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.

Mar 02, 2015
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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, 2/27/15 -- Solid Earnings Growth from LOW, ITC, ESRX

Berkshire Hathaway BRK.B is scheduled to report earnings over the weekend, which will officially close fourth-quarter earnings season for our holdings (at least among those with regular fiscal years). In the meantime, we received solid reports from three more holdings. The growth rates below reflect adjusted figures. The first number on each line refers to the fourth quarter, while the number in parentheses is for the full year.

Lowe's LOW
Revenue Growth: 8% (5%)
Operating Income Growth: 31% (15%)
EPS Growth: 59% (27%)

Lowe's is firing on all cylinders. Gradual U.S. economic growth and pent-up demand for home improvements should support mid-single-digit same-store sales growth for the foreseeable future. At the same time, the company's operating margin is steadily recovering to its pre-housing-crash level. Management believes that every percentage point of same-store sales growth above 1% will enable the company to expand its operating margin by 25-30 basis points. New store openings have slowed to a crawl as we seem to have reached a saturation point for home improvement stores in the U.S. As a result, Lowe's is swimming in free cash flow, which it is using to aggressively repurchase shares and pay a modest dividend. Earnings per share improved 27% in 2014 and management predicts another 21% advance this year, which may prove conservative. We raised our fair value estimate to $71 per share from $62. It's gratifying to see the Tortoise's investment thesis in Lowe's work out so nicely, and I plan to hold.

ITC Holdings ITC
Revenue Growth: 9% (14%)
Net Income Growth: 9% (13%)
EPS Growth: 9% (13%)

ITC's growth slowed again in the fourth quarter, but full-year adjusted earnings per share were up 13%--an exceptional performance for a regulated utility. Management's guidance calls for EPS growth of 8%-16% in 2015 as the company continues to build out its electricity transmission footprint. Lately the company has been expanding its development portfolio to include unregulated transmission projects (the vast majority of capacity would still be sold through long-term contracts) and regulated transmission outside of its traditional service territory (facilitated by recent regulatory changes). These efforts could modestly increase ITC's risk profile but accelerate and prolong its growth trajectory.

The most interesting development in the fourth quarter was an accounting charge related to the Federal Energy Regulatory Commission's review of allowed returns on equity for transmission operators in the MISO region. It is likely that ITC's allowed returns will be reduced following the precedent set by a similar decision in New England. If so, ITC will have to provide a refund to customers for its excess earnings since the MISO complaint was filed; the accounting charge covers the period from Nov. 12, 2013 through Dec. 31, 2014. More importantly, ITC's run-rate earnings power would be reduced, and its long-run growth rate could also take a hit.

I discussed this issue in some depth back in June. At the time, I estimated that FERC's new policy could cost ITC about $0.18 per share in annual earnings power, which just happens to be spot on with the recent accounting charge (though the charge covers a 13.5 month period--on an annualized basis, it would be more like 16-17 cents). There's still significant uncertainty surrounding FERC's final decision on the MISO case, which isn't expected until the second half of 2016. Based on disclosures in its annual report, it appears that ITC believes a worst-case scenario would involve a 30-31 cent reduction in its annual earnings power, or roughly 16% of the total. However, as I predicted in June, the company has also been applying for certain incentive adders to its allowed return on equity that it wasn't previously receiving but for which it is eligible. This will partly offset the impact of a lower allowed ROE.

Overall, I believe this situation is evolving consistent with our investment thesis for ITC. Most likely, FERC will lower allowed returns on equity in MISO, but ITC's allowed returns will be at the upper end of the "zone of reasonableness" and may only deteriorate by around 100 basis points. This is likely to cost the company roughly one year's worth of growth in earnings per share and lower the long-run growth rate by 1-2 percentage points. Growth should still be well above peers, and ITC continues to have one of the lowest-risk business models around.

We recently increased our fair value estimate for ITC to $39 from $37, and I consider the stock a favorite for new money even at a minimal discount to fair value.

