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 08, 2016
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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, 2/5/16 -- Four Core Holdings Deliver Solid Results

This week brought strong earnings reports from four Tortoise and Hare stocks that I consider to be core holdings:

- Magellan Midstream Partners MMP is in the best financial health among midstream master limited partnerships. Distributable cash flow covered the firm's distribution roughly 1.4 times, both in the fourth quarter and for all of 2015. Modest debt levels allow the company to fund all of its planned capital expenditures without tapping equity markets. And Magellan's low cost of capital puts it an ideal position to acquire assets from distressed peers if any should become available that fit with the company's strategic focus. Management announced plans to raise the distribution 10% in 2016 and at least 8% in 2017 while maintaining a minimum 1.2 times coverage ratio. Despite strong commodity price headwinds, I don't see any reason why the company won't be able to achieve--and probably exceed, at least with respect to coverage--management's target. Magellan remains my top pick in midstream energy.

- The strong U.S. dollar has been a hurricane-force headwind for Philip Morris International PM. However, the company's underlying, constant-currency results are remarkable. Organic revenue growth came in at 5.8% in 2015 despite a 1% decline in cigarette volumes. Only tobacco firms enjoy this degree of pricing power, which gives Philip Morris International one of the best growth profiles in the consumer staples sector despite our expectation for ongoing volume declines. Excluding currency headwinds, earnings per share would have been up 12% last year, and management forecasts 10%-12% underlying EPS growth in 2016. Whenever the dollar stops appreciating, I expect Philip Morris International to become an excellent long-term investment.

- Alphabet GOOGL also delivered exceptional fourth-quarter results, including 24% constant-currency revenue growth and 28% adjusted earnings per share growth. For the first time, the company also broke out the results of its Google segment from its "other bets" (though the Google segment still includes a fair bit of investment in areas that are related to the core business). The other bets generated more than $3 billion in operating losses last year, without which the Google segment had a non-GAAP operating margin of 38%--up three percentage points versus the prior year and compared to a 33% non-GAAP operating margin for the company as a whole. Alphabet is clearly playing the long game, and I expect management to continue spending billions of dollars on projects that may not pay off for years. For a company of Alphabet's size and past success, I'm impressed by management's tenacity and vision, and this is another stock I expect to hold for many years to come.

- CME Group's CME 2015 revenue improved 7% on record derivatives trading volume, while operating expenses declined 1%. Adjusted earnings per share were up 14%. One of CME's best features is its dividend policy, consisting of a generous regular dividend and an annual special dividend that returns substantially all of the company's excess cash to shareholders. This strikes me as an excellent way to reward shareholders while imposing capital allocation discipline on management. The company increased its regular dividend 20% to $0.60 a share per quarter, providing an ongoing yield of 2.7%. In January, we received a special dividend of $2.90 per share, or an additional 3.3 percentage points of yield based on the current stock price. The main downside to CME is its relatively rich valuation: The stock trades for 23 times trailing earnings. Derivatives trading volumes are inherently cyclical, so I plan to wait for the next downturn before adding to the Hare's stake.

In other news, Lowe's LOW agreed to acquire Canadian home improvement retailer RONA for a premium of more than 100%. RONA's year-to-date EBITDA margin was only about half that of Lowe's, so I hope to see the combined company achieve meaningful synergies by leveraging Lowe's scale. Lowe's stock dropped sharply on the news, presumably because investors think the company is overpaying. However, the magnitude of the drop doesn't make sense to me, since it wiped more value off Lowe's market cap than the entire purchase price, as if the company were throwing the money in a garbage can. At the current share price, I view Lowe's as a favorite for new money.


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

Magellan Midstream Partners MMP  |  Peggy Connerty

Magellan Midstream Partners reported fourth-quarter adjusted EBITDA of $315 million, up 4% from the $303 million last year and above both consensus and our estimate. Distributable cash flow increased 3.5% to $257 million versus last year’s $248 million. Distributable cash flow per unit was $1.13 for the quarter versus $1.09 in the year-ago quarter. The results were driven by reduced butane blending margin as a result of the lower commodity price environment but partially offset by contributions from Magellan's stable fee-based businesses. For the year, adjusted EBITDA increased 9% to $1172 million, while distributable cash flow increased 7% to $943 million. Coverage was a very impressive 1.4 times for the year.

Management announced its plan to increase the cash distribution by 10% 2016 and 8% for 2017. While management had originally intended "a minimum of 10% growth in 2016," the firm 10% target and the 8% target for 2017 reflect management and the investment community's strong preference for protecting the balance sheet given the difficult commodity backdrop. We believe the 10% growth rate in 2016 is very achievable, with many key projects due on line in 2016-17 to support this. Our forecast indicates the company can deliver this distribution growth while maintaining coverage levels in the healthy 1.2 times-1.4 times range. If commodity prices improve, we would expect the 2017 target to prove to be conservative. Guidance bakes in a crude oil price of $35 per barrel.

