Investment Strategy

Dear Investor:

Thank you for signing up for Morningstar MSIInvestor. We hope the information helps you make MSI a valuable tool in meeting your financial goals.

Download your Morningstar MSI Guide

MSI are powerful instruments that are often ignored by investors. But as someone who believes that MSI can be a smart tool for meeting a variety of financial goals, I'd like to make options accessible to a broad range of investors. I hope that MSIInvestor does just that for you.

I promise you'll get the fundamentals, applied intelligently and explained in plain English, and all of it is tied to Morningstar's fundamental company research.

Bottom line, we'll help you invest wisely with MSI.


Matthew Coffina
Editor, Derivatives Investing Strategist

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.

Oct 01, 2014
Welcome !
About Paul Matthew Photo
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, 9/25/14 -- CarMax Valuation Falls Back in Line; Wide Moat Focus Update

This week's roundup comes to you a day early because I have some conflicting engagements tomorrow. It's been a relatively rough week for the stock market, with the S&P 500 down 2.2% through Thursday, though there hasn't been much news affecting our portfolio holdings. The Treasury Department announced new rules aimed at making it harder for U.S. companies to avoid taxes by moving overseas though an "inversion" transaction. This could complicate Abbott's ABT planned sale of its developed markets generic drugs business to Mylan MYL, since the deal was structured as an inversion for Mylan. There's also been talk of changes to tobacco regulations in the U.K. and France that could have adverse implications for Philip Morris International PM. You can read more about these developments in our analysts' notes below, but for now we don't expect a material impact to our fair value estimates for Abbott or Philip Morris.

Paychex PAYX, which I sold earlier this week, reported solid earnings, including 9% revenue growth, 5% operating income growth, and 7% earnings per share growth. I always wish our former holdings well; after all, if a stock implodes soon after we sell it then we probably never should have owned it in the first place. However, my reason for selling Paychex still stands: I believe we can find significantly faster growth at a similar or cheaper valuation elsewhere.

Lastly, CarMax also reported earnings.

CarMax KMX
Revenue Growth: 11%
Net Income Growth: 1%
EPS Growth: 3%

CarMax was down nearly 10% after releasing second-quarter earnings, which I view as a sign that the stock had gotten ahead of itself--it had been trading for a 20% premium to our fair value estimate prior to the report. Furthermore, volatility has been typical following CarMax's recent quarterly reports; the stock was up more than 16% when first-quarter results were released. (For what it's worth, I said at the time that I thought the stock's jump was "premature" and that the results "weren't quite as strong as they appeared on the surface.")

In the most recent quarter, same-store used car volumes were flat, continuing a trend of decelerating same-store growth. Retail volumes were likely hurt by stronger competition from new cars, which are benefiting from favorable financing and incentives from manufacturers. CarMax's wholesale volumes were healthy--up more than 7%--but weren't enough to make up for weak retail volumes. Overall revenue growth of 11% was helped by new store openings and higher used car pricing. However, margins contracted, as it takes time for new stores to ramp up profitability and weak volumes in existing stores prevented operating leverage. Excluding a favorable legal settlement, earnings per share only advanced about 3%.

Even so, CarMax remains on track to achieve our long-term forecasts, and we raised our fair value estimate by $1 per share to $45 to account for cash earned since our last update. Given the cyclical nature of used-car retailing, investors should be prepared for some major ups and downs with CarMax. However, I still view the company as exceptionally well positioned to gain market share and deliver robust growth over the long run. I'll be looking for an opportunity to add to our position (now the smallest in the Hare with a 2.5% weighting), but I will require at least a modest discount to our latest fair value estimate.


It's time once again to rebalance Morningstar's Wide Moat Focus Index. As a reminder, this index includes the 20 cheapest wide-moat stocks based on price/fair value ratios as determined by Morningstar's analysts. It is equal-weighted and rebalanced quarterly. Master limited partnerships and most foreign companies are excluded. Year-to-date through yesterday's close, the Wide Moat Focus Index had delivered a total return of 10.0%, compared to 9.7% for the S&P 500.

