

3 Build a discounted cash flow model, which leads to the creation of a fair value estimate of the stock.

3 Write an Analyst Report explaining assumptions and key factors that influenced the projection of future cash flows.The report also includes a detailed discussion of the firm’s competitive position, business strategy, and “bull and bear” view points on the stock.

3. Submit the Report for Review

3 An Associate Director or the Model Auditor reviews the valuation model

3 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.

3 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-profile companies, reports are updated at least every six weeks.

3 When news happens, the analyst publishes a Stock Analyst Note on the company.

3 The analyst participates in conference calls, analyzes earnings releases, and updates the fair value estimate or writes a Stock Analyst Note as events warrant.



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Analyst Research Flow Chart

Background Research Research Conclusions

Financial Statements

Management Interview

Competitors Interview

Suppliers Interview

Distributors Interview

Customers Interview

Industry Tradeshows

Discounted Cash Flow Model

Fair Value Estimate

Investment Relations

Conference Calls

Trade Publications

Analyst Report D R A F T

Business Risk Analysis

Moat Analysis

Future Cash Flows Future Cash Flows


Fair Value Estimate



Fair Value Estimate



Moat Analysis

Future Cash Flows


Fair Value Estimate

Analyst Report


Moat Analysis

Future Cash Flows

Conducted by Analyst Developed by Analyst Associate Director and Model Auditor

Investment PolicyCommittee

Evaluations Release

Morningstar analysts engage in a fundamentally driven, iterative research process. The analysts conduct extensive backround research on their firms and industries, and use thisresearch to evaluate the size of each company's economic moat and level of business risk, to project future cash flows, and to build a discounted cash flow model. The modelgenerates a fair value estimate for each company. An Associate Director of Stock Research and the Model Auditor review the analysts' assessments of the firms' future cashflows, their DCF models, and the resulting fair value estimates. The Investment Policy Committee also challenges the analysts to defend their research conclusions. At any pointin 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, thereports are released.



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Example: Analyst Research of Biogen-IDEC

By Jill Kiersky, Associate Director of Stock Analysis

When I first picked up coverage of IDEC Pharmaceuticals in March 2002, I wasprepared to analyze another overpriced, underdeveloped biotechnology company. Itdidn't take long after navigating IDEC's web site, reading through 10Ks and proxystatements, listening to archived quarterly conference calls, and talking to doctorsand nurses before I sensed that IDEC wasn't just a struggling biotech. I dugdeeper to find that it was among the few profitable biotechnology firms to work itsway along the drug development value chain. It had nearly all the componentsnecessary to be a star within the industry.

My first task was to determine how IDEC had achieved its success (and whetherthe company could repeat it). I examined IDEC's alliances with other firms andvisited chief operating officer Bill Rohn to learn how the firm executed on thatstrategy. He answered questions such as why the company chose to build itsmanufacturing facilities before it had enough product to utilize the capacity, andhow the company attracts and retains talent. I toured the facilities and spoke withkey executives to learn about the firm's approach to research and development.

Gaining confidence that IDEC's strategy was well planned and executed, I assessedthe company's economic moat. Without the vast dollars in free cash flow (as apercentage of sales IDEC was exceptionally strong) that more-mature firmsGenentech and Amgen were bringing in, could IDEC sustain a consistent (andhigh) return on its invested capital?

For answers, I looked to the demand for IDEC's products. IDEC's leading drug,Rituxan, didn’t face any direct competition. I spoke with several physicians and anurse, who expressed enthusiasm for the drug's benefits (which study resultsconfirm). The consensus seemed to be that the drug’s benefits far outweighedpossible side effects such as nausea. Furthermore, several additional indications forthe drug were showing positive signs in clinical trials. With IDEC's concreteproduct demand, manufacturing capacity, and strong scientific capabilities,Morningstar’s Investment Policy Committee (IPC) signed off on the wide-moatrating I submitted for IDEC.



