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 17, 2014
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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, 9/12/14 -- Is Apple Pay a Threat to Incumbent Payment Networks?
Apple AAPL was in the news this week with its splashiest series of new product launches in years. It's hard to see larger-screen iPhones or the Apple Watch having much impact on our Tortoise and Hare holdings, but one new product did capture my attention: Apple Pay. We have more exposure to the payments industry than just about any other area, including Visa V, MasterCard MA, American Express AXP, Discover Financial Services DFS, and eBay's EBAY PayPal. Does Apple Pay threaten any of these companies?

The short answer, in my view, is probably not. Here are my reasons:

1) Mobile payments are a solution in search of a problem. At the launch event, Apple showed a video that was meant to illustrate how difficult it is to pay with a traditional credit or debit card: A woman rummages through her purse for her wallet; fumbles as she tries to slide out one of many cards; hands the card to the cashier, who asks for ID; the card has to be swiped twice before it is read; and finally the cashier hands back the card and receipt. Frankly, I didn't think the process looked all that onerous even in this exaggerated video. The reality is that paying for something doesn't get much easier than swiping a credit or debit card, and consumers have little incentive to learn a new system.

2) Network effects for incumbent payment firms create a chicken-and-egg problem. It is notoriously difficult to get merchants to adopt a new payment system. Unless a large group of consumers demands it, merchants don't want to incur the costs of installing new equipment, training employees, and troubleshooting inevitable problems. Apple boasts that Apple Pay will be immediately available at 220,000 locations in the U.S., including high-profile retailers such as Target TGT, Macy's M, Disney DIS, McDonald's MCD, Walgreen WAG, and Whole Foods WFM. However, there are more than nine million merchants in the U.S. that accept credit and debit cards, not to mention many millions more internationally. It costs several hundred dollars to install a device that can accept payments using near field communication technology--why bother if only a handful of consumers will use it?

3) Mobile payments aren't really convenient for consumers either. Apple stated that its "vision is to replace the wallet." A quick glance in my own wallet demonstrates that this won't happen anytime soon: I have a driver's license, multiple debit and credit cards, transit cards, a library card, a health insurance card, cash (which I still have to use at least a few times per week where credit or debit cards aren't accepted), business cards, appointment cards, rewards cards, and of course pictures of my kids. Apple Pay wouldn't even enable me to take out the credit and debit cards, since I would need them (a) for the 97.5% of merchants who won't be accepting Apple Pay, at least initially, and (b) in case my phone battery dies.

4) Other very capable companies have tried to get into mobile payments--including Google GOOG, eBay, Square, card networks, wireless telecom firms, and major retailers--with minimal success thus far. Gartner estimates that worldwide mobile payment transaction value will be $235 billion in 2013. However, more than 70% of this amount is money transfers (a serious concern for Western Union WU), and another 21% is e-commerce. In-store transactions using near field communication are believed to account for just 2% of mobile payments, or around $5 billion--a tiny drop in the bucket of overall global payments. Apple's solution may have some advantages over prior attempts, such as increased security using fingerprint identification, automatically linking credit and debit cards stored in iTunes, and the company's decision to partner right out of the gate with Visa, MasterCard, and American Express. However, in most important respects, Apple Pay doesn't seem much different from the numerous mobile payment offerings that already exist.

5) Putting all that aside, let's assume that Apple Pay really takes off--that five years from now, consumers have decided they love paying with their phones and a large number of merchants have concluded they must accept Apple Pay or risk losing business. Even in this unlikely scenario, it's hard to see how this is a material negative for the incumbent payment networks. (Discover was conspicuously absent from Apple's initial list of partners, but the company says it is in negotiations to be added to the platform.) Apple will rely on the traditional networks' infrastructure to make its payment system possible; the networks will still serve as a critical link between Apple, banks that issue cards to consumers, and banks that acquire transactions on behalf of merchants. Like almost all recent payments innovations, it appears that Apple Pay is intended to make it easier to pay with traditional credit and debit cards--not displace the incumbent networks.

6) Along those lines, this isn't a winner-take-all situation. According to MasterCard, cash and checks still account for 85% of global transactions. Any attempt to accelerate adoption of digital payments is a good thing, and the secular shift away from cash and checks should provide a tailwind to the entire industry for the foreseeable future. Furthermore, I would argue that the number of companies expressing an interest in digital payments far exceeds the number of viable, successful payment platforms. It's possible that hard-to-replicate assets such as Discover's network or PayPal could eventually become acquisition targets. Apple's move into payments could also increase pressure on eBay's management to consider spinning off PayPal, and I suspect a spin-off would unlock significant value for shareholders.

Regardless of whether Apple Pay succeeds or fails, I expect Visa, MasterCard, American Express, and Discover to do just fine--Apple Pay is complementary to traditional payment networks, not a substitute. MasterCard is my favorite name in this group, though I also consider Visa and Discover to be candidates for new money. There's a bit more risk to eBay's PayPal unit, as Apple Pay (along with emerging payment products from Google, Amazon AMZN, and others) will be a direct competitor. We have a 5.5% weighting toward eBay in the Hare, though perhaps only half of that is attributable to PayPal (and an even smaller percentage to parts of PayPal's business that could be at risk--for example, more than a quarter of PayPal's payment volume is tied to eBay's Marketplaces business). So from a portfolio perspective, I believe our downside risk is minimal. More importantly, eBay's valuation already incorporates low expectations--the stock is trading for a 17% discount to our $63 fair value estimate and for just 15 times forward earnings. I think eBay's risk/reward profile justifies continuing to hold.

