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.

Jul 30, 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
Baidu's Big Bet

We knew Baidu's BIDU management was making a big bet on "online-to-offline" commerce, but the size of this bet was only made clear by disclosures in yesterday's earnings report. Judging by the stock's reaction today—down more than 17%—investors don't like what they see. However, I believe there is a huge long-run growth opportunity in front of Baidu, and I'm willing to give management the benefit of the doubt on its aggressive investment spending.

Over the past few years, Baidu has reported decelerating (but still rapid) revenue growth and sharp operating margin contraction. It's harder to grow off a larger base, so I'm not bothered by Baidu's 38% year-over-year revenue growth in the second quarter. However, the margin contraction is potentially more concerning. Management predicted another jump in expenses in the second half of 2015, and we now forecast the full-year operating margin to come in around 17%, down from 26% last year and 52% at its peak in 2011. As a result, earnings per share were roughly flat in the second quarter and are expected to decline moderately for the full year—not what you want from a Chinese growth stock with a high price/earnings multiple.

But that's not the whole story. Starting this quarter, Baidu broke out the margin impact of its online-to-offline and iQiyi (online video) products. Online-to-offline includes Baidu's stakes in online travel agency Qunar QUNR, group buying site Baidu Nuomi, Baidu Takeout Delivery, Baidu Maps, Baidu Connect, Baidu Wallet, and similar products. These businesses have a few things in common: (1) They are aimed at connecting online consumers with real-world services; (2) many of them generate minimal revenue today; and (3) Baidu is spending aggressively to promote and subsidize its products and drive consumer adoption.

Baidu faces fierce competition in emerging areas from a variety of startups, some of which are backed by Baidu rivals Alibaba BABA and Tencent, along with venture capital. However, Baidu believes it has several advantages in pursuing these opportunities, including an extensive salesforce that can target China's many small and medium-size enterprises; integration with Baidu's search and maps applications, which provide a ready source of consumer traffic; and unmatched data and technological expertise. Perhaps most importantly, Baidu has significant financial resources and a management team that is willing to sacrifice near-term profitability in favor of long-term growth.

Baidu estimates that online-to-offline and iQiyi are creating an incredible 30.4 percentage-point drag on operating margins. I actually found this disclosure encouraging—it implies that the core search business is still generating operating margins north of 50%! In my view, it stands to reason that either the new initiatives will pay off in the long run or Baidu can simply discontinue the investment spending. Put another way, if Baidu weren't investing in these side projects, its earnings power would nearly triple.

Baidu believes online-to-offline expands its addressable market by a factor of 10, so it's an opportunity worth pursuing. China's economy is maturing at a key time for the mobile Internet, which could allow technology to play an even larger role in daily commerce than it does in developed markets. China already has the largest e-commerce market in the world—40% larger than the United States, even though the country's gross domestic product is 40% smaller. Furthermore, I think Baidu's management has earned a certain amount of trust given its stellar past execution, demonstrated by Baidu's dominant market share in search and successful transition to mobile devices.

We trimmed our fair value estimate for Baidu to $200 from $214 to account for higher expenses and lower near-term margins. Keep in mind that our fair value estimate remains highly uncertain—it probably goes without saying that any Chinese Internet stock is not for a conservative portfolio (hence Baidu's presence in the Hare rather than the Tortoise). However, I think Baidu presents an attractive risk/reward trade-off at the current price, and I intend 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 Note

Baidu BIDU  |  Michael Wu, CAIA

Baidu reported a second quarter slightly below our expectations and, more important, provided a disappointing outlook for the second half of fiscal 2015. Revenue grew 38.3% to CNY 16.6 billion in the second quarter, slightly below our assumption of 40%. Operating profit fell 2.5% to CNY 3.5 billion. While the CNY 18.17 billion-18.6 billion revenue guidance for the third quarter was below market expectations, more concerning is the significant increase in operating costs expected in the second half. With continued investments in its online-to-offline offerings, management has guided selling, general, and administration costs for the second half to rise 80%-90% from the first half. This implies around a 90% increase for fiscal 2015, and we estimate full-year operating margins will decline to 17% from 26% a year earlier with full-year operating profit expected to fall 11%.

The new guidance sees our fair value estimate lowered to 7% to USD 200, and we believe the company is fairly valued. The aggressive investment will prolong the margin recovery, and we now expect operating margins to reach 24% by fiscal 2019, compared with our previous assumption of 26%. There is no change in our thesis, and we reaffirm our narrow economic moat rating. We expect Baidu to maintain its leading position in both desktop and mobile search given its strong branding and established user base. Revenue growth will remain in a strong positive trajectory, but the key to Baidu going forward is the monetization of mobile search and its heavy investments in its online-to-offline offering. The new offering will be built on the foundation of Baidu's search business. Its large active mobile user base, which increased 48% year on year to 304 million, will provide an advantage over rivals. Along with its technology and search analytics, the company is also able to leverage its salesforce and relationship with small to medium-size enterprises for the new ventures.

Online marketing customers increased 21% to 590,000 in the quarter, ahead of our expectations, while revenue per online customer also improved 13% from last year and 15% on the previous quarter.

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