Express Scripts ESRX
Revenue Growth: 2% (-3%)
Adjusted EBITDA Growth: 13% (6%)
EPS Growth: 26% (18%)

In a year marked by major client losses, Express Scripts delivered solid double-digit earnings per share growth, and management expects more of the same in 2015. Total prescription volumes declined 11% last year (6% excluding UnitedHealth UNH, whose business was lost by Medco prior to its acquisition by Express Scripts). However, the company aggressively cut costs and repurchased shares, leading to adjusted earnings per share that rose 13% (18% excluding UnitedHealth). The primary reason we own Express Scripts is its robust free cash flow. The share count declined 7.6% in 2014, and despite the recent run-up in the stock price, the company is on track for a similar share count reduction this year. Going forward, the most important thing to watch will be Express Scripts' client retention and new client wins. I'm optimistic that the company's bungled Medco integration and related customer service problems are behind it, but we should know more in a couple quarters as the selling season unfolds. I plan to hold.


Matt Coffina, CFA
Editor, Morningstar StockInvestor


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


Morningstar Stock Analyst Notes

Lowe's LOW  |  Jaime M. Katz, CFA

Following suit with its closest peer Home Depot, Lowe’s fourth quarter delivered robust performance. In our opinion, years of improved merchandising and logistics are helping wide-moat Lowe’s close the gap on its rival, and we plan to raise our $62 fair value estimate modestly in response to recent results, our updated long-term assumptions, and a lower cost of equity (down to 9% from 10%). Like the other home improvement retailers on our coverage list, Lowe’s trades at a premium, at more than 23 times 2015 guidance, roughly in line with the 21% earnings growth the company expects in the upcoming year. Longer term, we have earnings growth pegged at a lower mid-teens rate.

Management’s outlook for the year ahead indicates the company expects demand in the home improvement category will continue to persist (and the company’s guidance didn’t vary wildly from Home Depot's). Lowe’s forecasts sales growth of 4.5%-5%, supported by comps of 4%-4.5%, helped by the opening of 15-20 new stores, driving earnings per share of $3.29. These metrics were in line with our prior outlook for sales of 4.9% and comps of 4.1%.

However, our prior earnings forecast was for $3.43 in 2015, closer to Lowe’s previous $3.44 estimate for the year, and the difference is now due mostly to share repurchases. Lowe’s expectation for 80-100 basis points of operating margin expansion puts the business in line with its updated 9.5% operating margin outlook in 2015, which it outlined at its investor day in December. It also indicates that the company will capture either more pricing power or expense leverage in the year ahead than Home Depot, which expects 60 basis points of EBIT expansion. However, we remind investors that Home Depot's operating margins are already meaningfully higher than Lowe’s (at 13% versus Lowe’s 8.5% in 2014).

Lowe’s fourth quarter grew revenues by 7.5%, with same-store sales rising 7.3%. We believe the top line was supported by better merchandising, including a shift to more seasonal categories, which likely led to lower markdowns and sustained gross margins. Gross margins were 34.7%, 10 basis points lower than our internal forecast and flat year over year, while the SG&A ratio leveraged 90 basis points, much better than the 60 basis points we expected. We believe the SG&A ratio will be the primary contributor to operating margin in the year ahead, as Lowe’s continues to leverage its fixed expenses on higher sales expectations.

In addition, the company is set to generate meaningful free cash flow again in the year ahead (Lowe’s earned more than $4 billion in free cash flow in 2014). We expect this will continue to be returned to shareholders in both the form of increasing dividends and share repurchases. With leverage under the 2.25 times its debt to EBITDAR target, we could see the company increasing leverage again over the next year to facilitate faster share repurchases as EBITDA continues to grow. The company should have no concerns about expanding operating margins longer term thanks to opportunities that still abound in merchandising and rising pro penetration, and we ultimately have EBIT margins growing to more than 12% (from 8.5% in 2014).


ITC Holdings ITC  |  Charles Fishman, CFA

We are reaffirming our wide economic moat, stable moat trend rating, and $39 per share fair value estimate after ITC Holdings reported solid 2014 earnings and reaffirmed 2015 earnings and capital expenditure guidance. Our 2015 EPS estimate of $2.08 is at the midpoint of management's $2.00-$2.15 guidance. ITC reported 2014 operating earnings of $1.85 per share, versus $1.63 per share in 2013. Operating earnings were $0.04 less than our estimate and $0.02 below guidance.

Management continues to talk positively about the Lake Erie Connector project and anticipates opening the non-binding solicitation process after applications are filed for major permits in April. ITC has not provided capital cost guidance for the project, but we suspect the 60-mile submarine line would be a material addition to the company's rate base and earnings growth if the project development is successful.  