The index experienced high turnover this quarter: Nine of the 20 holdings were replaced. The way the index is constructed, a stock with a price/fair value ratio of 0.91 can be replaced by a different stock with a price/fair value ratio of 0.90, even though the valuation difference is immaterial. Historical turnover has averaged around 120%-150% per year. This is one of the downsides of the Wide Moat Focus strategy, especially as compared to the low-turnover approach of the Tortoise and Hare.

The following stocks were added to the index this quarter:

Schlumberger SLB
Lorillard LO
National Oilwell Varco NOV
Monsanto MON
Exxon Mobil XOM
Qualcomm QCOM
General Electric GE
Polaris Industries PII
Expeditors International of Washington EXPD.

Of these, we already own Schlumberger and National Oilwell Varco in the Hare. Both stocks have been under pressure recently due to weakness in crude oil prices, concerns about the global economic outlook, and a cyclical downturn in offshore drilling. These external factors are completely outside the companies' control, and it's certainly possible that conditions could deteriorate further in the short run. For this reason, I intend to limit our overall exposure to oilfield services: SLB and NOV currently have a combined weighting of 9.7% in the Hare. I might be willing to raise this to the low-double digits, but probably no further. Additionally, I would only recommend these stocks to risk-tolerant investors with long time horizons. That said, both SLB and NOV trade at reasonable multiples of earnings and benefit from secular growth in capital spending by energy companies--an inevitable consequence of the fact that it is becoming increasingly difficult and expensive to locate and extract oil and gas. I consider either stock a potential candidate for new money, though I favor Schlumberger at the current price since it is trading at a steeper discount to our fair value estimate.

Of the other names that were added to the index, I plan to highlight Monsanto and Polaris in the upcoming October newsletter. The former has a dominant position in genetically modified seeds, though it faces patent expirations and growing competition. The latter was recently upgraded to wide moat status based on the strength of its brand in power sports equipment. Either stock could potentially fit in the Hare, though I have a few higher-priority prospects at the moment (mostly companies with narrow moats but more attractive valuations). The same goes for Qualcomm, which has been weighed down by concerns about the company's ability to enforce its intellectual property rights in China.

I'm somewhat less interested in the other four additions to the index. Lorillard is trading about half way between our fair value estimate for the stand-alone company and a pending acquisition offer by Reynolds American RAI, which basically makes it a merger-arbitrage play (I'm happy to leave those kinds of opportunities to hedge funds). Exxon Mobil is only down about 6% since I sold in April, and my rationale for selling still stands. I prefer SLB and NOV, which actually benefit from many of the same secular trends that are headwinds for Exxon. For Expeditors, I have similar concerns about the sustainability of the economic moat as I had with C.H. Robinson CHRW. Lastly, General Electric could possibly fit in the Tortoise, and I even listed it as a top prospect last month. However, I'm not convinced that General Electric's total return profile is attractive enough to offset its risk, particularly as the company's renewed focus on big-ticket industrial product lines could make it as cyclical as ever. As of now, I'm more inclined to add to some of our existing holdings in the Tortoise, such as HCP HCP, Unilever UL, Enterprise Products Partners EPD, Kinder Morgan Management KMR, Philip Morris International PM, or ITC Holdings ITC. I believe these stocks offer similar or better total returns with less economic sensitivity.

The following stocks remained in the Wide Moat Focus Index, carrying over from last quarter:

Western Union WU
Core Laboratories CLB
Exelon EXC
Amazon AMZN
Express Scripts ESRX
Sysco SYY
Baxter International BAX
Intercontinental Exchange ICE
Procter & Gamble PG
International Business Machines IBM.

We already own two of these stocks: Express Scripts and eBay. I have moat trend concerns about Western Union, Exelon, Sysco, and IBM. We own close substitutes for most of the others: NOV and SLB instead of Core Labs, eBay instead of Amazon, CME Group CME instead of Intercontinental Exchange, and Unilever instead of Procter & Gamble. That just leaves Baxter, which could potentially fit in the Tortoise but requires significant further research given the complex nature of the business.

Lastly, the following stocks were removed from the Wide Moat Focus Index, in all cases because of valuation:

Franklin Resources BEN
BlackRock BLK
Berkshire Hathaway BRK.B
MasterCard MA
Eaton Vance EV
Amgen AMGN
Coca-Cola KO
Bank of New York Mellon BK
Costco Wholesale COST.