We are maintaining our fair value estimate of $76 and continue to view Magellan as a top pick in the midstream sector. It's not a matter of if but when U.S. crude oil production will begin growing again given the very strong economics of the major shale plays relative to the rest of the industry. We believe Magellan has the wherewithal to survive the current period of weak activity and thrive when market conditions begin to recover.

Management increased its budget for 2016 to $800 million from $700 million last quarter and from $550 million announced in second quarter. Management indicated it has "well in excess of $500 million" in growth projects and acquisitions under review that are not included in the budget at this point.


Philip Morris International PM  |  Philip Gorham, CFA, FRM

Philip Morris International failed to run the board of positive earnings surprises in 2015, posting fourth-quarter results that missed our forecasts by a whisker. Of greater significance is that management provided guidance for 2016 below our forecast. The downside to guidance is likely, in our opinion, to reflect a stronger currency impact on reported results and an accelerated rollout of the firm's heat-not-burn e-cigarette iQOS throughout next year. Although we will reduce our 2016 margin assumptions, the fourth-quarter business performance indicates that industry fundamentals are still strong, so we do not expect to make a material change to our $92 fair value estimate. We are also reiterating our wide economic moat rating, as the firm's pricing power was once again clearly evident in the fourth quarter. Any weakness in the stock on this news should prompt long-term value investors, or those seeking a stable dividend, to kick the tires of this high-quality business.

Although the fourth quarter did not reach the heights of the previous three, 2015 was a solid year for Philip Morris International, excluding the strong negative impact of currency movements. Full-year organic revenue growth of 5.8% puts the firm in the top tier of large-cap consumer staples firms despite the secular headwind from falling volume, reflecting solid pricing power and market share gains from Marlboro 2.0. The European Union has been particularly strong, with full-year organic sales growth of 4.5%. Although momentum throughout Europe slowed somewhat in the fourth quarter, with revenue up 2.6%, volume fell just 0.5%, largely in line with the first nine months of the year. After a fairly weak third quarter, Asia rebounded with 8.3% organic growth, up from 4% in the rest of the year, driven by price hikes in Indonesia and the Philippines.

We think two factors are behind guidance being below our forecast. First, we have underestimated the impact of currency on reported earnings next year. Management has guided to a hit to earnings of $0.60 per share at current exchange rates, slightly worse than our initial estimate. We shall lower our 2016 estimates by around 5% accordingly, but we expect the negative effect of unfavourable foreign exchange to be offset by the positive impact of the time value of money in our model, so we remain comfortable with our valuation.

The second potential factor behind the guidance is incremental spending on iQOS. We expect Philip Morris to accelerate the roll out of iQOS in new geographies in 2016, which could provide a long-term boost to the top line. We think heat-not-burn is the category most likely to emerge as the long-term winner in the fragmented e-cig industry, so we think Philip Morris' investments are justified. At a time when e-cigs pose a risk to Big Tobacco's economic moats, heat-not-burn allows manufacturers to continue to benefit from procurement cost advantages and leverage the strong brand equity of their cigarette brands. For this reason, we believe Philip Morris may be one of the manufacturers most protected by the migration of smokers to e-cigs.

At the group level, Philip Morris is performing very well on an organic basis and above our forecasts of 6% medium-term, midcycle earnings per share growth. Although the strong dollar continues to erode value, we view the firm's e-cigarette strategy and competitive advantages in a positive light.


Alphabet GOOGL  |  Neil Macker, CFA

Alphabet posted mixed fourth-quarter results which beat consensus estimates for revenue and EPS while falling short versus operating income projections. The quarter was the first time management reported financial results by operating segments (Google and Other Bets). As expected, Google generates almost all revenue for the firm (99.4% of total revenue in 2015) and all of the operating income as Other Bets generated an operating loss of $3.6 billion for the year. Our fair value estimate is $755 and we are maintaining our wide moat rating.

Top line results for the full company were solid with 18% revenue growth (24% on a constant currency basis) driven by strong growth across all geography segments (U.S. up 24%, U.K. up 20% excluding FX, and Rest of the World up 26% excluding FX). Total operating margin improved 100 basis points to 32.0%. Within the Google segment, revenue growth of 18% was driven by 20% growth at Google Sites which more than offset the slower growth at Network Members (7%). Mobile continues to grow as other revenues improved 24%. We believe the investment in Android will pay off not only in driving mobile search, but also in other revenue streams such as the Google Play which increased spend per buyer 30% globally in 2015. Management also disclosed Gmail surpassed 1 billion monthly active users, joining the six other services (Chrome, Search, YouTube, Maps, Android and Google Play) with more than a billion monthly active users.