Regards,

Matt Coffina, CFA
Editor, Morningstar StockInvestor

Email: matthew.coffina@morningstar.com

Disclosure: I own all of the stocks in the Tortoise and Hare in my personal portfolio.


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Morningstar Stock Analyst Notes

eBay EBAY  |  R.J. Hottovy, CFA

Apple unveiled its iPhone 6 and Apple Watch products on Sept. 9, and as widely anticipated, mobile payments will play a prominent role. Apple Pay will allow iPhone and Apple Watch users to pay with Visa, MasterCard, and American Express cards stored to their iTunes account or Passbook. The system will use one-touch checkout, with a Secure Element chip to store data and near-field communication to transfer it to merchants at the point of sale (with Touch ID and device suspension capabilities offering additional security). Apple noted that it has acceptance from a wide range of merchants/aggregators, including Macy's, Walgreens, McDonald's, Panera, Starbucks, Target, Whole Foods, Groupon, and OpenTable. Apple Pay will be built into new iPhone products and available for other iPhones as part of the iOS 8 update in October.

Clearly, Apple Pay is a potential disruption to PayPal, which processed $27 billion in mobile volumes in 2013. The new platform represents one of the first digital wallets that can rival PayPal's convenience, security, and merchant acceptance. However, we don't view mobile payments as a zero-sum game, and we believe that PayPal's mobile platform offers some advantages, including consumer-to-consumer fund transfers, small-merchant acceptance (via PayPal Here), cross-border reach, and Bill Me Later, each of which could encourage collaboration between Apple and PayPal. Additionally, other mobile companies like Samsung are likely to follow Apple's lead and make more aggressive inroads into mobile payments, with PayPal being a potential partner because of its user base and functionality.

There is no immediate change to our $63 fair value estimate for eBay, and the implications for its wide moat depend on whether Apple Pay disrupts PayPal's network effect. We view shares as undervalued, and while Apple Pay adds risk to the PayPal investment story, it could also motivate PayPal to accelerate its mobile commerce plans.

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Payment Networks  |  Jim Sinegal

Apple has announced that its new iPhones will incorporate a mobile payment system called Apple Pay, which will initially allow users to pay with their phones using cards issued by major U.S. banks. We don't think the technology--which essentially functions as a secure storage mechanism for payment data--is disruptive to the moats of networks or issuers, since it will allow customers to use a variety of payment options. We expect network volumes to expand even as the form of electronic transactions transitions from cash to card to digital, and are maintaining our fair value estimates.

It is, however, an interesting technological change. Rather than storing a single card number, Apple Pay stores its own account number and generates unique data for individual transactions after validating the card with the issuer. Instead of a magnetic stripe and reader, Apple Pay will use a secure element to store the data and near-field communication to transfer it to merchants at the point of sale. Its fingerprint sensor adds a layer of security. We see better security as a major selling point for consumers and retailers. Furthermore, Apple has reportedly negotiated lower interchange fees in exchange for the security improvements, which could offset the impact of lower fees on issuers.

Apple is also dipping its toes into the merchant acquirer space, working with a variety of large merchants to enable immediate acceptance of Apple Pay and overcoming another significant hurdle. We have long believed that marketing and rewards will be the focus of competition in the payment sector, and these partnerships--as well as Apple Pay's likely dominance of the digital wallet--position the company well for a variety of opportunities in this much massive market. Aggregator firms like OpenTable and Groupon were specifically mentioned in the announcement, and Apple has already developed the iBeacon, which could enable numerous retail applications.

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CME Group CME  |  Michael Wong, CFA, cPA

BGC Partners announced that it intends to commence a $5.25 per share tender offer for GFI Group shares. This offer is 15% above the CME Group equity offer of $4.55 per share announced in late July. Besides the price, another major difference between the two offers is that CME Group's offer is structured as a tax-free exchange for CME shares, while the cash offer from BGC Partners will create an immediately taxable event for most shareholders. The BGC Partners offer is also contingent on enough shares being tendered for it to own a majority of GFI Group when added to its existing 13.5% ownership interest. With the change in GFI Group's management, large influx of cash at BGC Partners after selling eSpeed, and tough interdealer broker industry environment, we had always thought that BGC Partners was likely to be a consolidator and that GFI Group would be a likely target. We don't anticipate making a material change to our fair value estimates for BGC Partners or CME Group, but may raise our fair value estimate for GFI Group to reflect the probability of this tender offer going through. We are maintaining our wide moat rating for CME Group and no-moat ratings for GFI Group and BGC Partners. If BGC Partners is able to buy GFI Group, we would look to see if it rationalizes the interdealer broker industry and would consider changing BGC Partners' moat trend to stable from negative.

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