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.

 
Feb 27, 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, 2/20/15 -- Priceline Investment Off to a Good Start

American Express AXP can't seem to catch a break lately. A few weeks ago, investors were put on edge by accelerating marketing and rewards spending, which is a sign of intensifying competition for cardholders. Then last week the company lost an important partnership with Costco COST, which will create a major headwind to earnings per share growth over the next two years. The bad news kept piling up this week, as American Express lost an antitrust lawsuit to the Department of Justice.

If upheld on appeal, the court's decision in this case will enable merchants to steer consumers to lower-cost payment cards, which was previously prohibited by AmEx's contract terms. This ruling threatens to hurt American Express' pricing power with merchants and limit its ability to offer generous cardholder rewards, which is a key differentiating factor considering that AmEx isn't as widely accepted as MasterCard MA and Visa V. In a worst-case scenario, it's possible that the ruling will weaken AmEx's brand and erode its economic moat.

On the plus side, it's not clear that merchants will actively steer customers away from AmEx cards, even if they have the option. Merchants have to balance the modest potential savings against the risks of alienating affluent shoppers. Similar steering is already possible between cheaper debit cards and more-expensive credit cards, but most merchants have opted not to differentiate between the two. Additionally, the Tortoise and Hare's combined stake in MasterCard, Visa, and Discover DFS is roughly 6.7 times larger than our American Express position. Any market share loss by AmEx would benefit these competitors.

We maintained our $82 fair value estimate for American Express, which already incorporated competitive pricing and margin pressures. Although recent developments have mostly been negative, the stock is also down sharply thus far in 2015 (having previously traded at a premium to our fair value estimate). From the current stock price, I still find AmEx's risk/reward tradeoff acceptable, and I plan to hold.

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You win some, you lose some. Also this week, we received a strong fourth-quarter earnings report from Priceline:

Priceline PCLN
Gross Profit Growth: 26% (32%)
Adjusted EBITDA Growth: 23% (29%)
EPS Growth: 23% (28%)

Our investment in Priceline is off to a good start. Despite economic and currency headwinds in Priceline's core European market, the company delivered another quarter of robust top and bottom line growth. Gross travel bookings were up 23% in the fourth quarter and 30% for the full year (in constant-currency terms), reflecting the secular shift to online hotel reservations and Priceline's leading position in travel markets outside the U.S. Earnings expanded roughly in line with gross bookings as margins remained stable. Although management issued soft guidance for the current quarter, this was largely the result of severe foreign currency headwinds and investments in adjacent business lines such as restaurant reservations and hotel marketing services. (Priceline is also notorious for issuing conservative guidance.) The board authorized $3 billion worth of share repurchases--about 5% of the current market cap and the largest such authorization in Priceline's history. I view this as a good use of Priceline's cash, since the share price remains well below our fair value estimate. Although the stock is up 14% from our January purchase price and 23% from its recent lows, I still consider Priceline a favorite for new money in the Hare.

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Berkshire Hathaway BRK.B made some changes to its investment portfolio and agreed to acquire a small German retailer. Details can be found in the analyst notes below, but neither of these disclosures is material to our investment thesis. Novo Nordisk's NVO stock was up about 5% on Friday after the company announced successful Phase II clinical trial results for an oral GLP-1 analog to treat diabetes. Although it's only a mid-stage trial, this reinforces my view that Novo has one of the strongest pipelines in the pharmaceutical industry.

In other news, Morningstar has been rolling out new cost of equity assumptions across our coverage universe. The cost of equity is a key assumption in our valuation models, reflecting our view of the average investor's required return from stocks. The COE is used to discount future free cash flows to present value. If all of our cash flow forecasts were correct, you could expect our fair value estimates to increase roughly in line with the COE less the dividend yield each year (dividends are received in cash rather than accumulating in intrinsic value).

Previously, we used a COE of 8%, 10%, or 12% for U.S.-based companies with below-average, average, or above-average systematic risk, respectively. We've adjusted these values to 7.5%, 9%, and 11%. In my view, our new system aligns more closely with realistic long-run total return expectations from stocks (see my December cover story). Most Tortoise and Hare holdings will fall in the 7.5% or 9% bucket. All else equal, this change is likely to result in modest fair value increases across our coverage.

The first changes along these lines started to trickle in this week. We cut our cost of equity assumptions for PepsiCo PEP, Coca-Cola KO, and Novartis NVS to 7.5% from 8.0%. Pepsi's fair value estimate increased to $95 per share from $90, Coke's went to $43 from $42, and Novartis' increased to $100 from $95. We also reduced Priceline's COE to 9% from 10%, boosting our fair value estimate to $1,860 per share from $1,822. Note that changes to other assumptions--especially regarding foreign exchange rates--partly mitigated the COE impact. More adjustments are likely as our analysts continue to update their valuation models.

