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.

 
Sep 27, 2016
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Matthew Coffina, CFA
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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, 9/23/2016 -- Results for CarMax and an Acquisition for Unilever

StockInvestorSM focuses on the activities of portfolios of Morningstar, Inc. that are invested in accordance with the Tortoise and Hare strategies. These portfolios are managed by Morningstar Investment Management LLC, a registered investment adviser, which manages other client portfolios using these strategies.

This week in Morningstar analyst notes: an acquisition for Unilever UL, second-quarter results for CarMax KMX, Oracle's ORCL OpenWorld conference and analyst day, and Lowe's LOW was tagged in note about housing starts.

Unilever Gains More Exposure to Premium HPC Price Points With Seventh Generation Acquisition

by Philip Gorham, CFA, FRM | 09-20-16

Unilever is to acquire Seventh Generation, a North American household and personal care product manufacturer, for an undisclosed amount. With the target's sales likely to be around $250 million this year, we believe Unilever could have paid close to $1 billion. For Unilever, we reiterate our wide moat and stable trend ratings, our EUR 40 and $44 fair value estimates for the Amsterdam-listed ordinary shares and ADRs, respectively, and our GBX 3,250 and $44 fair value estimates for the London-traded ADRs.

The acquisition makes strategic sense for Unilever. Seventh Generation's household and personal care products contain fewer chemicals and use recycled packaging, which appeals to the environmentally conscious consumer. Although it is still a fairly niche category (at around 5% of the household detergent category), natural cleaning products are growing at a low-double-digit rate and offer one of the few premiumisation opportunities in a category that we believe will be susceptible to trading down in the long term. Store brand competition tends to be higher and pricing power weaker for products that are perceived to offer little consumption utility and are not consumed in social settings. Natural cleaning products, therefore, may add significant value to the environmentally conscious consumer.

This is evident in the sometimes hefty price premium achieved by natural household products at retail. We estimate that across the portfolio, Seventh Generation can sell at a premium of around 20% to competitive brands and a 60% premium to private label. U.S. sales of the brand are roughly equal to those of close competitors Mrs. Meyer's and Method in aggregate. While we do not believe this acquisition alone moves the needle on Unilever's valuation, we think the additional exposure to premium price points should drive a greater contribution from price/mix in the company's household and personal care portfolio (57% of 2015 sales).

Southern Housing Starts Merely a Speed Bump in Recovering Residential Construction Activity
by Charles Gross | 09-20-16

Although housing starts fell 5.8% sequentially to a disappointing rate of 1.14 million units, we believe this will be temporary as the housing market continues to heat up. Weakness in the South was the largest drag, falling by 56,000 units sequentially. We attribute this in part to a sustained period of poor weather that resulted in 20 Louisiana parishes being declared federal disaster areas, with the surrounding areas pounded by heavy rainfall. Supporting our argument that this weakness is transitory was an uptick in Southern single-family permits, up 3.6% sequentially to the highest level we've seen since November 2007. Further, builder confidence continues to rise. The National Association of Home Builders' Housing Market Index rose in August and September, including the South, signaling that homebuilders have an increasingly positive view of new home demand. We reiterate our outlook that single-family starts will build momentum in the second half of the year to 795,000 units for 2016, an 11.5% improvement from 2015.

Multifamily starts fell nearly 7% sequentially in August, with permits down almost 8.5%. We expect the fevered pace of multifamily construction relative to the last several years to wane during the second half of 2016. Rising rental rates have led to a substantial increase in multifamily units under construction, 16.5% year over year, with permits falling 13.1%. We believe financiers and investors have grown concerned about the sustainability of high rents, given the level of new supply on the horizon. This echoes the views of REITs Avalon Bay and Equity Residential that realized rental rates have come under pressure and plans for additional supply are limited. As a result, we expect seasonally adjusted starts to fall over the coming months, in line with falling permit activity. We believe multifamily starts will near 390,000 units in 2016, marginally lower than 2015.

Our outlook for wood products firms, homebuilders, and REITs is unchanged.

CarMax's Fiscal 2017 Second Quarter Shows Our Thesis Remains on Course
by David Whiston, CFA, CPA, CFE | 09-21-16

We are leaving our moat rating and fair value estimate for CarMax in place after its second-quarter fiscal 2017 results gave us no reason to change our thesis. Revenue grew 2.9% year over year to $4.0 billion, just missing consensus, while diluted earnings per share of $0.88 (excluding a $0.04 per share equity compensation charge for recently retired CEO Tom Folliard) matched consensus. Comparable-store used-unit volume rose by 3.1%, better than fiscal first quarter's 0.2% rate but below the prior year's second-quarter rate of 4.6%. Selling, general, and administrative, or SG&A, expenses per unit excluding the CEO compensation charge was essentially flat year over year at $2,085.