In October 2014, the Federal Energy Regulatory Commission issued an order setting the Midcontinent Independent System Operator base ROE rate for hearing. The hearing has been scheduled for the week of Aug. 17, 2015, and the Administrative Law Judge decision due by Nov. 30, 2015. ITC expects the final decision in mid-2016, although there is no stipulated period for FERC to issue a final decision. We reiterate our assumption of a 100-basis-point decline in average allowed ROE across ITC's entire system between 2014 and 2018.


Express Scripts ESRX  |  Vishnu Lekraj

Express Scripts exited a tumultuous 2014 on a high note as it reported solid fourth-quarter results and seems to have almost fully recovered from its recent operational missteps. The pharmacy benefit manager also gave full-year 2015 projections for adjusted claims (1,300 million), client retention rate (94%-97%), and earnings per share ($5.42) that largely fall in line with our forecasts, and we are reiterating our $89 fair value estimate given this quarter's developments. Revenue grew 2.1% year over year and represents the first year-over-year quarterly top-line increase since the first quarter of 2013. Throughout 2014, revenue growth trended up and finally broke into positive territory during the quarter. All profit measures also increased, as gross margin expanded 43 basis points to 8.0% and operating margin rose 116 basis points to 6.6%.

The firm was able to decrease its administrative costs at a good clip during the quarter, with the selling, general, and administrative cost margin decreasing 151 basis points to 4.3%. The subpar integration of the Medco acquisition had been a major headwind throughout most of 2014; however, Express seems to have turned the corner in correcting these issues. This positive expansion in profitability from both profit lines is highly encouraging and we believe points to increasing pricing leverage with suppliers, excellent generic conversions, and improved operational execution.

Additionally, all metrics on a per-adjusted-claim basis improved nicely during the quarter, with revenue increasing 3.6%, gross profit rising a solid 9.4% and adjusted EBITDA up an impressive 26.0%. We believe the increase in revenue and profitability per adjusted claim points to Express' ability to drive increased services and savings to clients. The firm was also able to increase its generic fill rate 310 basis points to 80.9%. Ultimately, these positive variables will increase value for investors.

We believe Express' outlook remains highly positive and the steady operational improvement over the course of 2014 provides a solid platform for 2015. As we have stated previously, we strongly believe the firm's command of the pharmaceutical supply chain is unparalleled, given its 30% market share. The PBM's recent exclusion of certain branded drugs from its national formulary and its Medicare Part D partnership with Walgreens highlight its advantages.


Google GOOG  |  Rick Summer, CFA, CPA

Google closed a commercial deal with AT&T Mobility, Verizon Wireless, and T-Mobile that will allow for "tap and pay" payments functionality to be pre-installed on all Android phones that these carriers sell at the end of 2015, according to a company announcement. Although the commercial terms were not released, we are generally positive about the move. We believe mobile payments are an important piece of the mobile offering for both consumers and developers, and success in this segment will fortify Google's wide moat. We are sticking with our $600 fair value estimate at this time.

Several publications have reported that Google has acquired intellectual property from Softcard, a mobile payments joint venture that was funded and operated by these three wireless carriers. In our view, these three carriers have thrown in the towel by partnering with Google, effectively ending their investment burden of funding this venture. For Google's purposes, the firm closes a functionality gap versus Apple Pay, as Android users will finally have the ability to tap a payments terminal (connected to the phone via a wireless technology called NFC), without opening an application. Previously, these three carriers had blocked Google from accessing the technology required to "tap and pay."

We largely view Google's move as both predictable and shrewd. In our November 2015 report, "The Apple Pay Ripple Effect," we predicted the company would be likely ride the wave of consumer adoption of Apple Pay by buying a company in an attempt to invigorate its GoogleWallet effort. Now that this has occurred, we note this is a reasonably small but measured step to complete its payments vision. Notably, the firm has done nothing to fortify its payments presence outside the U.S., which represents more than 80% of its installed base. Still, we look at payments as a service that can ultimately create consumer switching costs. As a result, we expect Google to continue to investing organically and inorganically, both to keep Apple from getting to far ahead as well as to stave off competitive pressures from "non-Google" forms of Android.


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