Within Other Bets, revenue grew 37% for the full year to $448 million, primarily via Nest, Fiber and Verily (life sciences) divisions. The majority of Other Bets businesses are in prerevenue stage and many are moonshots which may never generate revenue. Despite our expectation Other Bets will not meaningfully impact revenue for years, we believe the move to segment reporting allows investors to better gauge the level and success of investments made outside of the core Google business.


CME Group CME  |  Michael Wong, CFA, CPA

CME Group's wide-moat competitive position and value-add to clients, which will manifest in 2016 as modestly higher prices, will support earnings growth when many other financials may be facing headwinds. CME Group's revenue in 2015 increased 7% to $3.33 billion, while diluted earnings per share increased 10% to $3.69. The majority of the revenue increase came from higher volatility and consequently volumes in commodity products. We are skeptical that 2016 can bring much higher volumes that grow upon commodity and interest rate volumes that were already elevated in 2015, even after taking into account strong volume year-to-date driven by the swoon in equity markets and recent monetary actions. That said, the company should still experience growth from an approximately 2% increase in its trading product pricing and management estimated 4% to 5% growth in data revenue after reducing fee waivers. Expenses are also expected to be well-controlled at a 1% growth rate. These pricing and expense increases are within management’s control and should largely be considered locked in. Compared with many other financials that are facing at least near-term headwinds in the form of energy loan losses and a flattening of the yield curve, even modest earnings growth from CME Group is sound relative outperformance. We don't anticipate making a material change to our $93 fair value estimate for this wide-moat company.


Lowe's LOW  |  Jaime M. Katz, CFA

With the announcement of its intent to acquire Rona, wide-moat Lowe's has conveyed its dedication to grow more widely in the Canadian market. With only 42 locations currently and the incremental 12 leased locations purchased from Target last year, the additional nearly 500 corporate- and dealer-owned Rona locations offer Lowe's presence a massive boost in the CAD 45 billion home-improvement market north of the border. If we assume pared-back share repurchases in 2016, we think Lowe's can easily cover the cash price of $2.3 billion without jeopardizing its investment-grade rating (maintaining a debt/EBITDAR target of 2.25 times, which it should surpass in the near term and then operate under within a year). At 12.5 times 2015 consensus EBITDA, the deal doesn't appear particularly cheap, especially since Rona's operating margins are significantly lower than Lowe's. However, we suspect some premium was warranted for rapidly scaling to this degree, and we could see Lowe's attempting to bring Rona's operating metrics closer in line with its own over the next decade as best practices are shared across the brands.

We expect to lower our $79 fair value estimate by around $3 in response to the transaction. While we appreciate the accelerated footprint grab Rona offers, the lower gross and operating margins should weigh on Lowe's better operating metrics, at least in the near term. We believe that when more details regarding the transaction are offered, Rona's inclusion to next year could affect earnings by roughly $0.25 per share as integration is unlikely to benefit Rona's margins during 2016. However, in 2017, the utilization of a bigger distribution and buying network could help Rona ramp up its margins nicely from current levels, putting less pressure on overall enterprise metrics.

Management laid out a compelling argument in support of the acquisition, including recent restructuring of its operations, closing underperforming stores, the divestiture of noncore businesses, the continued acquisition of 20 franchise stores, and cost-saving initiatives. Moreover, Lowe's expects more than a CAD 1 billion benefit from revenue and cost opportunities, potentially doubling operating profitability in Canada over the next five years. We believe the Lowe's/Rona relationship could be very symbiotic, thanks to Lowe's newfound ability to tap into local demand trends and vendors and Rona's ability to learn from Lowe's solid distribution and sourcing abilities. With the transaction not expected to close until the middle of 2016, we think major operating margin improvement across the enterprise probably won't be material until 2018, when the businesses have been rolled together and the areas for improvement have been assessed and executed upon.


Enterprise Products Partners EPD  |  Peggy Connerty

Enterprise Products Partners reported a solid fourth quarter that was slightly ahead of our estimates. Adjusted EBITDA was $1.33 billion, up 39% versus last year and ahead of our $1.22 billion estimate. Distributable cash flow was $1.09 billion for the quarter versus last year’s $1.06 billion. Excluding proceeds from asset sales and insurance recoveries, distributable cash flow was $1.02 billion versus $1.04 billion last year, or down 2%. Management raised the distribution by 5.4% in the quarter to $0.385 per share and had healthy coverage of 1.3 times on the distribution (excluding one-time items). Retained distributable cash flow during the quarter (including proceeds from asset sales) was $302 million, and over $2.6 billion for the full year. Enterprise's conservatism continues to serve it well in this challenging environment where many of its competitors are facing stretched balance sheets and thin (or no) coverage on the cash distribution.