Management also said it has not seen as large of an increase in supply of late-model used vehicles coming off-lease as expected in calendar 2016, but they still seem to expect it to happen later this year and in calendar 2017 and 2018. We agree because we have seen industry sources with forecasts for off-lease volume of 3.1 million in 2016 growing to nearly 4 million in 2018. Once this supply enters the market more dramatically, we expect some gross margin contraction, but the higher volume will also help CarMax leverage its SG&A. Management has long said that it is willing to give up some margin for volume to get this leverage.

The earnings call had considerable talk about CarMax's Tier 3 customer exposure, which is commonly called subprime even though a majority of CarMax’s Tier 2 customers are also subprime from a FICO score point of view. Tier 3 customer mix fell to 9.5% of used-unit volume in the quarter, down from 13.7% in the prior year's quarter. Comparable-store used-unit sales to non-Tier 3 customers increased by a healthy 8.1%. Management estimates that about 40% of the decline in Tier 3 business is lower application volumes as these consumers are staying out of the market or buying from other sellers and 60% of the fall-off is due to Santander reducing its subprime lending.

Tier 3 mix has been steady since May, so we do not expect a large decline from recent levels. CarMax also recently opened a $100 million warehouse credit line to fund Tier 3 originations, but management stressed that this is more to continue the Tier 3 pilot program rather than to replace Santander’s lending.

CarMax Auto Finance income declined by 2.4% year over year while penetration net of payoffs increased by 200 basis points to 45.3%. The interest margin before loan losses has held steady now at 5.9% for three straight quarters, but it did decline by 30 basis points year over year in fiscal second quarter; which is not surprising given a slight increase in CAF’s cost of capital over the past few years. CAF's ability to take more business means we are not concerned about the interest margin contraction. Originations for the quarter grew by 8.4% to over $1.4 billion. A 30-basis-point increase in the quarterly loan loss provision to 1.4% of average managed receivables did hold back CAF’s earnings as well, but the overall portfolio's allowance for losses is still low at 1.08% compared with 0.96% a year ago. Some increase is expected given CAF taking on more lending and management did cite some "unfavorable experience" in the fiscal second quarter. Current losses however are not deviating from management's range of expectations.

Cloud Computing (What Else?) Takes Center Stage at OpenWorld, but Our Outlook is Unchanged
by Rodney Nelson | 09-22-16

We came away from Oracle's OpenWorld conference and analyst day with new insights into how the company is approaching the secular shift to cloud computing. The most surprising move came in the unveiling of the company's next-generation infrastructure-as-a-service offering, which management alluded to on its first-quarter conference call last week. Previously, Oracle had been reticent about the idea of competing directly with public cloud behemoths Amazon and Microsoft, but it appears Oracle will address this market full bore moving forward. While this move unlocks new opportunities for Oracle, we maintain our $38 fair value estimate (as we remain skeptical of the IaaS strategy), and we maintain our wide economic moat and negative moat trend ratings.

The bulk of the conversation during Oracle's analyst day focused around the company's cloud offerings spanning SaaS, PaaS, and IaaS. In particular, the SaaS and PaaS businesses represent the most developed product offerings for the company and the most readily addressable markets in the cloud. The company has now landed 12,500 SaaS customers (which does not account for the pending NetSuite acquisition), and management highlighted a strengthening pipeline that should yield significant growth over the next several years as enterprises migrate business applications to the cloud more aggressively. The company has 8,000 potential customers in its pipeline (ex-NetSuite), while more than 50% of its SaaS customers are new to Oracle. However, the bulk of the firm's SaaS customer base remains in the mid-market, and we continue to believe large customers could be at risk of jumping ship to cloud-native SaaS vendors such as Salesforce.com and Workday, which have proven their scalability. Further, the PaaS pipeline is growing (bookings more than doubled between third and fourth quarter last year), which instills confidence the company will not be caught flatfooted when considering the long term for its middleware customers.

Oracle offered compelling specs for its public cloud offering around compute and storage capacity, and the company theoretically should have some ability to differentiate its offering from Amazon and Microsoft. Most notably, Oracle's extensive presence in the IT infrastructure of its existing customers could give the firm a leg up in terms of speed and ability to migrate those customers to its cloud over other providers. By Oracle’s count, the firm’s compute offering will be 24 times faster for analytics and eight times faster for transaction processing compared with Amazon Web Services’ most premium offering.

