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 29, 2015
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Matthew Coffina, CFA
Editor,
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, 3/27/15 -- Five Fair Value Increases
Berkshire Hathaway BRK.B teamed up with private equity firm 3G Capital again this week in a merger between Heinz--which Berkshire and 3G acquired two years ago--and Kraft Foods KRFT. Berkshire's share of the deal is a little over $5 billion--too small to move the needle for this giant conglomerate. However, I'm more interested in the implications for the broader consumer staples industry. 3G clearly believes there is a lot of corporate bloat at consumer staples firms; it is known for aggressive cost-cutting using the "zero-based budgeting" technique, which it has successfully deployed at firms such as Heinz and Anheuser-Busch Inbev BUD. The firm is setting a precedent for how profitable a consumer products company can and should be, and I have no doubt that Kraft's peers are watching 3G's actions closely.

We already have outsized exposure to consumer staples in the Tortoise, with Philip Morris International PM, Unilever UL, Coca-Cola KO, and PepsiCo PEP. These firms are probably too large to ever be acquired, but they can certainly feel pressure from shareholders and activist investors to bring their cost structures in line. Amid volume and currency headwinds, I wouldn't be surprised to see cost cutting become a top priority; I believe all four of our holdings have room to expand margins. I don't plan to increase the Tortoise's weighting to consumer staples: We're already at the limits of my comfort zone in terms of currency risk, and U.S.-focused firms generally don't have the same pricing power or long-run volume growth potential of the multinationals. However, 3G's activities and the shifting industry tone make me more likely to hold our existing positions.

In contrast, we don't own any consumer staples firms in the Hare, and I consider that portfolio's currency exposure to be manageable. Ambev ABEV already has a lean cost structure and industry-leading margins thanks to 3G's involvement. Mondelez International MDLZ could also be of interest--the company's margins are well below peers, and activist investors are already agitating for change. We recently increased our fair value estimate for Mondelez to $42 from $35, giving the stock one of the cheapest price/fair value ratios in the industry. I plan to make Mondelez a priority for further research.

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It's not my birthday, but it felt like it with all the gifts we received this week. There were five meaningful fair value estimate increases affecting some of my favorite holdings.

--Our American Express AXP fair value estimate increased to $95 from $82. Combined with the recent weakness in the stock price related to customer losses and legal setbacks, this is the first time in years that AmEx is trading at a material discount to fair value.

--Our General Dynamics GD fair value estimate increased to $131 from $124.

--Visa V increased to $69 from $58.50.

--MasterCard MA increased to $104 from $88.

--CME Group CME increased to $96 from $72.

In all of these cases, we reduced our cost of equity assumption to 9% from 10%, consistent with our updated methodology. We also incorporated recent cash flows, and in some cases adjusted our long-run growth, margin, and return on capital assumptions. With the possible exception of American Express, I view all of these stocks as core long-term holdings for the Tortoise and Hare. MasterCard and American Express are trading at the steepest discounts to our new fair value estimates, and these would be my choices for new money.

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Novo Nordisk NVO announced that it plans to resubmit its application to the U.S. Food and Drug Administration for ultra-long-acting insulins Tresiba and Ryzodeg based on interim data from an ongoing cardiovascular outcomes study. Although the data itself wasn't disclosed, it stands to reason that the drugs have demonstrated a favorable safety profile. If regulators are satisfied by the interim data, it could allow Novo to launch these key next-generation insulins in early 2016, and would set the foundation for a possible launch of combination therapy Xultophy as early as 2017. I continue to see Novo Nordisk's pipeline as among the strongest in the pharmaceutical industry. However, Novo's stock is up 27% thus far in 2015 and is trading at a moderate premium to our unchanged $49 fair value estimate (we had already anticipated an early regulatory filing for Tresiba and Ryzodeg). Importantly, Novo is not alone--the entire biotech sector has been on fire. I worry that Novo's valuation is getting ahead of itself, and I consider the stock a candidate to be trimmed or sold.

Lastly, Google GOOGL recruited Ruth Porat to be its chief financial officer, replacing Patrick Pichette, who announced his retirement earlier this month. I'm impressed by the quick turnaround, which should result in minimal disruption to Google's business. Porat previously served as CFO of Morgan Stanley MS, and I'm hopeful that she will bring needed discipline to Google's investment spending and capital allocation policies. Google remains a top pick in the Hare.

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

Novo Nordisk NVO  |  Karen Andersen, CFA

Novo Nordisk has decided to resubmit its applications for approval of next-generation insulin products Tresiba and Ryzodeg to the FDA, based on interim data from the DEVOTE cardiovascular outcomes study. Given management's previous comments about its refiling strategy, this decision implies that the interim data was strong enough to satisfy the FDA's concerns about any potential cardiovascular signal from previous, smaller trials. We had already anticipated that Novo would file in 2015 based on an interim analysis and gain approval in 2016 in the U.S. market, and we're not making any significant changes to our fair value estimate as a result of this news.

