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.

May 27, 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, 5/20/16 -- Lowe's Shines in Challenging Retail Landscape

This week's analyst notes cover the following topics:

1. Lowe's LOW delivered excellent first-quarter results, which were even more impressive considering the challenges facing most other retailers. Consumers may be skipping the mall, but they're still willing to spend on home improvement.

2. A new analyst picked up coverage of Alphabet GOOGL. We raised our fair value estimate to $780 per share from $755, and we still think Alphabet has a very wide moat.

3. Hotels are trying to encourage consumers to book directly on their own websites, but this looks like only a minor headwind for Priceline PCLN, whose business is focused on boutique hotels that lack marketing resources and robust loyalty programs. The trend could pose a greater challenge to Expedia EXPE given its greater concentration in the U.S. market, which is dominated by large hotel chains.

4. Banks' exposure to energy sector losses continues to look manageable, especially for highly profitable and conservatively reserved banks like Tortoise holding Wells Fargo WFC.

5. Berkshire Hathaway's BRK.B 13-F filing provided an updated look at the firm's equity portfolio, including a new position in Apple AAPL.


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

1. Lowe's First-Quarter Print Supports Consumer Health in the Home Improvement Spending Category
- by Jaime M. Katz, CFA

Wide-moat Lowe's first-quarter report impressed just as well as peer Home Depot’s for the period, delivering same-store sales of 7.5%, revenue growth of 7.8%, and earnings improvement of 40% (24% without the benefit of its foreign exchange hedge contracts). Unlike Home Depot, however, the company has held firm on its top line and comp growth guidance for the full fiscal year, at 6% and 4%, respectively, indicating both metrics will be positive at a much lower rate over the remainder of the year. We don’t plan to make any material change to our $81 fair value estimate, which includes the closing of Rona in the second half of the year. Our assumption includes no margin accretion from the transaction closing in 2016, but does incorporate real benefits from synergies and best practices beginning to help profitability in 2017-18.

Our long-term outlook for the business remains unchanged, as we believe rising pro penetration, higher e-commerce conversion, and improving selling, general, and administrative leverage will likely persist over the next decade, leading to nearly 13% operating margins (from 9.3% in 2015). We expect this will be supported by mid-single-digit same-store sales growth through 2019, which will taper off to about 3% thereafter. In our opinion, these estimates are supported by the healthy domestic macroeconomic environment in the housing market, which, while experiencing slowing growth, remains positive. Demographic tailwinds, including rising household formations in the millennial demographic, could add an incremental boost.

In the near term, we anticipate low levels of both integration risk and consumer risk from the Canadian market--Rona’s first-quarter report pointed to the Canadian Mortgage and Housing Corporation metrics of single-family housing starts and home resales in Alberta, which fell 39% and 12%, respectively. However, this was offset by robust growth in Ontario, which experienced starts and resales growth of 64% and 11%, respectively. The lumpiness in these figures gives us pause, but we remind investors that Rona will still represent between 5% and 7% of sales upon combination, so the overall uncertainty regarding the Canadian market for the business isn't particularly worrisome.

During the quarter, sales rose 7.8%, helped by higher ticket (2.2%) and transaction (5.5%) with tickets over $500 rising 8.7%. Comp-store sales followed a similarly declining pattern to that experienced by peer Home Depot, with February rising 8.3%, March up 9.1%, and April tapering off to 4.9%. Gross margins were lower than we anticipated at 35%, falling 43 basis points, as more consumers participated in targeted promotions and incremental markdowns were affiliated with reset activity. Selling, general, and administrative expenses had an offsetting impact, also lower than we expected at 22.3%, helped by the foreign exchange hedge for financing the Rona acquisition, along with the leverage of payroll (overall, the hedge helped SG&A and operating margins by 105 basis points). The robust sales in the quarter allowed the inventory turnover ratio to tick up to 3.83 times, 5 basis points faster than a year ago.

