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 24, 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, 7/18/14 -- EBay Muddles Through Challenging Q2
Earnings season is in full swing, so I'll get right to it. Growth rates below reflect adjusted, constant-currency numbers where available.

Johnson & Johnson JNJ
Revenue Growth: 9%
Pre-Tax Income Growth: 13%
EPS Growth: 12%

J&J's second-quarter results were remarkable, led by a nearly 37% increase in domestic pharmaceutical sales and 21% growth in global pharmaceutical sales. Unfortunately, the acceleration in growth will likely prove temporary; more than half of global pharmaceutical sales growth was attributable to hepatitis C drug Olysio, which will face competition from superior drugs by Gilead GILD and AbbVie ABBV later this year. However, even without Olysio, pharmaceutical sales growth would have been solid at 9% as J&J's robust portfolio of recently launched drugs more than offset modest patent expirations. Sales in the consumer division were up 3.6% in constant-currency terms, which was the fastest quarterly growth rate in more than five years. I'm optimistic that J&J's consumer business is finally turning the corner after a series of manufacturing problems and product recalls. On the other hand, the medical device segment continues to struggle, with sales up less than 1%. I expect this business to remain challenged by intense competitive and reimbursement pressure for the foreseeable future. Overall, I continue to view J&J as capable of delivering a long-run total return in the neighborhood of 8% per year with modest risk, and I intend to hold.

Abbott Laboratories ABT
Revenue Growth: 3%
Pre-Tax Income Growth: 12%
EPS Growth: 17%

Abbott's latest results demonstrated significant improvement from the previous quarter, putting the company back on track for double-digit growth in adjusted earnings per share for 2014, largely driven by cost cutting. The nutrition segment returned to growth in the quarter, as Abbott is finally moving past last year's infant formula recalls in China. Abbott is pursuing direct ownership and operation of dairy farms in China, which should hopefully improve the integrity of its supply chain. I view the nutrition segment as having the strongest economic moat among Abbott's diverse operations. Growth in the diagnostics segment also remains surprisingly strong, while generic drugs and medical devices are stuck in first gear.

Earlier this week, Abbott agreed to sell its developed-market generics business to Mylan MYL. In conjunction with recent generics acquisitions in Latin America (CFR Pharmaceuticals) and Russia (Veropharm), Abbott's generics business will concentrate on emerging markets going forward. I believe these transactions will meaningfully enhance Abbott's competitive position in the generics segment. Developed markets are characterized by fierce competition, intense reimbursement pressure, and slow growth for generics, and Abbott lacked the scale to compete over the long run. In contrast, emerging markets offer faster growth and most patients pay cash, which alleviates reimbursement pressure. Quality concerns also make brands relevant, which can lead to a modest degree of pricing power.

The developed-market generics sale is being structured as a tax inversion for Mylan, allowing it redomicile in the Netherlands where it can achieve a tax rate in the high teens. Inversion transactions have experienced a sudden burst of popularity among health-care companies, and regulatory threats to close this loophole have only accelerated activity. Abbott will receive 21% of Mylan's stock as consideration for the sale, valued at roughly $5.3 billion. There will be an immediate 10% hit to Abbott's earnings per share, but management estimates that the ongoing growth rate of net income will be accelerated by more than two percentage points. I expect Abbott to sell off its Mylan shares fairly quickly and to use the proceeds for acquisitions or share repurchases aimed at replacing the lost earnings.

Our $40 fair value estimate is unchanged for now, but our analyst indicated that a modest fair value increase could be in store. I still view Abbott as a potential source of funds for the Tortoise, though I'm not in any rush to sell.

Kinder Morgan Management KMR
Revenue Growth: 19%
Distributable Cash Flow Growth: 11%
Distributable Cash Flow Per Unit Growth: 1%

Kinder Morgan Energy Partners
KMP (which is economically equivalent to KMR) continues to post steady results. The latest quarterly distribution of $1.39 was up 5.3% from the prior year. Distribution coverage was only 0.88 due to seasonality, but is expected to be around 1 for the full year. Cash flow growth in the quarter was well balanced between natural gas pipelines (up 13%), CO2 transportation and oil production (up 3%), products pipelines (up 17%), and terminals (up 19%, helped by the acquisition of an oil tanker business). KMP/KMR's project backlog also remains healthy at $15.4 billion, which should support at least a few more years of mid-single-digit distribution growth. However, Kinder's aggressive distribution and financing policies leave little margin for error over the long run, and KMR remains a possible source of funds.

