Making Sense of the Morningstar Style Box

Tom W.

You don't say whether this investment is a stock or a mutual fund, but I assume it's a stock from your use of the term "core". (The middle column of Morningstar's stock style box is called "core", while the middle column of the stock-fund style box is called "blend".) However, this question is relevant for funds as well, since a fund's style box is determined by the style boxes of the individual stocks in its portfolio. Exploring this question can provide some insights into how the style box actually works in practice, and can highlight the important difference between a fund's style box and its Morningstar category, among other things.

Style Box Basics
First, let's consider how Morningstar determines where a stock falls in the style box. The vertical axis (large/mid/small) is based on market capitalization. The stocks that make up the top 70% of the market capitalization in our stock universe are classified as large caps; those in the next 20% are mid-caps; and those in the bottom 10% are small caps. Of the 5,421 stocks in our database with style boxes (as of Sept. 30, 2004), 291 are large caps, 793 are mid-caps, and 4,337 are small caps.

The horizontal axis (value/core/growth) is based on a value score and a growth score, which we combine to get a total score ranging from -100 (extreme value) to 100 (extreme growth). Half of the value score is based on the price/projected-earnings ratio (forward P/E), and the other half is evenly divided between price/book ratio, price/sales, price/cash flow, and dividend yield. Lower valuations push a stock toward the value end of the spectrum, higher valuations push it toward the growth end. Half of the growth score is based on long-term projected earnings growth, and the other half is evenly divided between historical earnings growth, sales growth, cash flow growth, and book value growth. Higher growth rates push a stock toward the growth end of the spectrum, and lower growth rates push it toward the value end.

Within each size grouping (large cap, mid-cap, small cap), we divide stocks into roughly equal groups according to their scores. The most value-like group gets classified as value, the middle group gets classified as core, and the most growth-like group gets classified as growth. The criteria for classifying a stock as value, core, or growth will be slightly different for large caps, mid-caps, and small caps, and can change over time as the market changes. A given stock can also drift from one style-box category to another, if its valuations change and its market cap goes up or down.

The style box for an equity mutual fund is based on the asset-weighted market caps (for the vertical axis) and value-growth scores (for the horizontal axis) of all the stocks in its portfolio. If a fund owns mostly large-growth stocks, for example, it will probably fall in the large-growth section of the style box. If it owns stocks spanning the entire value-growth spectrum, it may land in the blend column, perhaps leaning toward either value or growth. A fund can also drift from one area of the style box to another--due to changes in the portfolio as well as changes in the style boxes of individual holdings.

(For more details on the style box, check out Russ Kinnel's 2002 columns "The New Morningstar Style Box" and "New Style Box Captures the Whole Picture", as well as our PDF fact sheet on style-box methodology.) 

Style Box Drift and Fund Categories
Both stocks and funds sometimes land near the border between two areas of the style box. When this happens, it's not uncommon for them to occasionally switch back and forth between two boxes. That's apparently what happened with the stock Tom asked about--it was so close to the line separating core from growth that it moved from large core to large growth and back again within a few weeks.

That's not a particularly big issue for stocks, where sector and stock type are more important and relevant classifications than style box. A fund's style box, however, is a central part of its identity. Whether a fund is classified as value, blend, or growth (or large cap, mid-cap, or small cap) will have a big influence on how people use it in their portfolios, and will also affect the peer group people compare it with. We update a fund's style box whenever we get a new portfolio, sometimes as often as once a month. It would be disconcerting and confusing to change a fund's style every month, or even once a year.

That's why we use each fund's Morningstar category, rather than its current style box, as a basis for comparison with other funds. We assign a fund's category based on the style-box characteristics of its portfolio over the past three years, and we only change it if the fund's strategy shows evidence of a long-term shift. These categories are meant to be stable over time, to minimize the effect of temporary style-box shifts. For an extremely consistent, middle-of-the-road fund such as  Vanguard 500 Index , the portfolio's style box classification may always match its Morningstar category. For other funds, especially those that hold stocks with a wide range of sizes and growth characteristics, style box and category can often differ.

As an example of the latter type, consider  Brandywine Blue . This used to be a mid-cap growth fund like its more-famous sibling  Brandywine Fund , but in 1999, Brandywine Blue's management made a conscious decision to own more large-cap stocks. The fund's style box inched up into large-growth territory, but not until late 2000 did we change its category from mid-cap growth to large growth. It has stayed in the large-growth category ever since then, even though management owns quite a few large-core and mid-cap stocks. The fund's style box has bounced back and forth between large growth and large blend, due to its volatility and high turnover. It was in large blend during most of 2001, moved into large growth in mid-2002, and has shifted between those two style boxes no fewer than five times since then. It was in large growth during most of 2003, but its most recent portfolio lands it in large blend.

This is an extreme example, but it does illustrate how frequently a fund's style box and category can diverge in the short term. Among other things, that's relevant for the Morningstar Rating for funds, which is based on a fund's historical risk-adjusted performance relative to its category peers. If we based the star rating on a fund's style-box peers instead, that peer group could potentially change with every portfolio, and there would be a lot more potential volatility in the relative performance of a fund like Brandywine Blue. As it is, we review funds for potential category changes just twice a year, in May and November, and we only make changes if they're warranted by a permanent shift in strategy.