Morningstar Magazine - February/March 2014 - (Page 39)

The Valuation Angle of Active Investing By Magdalena Mroczek The wider the dispersion of equity valuations, the greater potential for outperformance. In the previous article, my colleague Lee Davidson analyzed the historical performance of mutual funds to determine which fund categories have provided the largest opportunities for managers to generate alpha. In this article, I dissect the global equity landscape based on valuations to find the sectors and regions that we believe contain the most opportunities for active managers to outperform a benchmark. We start with a simple assumption--that we can estimate the potential for outperformance by active management by examining the dispersion of an equity category's valuations. That is, equity categories with tightly clustered valuations should experience a narrow distribution of future returns; therefore, an active investor will see limited opportunities to outperform a passive index in those categories. On the other hand, large dispersions offer a lot of potential to reward skilled stock-pickers. In this study, I will search for the equity investment categories with the most potential for active investors using Morningstar quantitative valuations. First, we will examine U.S. stocks by sector, and then, we will expand our focus to global regions and countries. valuation methodology. Morningstar's equity analysts cover about 1,500 companies, a fraction of the globe's tradable equity universe. We created the quantitative equity ratings to bring Morningstar's view on valuation to a much larger universe of stocks than our analyst staff is capable of covering. Our methodology is detailed, but in short, we use a small number of easily observable input variables and a sophisticated statistical algorithm to approximate our analyst-driven valuations as faithfully as possible. This technique allows us to assign valuations to more than 32,000 public companies traded on 64 exchanges worldwide. Finding Attractive Active Investments Using Valuation Dispersions To surpass passive index returns, managers need to select stocks that will differ positively from the average. Because the majority of companies in an equity category with a narrow valuation distribution should have tightly distributed future returns, it is more difficult for an investor to find companies with returns differing from the aggregate than if he or she looks in a category with widely distributed valuations. It follows, then, that the greatest opportunities for outperformance are in categories with a wide valuation distribution. Quantitative Equity Ratings Methodology Before diving into the finer points of our analysis, we should explain our quantitative In the exhibits, we demonstrate where current active equity opportunities lie by showing the valuation dispersion (as measured by the difference between the category's 75th percentile price/fair value ratio and the 25th percentile) of U.S. sectors, global regions, and countries. The dispersion of asset returns within a given category is what allows an active manager to differ from a benchmark. If the returns for all assets in the category were identical (zero dispersion), all managers would have the same outcomes regardless of their decisions. Accordingly, the expected dispersion of returns in a given category is an indicator of where active management at least has the opportunity to outperform the benchmark. In our analysis, I use our quantitative valuation dispersion as a proxy for expected return dispersion. Note that average valuations are irrelevant to the attractiveness of active management in a given category. In a highly undervalued category, an investor should expect high returns regardless of whether he or she chose active or passive management. If dispersion happens to be low in that category, it is unlikely that an active manager could perform much differently than the benchmark anyway. There are two main reasons for valuation dispersion to arise within a given category. The first is that the category contains heterogeneous stocks. Stocks with different characteris- global.morningstar.com/Morningstarmagazine 39 http://global.morningstar.com/Morningstarmagazine

Table of Contents for the Digital Edition of Morningstar Magazine - February/March 2014

Morningstar Magazine - February/March 2014
Contents
Contributors
Letter From the Editor
Preparing for the Next 50 Years
Morningstar Managers of the Year
Fixing the Trust Deficit
Rethinking the Path to Retirement
Trends
Same Old, Same Old
Global Briefs
The Economic Implications of an Older World
Banking on Performance
Is the Affordable Care Act Healing Health Care’s Woes?70
Baxter Has a Positive Prognosis
Leading Fidelity’s Charge for RIAs
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
Moving the Goal Post

Morningstar Magazine - February/March 2014