Novartis NVS
Revenue Growth: 2%
Operating Income Growth: 6%
EPS Growth: 7%

Despite muted sales growth, Novartis delivered respectable earnings growth in the second quarter thanks to operating margin expansion. The company has one of the stronger late-stage pipelines in Big Pharma, but this is largely offset by ongoing patent losses on past blockbusters. Pharmaceutical sales were up 1% in the latest quarter, overcoming a six percentage point headwind from generic competition. Aggressive cost cutting enabled the pharmaceutical segment to post 8% constant-currency operating income growth. The Alcon eye care division saw sales and operating income growth of 4% and 2%, respectively. The Sandoz generics business increased sales and operating income 4% and 3%, respectively. Recall that Novartis is focused around these three divisions following a series of recent transactions, including the sale of its vaccines and animal health segments and a joint venture with GlaxoSmithKline GSK for its consumer operations. Similar to J&J, I view Novartis as a steady business capable of delivering long-run total returns around 8% per year. In the absence of a substantially better opportunity, I expect to hold.

Philip Morris International PM
Revenue Growth: 5%
Operating Income Growth: 10%
EPS Growth: 20%

Philip Morris' reported results were weighed down by adverse currency movements and a large restructuring charge. These items masked a strong underlying performance--including 20% adjusted earnings per share growth--which reaffirms my view that Philip Morris International is one of the most compelling investments among consumer staples firms. Few if any other companies can match Philip Morris' combination of a generous 4.4% dividend yield, a reasonable 16.6 times price/earnings ratio (using adjusted earnings estimates for 2014), and mid- to high-single-digit long-run earnings per share growth. Cigarette volumes declined 2.7% in the latest quarter, but that didn't prevent Philip Morris from achieving constant-currency revenue growth of 4.5% and operating income growth of 9.5%. Price increases, disciplined cost control, and share repurchases remain the primary drivers of EPS growth. The second quarter was a notable improvement from the first, when cigarette volumes were down 4.4% and adjusted operating income fell more than 3%. On the other hand, management stuck with its guidance for full-year adjusted EPS growth at the low end of a 6%-8% range, as the company will face more challenging prior-year comparisons in the back half of 2014. Philip Morris International remains a top pick for new money in the Tortoise.

BlackRock BLK
Revenue Growth: 12%
Operating Income Growth: 15%
EPS Growth: 18%

BlackRock delivered solid second-quarter results, helped by the ongoing bull market. Assets under management advanced 19% to nearly $4.6 trillion. This was mostly due to market appreciation, but $38 billion of net inflows in the quarter represented an annualized organic growth rate of about 4% (slightly below management's long-term target of 5%). Revenue growth of 12% trailed AUM growth by 7 percentage points because of business mix shifts and ongoing fee pressure. However, operating leverage, a lower tax rate, and share repurchases enabled adjusted earnings per share to grow almost as quickly as AUM. Most of BlackRock's products continue to deliver strong results for both investors and shareholders, especially its bond funds and the iShares exchange-traded funds. Only actively-managed fundamental equity strategies continue to struggle, with just 35% of such funds ahead of their benchmarks over the last year. Unfortunately, active equity funds also tend to carry relatively high fees. BlackRock has been restructuring these funds and bringing on new managers, and I'm hopeful that this business can be turned around. In the meantime, strong overall results point to the benefits of BlackRock's broad diversification. BlackRock remains a core long-term holding for the Hare, but keep in mind that its performance is likely to be closely linked to stock and bond market returns in the short term.

Charles Schwab SCHW
Revenue Growth: 11%
Net Income Growth: 27%
EPS Growth: 28%

Schwab's trading revenue declined 10% in the second quarter as stock market volatility reached lows not seen in years. However, strong overall results--including 11% revenue growth and 28% earnings per share growth--demonstrate how little Schwab depends on trading commissions these days. The company gathered $22.7 billion in net new assets in the latest quarter for an annualized organic growth rate of about 4%. More importantly, Schwab continues to cross-sell investment advisory and banking services to existing clients. Assets managed by independent advisors in Schwab's network were up 20% from the prior year to over $1 trillion, while assets in Schwab's proprietary advice solutions were up 28% to $175 billion. At the same time, interest rates are finally turning from a headwind into a tailwind, with the net interest margin improving by 16 basis points to 1.65% in the second quarter. Schwab also constrained non-interest expenses to an increase of just 3.5%, enabling significant margin expansion. Although Schwab's stock price is still at a modest premium to our recently-raised fair value estimate of $25, I see substantial upside over a 5-10 year time horizon, and I plan to hold.