Overall, we still think the company is an excellent capital allocator, returning capital by way of share repurchases and dividends over the last quarter. In light of the increased leverage, which raised the lease adjusted debt to EBITDAR ratio to 2.45 times, ahead of the company’s 2.25 times target, we expect share repurchases will remain more tepid than the past few years, at $3.5 billion versus the nearly $4 billion on average the company has pursued over the past four years. Management anticipates leverage will tick back down to its stated goal within a year of closing the Rona transaction, which we think should be achievable with the increased EBITDA that Rona will contribute and the natural growth in EBITDA that Lowe’s is set to capture.

2. Reinitiating Coverage of Alphabet With Wide Economic Moat, Stable Trend, and FVE of $780
- by Ali Mogharabi

We are reinitiating coverage of Alphabet with a wide economic moat rating and a fair value estimate of $780. Alphabet’s wide moat is based on the sustainable competitive advantages derived from its intangible assets, including the firm’s technological expertise in search algorithms and machine learning, access to and accumulation of data, and the Google brand, in addition to the network effect. While we remain confident in Alphabet’s stable and wide moat, we recommend a slightly wider margin of safety before investing, as the shares are currently trading in 3-star territory.

Alphabet dominates the online search market via Google’s global market share of more than 80%, through which it generates strong online advertising revenue growth and cash flow. We expect the Google ecosystem to continue strengthening as its products are adopted by more and more users, increasing the attractiveness of Google’s online advertising services to advertisers and publishers.

We anticipate that Google will continue to benefit from the significant shift of digital advertising onto mobile platforms as its Android mobile operating system gains market share. In our view, this will help Google drive revenue growth and maintain leadership in the sector.

Among the firm’s investment areas, we particularly applaud its efforts to gain a stronger foothold in the growing public cloud market. In a short period of time, Google has leveraged the technological expertise it generated from creating and maintaining its private cloud platform to gain market share in the public cloud market.

With regards to Alphabet’s more futuristic project investments, although most are not yet generating revenue, the upside potential is attractive, as the company is targeting newer markets.

3. Hotel Direct Threat Manageable for Priceline But Could Impact Expedia; No Change to Fair Values
- by Dan Wasiolek

Recently, there has been discussion in the market around large hotel brands' increased focus on driving bookings direct to their websites through loyalty member initiatives but little in the way of quantifying its impact to Priceline and Expedia. We believe that over the next two years hotelier direct campaigns could create a 0.2-0.9 and 0.7-3.7 percentage point booking headwind to Priceline and Expedia, respectively. Therefore, in our opinion, this threat is manageable for narrow-moat Priceline, but could present some headwind to narrow-moat Expedia. That said, our fair value estimates of $1,800 and $145 for Priceline and Expedia, respectively, remain unchanged, and we still see both companies well positioned for long-term growth while trading at attractive valuations.

We see several reasons why the upper-end of our forecast is unlikely. First, both Expedia and Priceline have loyalty programs of their own, which they could elevate to counter hotel direct pressures if they start to have any noteworthy impact. Second, we believe that hoteliers will be careful to not over-promote rooms to members, as it risks deteriorating its brand intangible (key driver of moats in the hotel industry). Third, hoteliers could decide to allow Priceline and Expedia to offer loyalty promotions on their platforms, perhaps in exchange for better economic terms. Fourth, Priceline and Expedia have strong networks (key driver of their narrow moats) that offer much more accommodation and other travel service choice than any hotel chain. Fifth, the reach of Priceline’s and Expedia’s platform is an important one for hotel brands (often high-single- to low-double-digits of total bookings), and those chains that deemphasize exposure stand to lose share on this distribution channel. Sixth, Expedia’s recent Orbitz and HomeAway acquisitions offer incremental growth opportunity the next few years, which can offset any potential pressure from the direct threat over the next year or two.