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Next I developed a discounted cash flow model to calculate an intrinsic value forthe firm. As with most drug-development companies Morningstar covers, I used aprobability-based sales model for top-line sales growth. The biggest questionsincluded: how many years would it be before IDEC begins earning big-pharma-like margins; what discount rate should I use, and should future cash flows (whenthe company is presumably more stable and less risky than it is today) bediscounted at the same rate or a lower rate; and how long will IDEC earn returnsin excess of its cost of capital? To answer the last question, I turned to theeconomic moat. As a wide-moat firm, IDEC's strong excess returns should fade toits cost of capital over a 20-year period (the standard time period used forMorningstar's wide-moat stocks). For some inputs, I assumed similar biotechindustry standards that we use for mature drug-development firms. Afterdiscussions 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 stillovervalued.

A few months later, news hit that reimbursement for the firm's newest drug,Zevalin, would be lower than expected. Along with the broader marketwise declinein biotech stock prices, this bad news, which I had already factored into my fairvalue estimate through lower sales assumptions, sent the stock price tumbling. Thestock soon hit five 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 wasgetting when I first picked up coverage, the committee wondered if I had beenconservative enough in my estimates. I explained that while my earnings estimatesdidn't differ dramatically from those of other analysts, our valuation approacheswere night and day. Most analysts seemed to base their ratings on a price-to-earnings (P/E) multiple based on 2004 or 2005 earnings estimates. I felt this logicwas flawed because the multiple was arbitrarily based on that of other firms in thisuncertain biotech market, as was the year the analysts were choosing as a basis fortheir earnings denominator.

Instead, Morningstar's discounted cash flow model takes into consideration thefirm's wide economic moat and the fact that IDEC's best years would be severalyears away, likely not next year or the year after. Because I felt IDEC's moatwarrants excess returns fading over an extended period, our model forecasts



10

operating earnings and cash flow over a similar period. As a result, we give IDECcredit for more cash flow than a traditional P/E does, particularly when theearnings 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. Inevaluating the merger, I first needed to decide whether Biogen's weaker businesswould dilute IDEC's wide-moat status. Having covered Biogen, I was initiallyskeptical. IDEC was growing more rapidly and momentum had picked up, whileBiogen's only marketed product was losing market share. I was afraid that IDEC'sinnovation would become lost in Biogen's seemingly less adept researchcapabilities. 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) approvalfrom the IPC to raise my business risk rating from average to above average.

Again, I asked COO Rohn some tough questions: Why would a firm as innovativeas IDEC want to partner with less-savvy Biogen? Who would really make thetough decisions for the combined firm, and how much control would IDECexecutives truly retain? Would he and the other top minds move from Californiato Massachusetts to the new headquarters? I also dug deeper into each firm'stechnology and capabilities. Biogen specialized in autoimmune disorders and wasdabbling in oncology. IDEC specialized in oncology and had a foothold inautoimmune therapies. Together, each firm had something the other wanted--scientific and manufacturing success in the other firm's niche. A prior researchcollaboration proved the firms already work well together. Although Morningstaranalysts are typically skeptical of mergers and acquisitions, I began to warm to theidea of this particular union.

Next, I analyzed the SEC filings, which helped in building my discounted cashflow model for the combined firm. I lowered my expected long-term earningsgrowth rate--the combined firm's sales and earnings growth will be slower thanIDEC alone--and raised my discount rate to account for the risks mentionedabove. The combined-firm model shows that free cash flow per share dramaticallyimproves. That's because the company won't have to invest as much as each firmwould on its own, so return on capital gets better. The fair value estimateaccording to my combined-firm model increased from $49 to $52. I concluded



11

that, if executed well, the merger could be a good thing for both Biogen andIDEC shareholders.

Morningstar’s IPC was skeptical of my positive opinion. Biogen's sales are nearlythree times those of IDEC, so how could Biogen's narrow economic moat notdilute IDEC's wide moat? How much influence could IDEC’s California-basedmanagement team exert on Biogen’s Massachusetts-based team? Since I was amongthe few analysts who liked the merger, the IPC was curious how and why myassumptions differed from peers on the Street (again, the wide moat and valuationapproach were the leading differentiators). The higher fair value estimate, alongwith the rationale for my conclusions and diagrams of the pros and cons, wasenough for the IPC to agree with the resulting wide-moat, five-star rating.

Given the strong clinical support and demand for Biogen IDEC's products, theevidence convinces me that the market hasn't been giving either firm enoughcredit. Since the merger closed in November, Biogen IDEC shares have run up14% and now receive Morningstar's four-star rating.



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Quality Control

In addition to the ongoing review of each analyst’s work by the AssociateDirectors, we’ve instituted several additional checks on quality.

Daily Review of Stocks

To ensure the quality of research across the department, the Investment PolicyCommittee (IPC) meets daily with one or more analysts. The committee reviewsthe analyst’s recommendation and fair value, asks questions to determine whetherthe analyst can back up his argument, and either agrees or requests revisions. Thecommittee is made up of, among others, Morningstar’s Chief of SecuritiesAnalysis, Director of Stock Analysis, and Equity Strategist. We feel that thisstringent review process raises the quality of our stock coverage and ensures thateach 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 alsoreviews most large changes to fair-value estimates.

Review of Rating Changes

The Director of Stock Analysis reviews a list of proposed Morningstar Ratingchanges daily. The IPC reviews all stocks that reach 5 stars. The analyst mustreceive 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 influence several aspects of our valuation model and overallMorningstar Rating for Stocks.

Quarterly Review of Individual Stock Calls

It’s crucial that we analyze our best and worst stock calls on an ongoing basis. TheIPC reviews each analyst’s stock recommendations each quarter and gives feedbackto the Associate Directors.



13

Model Auditor

A model auditor reviews valuation models across the staff. The auditor checks theinternal consistency of each analyst’s model, makes sure there are no unrealisticassumptions built into the model, and ensures analysts properly incorporatedepartment-wide enhancements.

Review of Changes to the Valuation Model

Whenever a change to the valuation model is proposed, the IPC reviews thechange. For any major enhancement, Morningstar’s quantitative research staff alsoreviews the change and tests for bugs.



14

Analyst Performance Appraisals

Analysts receive feedback from an Associate Director on every Analyst Report theyproduce. We believe it’s also important for analysts to receive regular formalfeedback 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.

2. Associate Directors conduct quarterly performance reviews for the analystson 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 analyst’s work, progress toward past goals

and future goals. • Any feedback from the Investment Policy Committee on the

analyst’s work.• The analyst’s performance in each of the following categories:

• Knowledge of companies• Ability to create insightful investment theses• Ability to defend fair value estimates• Writing



15

Analyst Backgrounds

What kind of analyst does Morningstar look for? We look for the intellectuallycurious individual with a passion for investing. We place a high value on analystswho think independently and therefore won’t 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 aremainly individual investors. That means clear, concise prose with little of thejargon so common in investment reports.

Our analysts come from a wide variety of backgrounds. Many have previousexperience as equity analysts. Several have years of industry experience that gives them hands-on knowledge of various business models. Many have advancedacademic degrees outside of the finance area. All of them have a passion for investing.

Two thirds of the equity analysts have an MBA, a CFA, or other advancedacademic degree. On average they have between three and five years of tenure atMorningstar and an average of six years of experience in the financial servicesindustry. Associate Directors and members of the Investment Policy Committeehave an average of 10 years of equity research experience. We have 13 CFAs on theequity staff, as well as 17 MBAs.



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Hiring Process

The equity analyst hiring process at Morningstar is quite rigorous. We ask eachapplicant to submit a resume, cover letter, and writing sample. Then, the applicanttakes a 2 1/2 hour writing test asking them to analyze a data set about a fictitiouscompany and decide whether the company would make a good investment. Atleast two senior analysts or Associate Directors review each set of applicationmaterials, including the writing test.

We judge each applicant on analytical ability, argument presentation, and writingskills. If the writing test passes muster, we invite the applicant to a first round ofinterviews with two or three Associate Directors. If those directors approve theapplicant for the next round, they must act as advocates for the applicant, andexplain to the Director of Stock Analysis and the Chief of Securities Analysis whythey think the applicant would make a good analyst.

If we invite the applicant back for a second round of interviews, the applicantmeets with the Director of Stock Analysis, the Chief of Securities Analysis, thePresident of Securities Research and Retail Business Unit, and the department’sDirector of Human Resources. Each second-round applicant also interviews withMorningstar’s CEO.

Everyone who has met the applicant then expresses his view on the candidate, andthe group comes to a consensus about whether the candidate should be hired.

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