Revenue Growth: 10%
Net Income Growth: 6%
EPS Growth: 9%

Among our holdings, I was most nervous about eBay going into this earnings season. The company's second quarter included two severe headwinds: A data security breach that forced it to encourage users to change their passwords, and a change to Google's GOOG search algorithm that reduced organic traffic to eBay's websites. Despite these challenges, eBay delivered decent results, and the company should return to its former growth trajectory within a few quarters. Enabled commerce volume growth accelerated to 24% year-over-year, indicating that eBay continues to expand its role facilitating global e-commerce. Organic revenue growth of 10% consisted of 20% growth for PayPal (which was largely unaffected by the security breach and Google algorithm change) and 6% growth for marketplaces (which saw a marked deceleration starting in late May that is likely to persist into next quarter). Expenses to deal with recent challenges contributed to a declining operating margin. However, management maintained its full-year adjusted earnings per share outlook, helped by aggressive share repurchases. EBay is still forecasting earnings per share growth in the neighborhood of 10% for the full year, which I view as acceptable considering the stock's undemanding valuation (17.3 times current-year earnings estimates). EBay is a possible destination for new money.

Google GOOG
Revenue Growth: 22%
Operating Income Growth: 22%
EPS Growth: 23%

Google delivered solid second-quarter results, and we raised our fair value estimate to $545 from $520 to account for cash earned since our last update. Year-over-year revenue growth of 22% is remarkable for a company of Google's size, reflecting both the enormous opportunity in digital advertising and Google's super-wide moat. Advertising growth on Google's owned web properties like Search and YouTube continues to handily outpace third-party partner websites. Additionally, the "other revenues" category expanded 53% and represents a substantial opportunity as Google extends its reach beyond advertising into areas such as enterprise software, cloud computing, and app distribution. The operating margin held steady for the first time in several quarters, allowing all of the revenue growth to reach the bottom line. I continue to believe that Google is capable of a much higher operating margin, but I'm willing to give management the benefit of the doubt on its wide-ranging investment program, especially in light of such rapid revenue growth. Google remains a core long-term holding for the Hare.


Besides earnings, there were only two other developments worth mentioning this week. First, we raised our fair value estimate for TransCanada TRP to $54 per share from $49. Roughly half of the increase was because of an accelerated timeline for the Energy East project, with the remainder due to strong results in the electricity generation segment. I've occasionally mentioned TransCanada as a potential source of funds, but I'm likely to hold for now considering our latest appraisal. Second, we added $1 to our fair value estimate for Wells Fargo WFC--now $50--to account for cash earned since our last update. I expect 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 Notes

eBay EBAY  |  R.J. Hottovy, CFA

EBay's second-quarter update confirmed that the one-two punch of a data breach and changes to Google's search algorithm in May hurt Marketplaces volume, with gross merchandise volume growth slowing to 7% in June after starting the quarter in low-double-digit territory on a constant currency basis. This was the impetus behind our recent revenue forecast reduction, and our updated estimates are aligned with management's revised full-year revenue outlook calling for $18.0 billion-$18.3 billion (versus $18.0 billion-$18.5 billion previously). There is no change to our $63 fair value estimate as the second-quarter results and updated guidance were consistent with our model.

Although eBay's Marketplaces challenges shouldn't be taken lightly, our positive long-term outlook remains in place and we find several key takeaways from the quarter. One, we believe management took appropriate measures to protect its network effect--the primary source behind our wide moat rating--in asking Marketplaces users to change passwords following the data breach, even if it comes at the expense of near-term user engagement levels and profitability. We're encouraged that the company's response, including couponing, seller incentives, and marketing investments, has prompted a modest recovery in GMV trends thus far in July, though we agree with management that a return to double-digit GMV growth will take time (our model assumes low-double-digit growth resumes in 2015).

