Investment Strategy

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Investment Strategy
What is the goal of the Tortoise Portfolio? The Tortoise Portfolio aims to outperform the S&P 500 index over time. Companies in this portfolio tend to be mature, relatively slow-growing, and with moderate to low risk. New purchases must have an economic moat, preferably wide. We attempt to tilt the portfolio toward companies with at least stable competitive advantages (stable moat trends).

What is the goal of the Hare Portfolio? The Hare Portfolio aims to outperform the S&P 500 index over time. Companies in this portfolio tend to be faster-growing, with both higher risk and higher return potential than those in the Tortoise. New purchases must have an economic moat, preferably wide. We attempt to tilt the portfolio toward companies with growing competitive advantages (positive moat trends).

Investment Strategy
Morningstar StockInvestor invests in companies with established competitive advantages and generous free cash flows, trading at discounts to their intrinsic values. These are core holdings, with more conservative ideas appearing in the Tortoise Portfolio and more aggressive ideas in the Hare Portfolio. We expect both portfolios to beat broad U.S. stock index benchmarks, such as the S&P 500, over rolling three-year periods.
About the Editor
As editor of Morningstar's StockInvestor newsletter, Matthew Coffina manages the publication's two real-money, market-beating model portfolios — the Tortoise and the Hare. Matt was previously a senior healthcare analyst, covering managed care and pharmaceutical services companies. Matt also developed the discounted cash flow model used by Morningstar analysts to assign fair value estimates to most of the companies in its global coverage universe.

Matt joined Morningstar in 2007. He holds a bachelor's degree in economics from Oberlin College and also holds the Chartered Financial Analyst (CFA) designation.

Jun 25, 2016
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Matthew Coffina, CFA
Morningstar StockInvestor
As editor of Morningstar's StockInvestor newsletter, Matthew Coffina manages the publication's two real-money, market-beating model portfolios -- the Tortoise and the Hare. Matt was previously a senior healthcare analyst, covering managed care and
Featured Posts
Roundup, 6/24/16 -- Priceline Most Exposed to Brexit, but Risk Looks Manageable

U.K. voters' surprise decision to exit the European Union sent the stock market tumbling on Friday and created disarray in other financial markets. The British pound plunged; so did U.S. Treasury yields as investors sought a safe haven. Among our holdings, Priceline PCLN is probably most exposed to macroeconomic risk in Europe, though in the past European travel demand has proven remarkably resilient to economic concerns. One thing's for sure--I'm not sorry that we have outsized cash positions in both our portfolios at the moment (9.4% in the Hare, 16.9% in the Tortoise). I'll be on the lookout for a chance to put this cash to work in undervalued, high-quality businesses we can own for the long run.

Other news this week included a lackluster quarterly earnings report from CarMax KMX, which faces cyclical challenges in the used car market, and the results of the Federal Reserve's annual bank stress tests, which generally showed domestic banks (including our own Wells Fargo WFC) to be in solid financial health.

Priceline’s Exposure to the U.K. Is Manageable; We Plan to Cut Our Fair Value by Low-Single-Digits
- by Dan Wasiolek

We estimate that the United Kingdom is around 15% of Priceline’s total bookings, and should the Sterling remain at current levels of 1.37 to the U.S. dollar, it would represent around a one-percentage-point headwind to total bookings growth this year. Forecasting the economic impact from Brexit is challenging, but we note that both Priceline and European travel bookings remained fairly resilient in 2011 through 2013 despite the uncertainty of sovereign debt and financial unity that existed in the eurozone and which drove lower overall GDP growth at that time. We plan to lower our $1,800 fair value estimate on Priceline by low-single-digits, to account for sterling currency headwinds that mostly impact this year and for some slowdown in European GDP growth due to the uncertainty that might be created by Brexit. We maintain Priceline’s narrow moat that is driven by an increasingly powerful network and recommend investors take advantage of pullbacks.

According to Phocuswright, the U.K. represents 27% of the total European online travel bookings market. We estimate that Priceline gets around 55% of its total bookings from European customers, so assuming that the company’s mix to the U.K. is similar to the overall market results in the company having around 15% of its total bookings based for the country.

Although slowing to some degree, European travel and Priceline bookings were fairly resilient during the European GDP slowdown that occurred in 2012 and 2013. European GDP was roughly flat during 2012 and 2013, declining from around 2% growth the prior two years. Despite that economic slowdown, Europe travel bookings growth (based in Euros) was 1.8% in 2011, 6.1% in 2012, and 1.2% in 2013. Meanwhile, Priceline’s total bookings growth was 59% in 2011, 31% in 2012, and 38% in 2013. Finally, Europe RevPAR was up high-single-digits in both 2011 and 2012 before dropping to low-single-digits growth in 2013.

