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Course 207
Examining a Stock Fund's Portfolio, Part 1


Most of us wouldn't buy a new home just because it looked good from the outside. We would do a thorough walk-through first. We'd examine the furnace. We'd check for a leaky roof. We'd look for cracks in the foundation.

Mutual fund investing requires the same careful investigation. You need to do more than give a fund a surface-level once-over before investing in it. Knowing that the fund has been a good risk-adjusted performer for investors in the past isn't enough to merit a financial commitment from you today. You need to understand what's inside the fund's portfolio now or how it invests.

Such information, which tells you how your fund will likely behave, helps you set realistic expectations. A fund manager who quickly buys and sells a compact portfolio of high-priced, fast-growing companies will produce different results from a manager who owns 300 stocks of larger companies with lower earnings but cheap prices. Further, unless you know what a fund owns, you can't determine what role the fund fills in your portfolio. For a fund to fill the large-cap growth portion of your portfolio, you need to know that it actually invests in large-growth companies. Finally, examining a fund's portfolio can tip you off to risks the fund may be harboring risks that might not have surfaced yet.

For U.S. stock funds, you'll want to know a handful of things, starting with the size of the companies in which the fund invests, as well as how much the manager is willing to pay for these companies and how quickly they're growing. A quick way to identify the relative size and characteristics of the stocks a fund owns is the Morningstar style box, which appears on the Morningstar fund report.

The Style Box Defined

The Morningstar style box is a nine-square grid that gives you a quick and clear picture of a fund's investment style. The style box classifies funds by whether they own large-, mid-, or small-capitalization stocks, and by whether those stocks have growth or value characteristics or land somewhere in between.

We'll look first at the stock size and growth and value dimensions and then explore the ways in which they come together in the style box.

Company Size. A company's size is commonly measured in terms of its market capitalization (or market cap), which is based on the total market value of its shares. A company's market capitalization fluctuates with the share price, which usually, though not always, reflects the health and growth (or expected growth) of its fundamental operations: sales, earnings, etc.

Investors typically divide companies into three size bands: large cap (for companies with the biggest market capitalization), mid-cap, and small cap. Larger companies are often more established and tend to be more predictable (and less susceptible to operational shocks) than smaller companies. Thus, on average, their market capitalizations tend to be less volatile than those of small- and mid-cap companies.

Rather than assigning a fixed number of "large cap" or "small cap" stocks, Morningstar uses a flexible system that isn't adversely affected by overall movements in the market. Large-cap stocks are defined as the group that accounts for the top 70% of the capitalization of each geographic area; mid-cap stocks represent the next 20%; and small-cap stocks represent the balance.

Growth and Value Metrics. Morningstar determines a fund's style whether it invests in "growth" or "value" stocks by applying a set of growth metrics and a set of value metrics to each individual stock the fund holds. These characteristics are compared with those of other stocks within the same capitalization band, arriving at a score for each company that ranges from zero to 100. For the purpose of Morningstar's style box, we group each stock into one of seven style "zones" based on geographic locales: the United States, Latin America, Canada, Europe, Japan, Asia (excluding Japan), and Australia/New Zealand.

We begin by measuring the "value" aspects of a stock by comparing the price of one share of a stock with the company's projected earnings per share. The other 50% of the value score comes from four equally weighted historical measures: a stock's price/sales (P/S), price/book (P/B), and price/cash flow (P/CF) ratios, as well as its dividend yield. We rank these measures against those of other U.S. stocks in the same size range, and their combined rankings go into the stock's value score.

The growth score similarly uses one forward-looking measure and four equally weighted historical metrics. Half of the stock's growth score comes from ranking its long-term projected earnings growth rate against those of other U.S. stocks in the same capitalization band. Next, we rank the stock based on its historical earnings growth, sales growth, cash flow growth, and book-value growth rates against other U.S. stocks in its market-cap band. The resulting rankings make up the other 50% of the stock's growth score.

We calculate a stock's style score by subtracting its value score from its growth score, resulting in scores that can range from -100 to 100. A stock with a style score of -100 would be a cheap, high-yielding, low-growth stock, while one with a score of 100 would have no yield and very high historical and projected growth rates. We classify stocks in the middle as "core" stocks. The dividing lines between value, core, and growth can vary over time with changes in the market, but on average each style will include approximately one third of all stocks in each market-cap range.

Tackling the Funds. A stock fund is an aggregation of individual stocks, and its style is determined by the style assignments of the stocks it owns. By plotting all of a fund's stocks on the stock style grid, the range of stock styles included in the fund immediately becomes apparent. An asset-weighted average of the underlying stocks' style and size scores determines a fund's placement in the Style Box.

Style box assignments for stocks are updated each month. Assignments for funds are recalculated whenever Morningstar receives updated portfolio holdings for the fund.

Just as with individual stocks, the thresholds between value, blend, and growth funds vary to some degree over time, as the distribution of stock styles changes in the market. However, on average, the three fund styles each account for approximately one third of each market-cap range.

Putting the Morningstar Style Box to Work

When you look at a fund's Morningstar style box, you immediately get some insight into the manager's investment strategy. A growth portfolio will mostly contain higher-priced companies that the manager believes have the potential to increase earnings faster than the rest of the market. A value orientation, on the other hand, means the manager buys stocks that are cheap, but that could eventually see their worth recognized by the market. A blend fund will mix the two philosophies: The portfolio may contain growth stocks and value stocks, or it may contain stocks that exhibit both characteristics.

Because the style box shows you how a fund actually invests, you can use it to get an idea of what sort of risks the fund harbors today. A fund that owns smaller, more expensive stocks is bound to be more volatile than one holding large, cheap names. And the style box allows you to quickly see where a fund's portfolio lands.

Quiz 207
There is only one correct answer to each question.

1 The Morningstar style box does not summarize which of the following?
a. The size of the stocks the fund owns.
b. The value or price of the stocks the fund owns.
c. How rapidly a fund manager buys and sells stocks.
2 What is a company's market capitalization?
a. A company's size based on the market value of its shares.
b. A company's size based on its earnings.
c. A company's size based on its sales.
3 The stock of which type of company is likely to be the least volatile?
a. A small size company.
b. A midsize company.
c. A large size company.
4 In gauging the value of a stock, examine its:
a. Market capitalization.
b. Price/book ratio.
c. Earnings-growth rate.
5 Which type of fund is likely to be the most volatile?
a. A large-cap value fund.
b. A mid-cap blend fund.
c. A small-cap growth fund.
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