Two, eBay's Marketplaces issues have overshadowed impressive payment volume (up 26% on a constant currency basis to $55.0 billion), mobile volume (up 68% to $12.3 billion, which now represents 20% of total enabled commerce volume), and cross-border payment volume. These trends suggest increased engagement among users (which increased 15% for both Marketplaces and PayPal) and reinforce our views of eBay as a key facilitator of commerce in the years to come, something we believe the current market price underappreciates.

Three, despite questions about the motivations and timing behind last quarter's charges to facilitate the potential repatriation of $6.0 billion in net foreign earnings (especially when the company has ample credit availability), we generally believe management has struck the right balance between near-term investments (including PayPal brand marketing and other payment infrastructure improvements) and other capital-allocation efforts (including $1.7 billion in share repurchases during the quarter and $2.2 billion remaining on the current authorization). We also believe that share repurchases, combined with consumer and small-business credit initiatives within PayPal, should be enough to meet the low end of management's earnings per share targets for the year (which remain unchanged at $2.95-$3.00 excluding one-time items).

CEO John Donahoe also provided a brief update on the company's search for a new PayPal President following the June 9 departure of David Marcus. Over the near term, management is focused on maintaining current momentum in the PayPal business and will turn its attention to finding permanent leadership over the next few months. We've long thought PayPal had one of the deeper and more entrepreneurial benches in e-commerce (partly the result of recent acquisitions like Braintree), and believe there are several candidates qualified to lead PayPal. Our model continues to assume that PayPal will meet management's previous 2015 goals, including $9.5 billion-$10.5 billion in segment revenue.


Abbott Laboratories
ABT  |  Debbie S. Wang

Abbott posted mixed second-quarter results that on balance slightly exceeded our expectations, but not enough to move the needle on our valuation. However, we do plan to modestly bump up our fair value estimate after incorporating the acquisitions of CFR and Veropharm, along with the divestment of Abbott's established pharmaceuticals in the developed markets to Mylan. Importantly, Abbott made progress on profitability as it held manufacturing and operating costs down. We continue to stand behind Abbott's narrow moat and stable trend ratings.

We were pleasantly surprised by quarterly core diagnostics growth of 6%, and the optics business delivered strong 12% quarterly growth thanks to the launch of several new cataract products in key markets. Strength in these areas was tempered by steeper-than-expected declines in diabetes and coronary stents. While we do not expect any near-term improvements to the weak percutaneous intervention volume that has slowed the entire coronary stent market, we anticipate diabetes should return to growth over the next few quarters. First, the effects of Medicare's competitive bidding program should moderate as we reach the one-year anniversary of the program in third quarter. Second, Abbott should receive European regulatory approval on its new Freestyle Libre glucose monitor by the end of this year. We have seen this new product demonstrated and walked away impressed by how discreet and patient-friendly it is. Attaching the small, wearable sensor eliminates the need for multiple finger sticks each day. Additionally, unlike existing continuous glucose monitors, Freestyle Libre eliminates the need to periodically calibrate the monitor with finger sticks. We think Freestyle Libre is substantially different and easier to use than competitive monitors and expect it will reach commercial success. We'll be keeping an eye on Europe to see how the product introduction unfolds.


Abbott Laboratories ABT  |  Michael Waterhouse

Mylan announced an all-stock acquisition of Abbott’s developed-market generic and specialty pharmaceutical operations valued at roughly $5.3 billion based on Mylan’s recent closing price. Overall, we think the deal appears financially and strategically attractive for Mylan, for the most part, but we view the tax savings, which follows a pack of other recent tax inversions in the industry, as the primary impetus for the deal. We’ll likely raise our fair value estimate for Mylan, but despite the benefits of enhanced economies of scale, greater product diversification, and a lower tax rate, we don’t anticipate any change to our narrow moat rating for the company. Abbott's fair value estimate and narrow moat remain unchanged. As part of the tax inversion, Abbott will own approximately 21% of the new Mylan.

Cost synergies, including both operating and tax savings, in addition to a strengthened balance sheet are the biggest advantages to Mylan as a result of this deal, in our view. Management expects up to $200 million in pretax operating synergies within three years in addition to the company’s tax rate falling near 20%, with additional declines over time placing a longer-term rate in the high teens. Management also expects a debt/EBITDA ratio near 2.3 upon the deal close, which suggests that there’s capacity for further deal making in the near term.

