The Limits of Pure Fundamental Analysis – How Morningstar Gets Things Wrong
I find Morningstar’s stock and mutual fund analysis useful, which is why I am a premium subscriber, but I am constantly frustrated with their lack of an ability to integrate a macro economic perspective into their analyses. They seem to operate from the macro perspective that things in the future will pretty much be as they have been in the past. Hence, they have been bearish on commodities for quite some time as those companies earnings and stocks have soared.
This issue was brought to my attention again when I visited their home page. On it, they have a video clip from their Director of Equity Research, and regular Saturday morning Bulls & Bears Fox News contributor, Pat Dorsey recommending home furnishings discounter Tuesday Morning (NASDAQ: TUES). The stock has been cut almost in half to around $14.50 since last November when it traded at $27.50.
But the thing is: its been cut in half for good reason! The macro environment is not good for a retailer that sells discretionary merchandise.
On July 25, 2006 Tuesday Morning announced a disastous first half. Same store sales fell 10.8% in the 2nd quarter and 7.9% in the 1st half from the comparable period last year. Free cash flow was about -$25.5 million for the 1st half. In order to pay their hefty 80 cents per share dividend the company borrowed $21 million.
Despite what he admits as a “tough” second quarter, Morningstar analyst Anthony Chukumba maintained his $28 fair value estimate and 5 star rating on Tuesday Morning (subscription required).
But the stock just isn’t worth $28 right now. The only way you get there is if you assume that everything will be okay in the economy, everything will be fine, things in the future will be pretty much as they have been in the past.
This approach lacks imagination! Given the macro-economic situation that I’ve continuously hammered on on this blog, this stock has some serious near term risks that should be integrated into any estimate of its value.
I think this is a $12 stock, which would translate into about 2 stars over at Morningstar. And I bet that it will trade flat to down over the next 6 months until we get some clarity on the housing industry and the macro situation.
See my essay “My Investment Philosophy” for more on the importance of a macro-economic perspective.
UPDATE (Thu Sept 28, 11:37am):
Another good example of this is their 4 and 5 star ratings on most of the home builders and home improvement retailers. Of the 17 companies in their Home Building and Supply category, 15 receive 4 or 5 stars. The other two, Toll and NVR, get 3 stars.