Alternatives

Morningstar charts course for growth

Despite a sinking stock market, investment research firm Morningstar Inc. is mapping plans to increase its product lineup in 2008.

The firm is widely rumored to be considering plans to get into the market for rating corporate debt, a business that is currently dominated by Standard & Poor’s, Moody’s Investors Service and Fitch Ratings Inc., all of New York.

“It’s an area we have an interest in,” said Scott Cooley, Morningstar’s chief financial officer, who added that no such plans are actually in the works.
Instead, the Chicago-based firm, which went public in 2005, is working to bolster Morningstar Advisor Workstation, its popular online investment-planning system used by financial advisers.

It is also focused on building its business of overseeing asset allocation for funds of mutual funds. At the end of 2007, the company advised $97.5 billion in fund-of-funds assets, up from nothing eight years earlier.

Finally, Morningstar is also focused on continuing its push into the alternative space and expanding its business outside the United States, Mr. Cooley said.

“I feel like were in a really good spot,” he added. “We are growing at a nice clip.”

Morningstar recently reported that its fourth-quarter earnings climbed to $20 million, from $13.6 million a year earlier. Revenue increased to $118.1 million, from $87 million.

Even so, Morningstar faces one major obstacle: the dismal stock market environment.

With 16% of its revenue coming from asset-based fees, the firm is highly susceptible to the ups and downs of the stock market.

“That’s their biggest challenge,” said Murali Gopal, an analyst with Keefe Bruyette & Woods Inc. in New York.

Indeed, a prolonged stock market downturn would certainly cut into Morningstar’s bottom line. That’s because the firm derives its revenue from three lines of business and all three ride the market’s coattails.

During the recently ended fourth quarter, Morningstar’s institutional segment accounted for 53.7% of revenue. Its adviser and individual investor segments, meanwhile, accounted for 25.1% and 21.1% of revenue, respectively.

A significant decline in asset-based fees “could have an impact on our business,” conceded Mr. Cooley.

Investors apparently are catching on.

While Morningstar’s stock price had gained 26.4% for the one-year period ended last Thursday, it had lost 18.7% year-to-date.

Morningstar could face even more difficulties if advisers begin to cut back on their spending with the company, Mr. Gopal said.

Eric Lewis, chief investment officer of Bedrock Capital Management Inc., a Los Altos, Calif., firm with $150 million in assets, said his firm recently signed up for Advisor Workstation.

So far, he is “impressed” with the offering,” he said.

But there have been exceptions.

Morningstar Asset Allocator — a program designed to help advisers determine a combination of asset classes that offer clients the best chance of meeting their investment goals — proved “too-backwards-looking” for Gregory S. Sloan, managing director and chief investment officer of The Daniel Financial Group LLC of Lilburn, Ga., which has $20 million in assets.

Louis Kokernak, principal with Haven Financial Advisors, an Austin, Texas, firm with $20 million under management, said he doesn’t plan to drop any Morningstar services, but its “star rating system is overrated and unreliable.”

Of course, Morningstar’s ratings have been controversial for years — although they remain the leading yardstick for advisers and investors. Many advisers believe that the system relies too much on historical performance, making it backward-, not forward-, looking.

That hasn’t stopped Morningstar from expanding ratings to cover more than mutual funds.

Last month, the firm unveiled a star ratings system for hedge funds. The move followed nearly four years’ worth of data gathering on hedge funds and coincided with the launch of the Morningstar 1000 Hedge Fund Index and 17 index subcategories.

The ratings system for hedge funds is similar to the ratings of mutual funds and separately managed account strategies, which are ranked on a scale of one to five stars, with five being the best.

In addition, the firm also rates exchange traded funds. In fact, Morningstar last month tweaked its ETF ratings so that the funds are rated based on the valuation of the underlying stocks in which they invest. Previously, Morningstar’s ratings were based largely on their risk-adjusted performance.

E-mail David Hoffman at [email protected].