A subscriber pointed out--with good reason, in my view--that my choice of words in last week's roundup may have been a bit misleading. In particular, I followed a common convention by claiming that Alibaba BABA "soared" in its initial public offering. To be clear, Alibaba only soared relative to its IPO price of $68, which was only available to a select group of institutional investors. According to the Wall Street Journal, 1,700 investment firms put in orders for Alibaba shares, but half didn't receive any. About 50% of the shares were allocated to just 25 firms. The vast majority of retail investors were shut out from the IPO altogether; their first opportunity to buy Alibaba came when the shares started trading at $92.70, which was already above our $90 fair value estimate. The point is that I wouldn't want to give you the impression that there was an easy way to make a quick buck on Alibaba's IPO--or any IPO for that matter. That privilege is usually reserved for a handful of well-connected institutions. The rest of us are better off watching from the sidelines until the initial enthusiasm dies down, hoping for an attractive entry point.


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

CarMax KMX  |  David Whiston, CFA, CPA, CFE

We think CarMax had a weak second quarter for fiscal 2015 results that were reported on Sept. 23, but we still see our investment thesis and moat rating intact after analyzing the results. We plan to increase our fair value estimate to about $45 solely for the time value of money since our last update. The stock fell by nearly 10% on the morning of Sept. 23 because although revenue increasing 10.9% year over year essentially matched consensus, the company posted a poor comparable used-vehicle unit sales increase of just 0.2%. This low comp number meant no SG&A leverage; so excluding a $20.9 million reduction in SG&A from proceeds from a legal settlement regarding Toyota residual values, the company’s diluted EPS of $0.64 missed consensus by $0.03. This year’s calendar meant CarMax had one less Saturday than the prior year’s quarter but management estimated that this cost the company only about 1 percentage point of comp growth.

These results are not great, but we are not concerned about CarMax’s long-term health. Management has always executed its playbook well over time and we still believe the company is the best used-car retailer in our dealer coverage. CarMax has increased its store base by 15% since the beginning of the second quarter of fiscal 2014, so we think that these stores need more time to mature and leverage their SG&A. The company’s subprime volume also fell to 13.8% of vehicles retailed from 18.5% in the prior year’s quarter. Store traffic was up only modestly and actual conversions were flat, so it’s not surprising to see flat comparable-store sales as well. We also suspect some consumers who may have normally bought used instead decided to buy a new vehicle due to attractive new product and excellent financing deals. Over time as new vehicle sales rise we expect CarMax’s traffic to also rise as more consumers are in the vehicle market however, this quarter may have been a large bump along the way in that process.


Philip Morris International PM  |  Philip Gorham, CFA, FRM

Two new regulations proposed in the U.K. and France pose a threat to Big Tobacco profitability. Both are far from being implemented, however, and we are retaining our wide economic moat ratings and fair value estimates for the tobacco firms under our coverage until we see evidence of the probability of implementation growing.

At the Labour Party conference yesterday, opposition leader Ed Miliband announced a plan to provide additional funding for the U.K.'s National Health Service in part through a tax on tobacco companies' net profit in the event of his party winning the general election, scheduled for May 2015. The tax should generate around GBP 150 million in annual incremental revenue. As the U.K. leader with a share of around 44%, Imperial Tobacco would be the hardest hit by such a tax, and would contribute GBP 60 million to 65 million per year, followed by Japan Tobacco (not covered) with GBP 57 million. We estimate that this would negatively impact our fair value estimate for Imperial Tobacco by GBP 7 per share, or 8%.  Both Philip Morris International and British American Tobacco have high single digit volume shares in the U.K., and our valuation would likely not be materially impacted by the tax.

In another threat to the tobacco industry, the newspaper Les Echos this morning reports that the French government is considering the introduction of standardized packaging. We regard plain packs as the single most dangerous regulatory threat to tobacco profitability, and we would reconsider our wide moat ratings in the event of adoption in more major markets. Philip Morris would be most affected by such a measure, as it holds a volume share of around 41% in France, and its portfolio is more vulnerable to trading down. However, we believe the risk to the government's tax revenues keeps the probability of implementation well below 50/50 at this stage, and unless we see evidence to the contrary, we will reiterate our wide moat rating and $90 fair value estimate.