The maturity of these Abbott assets and ongoing weak pricing conditions on the European continent don’t suggest strong growth opportunities from this combination. Mylan will gain roughly $1.9 billion in revenue, but Abbott is retaining its most prized pharmaceutical assets, including branded and emerging-market generics. Despite greater product and geographic diversification, Mylan will remain largely exposed to the U.S. and European generic markets. Regardless, we think Mylan’s scale and market share in the European region gives management the opportunity to improve returns on these assets.


Philip Morris International PM  |  Philip Gorham, CFA, FRM

Philip Morris International reported second-quarter results that beat consensus estimates both on the top and the bottom lines, and the report contained several positives that suggest our investment thesis and wide moat rating remain intact. We are reiterating our $90 fair value estimate. Despite the transformative transactions announced in the industry this week, we continue to regard Philip Morris International as the pick of the tobacco group both on long-term competitive positioning and valuation. Turnarounds in Europe and Asia are the upside catalysts to the stock, in our opinion, and while there is still work to do on both fronts, particularly in Indonesia, second-quarter results showed some green shoots of improvement.

Europe and Asia are two of the most important geographies for Philip Morris, and both regions reported a strong performance in the second quarter. Organic revenue in the European Union, which is likely to be a critical driver of the turnaround in  business performance, grew 2.7%, with contributions from both volume and pricing. Although top-line growth remains slightly below our long-term assumption of 3.0%, it is a significant improvement from the 0.4% decline in organic revenue in the first quarter and could be a sign that some of the troubled Southern European markets are finally stabilizing. We see mixed read-throughs for Imperial Tobacco's European business from management's commentary. In Spain, where Imperial is the market leader, the total market declined 1.2%, a sequential improvement from the 3.6% decline in the first quarter. On the other hand, management cited slower trading out of cigarettes and into roll-your-own tobacco, a category in which Imperial also leads, as a contributor to the improving volume performance in the EU.

Although the company's Asia segment is far from out of the woods, there were some encouraging signs in the second quarter. We regard Asia as a long-term growth driver, and a recovery is important to our investment thesis. However, organic revenue in the region fell 3.6%, driven by a tax increase in Japan on April 1. We expect Japan to remain a drag on results for the next three quarters as Philip Morris' price increases along with the tax hike were muted.

On a more positive note, the market in Indonesia increased 4.9%, rebounding strongly from a 1.0% decline in the first quarter, and Philip Morris' volume increased 1.3%. However, the firm's market share fell by a further 1.2 percentage points, as the kretek category continued to take share of the overall market. Indonesia is Philip Morris' single-largest market by volume and had been a key driver of its strong financial performance until 2012. With a strong distribution platform (the firm remains the market leader in Indonesia with a 34.9% share, although the local players are close behind), we believe Philip Morris has a wide economic moat in the Indonesian market, and we anticipate it will use its platform to respond to the shift in tastes and preferences by taking steps to further penetrate the kretek category.

With the exception of Indonesia, we regard Philip Morris' operational problems--namely a strong U.S. dollar, macroeconomic weakness in parts of Europe, and predatory pricing practices by a competitor in the Philippines--as mostly temporary in nature. We still regard the firm as the best-positioned business in the global tobacco industry, as we believe it possesses a wide economic moat through a cost advantage over local manufacturers and strong brand loyalty to Marlboro in developed markets. For investors who can accept the risk of the spread of plain packs, we continue to recommend building a position when the stock trades at an attractive discount to our fair value estimate.


Kinder Morgan Management KMR  |  Jason Stevens

Kinder Morgan Energy Partners' second-quarter results tracked our estimates fairly closely, and we are maintaining our $90 fair value estimates and wide moat ratings for KMP and KMR. Declared distributions of $1.39 per unit are up 5% year over year and up a penny over last quarter. Distributable cash flow increased to $561 million, or $1.23 per unit, up from $505 million, or $1.22 per, unit last year. In other words, while overall distributable cash flow increased 11%, increases in units outstanding (from equity issued to fund new growth) ate up the majority of those gains, leaving Kinder with only an additional penny of distributable cash flow per unit. Coverage for the quarter was below 1.0 times, as expected due to seasonality. We continue to expect full-year coverage to be just a hair above 1.0 times.