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

Priceline PCLN  |  Dan Wasiolek

After reviewing Priceline's fourth-quarter results and adjusting our long-term assumptions, we could modestly increase our $1,822 fair value estimate as demand and the profitability of the firm's network advantage are evident, supporting our narrow moat rating. We believe the shares are currently at an attractive margin of safety to initiate a position.

In our opinion, results indicate that the network advantage is intact. Total bookings were up 17% in the fourth quarter (23% constant currency), and the currency headwind of 6 percentage points was slightly below the midpoint of guidance (which called for 7.5). International fourth-quarter constant currency bookings rose 27% and were well ahead of management's 16%-23% guidance (and our 21% estimate), while U.S. bookings growth was 3.4%, in line with company guidance for 0%-5%. In total, 2014 bookings growth of 28% was in line with our estimate. Our view that Priceline is well positioned in the growing mobile space, China, and restaurant markets is intact. Highlights in performance included mobile, which continues to drive an increased mix of lower-cost direct traffic and some days represented 50% of total bookings; OpenTable revenue, which increased 43% over last quarter; and Ctrip, agoda, and booking.com, which experienced very strong growth in China. Additionally, booking.com property growth was 41%, which was impressive.

Profitability remains strong, as fourth-quarter agency revenue margins of 13.7% were up from last year's 13.2% (impressive, given the lower trend experienced at key peer Expedia). Additionally, fourth-quarter adjusted EBITDA growth of 23% exceeded the 13% midpoint of guidance.

This profitability came despite increasing investment in sales and marketing, which we think is warranted. 2014 online and offline advertising as a percentage of total revenue was 28% and 2.7%, respectively (versus last year's 26.5% and 1.9% and our estimate of 28.4% and 2.9%). Priceline noted that the offline TV campaign continues to yield positive results. We forecast continued increases in marketing for Priceline and the industry over the next few years, but may have to raise our spending outlook further.

Priceline's first-quarter 2015 international constant currency bookings growth guidance (which typically proves conservative) is for 17%-24%, which implies a continued healthy trend and is in line with our 21% constant currency estimate. That said, the currency impact is forecast to be 12 percentage points, which is above the high-single-digit rate we modeled in early January. We do not find the higher currency headwind as shocking, but will be adjusting our near-term agency bookings to account for this.

Priceline announced a $3 billion share-repurchase authorization (around 5% of shares outstanding at current levels). This is the largest authorization amount ever for the company, and we believe it is a good use of capital as the shares are trading at an attractive price compared with our fair value estimate.

On the call, we were encouraged by the response to a question asked on the implications Priceline sees from the proposed Orbitz acquisition by Expedia. Management spoke highly of Expedia, but noted that Priceline's strategy continues to be focused on organic growth and acquisitions of premium brands in either new verticals (such as restaurants) and geographies (emerging markets). We applaud this strategy, which is one reason we view Priceline as best positioned for long-term growth in the online travel agency space. That said, given the increased use of loyalty programs in the industry, we would like to see some increased capital allocated here, although management notes it is interested in loyalty and that the experience it provides has continued to drive increasing return visits.

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American Express AXP  |  Jim Sinegal

A New York District Court ruled against American Express in a long-standing antitrust case, finding that the company’s rules constituted an unlawful restraint on trade. American Express’s rules require that its merchants could not indicate a preference for other payment products or attempt to dissuade cardholders from using American Express, provisions that the court found to limit competition.

While the company plans to appeal, we view the case as another step in the direction of increased competition. We are not lowering our $82 fair value or moat rating for American Express, as we believe it will remain difficult for most merchants to steer customers away from American Express, and our fair value estimate incorporates continued pricing pressure on the company’s discount fees. However, we will be closely monitoring American Express’ market share and discount rates in coming quarters, as well as new promotions by merchants and card networks, in order to verify our thesis. Finally, we expect the reduction in competitive restraints to benefit Discover Financial and Synchrony Financial.

Our concern is moderated by the notion that competition of the sort previously prohibited by American Express is difficult even when allowable. The Durbin Amendment opened up similar competitive practices for debit cards, yet widespread steering to debit has not taken place in the years since the Durbin Amendment--though there are significant differences between debit and credit, as the court pointed out. Visa and MasterCard also settled their part in this issue in 2011, with few adverse effects to date. One reason is that consumers must balance current discounts against potential rewards, and manage spending volume across multiple cards in order to maximize their benefits. This can be a difficult calculation at the point of sale. It can also be difficult for merchants to balance the benefits of lower network pricing with the risk of alienating some of their best customers. Costco, for instance, maintains particularly strong customer loyalty among retailers, and yet many American Express customers were disappointed with the firm when the two companies disclosed the end of their relationship. Ironically, increasing competition in the premium space from Visa and MasterCard issuers may also make steering more difficult, as cards that look the same to cardholders may carry far different costs for merchants.