The low end of our forecast is derived by estimating the number of unused loyalty room nights hotel chains have lost due to guests booking through a third party. According to Hilton, it lost 1.6 million room nights last year. We estimate that in 2015 Hilton had 4.9% of global rooms, and that the other main six hotel brands had 20.8% room share, respectively. From this we estimate that around 8.4 million unused point-based room nights were lost by hotel brands a year ago. We then assume that 60% of these rooms shift back to hotel websites from OTAs with Priceline and Expedia representing 80% of those transactions, equating to 4 million direct room bookings at the expense of Priceline and Expedia. We believe that 3 million of those 4 million rooms stand to be lost by Expedia as we estimate around 40% of its bookings come from hotel brands versus only 10%-15% for Priceline, which has a lower U.S. mix where brands constitute a larger mix of rooms. Based on that and our forecast that Expedia and Priceline book 250 and 540 million room nights on their platform this year, respectively, with 60% and 90% of all bookings from hotels, respectively, equates to an Expedia and Priceline booking impact of 0.7 percentage points and 0.2 percentage points, respectively, over the next two years.

The high end of our forecast assumes that each of the largest seven brands (Marriott, Hilton, InterContinental, Wyndham, Accor, Starwood, and Hyatt) see around 10% growth to the percent of total room nights booked by loyalty members directly on hotel websites over the next two years. The 10% is based on Hilton’s room nights booked by loyalty points representing 55% of total room nights in the first quarter of 2016 versus 51% the previous year, which represents an acceleration from the 50% level reported in both 2013 and 2014 and the 52% level witnessed last year. Hilton has been one of the earliest and most aggressive in its campaign to drive direct traffic, so we think the recent increase in room night member mix shows the potential opportunity for key peers. Under this scenario, we estimate around 40 million incremental loyalty room nights being generated, and assuming 60% of those are taken from the OTA channel, of which 80% are transacted through Priceline and Expedia with 75% taken away Expedia (due to its higher exposure to hotel chains), equates to around a 0.9 percentage point headwind to Priceline and 3.7 percentage point one for Expedia.

4. Potential Bank Energy Losses Look Manageable, but Canadian and European Banks Remain Under-Reserved
- by Erin Davis

After rounding up first-quarter updates, we remain convinced that exposures to energy remain manageable for most U.S., Canadian, and European banks. We see positive indicators for investors on four fronts. First is the strength of underlying markets--the price of Brent crude has risen to nearly $50 per barrel from below $30 in early January, alleviating pressure on oil companies and reducing likelihood of default. The second indicator, that market expectations of losses have lessened significantly, is related. In our note of Feb. 11, we noted that the S&P 500 Energy Corporate Bond Index (essentially all investment-grade) was projecting losses of about 15%, while the Bloomberg USD High Yield Corporate Bond Energy Index (junk) was projecting losses around 30%. These indexes are now projecting losses of 5% and 20%, respectively. Third, enhanced disclosures show that banks’ energy exposures tend to be high-quality. Among the U.S., Canadian, and European banks that we cover, around 59% of credits are high-quality (investment-grade or similar at the 58% of covered banks that provide quality metrics). Finally, and perhaps most importantly, at an absolute level, energy exposures remain low and manageable relative to banks' common tangible equity. We estimate that 15% energy losses would consume an average of 3.1% of common Tier 1 equity. For a bank earning a 10% return on equity, that’s one quarter’s worth of earnings--clearly not a material threat to capital strength or bank moat ratings. Current market projections (losses of 4% on energy exposure) make potential additional write-downs look even less threatening, averaging near zero for U.S. banks and just 1% of common equity Tier 1 capital for Canadian and European banks. We still think investors should take advantage of market worries to invest in Citigroup and TD Bank, which are among our top investment ideas; both are significantly undervalued and face no significant threat from a renewed fall in energy prices.

Taking a more granular look at the updated first-quarter data, we see two interesting results.

First, U.S. banks, which report under U.S. GAAP, tend to be much better reserved for energy losses than Canadian and European banks, most of which report under IFRS. At U.S. banks we cover, we calculate that reserves are sufficient to cover 44% of potential losses in a 15% loss scenario, with coverage ratios ranging from more than 60% at Wells Fargo and Huntington to a still-reasonable 30% at Citigroup and Bank of America. In contrast, at the Canadian banks we cover, reserves are sufficient to cover just 5% of losses in a 15% loss scenario, with coverage ranging from a high of 12% at Royal Bank of Canada to a low of 3% at Bank of Montreal. Disclosed energy-specific provisions at the European banks we cover are essentially nonexistent, leaving these banks still fully exposed to potential losses. To be fair, we should note that this gap in provisioning springs from differences in how the two accounting standards require banks to recognize losses. U.S. GAAP recognizes expected losses, while IFRS recognizes only incurred losses. These standards are expected to largely converge in 2018, when IFRS rules will change to require banks to recognize lifetime expected losses.

Second, while average exposure to energy is manageable, some banks have significantly more exposure than others. None of the banks that we cover would face losses equivalent to 10% of common equity Tier 1 capital, or a full year’s earnings for a bank earning a 10% return on equity, in a 15% energy loss scenario, but a few are close. We’re particularly concerned about Standard Chartered, where a 15% loss on energy loans could consume 9.3% of common equity Tier 1 capital, and Cullen-Frost, where this loss could be 8.1% of common equity Tier 1 capital. In the case of Standard Chartered and many European banks, there may not be much in the way of near-term earnings to offset these losses, and capital raises or other long-term setbacks could result. We also call out National Bank of Canada, BNP Paribas, Bank of Nova Scotia, and CIBC as more exposed, with potential 15% losses consuming 5%-7% of common equity Tier 1 capital. We think all of these banks will be able to muddle through if today’s improved conditions persist, but could face devastating losses of 10%-20% of common equity Tier 1 capital if losses were to rise to a 30% worst-case level.

5. Interest in Technology Stocks Apple and Yahoo Overshadows Berkshire's Recent Investment Activity
- by Greggory Warren, CFA

While all of the talk the last time we looked at Berkshire Hathaway's end of quarter holdings was the firm's purchase of Energy sector stocks during the fourth quarter of last year and early part of this year, the big story following the release of the company's first-quarter 13-F filing this week revolves around its dabbling in Technology stocks. Even before the filing came out, news had surfaced over the weekend that CEO Warren Buffett had joined forces with Dan Gilbert, the founder of Quicken Loans, in a second round of bidding for some of the assets of Yahoo!, the struggling technology and media firm business. We're not sure what to think of this move, as Buffett has generally eschewed auctions, especially of businesses that need a lot of fixing up (as it is something he's never really had the stomach for and doesn't necessarily need to go down that road anymore). From what we can tell (and it looks like Buffett confirmed it this morning), Berkshire is merely positioning itself to provide financial backing for any deal that gets done.

Looking more closely at the first-quarter purchases, the most notable transaction, besides the firm's pickup of 14.1 million additional shares of Phillips 66 during the quarter (which we noted back in February), was Berkshire's acquisition of 9.8 million shares of Apple during the period. This looks to be more of a Todd Combs or Ted Weschler purchase, but valued at nearly a billion dollars we cannot imagine Buffett not being aware of the purchase. Berkshire also slightly increased its stakes in John Deere, IBM, Bank of New York Mellon, Visa, and Charter Communications. On the sales front, Berkshire eliminated its holdings in AT&T, and sold off shares of Wabco, MasterCard, and Wal-Mart. The elimination of Precision Castparts from the holdings were due to Berkshire's acquisition in full of that company, whereas the reduction of nearly its entire stake in Procter & Gamble was tied to its purchase of Duracell.

Even with these transactions, as well as the unrealized gains/losses, that occurred during the first quarter of 2016, the makeup of Berkshire's top 5 stock holdings--Kraft Heinz (19.9%), Wells Fargo (18.0%), Coca-Cola (14.4%), IBM (9.6%) and American Express (7.2%)--remained basically the same. With the top 5 stock holdings in Berkshire's equity portfolio accounting for close to 70% of the overall portfolio (and the top 10 holdings making up 84%), the insurer's equity portfolio (which had 47 total stock holdings at the end of March) remains fairly concentrated, adding to the performance woes when any of the insurer's top stock holdings are underperforming.


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