Two points from the analyst call bear mentioning, in our view. First is a comment on the Trans Mountain project, where a National Energy Board decision this week will add another six months to review time and ultimately lead to slippage for Kinder's targeted in-service date, which now moves into 2018. We don't view this news as a negative yet, but it does underscore the risk that the large ($5 billion-plus) project could continue to face the kinds of delays and obstacles we've seen with other large pipeline projects (Keystone XL, Northern Gateway). At this time, we still think Kinder will pull it off, but it may cost more and take longer than initial expectations.

The second point is that Kinder's project backlog continues to grow. This quarter Kinder Morgan brought another $700 million of new projects on line, while increasing its project backlog to $17 billion, adding $1.3 billion in projects into backlog this quarter. This creates a very significant tailwind for the partnership as the majority of these projects will sustain and prolong excess returns, supporting our wide moat rating.


Johnson & Johnson JNJ  |  Damien Conover, CFA

Johnson & Johnson reported strong second-quarter results that exceeded both our and consensus expectations largely because of stronger-than-expected pharmaceutical sales. In particular, sales of hepatitis C drug Olysio significantly outperformed expectations. Despite the strong quarter, we do not plan to change our $99 fair value estimate, as Gilead and AbbVie are set to launch new competitive hepatitis C drugs by the end of the year, diminishing the strength of J&J's competitive positioning in that disease. Nevertheless, the overall strength in the high-margin pharmaceutical division continues to support our wide moat rating on the company.

In the pharma segment, total sales increased 21% year over year, boosted by Olysio as well as several strong product launches. While we expect this growth will moderate in 2015 as competition arrives, J&J is still in the launch phase for several new potential blockbusters, including diabetes drug Invokana, cardiovascular drug Xarelto, and cancer drug Imbruvica. Further, J&J's near-term patent losses involve complex injectable drugs (Invega Sustenna and Risperdal Consta for neuroscience indications) as well as a biologic (Remicade for immunology disease), which lead us to project smaller market share losses to generic competition relative to typical generic competition.

J&J's device division continues to struggle (up 1% year over year) while the consumer group is rebounding (up 4% year over year) from manufacturing issues. We believe continued low medical utilization is weighing on the medical device segment as higher cost sharing with patients seems to have slowed the typical rebound in health-care spending coming out of a recession. While we expect minor improvement in growth for the medical device segment, we expect the structural change of increased cost sharing and more price-sensitive payers is likely to lead to long-term growth of 3%.


Google GOOG  |  Rick Summer, CFA, CPA

Google logged another dependably strong quarter, notable only by a lack of surprises in either growth, margins, or pricing metrics. Our core thesis stands, although we acknowledge there may be some unappreciated upside in non-advertising segments that, while nascent, have strong potential for revenue growth, although likely at lower margins relative to the legacy businesses. Still, there was a lot to like in the quarter. We are reiterating our wide economic moat rating, and we're increasing our fair value estimate to $545 to account for the time value of money.

Revenue and profitability for the quarter were generally in line with our estimates, as heavy investment in data centers and more nascent products and services (e.g. hardware, Google Compute Engine and Google Fiber) depressed operating margins, in our view. As a sign of strength in the core business, overall revenue grew 21.7%, driven by products such as Google Search and YouTube. Furthermore, growth in clickable ad revenue grew 18% versus 2013, implying greater contribution from display advertising, such as YouTube’s TrueView ads, and the "other" segment, including Google cloud-related products and hardware.

Revenue growth from non-traditional products is critical to our valuation model, although we note that most of these services are likely to generate lower margins than the legacy search advertising business. Because of this view, we still expect operating margin improvements to be constrained, increasing from approximately 27% in 2014 to less than 29% in 2018. Still, in this environment, we believe the firm’s wide economic moat, 3-star rating, and dearth of relatively attractive investment opportunities support the consideration of Google as a core holding for many investors.


Novartis NVS  |  Damien Conover, CFA

Novartis posted second-quarter results that fell slightly short of our expectations and those of consensus. Part of the weakness stemmed from lower-than-expected vaccine sales, which were affected by irregular timing on some bulk orders. However, we don't expect any material changes to our $83 fair value estimate, which is just under the current market price. While we believe Novartis holds an excellent pipeline, we believe the majority of this upside is offset by major patent losses over the next two years.

