Introduction To Morningstar Style Box

In doing your investment research, you may have come across a Tic-Tac-Toe-like box similar to the one below. This box is called the Morningstar Style Box. This particular one came from Vanguard 500 Index (VFINX) profile on Yahoo! Finance.

What Is a Morningstar Style Box?

Morningstar Style Box is a visual tool created by Morningstar, a premier mutual fund data sources provider. Morningstar helps make asset allocation decision easier by categorizing mutual funds by their market capitalization and valuation to nine categories.

• Large Value
• Large Blend
• Large Growth
• Medium Value
• Medium Blend
• Medium Growth
• Small Value
• Small Blend
• Small Growth

Market Capitalization

Market capitalization is the market price of an entire company, calculated by multiplying the number of shares outstanding by the price per share. Morningstar categorizes a fund’s market capitalization by studying the size of the companies that the fund is investing in. There are three categories: large, medium, and small. In general, the largest 250 stocks are considered large cap, the next 750 are considered medium cap, and the rest are considered small cap.

In term of risk/reward relationship, large cap companies tend to be more stable and provide lower rate of return due to its relative safety. On the other hand, small cap companies tend to be more risky and volatile, thus provide higher rate of return as risk premium.

Valuation

Valuation is based on two calculations:

• Price to earnings ratio (P/E) – Price to earning ratio is calculated by taking the stock price and divided it by the earning per share. For example, if a company is currently trading at $20 a share and earnings over the last 12 months were $2.00 per share, the P/E ratio for the stock would be 10.00 ($20/$2.00).
• Price to book ratio (P/B) – Price to book ratio is calculated by taking the stock price and divided it by the total assets minus intangible assets and liabilities. Don’t worry about the calculation because you can look it up.

For both ratios, lower number generally means that the company is undervalued (underpriced) relative to its earning or book value. However, this could also means that there is something fundamentally wrong with the company — i.e., bad management — therefore the price is being pushed down. These companies are called value stocks.

On the other hand companies that has high P/E and P/B are expensive (overpriced) relative to its earning or book value. This usually means that investors have high hope for the company and expect the earning or the book value to catch up to the stock price. These companies are called growth stocks.

Lastly, blend simply means that the company is in the middle relative to value-growth scale.

How to use the Morningstar Style Box

There is no right way to use the box. At the minimum, it’s a great tool to assist you in building an investment portfolio, since a typical asset allocation calls for investing in large cap, mid cap, small cap, and international funds.

Personally, I use the Morningstar Style Box along with other metrics such as: sector, region (i.e., U.S., Europe, Asia, etc.), and total expense ratio to decide what fund(s) I want to add to my existing portfolio. At the every least, I like the corners to be balanced — i.e., large value, large growth, small value, and small growth are similarly represented in the portfolio — with slight bias toward value funds due to my frugal nature.

Additional articles about Morningstar Style Box:

• How to Evaluate a Mutual Fund in 60 Seconds Flat at The Dough Roller
• Quick Guide to a Morningstar Style Box at About.com
  
• Understanding The Style Box at Investopedia

Pinyo is the brain behind Moolanomy personal finance blog and a few other web sites. If you like this article, please subscribe for free daily email updates.

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