CarMax Starts Fiscal 2017 With Growing Pains and Lower Tier 3 Sales
- by David Whiston, CFA, CPA, CFE

CarMax started fiscal 2017 with another soft quarter, in our view, but we see no reason to change our moat rating or fair value estimate. Earnings per share increased 4.7% year over year to $0.90, missing consensus of $0.92. We calculate that excluding buybacks, EPS fell 3.5% to $0.83. A 2.8% revenue increase met consensus, but comparable-store unit volume increased only 0.2% and was essentially flat for the third consecutive quarter.

We see two dynamics hurting results this quarter. First, CarMax seems to be experiencing some growing pains via selling, general, and administrative deleveraging as it increases its store count. These stores take time to mature, and the firm has opened 16 since the start of fiscal 2016. In addition to more overhead without the full revenue benefit of these new stores, CarMax incurred a $7 million increase in stock compensation expense and $3 million in Texas hail damage, resulting in SG&A as a percentage of revenue increasing 50 basis points to 9.2%. SG&A per used retail unit increased by $97, or 4.6%, to $2,223.

The second factor is a decline in store traffic and credit applications from lower-credit-spectrum customers, often called Tier 3. Tier 3 customers made up 11.9% of used unit volume, down from 14.7% in the year-ago quarter. We were surprised that management could not say why this decline is happening, but it is likely these customers are putting off buying a vehicle, buying new instead of used, or finding an alternative to CarMax. We are not bothered by the company reducing its subprime exposure at this point in the cycle; same-store used unit sales excluding Tier 3 business increased 3.6%, so we don’t think CarMax’s business model is faltering. A new website launched in April, and management is currently running a test program to preapprove potential customers online for a loan; this makes a lot of sense to us in an e-commerce world and should drive traffic to stores.

The prior-year quarter saw some favorable loan-loss provision numbers that reversed themselves in this year’s first quarter. The loan-loss provision as a percentage of average managed receivables increased 50 basis points to 1.1%, as the easy comparable with last year, more subprime loans from a few years ago, and about a 5-percentage-point decline in wholesale recovery rates--probably due to more used-vehicle supply in the industry--meant more loss reserves. Management did say these losses were mostly expected, other than the decline in wholesale recovery, and we would also have expected loss reserves to increase over time, given the company’s move into subprime after the last recession. This issue along with the interest margin declining 40 basis points to 5.9%, a function of U.S. monetary policy, led to CarMax Auto Finance income falling 7.7% to $100.8 million. CAF remains a strong lender, in our view, and is not done growing as net originations in the quarter increased 5.8% year over year while net CAF penetration increased 120 basis points to 43.9% of unit sales.

Once Again, Banks Breeze Through Federal Reserve's Annual Quantitative Stress Tests
- by Dan Werner

Late on June 23, the Federal Reserve released the results from the supervisory stress tests conducted as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The tests serve to inform regulators, financial markets, and the general public how institutions’ capital would withstand a hypothetical set of adverse economic conditions.

This year, the stress test was similar to last year’s in that the Fed used two scenarios, adverse and severely adverse, with the latter characterized by a substantial global weakening in economic activity, including a severe U.S. recession, large reductions in asset prices, significant widening of corporate bond spreads, and a sharp increase in equity market volatility. In addition, the severely adverse scenario included negative yields for short-term U.S. Treasury securities.

All 33 of the banks subject to the stress test passed as all of the banks had common equity Tier 1 ratios above 5% under both the severely adverse and adverse stress-case scenarios. The results are no surprise to us, as they are generally in line with our own analyses.

Cumulatively, the stress tests under the severely adverse scenario projected loan losses of $385 billion over two years, with total losses of $526 billion when including trading and counterparty losses. On average, the aggregate common equity Tier 1 capital ratio would be 8.4%, improved from 8.3% a year ago. These solid results are not surprising given that banks have been adding capital, approximately $700 billion since 2009, to strengthen their balance sheets. Overall, we think the combination of rising capital levels and rising payout ratios across the banking industry means that the importance of the annual stress tests to investors will continue to decrease in importance over time.

The Fed noted in its press release that for all 33 banks as group, the cumulative loss rate for all accrual loan portfolios is 6.1% over a nine-quarter period, lower than the loss rate from the 2015 stress test. This reflects a “continuing a trend of declining loan loss rates under the severely adverse scenario over time, as borrower and loan characteristics have continued to improve,” the Fed said.

