The Morningstar Style Box Defined

The Morningstar style box is a nine-square grid that gives you a quick and clear picture of a fund's investment style. The style box classifies funds by whether they own large-, mid-, or small-capitalization stocks, and by whether those stocks have growth or value characteristics or land somewhere in between.

We'll look first at the stock size and growth and value dimensions and then explore the ways in which they come together in the style box.

Company size

A company's size is commonly measured in terms of its market capitalization (or market cap), which is based on the total market value of its shares. A company's market capitalization fluctuates with the share price, which usually, though not always, reflects the health and growth (or expected growth) of its fundamental operations: sales, earnings, etc.

Investors typically divide companies into three size bands: large cap (for companies with the biggest market capitalization), mid-cap, and small cap. Larger companies are often more established and tend to be more predictable (and less susceptible to operational shocks) than smaller companies. Thus, on average, their market capitalizations tend to be less volatile than those of small- and mid-cap companies.

Rather than assigning a fixed number of "large cap" or "small cap" stocks, Morningstar uses a flexible system that isn't adversely affected by overall movements in the market. Large-cap stocks are defined as the group that accounts for the top 70% of the capitalization of each geographic area; mid-cap stocks represent the next 20%; and small-cap stocks represent the balance.

Growth and value metrics

Morningstar determines a fund's style whether it invests in "growth" or "value" stocks by applying a set of growth metrics and a set of value metrics to each individual stock the fund holds. These characteristics are compared with those of other stocks within the same capitalization band, arriving at a score for each company that ranges from zero to 100. For the purpose of Morningstar's style box, we group each stock into one of seven style "zones" based on geographic locales: the United States, Latin America, Canada, Europe, Japan, Asia (excluding Japan), and Australia/New Zealand.

Morningstar begins by measuring the "value" aspects of a stock by comparing the price of one share of a stock with the company's projected earnings per share. The other 50% of the value score comes from four equally weighted historical measures: a stock's price/sales (P/S), price/book (P/B), and price/cash flow (P/CF) ratios, as well as its dividend yield. These measures are ranked against those of other U.S. stocks in the same size range, and their combined rankings go into the stock's value score.

The growth score similarly uses one forward-looking measure and four equally weighted historical metrics. Half of the stock's growth score comes from ranking its long-term projected earnings growth rate against those of other U.S. stocks in the same capitalization band. Next, we rank the stock based on its historical earnings growth, sales growth, cash flow growth, and book-value growth rates against other U.S. stocks in its market-cap band. The resulting rankings make up the other 50% of the stock's growth score.

Morningstar calculates a stock's style score by subtracting its value score from its growth score, resulting in scores that can range from -100 to 100. A stock with a style score of -100 would be a cheap, high-yielding, low-growth stock, while one with a score of 100 would have no yield and very high historical and projected growth rates. Stocks in the middle are classified as "core" stocks. The dividing lines between value, core, and growth can vary over time with changes in the market, but on average each style will include approximately one third of all stocks in each market-cap range.

Tackling the funds

A stock fund is an aggregation of individual stocks, and its style is determined by the style assignments of the stocks it owns. By plotting all of a fund's stocks on the stock style grid, the range of stock styles included in the fund immediately becomes apparent. An asset-weighted average of the underlying stocks' style and size scores determines a fund's placement in the style box.

Style box assignments for stocks are updated each month. Assignments for funds are recalculated whenever Morningstar receives updated portfolio holdings for the fund.

Just as with individual stocks, the thresholds between value, blend, and growth funds vary to some degree over time, as the distribution of stock styles changes in the market. However, on average, the three fund styles each account for approximately one third of each market-cap range.