Despite the firm's impressive presentation and large potential market opportunity, we maintain some skepticism about Oracle’s go-to-market approach for its new IaaS offering. First, the timing of the move is puzzling, particularly in the wake of Oracle’s decision to forgo this market for several years. We have already seen vendors such as HP and VMWare exit or pivot away from the public cloud compute and storage markets because they simply could not attract enough customers to scale with the likes of Amazon, Microsoft, Google, and others.

Second, given the amount of scale required to generate profitability in the public cloud market, Oracle is certainly behind the eight ball. Oracle's broad customer base will give it ample opportunity to onboard users to its infrastructure-as-a-service product, but we question how willing these customers will be to further lock in their IT infrastructure (both on-premise and in the cloud) with one vendor. We believe enterprises will increasingly look to leverage multiple, at-scale public cloud vendors (for security and reliability reasons) and potentially utilize a variety of technological architectures (including database and middleware options beyond Oracle's proprietary purview) within those clouds to keep as many options open for development, testing, and deployment of applications.

Third, a strong push into IaaS will likely hamper cloud (and ultimately consolidated) margins, particularly if Oracle brings its offering to market as a low-cost provider (20% below Amazon pricing, according the company). We are hard-pressed to believe that the company has ample supply to allow for torrid growth that would be necessary to materially close the revenue gap between it and the largest players any time soon, which we believe will translate to increased capital expenditure to meet demand and ultimately hamper free cash flow over the next few years. As chairman Larry Ellison pointed out during analyst day, it costs "billions of dollars" to build an IaaS offering. As a point of reference, Microsoft has spent $24 billion in capital expenditure over the last four years, with the bulk of that spend going toward capacity buildouts for its IaaS offering, Microsoft Azure, and other cloud services. In the same period, Oracle has spent just $3.8 billion in capital expenditure.

In general, details on the financial impact of a more concerted effort to bring a broader IaaS offering to market were scant during the meeting, and we have not explicitly modeled any assumptions for the business in our financial model yet. While management contends Oracle can be the largest and most profitable IaaS vendor on the market based on its technological synergies and superiority, we will abstain from modeling any explicit expectations until we have a more concrete idea of how the new IaaS product will be adopted.

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©2016 Morningstar, Inc. All rights reserved. The Morningstar name and logo are registered marks of Morningstar, Inc. The information contained in this document is the proprietary material of Morningstar, Inc. Reproduction, transcription, or other use, by any means, in whole or in part, without the prior written consent of Morningstar, Inc., is prohibited. All data presented is based on the most recent information available to Morningstar, Inc. as of the release date and may or may not be an accurate reflection of current data.  There is no assurance that the data will remain the same.

Disclosure:
The commentary, analysis, references to, and performance information contained within Morningstar® StockInvestorSM, except where explicitly noted, reflects that of portfolios owned by Morningstar, Inc. that are invested in accordance with the Tortoise and Hare strategies managed by Morningstar Investment Management LLC, a registered investment adviser and subsidiary of Morningstar, Inc. References to "Morningstar" refer to Morningstar, Inc.

Opinions expressed are as of the current date and are subject to change without notice. Morningstar, Inc. and Morningstar Investment Management LLC shall not be responsible for any trading decisions, damages, or other losses resulting from, or related to, the information, data, analyses or opinions or their use. This commentary is for informational purposes only and has not been tailored to suit any individual.

The information, data, analyses, and opinions presented herein do not constitute investment advice, are provided as of the date written, are provided solely for informational purposes and therefore are not an offer to buy or sell a security. Please note that references to specific securities or other investment options within this piece should not be considered an offer (as defined by the Securities and Exchange Act) to purchase or sell that specific investment.

This commentary contains certain forward-looking statements. Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results to differ materially and/or substantially from any future results, performance or achievements expressed or implied by those projected in the forward-looking statements for any reason.

Investments in securities are subject to investment risk, including possible loss of principal.  Prices of securities may fluctuate from time to time and may even become valueless.  Securities in this report are not FDIC-insured, may lose value, and are not guaranteed by a bank or other financial institution. Before making any investment decision, investors should read and consider all the relevant investment product information. Investors should seriously consider if the investment is suitable for them by referencing their own financial position, investment objectives, and risk profile before making any investment decision. There can be no assurance that any financial strategy will be successful.

Common stocks are typically subject to greater fluctuations in market value than other asset classes as a result of factors such as a company’s business performance, investor perceptions, stock market trends and general economic conditions.

All Morningstar Stock Analyst Notes were published by Morningstar, Inc. The Weekly Roundup contains all Analyst Notes that relate to holdings in Morningstar, Inc.’s Tortoise and Hare Portfolios.

David Harrell may own stocks from the Tortoise and Hare Portfolios in his personal accounts.

 
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