By Tommy Fernandez
June 21, 2012 -- Ever wonder how a Morningstar analyst develops a mutual fund rating?
When Morningstar's director of mutual fund analysis Michael Herbst grades a fund, he asks questions nonstop for two-to-six weeks.
He drills into the fund's nuts and bolts, focusing on five key inquiry areas, known at Morningstar as "pillars": people, process, parent, performance and price.
Here are some of the questions, and some of the answers, that led to Herbst's May 31st Silver rating of the Templeton Institutional Funds Inc Foreign Equity Series.
Pillar 1: People
"What I do first is I try to get a good sense of how this team is oriented. Who are the key decision makers?'' Herbst says of his inquiry in this area. Gary Motyl, a protégé of founder Sir John Templeton, has overseen this fund since July 1996.
In that team, there are roughly 40 analysts globally, based in cities like Fort Lauderdale, Edinburgh and Hong Kong. Two-thirds of the senior analysts are portfolio managers. Conversely, all of the portfolio managers except for Motyl are equity research analysts.
Common industry practice, he says, is to have one distinct group of research analysts studying individual stocks, and a separate group of portfolio managers who build and maintain the portfolios. They are all working off a process that has evolved over the past 30-plus years since Sir John first developed it. There is a good deal of stability in the personnel backing this fund.
Pillar 2: Process
"What is this team trying to do?" is one of the questions Herbst asks here.
Herbst says "this team is very value-oriented." The analysts essentially look for stocks that they believe are relative bargains in terms of price compared to what the companies are actually worth, based upon such metrics as book value, cash flow, debt/capital ratio and earnings. They look for stocks whose prices they believe can roughly double over three to five years.
When they find stocks fitting these criteria, it goes on the "bargain list," meaning managers can buy them. Once bought, stocks go to the fund's "core" list. As they appreciate, they go to the "source of funds" list, where managers look to sell at certain targets.
While valuations are key, Herbst says, more often than not, analysts are also looking for firms with enough cash to fix whatever short-term problems they are going through.
"It is a very, very consistent process. You can essentially have a solid expectation of how people will assess opportunities, add and sell stocks in and out of the portfolio," Herbst says.
He says the fund did get burned in two sectors during the credit crisis: financial firms and telecom companies (particularly European), which have been especially hit hard by Europe's economic woes. During crisis years 2007 and 2008, "this team underestimated some of the systemic risks that harmed the financial sector." Ditto for telecom.
"By no means were they the only team that did that," he said. "But others were able to recognize it and escape the carnage."
Pillar 3: Parent
The team has functioned fairly autonomously under Franklin Templeton's umbrella. Herbst says some firms have a larger parent who meddle, are too hands on and don't let the managers do their best. That tends to reduce results.
"To Franklin's credit, they have let this team operate autonomously. Franklin has been a supportive owner and hasn't meddled," he says.
Pillar 4: Performance
This particular fund is benchmarked against the MSCI All Country World ex-U.S. Index. The benchmark has outperformed more than three-fourths of this category's funds over the past decade.
Even if the fund just kept pace with this benchmark, it would have been in the top quartile. However, it beat the benchmark in roughly two-thirds of the rolling five year periods during Motyl's 16-year tenure through March 2012. ''How consistent has the fund been? Are there understandable reasons for underperformance or outperformance?" Herbst says.
Pillar 5: Price
The fund charges a management fee of 80 basis points a year for its Primary Share class (95% of the fund's assets are owned in this class). It is cheaper by 30 basis points than the median fee in this category, according to Herbst.
In the end, Herbst will talk to managers at least once, while grading each fund. He also keeps a running list of open questions needing research.
After he builds his case, he reaches out to colleagues and those who previously covered the fund. "Believe you me, this is a very opinionated bunch. Any note that I send out gets at least three-to-five comments," he says.
He vets his grade with a parent rating committee of senior analysts, then with the full ratings committee, made of the most senior people. For example, Herbst is that committee's newest member, even though he has been there since 2006.
But when a rating, in this case Silver, gets a green light, what does that mean?
First, it's important to bear in mind what it doesn't mean, says Morningstar's president of fund research, Don Phillips. Ratings aren't market calls, he says. Rather, the reports ask questions investors would love to ask, but rarely get the chance to do themselves.
Second, it does mean that the fund has its act together in the five pillars graded, and so is worth further examination.
"We want to ratchet up the debate of these funds, make them more vibrant," Phillips says. "Even if you don't agree with the rating, you can look at one element of the report that you wouldn't have known otherwise and that would inform your decision."