We think this decision supports our thesis that Novo possesses strong intangible assets in the field of biologic diabetes therapies, a key part of its wide moat. The likely approval of Tresiba in the U.S. around the end of the year (Novo plans to file for approval in April, with an expected six-month review) puts the firm in a good position to launch the product in early 2016, ahead of Lilly's biosimilar version of Sanofi's dominant basal insulin therapy Lantus. While Sanofi's own next-generation basal insulin Toujeo was approved in the U.S. in February and is set to launch in April, we think Tresiba is more likely to get a label that includes hypoglycemia benefits (which Toujeo did not). Overall, we see Novo's global insulin and diabetes care sales growing at an average rate of 8% annually over the next five years on a constant currency basis, allowing it to slightly grow its global insulin market share above the 41% level today.

While both Sanofi and Novo have given weak forecasts for insulin pricing power in the U.S. market in 2015 (Novo sees a flat to slightly positive pricing environment this year, and Sanofi's flat diabetes sales forecast implies a similar pricing impact), we think Tresiba will support Novo's long-term pricing power. Tresiba looks differentiated enough to allow Novo to continue to see low-single-digit growth from both higher net pricing and a mix shift to modern insulin regimens, with the remainder of growth coming from global demand increases.

Tresiba also gives Novo an important foundation for future combination regimens in the U.S., which accounts for slightly more than half of a $23 billion global market. The combination of Tresiba and Victoza, which Novo is starting to market as Xultophy in Switzerland, could see FDA approval in 2017. We think Tresiba and Xultophy remain multibillion-dollar opportunities, and the recent DUAL V data for Xultophy could help differentiate the combination product from basal insulin treatment alone.

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Berkshire Hathaway BRK.B  |  Greggory Warren, CFA

Wide-moat-rated Berkshire Hathaway announced this morning that it has once again joined forces with 3G Capital to facilitate a merger between H.J. Heinz, which the two firms bought jointly in February 2013, and Kraft Foods Group. The terms of the deal have Kraft shareholders receiving shares of the combined firms and a special cash dividend of $16.50 per share, leaving them with a 49% equity stake in the new Kraft Heinz. The special cash dividend requires a $10 billion cash infusion on the part of Berkshire and 3G Capital, with the two firms also contributing their equity holdings in Heinz to the combined entity. Berkshire's share of the special dividend is expected to be $5.2 billion, and the insurer will own just over a quarter of the common stock of Kraft Heinz once the deal is completed later this year. Once the deal is done, shareholders of Heinz will own 51% of the new entity. We view this as a good use of capital for Berkshire, and expect it to have a positive long-term effect on our valuation (primarily because the company has been earning next to nothing on its growing cash hoard of more than $60 billion).

CEO Warren Buffett had noted in his most recent annual letter to shareholders that Berkshire was likely to partner with 3G Capital in another deal, and we had assumed that it would likely involve a packaged food company, with Kellogg and Campbell Foods being the possible candidates. As such, we were a bit surprised to see Buffett going along with a purchase of Kraft, especially since he has been a net seller of the shares for several years now, holding just over 192,000 shares of Kraft at the end of the fourth quarter of 2014. This is down from 138.3 million shares at the end of 2008, when Kraft Foods accounted for more than 7% of Berkshire's equity holdings. To be fair, though, Buffett had sold off shares in not only Kraft, but Procter & Gamble, Johnson & Johnson and ConocoPhillips in order to raise capital for Todd Combs and Ted Weschler to manage.

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Priceline PCLN  |  Dan Wasiolek

After reviewing recently reported fourth-quarter 2014 results from the major Chinese online travel agencies, we reiterate our thesis that Priceline is better-positioned there than Expedia and that the region is the largest opportunity in the travel industry over the next decade. Our narrow moat for Priceline, a result of its network effect, remains intact, and we think shares are trading at an attractive entry point for new investment.

The recent results support our view that Qunar (partly owned by Baidu) and CTrip (Priceline’s partner) are best-positioned for long-term growth in the intensively competitive China region, while eLong (an Expedia majority-owned subsidiary) is in danger of continued share loss. ELong, CTrip, Qunar increased marketing spending 21.6%, 18.2%, and 10.2% sequentially to $193 million (73% of total revenue), $707 million (36% of total revenue), and $276 million (53% of total revenue), respectively. Despite the accelerated marketing spending from eLong, its fourth-quarter net revenue decreased 6%, while CTrip's and Qunar's fourth-quarter net revenue grew 32% and 107%, respectively. We believe this highlights eLong’s disadvantage of being predominantly a hotel, while CTrip and Qunar are more diversified one-stop shops for travelers.

This dominance is evident after comparing downloads of the companies' mobile applications: CTrip had 600 million fourth-quarter 2014 downloads compared with 350 million in the previous quarter; Qunar had 457 million third-quarter 2014 downloads (metric not given for fourth-quarter); and eLong had 132 million fourth-quarter 2014 downloads compared with 100 million in the previous quarter. Additionally, CTrip said it expects 40%-50% net revenue growth in both the first and second quarter of 2015, a growth rate the firm hasn't had since 2010.

Priceline does not disclose its percentage of revenue from Asia Pacific or China, but we believe that Asia Pacific is around 15%-20% of total revenue (composed of agoda.com and CTrip), while CTrip specifically can grow to midsingle digits as a percentage of total revenue from its current low-single-digit percentage of revenue over the next five years.

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