Consistent deviations from mutual funds’ Morningstar style box categories are sometimes referred to as “style drift” — when mid-cap funds start holding more large-cap stocks or when value managers develop a habit of holding growth stocks. But there is a big difference between meaningful style shifts by active managers targeting well-positioned opportunities and portfolio managers with lax investment standards.
Morningstar’s style framework is generally considered the industry standard for analyzing and evaluating fund investments. The Style Box categorizes funds based on market cap (small-cap, mid-cap, large-cap) and investment style (growth, value, or hybrid). Morningstar also tracks how funds have invested in these nine segments over the past five years. This can provide a valuable comparison point to see how a fund’s current weightings stack up against its typical allocation. Tracking a fund’s allocations over time can provide advisors with valuable and objective insights, but understanding Morningstar’s calculations can also help understand where these rankings fall short.
For example, a disciplined active value manager—looking for securities with strong fundamentals, positive business momentum, and reasonable valuations—can and will hold in their portfolio a Morningstar Value Score, a Growth Score, or even both. Stocks that rank high in terms of both.
To illustrate this point, consider Halliburton.
Before the pandemic hit in 2020, the energy industry was still dealing with the effects of sharp falls in energy prices and market oversupply, and investment in fracking, especially in North America, had been accelerating. Then, in the first half of 2020, the stock plummeted to levels not seen in more than 30 years.
At the time, a value manager might have formed the view when looking at the stock that the company was attractive from a valuation perspective, and that the consensus expectations for its future growth at the time were promising for a company with such solid fundamentals. Unreasonably pessimistic. It’s also possible to see catalysts for change emerging, given increasing consolidation in the industry, particularly in oilfield services.
Halliburton is a stock that meets all three of the broad investment criteria above—fundamentals, positive business momentum, and attractive valuation—and is one that active fund managers can trade at a substantial discount to what they believe is the intrinsic value shares purchased.
Today, however, Morningstar classifies Halliburton as a growth stock, largely because its business momentum has improved significantly relative to shallow comparisons during the pandemic. Therefore, value managers who keep this company in their portfolios may be penalized from a Morningstar Style Box classification perspective.
It’s worth considering that Morningstar’s Value Score is the only one that considers price, which tends to be the fastest-moving indicator in the stock market. A company’s expected earnings (a factor in its Growth Score) may not change meaningfully from one quarter to the next, but its price will certainly change, affecting the Value Score it earns. The bottom line is that stocks with strong value characteristics may not stick around for the long term.
Proactive value managers, on the other hand, often need to act quickly to seize attractive opportunities. The style box is a helpful guide, but it’s far from authoritative.
Because the best investors are educated investors, transparency is critical when it comes to investment portfolios and processes. To that end, Morningstar’s Style Box remains a valuable tool in helping you learn more about the types of securities a fund targets, how widely it casts its net, and how consistent it is over time, all aspects of portfolio construction. key messages in. But advisors must also remember that in active management, the boundaries between styles are often fluid and the variables that determine a single security classification can change quickly and dramatically, especially in volatile markets.
In any market environment, advisors must recognize the enduring value of a disciplined investment approach. Prioritizing securities with compelling valuations, solid business fundamentals and good business momentum is a time-tested strategy. These characteristics are often the foundation for long-term outperformance, providing advisors with a reliable framework to navigate market fluctuations and create value for clients.
John Forelli, CFA, Director of Portfolio Research boston partnersis an asset management company specializing in actively managing value stocks.