Management announced 2016 growth capital expenditures of $2.5 billion-$2.8 billion with an incremental $1.0 billion for the second installment on the EFS Midstream acquisition and $275 million in maintenance capital expenditures. Management estimates the cash distribution will reach $1.61 per unit in 2016, a respectable 5.2% increase versus 2015. Total liquidity was $4.4 billion at year-end, including cash and capacity on its revolving credit facilities. EPD plans to utilize its retained cash flow, equity financing, including additional EPCO equity purchases, debt, and non core asset divestitures to fund its growth and distribution plans. We expect management to continue allocating capital prudently, using retained distributable cash flow to offset some of its need to tap the capital markets. This is a key advantage over many of its peers that have been more aggressive with their growth plans and are now having to scale them back. We are maintaining the company's wide moat rating and our fair value estimate of $32.

Enterprise’s business model has proved robust thus far during the oil market's downturn, and we expect this to continue. Enterprise's simple structure, which lacks incentive distribution rights, gives it a lower cost of capital versus many peers. Its focus on fee-based businesses and its extensive network of tightly integrated assets spanning the midstream value chain help minimize direct commodity exposure and collect economic rents across the entire system. Importantly, Enterprise has a great management team that's been through the boom and bust periods and has grown its business along the way. We expect management to continue to be prudent as it navigates through current market challenges and view the downturn as an opportune time for patient investors to bulk up on EPD units.


Banks  |  Erin Davis

We've taken a close look at banks' energy exposures and potential losses, and see both good news and bad news for investors. First, the good news--for most banks, we think the losses will be manageable. And now the bad news--nearly all banks are under-reserved and several could be facing capital shortfalls in a worst-case scenario.

We use the bond markets to proxy what total losses could be. The S&P 500 Energy Corporate Bond Index (essentially all investment-grade) is down about 15% peak to trough, and the Bloomberg USD High Yield Corporate Bond Energy Index (junk) is down about 30%. We use these to model mark-to-market (15%) and stress case losses (30%). We then compare these to the reserves banks already have in place, and to the banks' common equity. This helps us to gauge whether energy losses are likely to be merely painful, or whether they could pose a serious risk to capital. As a rule of thumb, we think that anything under 10% of common equity (remembering that losses are likely to roll in over two to three years) is likely absorbable by a well-capitalized bank. After that, we think the risk becomes more serious, depending on the bank's existing capital and the quality of its book. On average, we think cumulative losses will be approximately 2.7% of common equity for the banks we cover, and could average 4.6% of common equity in a worst-case scenario. We think Commerzbank, Credit Agricole, and Standard Chartered are most at risk.

Most U.S. banks have reported their 2015 results, and the banks with material energy exposures have reserves averaging 2.8% of energy loans, far below the 15% cumulative losses the markets are forecasting. This means that additional losses are likely, in our opinion. Of the U.S. big four, we think Citigroup and Bank of America are the most exposed. Given their current reserves of about 3.8% and 2.4% of energy loans, respectively, we think they could face additional impairments worth about 1.1% of the common equity. We think this would dent earnings, but would not pose a threat to their financial health.

The Canadian banks have also reported and provide an interesting contrast. Canadian firms use IFRS accounting standards, while U.S. firms use GAAP. U.S. GAAP allows banks to reserve for losses earlier, so the Canadian reserves are notably lower than those of U.S. banks. Canadian banks have reserved an average of 0.4% of energy loans, compared with 2.8% in the U.S., which means they have further to go to absorb likely cumulative losses. We think the pain will be the greatest at Bank of Nova Scotia, where losses could consume 3.4% of common equity, and the least painful at TD Bank, where losses could be just 0.6% of common equity.

European banks are just beginning to report, and given that they use IFRS, we think Canadian bank provisioning is a better proxy for what we'll see in 2015 results-–therefore, we expect losses to be low and manageable in the short term. In the longer term, we think cumulative losses could be a bigger issue. We think energy losses could consume about 10% of common equity at Commerzbank and Credit Agricole and 7.8% at Standard Chartered. The rest of the European banks we see as less exposed. We anticipate cumulative losses of 3.1% of common equity at Barclays, about 2.0% at Lloyds, UBS, and Nordea, and under 1% at Danske. We'll keep a close eye on this issue, as reporting on energy exposure has been thin among European banks, but we expect greater disclosure as results roll in over the next several weeks.


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