Nevertheless, we continue to see strong support for the company's wide moat rating, which we think will strengthen with the recently announced corporate restructuring (sale of the animal health and vaccine units along with the formation of a consumer health joint venture with Glaxo). In the quarter, Novartis posted an operating margin of 29% based on the new formation (restructurings expected to be finalized in early 2015), which was 300 basis points higher than the old Novartis structure. As the company increases focus on its remaining high-margin businesses, we expect margins will increase further. Additionally, we estimate a reduction in relatively higher investment related to the divested units should lead to an overall higher return on invested capital.

Leading the divisions for Novartis, the drug unit posted a slight gain of 1% year over year as generic competition weighed on growth from new product launches. We expect this trend will continue over the next two years. The patent losses on blockbusters Diovan for cardiovascular disease in 2014 and Gleevec for cancer in 2016 will cost the company close to 13% of sales. However, we expect several well-positioned currently marketed drugs combined with a strong pipeline (led by psoriasis drug AIN457 and hypertension drug LCZ696) will largely offset the patent losses. Novartis' eye-care business (Alcon) and generics unit (Sandoz) should help mitigate the patent losses as well.


BlackRock BLK  |  Greggory Warren, CFA

With the equity and credit markets both in positive territory during the second quarter, wide-moat BlackRock posted another gain in its managed assets. Total assets under management increased more than 4% during the quarter (and 19% year over year) to a record $4.6 trillion, with the iShares exchange-traded fund business coming extremely close to breaking the $1 trillion mark during the period. While total equity inflows of $9.7 billion were below our forecast of $17.2 billion, BlackRock did pick up $20.6 billion with iShares during the period (offsetting a combined $10.9 billion in net outflows from its active equity and institutional equity index operations). It made up most of the shortfall in our equity forecast with net inflows of $21.3 billion into fixed-income products, better than our projection of $16.7 billion. BlackRock's $38.0 billion of net long-term inflows in the second quarter reflected a 4% annualized rate of organic rate. While still below the firm's targeted 5% rate of growth, it is more than respectable for a firm of its size and scale.

Although average AUM increased 15% year over year, a slight reduction in the company's realization rate (due to mix shift as well as ongoing fee compression in the industry) led BlackRock to post a 12% increase in revenue compared with the year-ago quarter. Top-line growth through the first six months of 2014 was 11%, in line with our full-year forecast of high-single-digit to low-double-digit growth. BlackRock continues to see positive operating leverage in its business, with operating income increasing 15% year over year. Operating margins through the end of June were just over 40%, in line with our full-year forecast. With sales and profitability through the first two quarters tracking our forecast for the year overall, we see no reason BlackRock cannot produce more than $3.6 billion in free cash flow this year. Our fair value estimate remains at $350 per share.


Charles Schwab SCHW  |  Gaston F. Ceron

We don’t plan to make dramatic changes to our fair value estimate for Charles Schwab after its solid second-quarter earnings. Overall, Schwab earned $302 million, or $0.23 per share, compared with $233 million, or $0.18 per share, a year ago. Net revenue rose 11% to $1.48 billion. In sum, we still view Schwab as a well-run company whose true profit-making potential will become more evident as interest rates improve.

To that point, a modest improvement in Schwab’s net interest margin so far this year underscores the firm’s potential to benefit from higher rates. Net interest revenue gained 19% to $562 million, which reflected higher interest-earning assets and improved yields on securities held to maturity. The overall NIM held up somewhat better than how we thought it would perform, moving up 16 basis points year over year to 1.65%. Still, while improved, this is far from the profitability that we believe Schwab can eventually produce in a higher interest-rate environment.

Higher advice-solutions revenue continues to help Schwab. The firm’s overall asset-management fees rose 10% to $632 million. This business is still hobbled by the money-market fund fee waivers that the low interest-rate climate has foisted upon Schwab--so far this year, Schwab has waived $368 million in fees, reducing the related revenue by more than three-quarters. But gains from Schwab’s advice-solutions business, where quarterly revenue rose 18% year over year, have helped offset this. We believe the firm has an opportunity to continue making its customer assets stickier through its investment-advice offerings, which we think can protect or enhance Schwab’s narrow economic moat.

We do not expect a bang-up performance from Schwab’s trading business during the usually slower summer months, but things should pick up in the fall. In the second quarter, trading revenue fell 10% as transactions declined. The firm’s operating expenses edged up 3% to $957 million, near our expectations.


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