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.
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.
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 is based on two calculations:
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.
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: