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.

Nov 22, 2014
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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, 11/21/14 -- More Good News from Lowe's and PetSmart
Kinder Morgan's consolidation deal received overwhelming support from shareholders and unitholders, and is expected to close on Wednesday, November 26. We currently own 117.726 shares of Kinder Morgan Management KMR in the Tortoise, which will be converted into roughly 292 shares in Kinder Morgan, Inc. KMI. The company reiterated its plan to pay dividends of $2 per KMI share in 2015 and to increase the dividend 10% per year through 2020. Based on KMI's current share price, that puts the forward yield at 5.0%; if KMI's dividend yield stays roughly flat and management achieves its growth goal, we can look forward to a total return somewhere in the midteens. I think this total return outlook more than compensates for Kinder's risks, which include commodity price sensitivity, thin dividend coverage, regulation, and a high degree of leverage. There may even be upside to management's forecast if Kinder can find accretive acquisitions--a task that will be much easier with its new, dramatically lower cost of capital. I plan to hold.

Russian potash miner Uralkali had to shut down a major mine after a nearby sinkhole caused it to flood. The mine is separated from a second facility by a concrete wall. It remains unclear whether water will infiltrate the second mine or if damage to the first mine is permanent, but as much as 5% of global potash supply could be at risk. That's good news for PotashCorp POT (and to a lesser extent Compass Minerals CMP), which could benefit from higher potash prices and a chance to steal market share. We should know more within a few weeks as Uralkali assesses the damages. I plan to hold.

Halliburton HAL and Baker Hughes BHI officially agreed to merge, with the former paying a roughly 45% premium for the latter (relative to where Baker Hughes was trading prior to acquisition rumors). My view of the impact on Schlumberger SLB hasn't changed: The new Halliburton could be a stronger competitor in the long run, but this risk is more than offset by the prospect of industry capacity reductions, more rational pricing, and operational disruptions at Halliburton during the regulatory approval process and integration. I plan to hold our Schlumberger shares.

Sanofi SNY predicted that its diabetes sales will be "flat to slightly growing" through 2018 despite the anticipated launch of several promising drugs including ultra-long-acting insulin Toujeo, inhalable insulin Afrezza, and combo GLP-1/insulin therapy LixiLan. It's hard to determine what this means for Novo Nordisk NVO. On one hand, Novo Nordisk has been gaining market share from Sanofi in the long-acting insulin space, and Sanofi may be worried that its market share losses will accelerate with Novo's launch of ultra-long-acting insulin Tresiba. Additionally, Novo's Levemir was already priced at a meaningful discount to Sanofi's Lantus--Sanofi may feel compelled to cut Lantus' price to bring it in line with Levemir, but that doesn't necessarily mean Novo will have to make price concessions too. On the other hand, evidence is mounting that the diabetes market has become significantly more competitive. Powerful payers like Express Scripts ESRX have shown a willingness to exclude major treatments from formularies, which hurts pharmaceutical firms' bargaining power. And this situation may only get worse when biosimilar insulin hits the market.

I had originally intended for Novo Nordisk to be a core long-term holding for the Hare. However, it's critically important that we don't anchor our views to out-of-date information. While Novo's stock has performed well since our first purchase in mid-2013, most developments since then have been negative. At Novo's current stock price--which represents a premium price/earnings multiple relative to peers--I don't see much margin of safety. I am considering trimming or selling our stake.


This week we also received earnings reports from two of our retailers.

Lowe's LOW
Revenue Growth: 6%
Operating Income Growth: 18%
EPS Growth: 26%

Lowe's reported very strong third-quarter results, prompting us to raise our fair value estimate to $57 from $49. Same-store sales were up 5.1%, just shy of Home Depot's HD 5.2% advance (Lowe's same-store sales have been lagging those of Home Depot for most of the past five years). More importantly, Lowe's operating margin continues its steady climb back toward pre-recession levels. The third-quarter operating margin came in just below 8%, an improvement of 80 basis points from the prior year. Aggressive share repurchases also helped to trim the share count by almost 7%. Management bumped up its forecast for full-year earnings per share by 5 cents to $2.68. While Lowe's is trading at a modest premium to our new fair value estimate, I plan to hold for the long haul.

PetSmart PETM
Revenue Growth: 3%
Operating Income Growth: 11%
EPS Growth: 16%

PetSmart's third-quarter results were solid despite flat same-store sales, powered by new store openings, cost reduction efforts, and share repurchases. We raised our fair value estimate to $73 from $71 to account for cash earned since our last update. Management plans to cut a total of $200 million in annual costs by 2016, which is more than a quarter of run-rate operating income. We're taking a wait-and-see approach with respect to these cost savings; our model incorporates roughly flat operating margins, but there could be significant upside if the full savings are realized. In other news, multiple private equity firms are reportedly bidding for PetSmart, with offers rumored to be at least in line with the current stock price. I plan to hold for now.


Next week will be busy for my family: Besides Thanksgiving, we're moving to a new house. (A special thanks to the Federal Reserve for enabling us to get a 30-year fixed-rate mortgage under 4%!) I don't expect much news given the holiday, but I'll check in briefly early in the week.


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 a rough start to the year for home-improvement retailers because of difficult weather, Lowe's has regained its footing and delivered solid results in recent periods, indicating that brand strength remains strong for the business. Expense leverage in the quarter was robust, and cost leadership is still one of the pillars underlying our wide moat rating. We expect to increase our $49 fair value estimate to account for improved expense management and increased operating margin performance, but view Lowe's as overvalued. The shares are trading up 24% year to date (in line with expected earnings per share growth for 2014), versus 11% for the S&P.

Sales in the quarter increased 5.6%, supported by 5.1% comps along with comp ticket growth of 3.4% and comp transaction growth of 1.7%. Strength in the business was broad-based, as all 14 regions experienced positive comp growth (even Canada delivered double-digit comps) and pro services again outperformed the company average. While gross margins ticked down 10 basis points to 34.5% in response to promotions and mix, expenses (selling, general, and administrative as well as depreciation) leveraged materially. The SG&A ratio contracted an impressive 80 basis points to 23.8%, and management's focus on efficiency is something we think will persist in periods ahead as the company finds new opportunities to improve productivity. Improved sales and operations planning, better utilization of the store footprint, increased innovation in the brand portfolio, and healthy vendor relationships should help Lowe's get close to the 9.7% operating margins it expects next year. Our estimate falls just shy of 9.7%, even with gross margin and SG&A leverage leading to operating margin expansion of 80 basis points in 2015. We expect a moderate increase in the gross margin ratio as the company goes through its next round of value-improvement initiatives.

Lowe's ticked its full-year guidance up and now forecasts full-year sales to rise 4.5%-5% (previously 4.5%), comp-store sales to tick up 3.5%-4% (previously 3.5%), operating margin expansion of 70-75 basis points (previously 65 basis points), and earnings per share of $2.68 (from $2.63). Both sales and comp guidance were in this range earlier in the year and then were reduced in response to the slow start to the spring season. This implies fourth-quarter sales growth of around 6%, comps of about 5%, and operating margin expansion of close to 100 basis points. Capital expenditures had also been reduced to $1 billion for the full year, allowing for share repurchases of about $3.7 billion in 2014.

We still believe Lowe's is an excellent steward of shareholder capital, returning $597 million in dividends and $2.95 billion in share repurchases to shareholders over the last nine months. The company raised $1.25 billion in debt during the quarter at an average rate of 2.25% and remains below its leverage target of 2.25 times. We expect the company will continue to raise debt as EBITDA increases, staying close to its current 2.2 times, using at least part of forward issuances to buy back shares in the open market. We like the return of excess capital, but with the shares trading above our fair value estimate, buybacks could prove expensive.


PetSmart PETM  |  Liang Feng

We expect to modestly increase PetSmart’s $71 fair value estimate due to the time value of money, after the firm reported soft but modestly improved third-quarter results. Sales grew 2.6% to $1.74 billion due to store expansion (adding 73 net new locations to 1,387), as comps were flat during the period (with a 2.4% decline in transactions offsetting ticket growth). However, management believes the firm can improve traffic by retargeting customers it lost to grocery and mass retailers. Pet supplies retail has become more competitive recently, in our view, but we still expect narrow-moat PetSmart will capture share and generate attractive long-term returns, as the firm benefits from intangible assets and cost advantages.

Operating income dipped 1% to $151 million, but management attributed the decline to restructuring costs associated with its profit improvement program. Management plans to realize almost $200 million of pre-tax cost savings, with 60% being achieved in 2015, and the remainder by 2016. As a result, management expects to achieve meaningful gross margin and OG&A cost leverage in fiscal 2015, and guided toward low-single digit comps and mid-teens profit growth next year. However, our base case forecasts 10.5% normalized margins, and we do not expect to increase our forecasts until we can evaluate early signs of execution.

Management declined to comment on strategic alternatives, but on Nov. 11, Reuters reported that KKR and Clayton, Dubilier & Rice are planning to submit a joint bid next month for more than $7.5 billion, with Apollo and BC Partners also considering a joint proposal. From our view, management prefers that PetSmart remain public, and announced its strategic initiatives in part so that it could convince shareholders to resist the private equity bids. However, with PetSmart’s two largest shareholders open to a sale, it will be difficult for management to resist if an attractive offer emerges.

Management announced a number of initiatives during the call to address existing investor concerns, and to detail how the firm plans to rejuvenate sales and profit growth.

On the top line, management continues to believe that its loss of widely distributed customers has contributed to much of the recent traffic woes. As a result, the firm has expanded its marketing (both through traditional and digital mediums) to bring these widely distributed customers back in, and re-expanded its shelf-space dedicated to grocery-level goods (after several consumables resets that have removed grocery products, for premium channel-exclusive brands). We are cautiously optimistic on these proposals, and think that weakness should also be attributable to increased competition with grocery and mass merchants, which have focused more on their own natural products (though they still do not hold the channel-exclusive brands) and think it will be difficult to recapture traffic. Still, we believe these initiatives do make sense, and remain positive on PetSmart’s ability to upsell customers toward premium channel-exclusive products once they are in the store. Additionally, the firm has finally rolled out buy-online/pickup- in-store capabilities across its store base, and we are encouraged that the firm is investing more in its omnichannel programs.

Management also announced a number of cost reduction programs to achieve its $200 million in annual proposed savings, with 40% estimated to come from COGS, and 60% from OG&A expenses. Additionally, the firm announced that it is working with outside consultants to implement zone pricing, so that it can more effectively price-discriminate on its products (a definite step in the right direction, in our view). Management explained that the opportunities have come to light as the firm is more focused on cost management (versus growth, when comps were up in the mid-single-digit range). However, we are cautious that management is taking too much on its plate at once in its attempt to convince investors that it could rejuvenate profit growth as a stand-alone entity, and are still curious why these savings were not achieved in previous years given its magnitude (even if management was prioritizing growth at that stage). Consequently, while we do think there are incremental opportunities to improve productivity, we are not yet ready to incorporate this level of rapid margin expansion in our base-case forecasts, and still forecast relatively flat operating margins at about 10.5%.


Kinder Morgan KMR  |  Jason Stevens

Kinder Morgan announced on Nov. 20, 2014, that shareholders and unitholders of Kinder Morgan Inc., Kinder Morgan Energy Partners, Kinder Morgan Management, and El Paso Pipeline Partners voted in favor of the consolidation transactions proposed in August 2014. This result is as we expected, and we reiterate our fair value estimates and wide moat ratings for the Kinder family ahead of the expected Nov. 26 close.

The consolidated Kinder Morgan will be a midstream behemoth. With an enterprise value around $125 billion and generating $8.6 billion in EBITDA in 2015, Kinder will be the largest midstream energy firm hands down, and one of the largest energy firms globally. We continue to see Kinder Morgan as a consolidator; once the mergers close and the dust settles, look to see Rich Kinder's team sharpening their pencils for the next deal.


Potash  |  Jeffrey Stafford, CFA

We're holding steady on our potash producer fair value estimates following reports that Uralkali, a major Russian producer, has been forced to shut down one of its mines due to brine inflow issues. The Uralkali mine represents a meaningful portion of global potash production, with an annual capacity of 2.3 million metric tons. Total potash demand currently sits in the 55 million to 60 million metric ton range. In the short term, the lost supply should benefit potash prices, and could lead to higher prices when China and India sign their next potash contracts, likely in early 2015.

If the Uralkali mine is shut down permanently, we would adjust our potash supply forecast accordingly. This would likely inspire a slight boost to our long-term price forecast, which currently sits at $350 per metric ton. For now, we're holding steady with both our fair value estimate and our long-term price forecast. We see potash supply and demand growing at similar rates through the end of the decade.


National Oilwell Varco NOV  |  Robert Bellinski, CFA

We attended National Oilwell Varco's first-ever analyst day in Houston. Though we came away with a deeper understanding of the firm's perspective on strategic positioning and the forces that drive its wide moat, there were no revelations that were meaningful enough to change our $89 fair value estimate.

In the near term, we continue to expect falling offshore rig orders in 2015, with a lagged effect on 2016 revenue. The wellbore technology and completion and production solutions' revenue is tied to drilling activity, which is also facing pressure from lower oil prices. Despite the headwinds currently faced, we still think the firm's long-term opportunity is immense.

We were encouraged by management's take on capital allocation. After meeting the immediate cash needs of the business (i.e., working capital) management first looks for opportunity to deploy cash in return generating activities, both organic and acquired. Only then does it consider returning capital to shareholders. We prefer this to the more conventionally accepted corporate groupthink in the energy sector espousing the necessity to balance investment with returning capital to shareholders. We think this is nonsensical. Excess capital should absolutely be returned. But, management's priority should always be in the pursuit of investing capital at incrementally higher returns to the fullest extent of its capital resources or investment opportunities. We think the team at National Oilwell Varco not only gets this, but also executes it well, which is why we continue to view them as Exemplary stewards of shareholder capital.

In the presentations, management was more keen to discuss the company's internal process rather than external catalysts. Essentially, the managers view themselves as having a unique industrial insight into the oil and gas sector, which allows them to allocate capital to organic opportunities and acquisitions of key products and services. These are then integrated and developed as systems. The best example of this is in the rig systems segment, which was assembled through multiple acquisitions, and is now capable of outfitting an entire rig with equipment. The last step is what the company calls "transformative solutions," a far more intangible process. Before the merger of National Oilwell and Varco, a drilling contractor would have to communicate with a multitude of parties to build a rig, from the oil producer to the shipyard to the individual equipment suppliers. Now, though, National Oilwell Varco's integrated rig systems have cut down the number of parties a drilling contractor deals with to two--the oil producer and the shipyard. National Oilwell Varco can provide the rest, saving the contractor time and money in the construction process. As such, the process of ordering a floating or jackup rig was transformed, with National Oilwell Varco setting the standard.

We think this is important to point out because we see it developing in another aspect of its business: floating production storage and offloading (FPSO) vessels. As oil producers continue to drill wells at increasing water depths, FPSOs are the primary topside solution. Unfortunately, the complexity of these vessels has resulted in most of the deliveries to date being massively over budget and behind schedule. This looks like fertile ground for National Oilwell Varco, in our opinion. We do not think the company will develop an entire FPSO system anytime soon, but the ability to provide integrated components to FPSOs could transform how they are designed, ordered, and constructed, providing the firm with another moaty business within a large and growing opportunity in oil production.


Berkshire Hathaway BRK.B  |  Greggory Warren, CFA

While wide-moat Berkshire Hathaway's third-quarter 13-F filing was overshadowed this week by the firm's announcement that it would be exchanging its 52.8 million share stake in Procter & Gamble (worth $4.7 billion) for the Duracell battery business, the company did report some changes to the stock portfolio (that look to be more the work of Todd Combs and Ted Weschler than Warren Buffett). Berkshire's 13-F equity holdings, which do not include foreign investments held abroad like BYD and Tesco, were valued at $107.8 billion at the end of the third quarter, with the top five holdings--Wells Fargo (22%), Coke (16%), American Express (12%), IBM (12%), and Wal-Mart (4%)--accounting for more than two thirds of the portfolio.

The insurer's only new money purchase during the period was 450,000 shares of Express Scripts for an estimated cost of around $32 million. Berkshire also more than doubled its stake in Charter Communications (making it a $750 million holding), and made meaningful additions to its stakes in DirecTV, General Motors, Visa and MasterCard. (The last two purchases look to be fairly prescient, as both stocks have risen more than 15% since the start of the fourth quarter.) The company also held 8 million shares of Liberty Media Class C, which was paid out during the period as a stock dividend on Berkshire's holdings in Liberty Media Class A shares.

As for the sales reported for the third quarter, the firm eliminated its stake in Deere (netting an estimated $340 million), and unloaded close to two thirds of its holdings in ConocoPhillips (for $70 million), 920,000 shares of National Oilwell Varco ($70 million), 1.3 million shares of Bank of New York Mellon ($50 million), and 290,000 shares of Phillips 66 ($25 million). As always, the quarterly share changes in Berkshire's stock portfolio have no real impact on our fair value estimate for the firm, which continues to be driven to a large degree by the performance of its operating businesses.


Oilfield Services  |  Robert Bellinski, CFA

After a weekend of reports suggesting that investors were in for a proxy battle or a failed deal, Halliburton and Baker Hughes surprised the market with the announcement that they had reached an agreement to combine. Baker Hughes' shareholders will receive 1.12 shares of Halliburton and $19 in cash for each share held. We will raise our fair value estimate for Baker Hughes to reflect Halliburton's offer. We are still digesting the details as it pertains to Halliburton shares, but based on our preliminary calculations we are not changing our fair value estimate. Our moat ratings are unchanged at this time.

The offer looks outstanding for current Baker shareholders, representing a 45% premium to where shares were trading last week, and a 17% premium to our previous fair value estimate. We also think the prospects for the combined company are strong, with the potential of being a wide-moat peer to Schlumberger, and the dominant player in the North American frac market.

Halliburton will need to harness its strength in execution, however. Driving the deal's economics is Halliburton's estimate of $2 billion in annual cost savings. Roughly $800 million will come from better execution in North America to raise Baker's margins to parity with that of Halliburton's. The company estimates another $1 billion or more related to fixed cost savings (real estate, logistics, back-office, and management). Of course, this will be offset by roughly $1.1 billion in cumulative integration costs through 2017.

For the long-term investor, the deal is attractive. Considering the amount Halliburton is paying over our prior $63 fair value estimate for Baker Hughes ($11/sh based on today's closing price), and factoring in the annual cost savings hitting full stride in 2018, less integration costs, we calculate the premium to be net present value (NPV) positive by the end of 2020.


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