While three banks under our coverage, Zions Bancorp, KeyCorp, and Huntington Bancshares, were below the average post-stress capital levels, two out of the three banks have no moat, indicative of our view of the banks as lower-quality.

Next on the calendar for the Fed is the June 29 release of the results from the Comprehensive Capital Analysis and Review. The CCAR takes into account each company's capital plans, such as dividend payments, stock repurchases, or planned acquisitions, along with a qualitative assessment of the bank’s capital planning process. The Fed basically evaluates whether each bank would still pass the stress test even after planned capital releases. We think the capital return plans of the U.S. banks we cover will be accepted by the Fed, given these banks’ experience with the process.

We would not be surprised to see certain companies approved for dividend increases at that time. Given that all companies would maintain adequate capital buffers under a severely adverse scenario, we think firms with exceptionally low payout ratios like Bank of America and Citigroup could easily boost payout assuming their qualitative processes have improved. We note that Citigroup would maintain a 9.2% common equity Tier 1 ratio even in a severely adverse scenario, supporting our thesis that the firm’s stability—and its relationship with regulators—are much improved over the last decade.

Brexit Vote Will Impact Asset Manager AUM Levels as Global Markets React to Economic Dislocation
- by Greggory Warren, CFA

With the United Kingdom voting narrowly June 23 to exit the European Union, there will be ramifications for not only the British pound but for the value of equity and fixed-income assets. While the U.S.-based asset managers we cover are not quite as exposed as firms based in the U.K. or Europe, there will be an impact on their assets under management levels in the near term as global markets react negatively to the news. The longer-term problem for those operating in the region will be the increased costs associated with having to operate in a less cohesive market.

While most of the asset managers we cover have exposure to the region by virtue of investing in the stocks and bonds of European-based firms, a handful also have exposure by way of clients being domiciled in the region--namely, BlackRock, Franklin Resources, Invesco, Legg Mason, AllianceBernstein, and Affiliated Managers Group. Less exposed firms include T. Rowe Price, Federated Investors, Eaton Vance, Janus Capital Group, Waddell & Reed, and Cohen & Steers.

That said, we expect all of these firms to be caught in the undertow of declining global markets in the near term. Although there is likely to be a fair amount of market and currency turmoil, primarily because most market participants were caught flat footed by the vote (having believed the British people would vote to remain in the EU), we're not anticipating making wholesale changes to the fair value estimates of the companies we cover.

Having reduced the valuations for most of the U.S.-based asset managers in mid-January, we held off on raising them back up again after the global markets rallied off their mid-February lows, believing that the rally was unlikely to hold (with one of the potential downdrafts coming from a U.K. vote to exit the European Union). In instances where a firm's exposure to the European markets is heavier, we expect to revisit our model assumptions to ensure that we are adequately compensating for the increased risk.

Rates, FX, Asset Prices, and Volatility May Have More Effect Than Brexit Operational Changes
-by Michael Wong, CFA, CPA

Our impression on Brexit for capital market-related companies is that their earnings may be more affected by the knock-on macro effects of Brexit than the future operational disruption. Based on our current understanding, a relatively simple response to Brexit is for institutions to open a subsidiary in the EU to continue enjoying trade privileges similar to the ones in the United Kingdom. Some additional capital may be locked-up for regulatory requirements and duplicative expenses will be incurred, but overall we don’t expect it to be material.

More material to near- to intermediate-term earnings will be Brexit effects on macro factors. Global uncertainty shifts central bank policy to a more accommodative stance. Firms leveraged to rate hikes, such as retail brokerages, may have to wait longer to receive earnings boosts. Companies with material earnings denominated in European currencies will have EPS depressing translation effects--25% of Goldman Sachs’ and 15% of Morgan Stanley’s revenue comes from EMEA. Wealth and asset management firms that bill based on client asset levels will also have their fortunes affected by any decrease in asset prices and assets denominated in foreign currencies. Volatility will increase trading volumes, definitely helping trading platforms like the financial exchanges, while having a somewhat mixed effect on brokerages that will have higher trading volumes potentially offset by valuation marks on their trading inventories. Continued capital market volatility will also dampen underwriting and advisory revenues.

In the long run, if more countries split off the European Union, we believe that brokerages, exchanges, and financial information providers stand to benefit. More countries with their own currencies and monetary authorities with disparate interest rate policies would lead to higher currency and rates trading volumes. Information providers collecting and disseminating these new data points will also be more valuable.


Disclosure: Matthew Coffina owns all of the stocks in the Tortoise and Hare in his personal portfolio.

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