Paychex PAYX  |  Brett Horn

Paychex’s fiscal first-quarter results contained no major surprises and were largely a continuation of recent trends. Revenue increased 9% year over year. While the payroll segment continued to record only modest growth of 4%, Paychex saw 17% growth in ancillary human resources services. This growth was partially driven by an accounting change in its PEO business, which accounted for 3 percentage points of this growth. But in our view, the strong results in this area demonstrate that these ancillary services remain a material growth engine for the company. We’ve seen similar trends at Paychex’s larger peer, ADP, and we are pleased to see these companies exploiting the opportunity to cross-sell these services and effectively expand the moat around their traditional payroll business. While these ancillary services are not as moaty as the payroll business on a stand-alone basis, in our opinion, the trend is not dilutive to the company’s moat due to the significant synergies inherent in providing a broader range of services. We expect these services to make up an increasing portion of revenue over time.

Interest income ticked up slightly year over year, and management pointed out that it believes the pressure on yield has bottomed out. While the timing of any improvement in interest rates is uncertain, we estimate that a 1 percentage point increase in yield would increase Paychex’s operating income by 4%, providing significant leverage to any improvement in this area. For reference, yields in the precrisis period were about 2 percentage points higher than the current level. Operating margins in the quarter fell to 40.1% from 41.6% last year, but this was primarily driven by the accounting change. We will maintain our fair value estimate and wide moat rating.


Abbott Laboratories ABT  |  Damien Conover, CFA

The U.S. Treasury's plan to increase the difficulty in completing tax inversions slightly lowers the odds of major announced tax inversions, putting pressure on the valuations of targeted companies including Shire (AbbVie acquisition) and Covidien (Medtronic) as well as AstraZeneca (likely a Pfizer target). However, we don't expect much impact on the valuations of the acquiring companies, as most of the benefits of these deals appear to be benefiting the targeted companies with the high takeover premiums. While these deals are still likely to be completed, since strong strategic reasons are evident and some tax benefits are still likely, the new tax regulations slightly reduce the odds of the mergers.

However, the U.S. Treasury's provision that specifically targets "spinversions" makes the Mylan/Abbott subsidiary deal less likely to proceed, hurting Mylan's valuation. In this case, the valuation of Mylan (not Abbott) would be under pressure, given the positive deleveraging impact the merger has on Mylan. We are maintaining our valuation of Mylan until more details emerge from the new tax regulations.

The final details of the new U.S. tax plans are still uncertain and the legality of the new proposals is still unclear, which increases the uncertainty of the completion of the announced inversions. We expect increased clarity from both the U.S. Treasury and inverting companies over the next few weeks.

Importantly, the actions will not be retroactive, and companies that have already completed such transactions, such as Valeant and Endo, will not be significantly affected by these measures. We believe these firms are best positioned to continue to benefit from their low-tax structure. Alternatively, potential targets such as Mallinckrodt and Smith & Nephew hold less appeal as inversion targets with the new U.S. tax plan.


Morningstar Investment Services

Interested in investing in the Tortoise and Hare portfolios? Now you can! Morningstar Investment Services, Inc. now offers customizable portfolios patterned after the Morningstar StockInvestor portfolios. Call 866-765-0663 to learn more.

Morningstar Investment Services is a registered investment advisor and wholly owned subsidiary of Morningstar, Inc.

Contact Us | © Morningstar StockInvestor
Customer Support
Product Support
Inquiries regarding your subscription such as address changes, missing/damaged issues, etc.
Phone: 1-800-957-6021 | Mon-Fri 8:30AM-5:00PM
Inquiries regarding technical issues such as logging in or downloading
Phone: 1-312-424-4288 | Mon-Fri 8AM-6PM
Product Sales
Inquiries regarding your subscription renewal, billing or to learn about other Morningstar investment publications and resources
Phone: 1-866-608-9570 | Mon-Fri 8AM-5PM
Contact Your Editor