Second, American Express’ powerful relationships with certain customers will be hard to break. The company is particularly strong with business travelers, capturing nearly two thirds of corporate card spending in the first half of 2013, according to the case documents. In fact, employers often mandate the use of the company’s cards due to American Express’ services for business users. Hence, the court found that such customer insistence was evidence of American Express’ market power which is still a good thing for American Express. It’s possible that attempting to steer customers to other cards may have the same deleterious effects on merchants as refusing to accept American Express has in the past. We note that American Express has occasionally allowed companies to steer customers to their own preferred payment methods, with little permanent effects on their loyalty to American Express.

Third, we still see American Express’ closed-loop network as increasingly valuable due to its ability to collect mass amounts of data. JPMorgan Chase, for instance, made a deal with Visa to effectively achieve similar capabilities in transactions in which it serves as the card issuer and merchant acquirer. We don’t attribute much explicit value to these offerings, but the capability to provide additional high-value services in the years to come provides a modest margin of safety.

We see this decision as a positive development for two firms we cover: Discover Financial Services and Synchrony Financial. Discover’s management has indicated a desire to serve as a low-cost provider were it not for such rules, and this decision opens the door for the relative outsider to compete successfully on that basis. Discover’s minimally profitable network would benefit significantly from additional volume, and this decision gives it the ability to gain it by undercutting on price and allowing merchants to pass on savings to customers. Merchants would very much like to provide their own rewards to customers, gain loyalty, and lower their costs of accepting payments. This ruling opens the door for merchants to compete harder in the payment space with the aid of private-label issuers like Synchrony.

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Berkshire Hathaway BRK.B  |  Greggory Warren, CFA

Wide-moat Berkshire Hathaway's fourth-quarter 13-F filing highlighted a shift in strategy as the firm unloaded most of its Energy holdings and funneled most of the capital raised into Deere and International Business Machines. The company's 13-F equity holdings, which do not include foreign investments held abroad, were valued at $110 billion at the end of the December quarter, with the top five holdings--Wells Fargo (23%), Coke (15%), American Express (13%), IBM (11%), and Wal-Mart (5%)--accounting for more than two thirds of the portfolio.

Likely spurred on by the collapse in oil prices, the insurer eliminated its stakes in ExxonMobil and ConocoPhillips (and sold off a fifth of its holdings in National Oilwell Varco) during the fourth quarter, picking up more than $3.5 billion in proceeds from the sales. Berkshire also reduced its stake in Bank of New York Mellon (picked up in the third quarter of 2010) and eliminated its Express Scripts holdings (bought during the third quarter of 2014), picking up another $100 million (by our estimates).

The rest of the cash that was raised was used to fund fairly meaningful additions to its holdings in Precision Castparts, Charter Communications, Suncor Energy, Visa, MasterCard, and Viacom; as well as smaller additions to Phillips 66, Directv, Liberty Global, DaVita, and General Motors. Berkshire also reported 8.4 million shares of Restaurant Brands International, acquired from its wholly owned subsidiary National Indemnity Company during December.

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Berkshire Hathaway BRK.B  |  Greggory Warren, CFA

Having questioned wide-moat Berkshire Hathaway's interest in buying non-U.S. companies at last year's annual meeting, and seeing CEO Warren Buffett recently state that he was likely to buy a small business in Europe in the near future and would like to eventually buy more (and bigger) businesses abroad, we were not too surprised by the news that the firm is spending about half a billion dollars on an acquisition in Germany. What did surprise us a little was the type of company: Detlev Louis Motorradvertriebs, a motorcycle apparel and accessories retailer based in Hamburg, which has more than 70 stores in Germany and Austria and gross revenue of around $300 million.

That said, there are some similarities with the purchase of Van Tuyl Group, the largest privately owned auto dealership group in the United States, which Berkshire acquired in early October 2014. Both are family-owned businesses that have rejected going public, being taken out by a private equity firm, or selling to one of their rivals. And both have seen a greater involvement on the part of Buffett's two lieutenants--Todd Combs and Ted Weschler--with the latter expected to oversee the German retailer once it is brought under the Berkshire umbrella. It looks as if Louis will keep its brand name for now, highlighting that there are some limits to the Berkshire branding efforts (Van Tuyl did change its name to Berkshire Hathaway Automotive after the deal closed).

Buffett sees the Louis deal as the first of many he expects to do in Europe longer term, believing that the transaction will alert the owners of family-owned businesses to the attractiveness of Berkshire as a potential acquirer. With the insurer closing out the third quarter of last year with more than $40 billion in excess cash on its books (and probably ending the year at a similar level), there should be plenty of cash to put to work in acquisitions in the near to medium term.

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