What's a Stock Rating Really Worth?

A couple of weeks ago, I warned readers to take advice from analysts, columnists and other "experts," including me, with a grain of salt. But what I didn't touch on was ratings. Star ratings, Top 10 ratings and numerical ratings are handy ways to get an investor's attention. But what are they worth?

What brings this to mind is Morningstar's recent introduction of star ratings for stocks, much like the ones it famously gives to mutual funds. Perhaps it's an exaggeration, though not much of one, to say that Morningstar built its reputation on star ratings. So I expect investors will pay attention to its stars for stocks. They're available only to subscribers for $99 a year.

I'm both a fan and a critic of the fund stars. The idea was ingenious. And back in my days as a beginning investor, I even suggested that investors select from those funds that carry five stars. Most investors want to simplify their search, and I saw it as a way to eliminate noise and cut to the chase.

Once I got a bit savvier, though, I realized that the star system was flawed as a way to pick funds because it looks backward, emphasizing recent past performance. The better the performance, the higher the rating. That puts too much momentum into the ratings.

In other words, five-star funds are likely to have performed well in recent days. Consider, for example, (FBTAX)Fidelity Advisor Biotechnology. It had five stars at its peak and one star at its trough. Think about it a minute and you'll see why. Biotechnology is a cyclical business. When it has a good run, this fund does well and gets a good rating. But those five stars probably signal the end of a run for biotech. A better time to buy biotech -- and this fund -- is when it has one lowly star.

Different Approach to Stocks

Morningstar has acknowledged these -- what shall I call them? -- "characteristics" of its star ratings for funds. It's not surprising to see, then, that the stock ratings turn the fund stars on their heads. The stock ratings are based on what Morningstar's analysts see as a stock's intrinsic value. So a five-star stock trades below its fair value -- in the analyst's opinion -- and offers a good buying opportunity.

The analysts use a discounted cash-flow model to determine the worth of each business, said Don Phillips, Morningstar managing director. In other words, the analysts estimate the present value of all future payments a business will generate. They then compare that with the stock's current price. The approach similar to that used by value investors like Warren Buffett at Berkshire Hathaway.

I took a look at some of the five-star stocks, which included Nokia (NOK), Global Crossing (GBCHP), Sun Microsystems (SUNW), Oracle (ORCL), EMC (EMC), Nextel (NXTL), AMCC Applied Micro Circuits (AMCC), Apple Computer (AAPL) and JDS Uniphase (JDSU).

I clicked on JDS Uniphase because I own it and wanted to hear something good about it. I was disappointed. The stock was trading at $9.13 in early August; the analyst considered its fair value to be $12.

A Different Take From StockScouter

But things got worse. I decided to compare the five-star ratings from Morningstar with the ratings of MSN Money's new StockScouter system. StockScouter assigns stocks a numerical rating from 1 to 10, with 10 being the best. JDS Uniphase got a 4, with the notation that it is expected to underperform the market over the next six months with very high risk. Not much of a recommendation.

When I took a look at the stocks awarded a 10 by StockScouter, I saw many in the financial services industry and quite a few energy players. I also learned that StockScouter forecasts that over the next year, growth stocks and large-cap stocks will be neutral and technology will be out of favor.

What are we to make of this? It's a nice lesson in analysis. StockScouter gives each stock a report card with grades from A to F in four different areas. The first area is fundamentals, which Scouter defines as earnings growth and the capacity to beat analysts' estimates, among other things. Those are not precisely what I would call fundamentals, which are generally thought of more as balance-sheet analysis. What Scouter is looking for, I think, is momentum potential in the stock: some lift-off power.

The second category on Scouter, ownership, can be key. Scouter gives the stock a grade based on whether it is being acquired by owners and insiders. Insider ownership is often a reliable predictor of performance, as insiders generally know things about the company that you and I don't.

The third grade is for valuation, which assesses the stock's price relative to sales, earnings and expected growth, and the final category is technical analysis. (For more details on how Scouter works and how these four categories are mixed together to come up with an overall score, see Jon Markman's column, A Stock-Picker That's Always on the Lookout.

Different Systems, Different Ratings

Morningstar's analysts and the Scouter are looking for different things. Morningstar offers what I consider a value-based analysis, while the Scouter wraps a number of things into one, including an economic and sector outlook and projections for the company.

Of course, both rely on the talent of the analysts involved, and these experts can be as fallible as the rest. It's best not to buy a stock or fund or any other investment based solely on its rating, just as we shouldn't buy an investment based on what an analyst, a columnist or any other expert has to say.

They can be a good starting point, a source of fresh ideas, but each of us is ultimately responsible for sifting through this information.

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