Morningstar Advisor - October/November 2013 - (Page 60)

Gray Matters The Upside Exhibit 2 Portfolio Performance of Five Fair Value Portfolios from January 2003 to March 2013 Overvalued Undervalued Q1 Q2 Q3 Q4 Q5 Ari. Mean 12.33% 11.81% 12.21% 13.27% 19.69% Geo. Mean 10.09% 10.09% 10.48% 11.29% 16.54% Volatility 20.04% 17.59% 17.64% 18.87% 23.43% 0.62 0.67 0.69 0.70 0.84 0.45% 1.42% 2.00% 2.63% 6.33% 0.26 1.28 2.07 2.22 4.07 Sharpe ratio Alpha Alpha t-stat Downside Capture 1.29 1.10 1.05 1.06 1.20 Upside Capture 1.36 1.21 1.19 1.24 1.57 –0.62 –0.66 –0.67 –0.26 0.10 Skewness James X. Xiong, Ph.D., CFA, is a senior research consultant with Morningstar Investment Management. Warren Miller, CFA, is vice president, global quantitative research with Morningstar. Thomas Idzorek, CFA, is president of Morningstar’s investment management division. Exhibit 3 Returns by Morningstar Fair Value for U.S. Stocks $ Q1 5 Overvalued Q2 Q3 Q4 We demonstrate that Morningstar’s fair value estimate can predict stocks’ future performance. Stocks that were undervalued outperformed other stocks significantly over the time period studied. The annual geometric return for the most undervalued quintile was 6.45 percentage points higher compared with the most overvalued quintile over the last 10 years. On a risk-adjusted basis, the Sharpe ratio for the most undervalued stock quintile was 0.22 basis points higher (0.84–0.62) than the Sharpe ratio for the most overvalued quintile. In addition, the most undervalued stocks have positive skewness, indicating a large upside potential. K Q5 Undervalued Note The Morningstar Rating for stocks identifies stocks trading at a discount or premium to Morningstar’s fair value estimates. Stocks trading at large discounts to our fair value estimates generally receive 4 or 5 stars. Every issue in By the Numbers (Page xx), we list 4- and 5-star stocks but with a high-quality twist— stocks with wide moats. We believe that undervalued stocks with significant competitive advantages make attractive long-term holdings. 4 3 2 1 0 12/2002 12/2003 12/2004 12/2005 12/2006 12/2007 12/2008 12/2009 12/2010 12/2011 model, which is composed of the three Fama-French factors (Fama and French, 1993), and a momentum factor (Jegadeesh and Titman, 1993). The alpha is the regression intercept and the t-stat of alpha is simply the t-stat of the regression intercept. The annualized alpha for the Q5 portfolio is quite large and statistically significant at 6.33%. In sharp contrast, the alpha for the Q1 portfolio is only 0.45%. The skewness, downside capture, and upside capture in Exhibit 2 are measured on 60 Morningstar Advisor October/November 2013 12/2012 the monthly return series over the entire period for the five portfolios. Skewness for Q1 and Q5 are –0.62 and 0.1, respectively, indicating that the most undervalued stock composite has positive skewness. The undervalued stock composite has the largest upside capture, which might have contributed to the positive skewness. Exhibit 3 shows the growth of value for Q1 and Q5 for U.S. stocks. For the entire period, the most undervalued stocks dominated all of the other quintiles. References Carhart, Mark M., 1997, “On Persistence in Mutual Fund Performance,” Journal of Finance, vol. 52, pp. 57–82. Fama, Eugene F. and Kenneth R. French, 1993, “Common Risk Factors in the Returns on Stocks and Bonds,” Journal of Financial Economics, vol. 33 (1), pp. 3–56. Fama, Eugene F. and James D. MacBeth, 1973, “Risk, Return, and Equilibrium: Empirical Tests,” Journal of Political Economy, vol. 81, pp. 607–636. Jegadeesh, Narasimhan and Sheridan Titman, 1993, “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency,” Journal of Finance, vol. 48, pp. 65–91.

Table of Contents for the Digital Edition of Morningstar Advisor - October/November 2013

Morningstar Advisor - October/November 2013
Contents
Contributors
Letter From the Editor
How to Make Social Media Work for You
Do Mutual Funds Still Have a Role?
More Personal Than Finance
How to Handle Your TIPS Positions
A Real Estate Veteran Starts From Scratch
Investments á la Carte
Investment Briefs
When to Say No
Take a Guarded Approach to Homebuilders
Fund Distribution Has Been Turned on Its Head. Now What?
Winning the Distribution Battle
Active ETFs Wait for Their Heyday
A Fund Firm Defies Indexing Trend
Piloting New Channels
A Good Fit
The Predictive Power of Fair Value Estimates
Does Being Prudent Pay Off?
Utilizing Utilities’ Total Return
Stuck in the Middle Is Not a Bad Place to Be
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
The Good Guys Win

Morningstar Advisor - October/November 2013