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.

Oct 28, 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, 10/21/2016 -- A Slew of Earnings Releases

StockInvestorSM focuses on the activities of portfolios of Morningstar, Inc. that are invested in accordance with the Tortoise and Hare strategies. These portfolios are managed by Morningstar Investment Management LLC, a registered investment adviser, which manages other client portfolios using these strategies.

This week in Morningstar analyst notes: earnings releases for American Express AXP, Bank of New York Mellon BK, BlackRock BLK, General Electric GE, PayPal PYPL, and Union Pacific UNP, and a CEO change for Visa V.

Also, if you didn't see it, Michael Corty purchased Sanofi SNY for Morningstar's Tortoise portfolio today and added to the portfolio's existing stake in McKesson MCK. You can read his trade alert here.

Strength in GE's Industrial Portfolio Manages to Offset Oil and Gas Weakness in Third Quarter
by Barbara Noverini | 10-21-16

Following wide-moat GE's third-quarter earnings report, we're maintaining our fair value estimate of $30 per share. GE managed to eke out industrials' segment organic revenue growth of 1% year over year, as ongoing weakness in the oil and gas business masked otherwise robust 6% organic sales growth throughout the rest of the industrial portfolio. In particular, sales strength persisted in power, aviation, renewables, and the ongoing turnaround in healthcare as new products in each of these segments continued to see healthy demand. That said, oil and gas remained a significant drag on the overall portfolio, as recent signs of life in both rig and well counts haven't yet translated into improved levels of spending in GE's customer base. Nevertheless, the investments GE made in research and development since the Great Recession appear to be paying off, as new products like the HA-Turbine, the LEAP engine, and the company's growing digital services portfolio continue to resonate with customers despite persistent reports of a slow global growth environment across the industrial sector.

Including Alstom, industrial gross margins improved 120 basis points year over year to 27.8%, reflecting progress in GE’s ongoing efforts to drive excess cost out of the portfolio. Notably, service margins climbed 220 basis points year over year as the deployment of analytics technology continues to drive positive results throughout GE’s services portfolio. While oil and gas will undoubtedly remain a near-term challenge for GE, we like that the company has plenty of opportunity in the remainder of the portfolio to offset further underperformance in the segment. With the Alstom integration progressing as expected, momentum building in digital, new product ramp-ups proceeding well, and cash on hand for additional buybacks if necessary, we’re still confident the company can hit its 2018 earnings target of $2.00 per share.

Growth Momentum Offset by Margin Pressure at PayPal
by Jim Sinegal | 10-21-16

PayPal's position as a leader in e-commerce contributed to continued momentum in the third quarter, and we are maintaining our $48 per share fair value estimate for the narrow moat payment firm.

Payment volume processed grew by 25% during the year, including a 3 percentage point adverse effect of foreign currency movements. We believe the company's solid competitive position and the tailwind provided by the growth of the online and mobile payment market leave PayPal in an enviable position in the near term despite the entrance of numerous new players. Revenue grew at 18% during the year, as the company's larger customers exerted pressure on pricing and transaction expenses grew by 27%. We believe the company's move toward a more open model, including its partnerships with large networks, will squeeze margin going forward.

GAAP earnings per diluted share expanded by 8%, while the company presented adjusted earnings per share growth of 14%. We don't see the company having any trouble maintaining earnings growth at this pace.

American Express Benefits From Market Tailwinds and Cost-Cutting Despite Growing Competition
by Jim Sinegal | 10-20-16

American Express maintained flat adjusted earnings of $1.24 over the past 12 months despite the loss of its Costco relationship, as the firm benefited from growth in consumer spending, cost-cutting initiatives, and near-pristine credit performance. We are maintaining our $76 fair value estimate for the wide-moat firm, as we think the company still has work to do in adapting its strategy for a changing payment environment. In particular, American Express is competing against aggressive rewards offerings from diversified lenders like JPMorgan, which are spending aggressively in hopes of deepening broad financial relationships. American Express, on the other hand, offers only cards. As competitors offer ever-increasing rewards to card customers, top-line pricing remains under pressure as large merchants attempt to lower fees through negotiation, litigation, and legislation. On this front, at least, American Express scored a win in recent months as an appeals court overturned a previous antitrust decision that made it easier for merchants to steer customers away from American Express and other high-cost payment methods. However, we’re still looking for American Express to utilize its unique competitive advantages. In particular, we’d like to see American Express present a plan to monetize the unique data provided by its closed-loop network. Details on this front have been lacking.

Bank of New York Mellon's 3Q Enhanced by Improved Net Interest Margin and Fees
by Greggory Warren, CFA | 10-20-16

There was little in wide-moat-rated Bank of New York Mellon's third-quarter results that would alter our long-term view of the firm. We are leaving our $49 per share fair value estimate in place. Net interest margin of 1.06% was an improvement on the second quarter (0.98%), as well as the third quarter of 2015 (0.98%), while lower money market fee waivers also contributed to overall results, with waivers falling from $28 million in the year-ago period to $11 million during the third quarter.

Assets under custody/administration increased 7.0% year over year to $30.5 trillion despite the increased volatility in the markets (as well as adverse currency exchange) since the start of 2016. BNY Mellon had $1.7 trillion directly under management at the end of the third quarter, with market gains and flows offsetting the effect of adverse currency, leaving AUM up 5.5% year over year. Fee revenue increased 2.1% when compared with the prior year's period, as improvements in investment services fees and performance fees improved overall results. Total revenue increased 3.2% year over year as a result, while effective costs controls led to a 1.4% decrease in noninterest expense. This allowed the firm to post third-quarter earnings per share of $0.90 compared with $0.74 during the prior year's period.

BNY Mellon remains fairly well capitalized, with management committed to returning funds to shareholders. The bank's fully loaded common equity Tier 1 ratio at the end of the third quarter was 9.8%, at the upper end of the 9.3%-9.8% range we've seen from the bank during the past year. BNY Mellon paid out a quarterly dividend of $0.19 per share, and repurchased 11.6 million shares (for $464 million), during the third quarter.

EBay's Moat-Building Approach Admirable, but Competitive Headwinds Raise Feasibility Questions
by R.J. Hottovy, CFA | 10-20-16

With our emphasis on economic moats, we're encouraged by eBay's focus on improving its brand intangible asset and user experience while reducing its dependence on promotions and other contra-revenue measures to drive traffic. Nevertheless, third-quarter results have reignited concerns about whether structural headwinds--namely Amazon and other e-commerce marketplaces possessing stronger network effects--will negate efforts to improve its brand positioning. As such, we're struggling to build a blueprint that will bring eBay's GMV growth closer to global e-commerce trends in the low double digits.

We still view eBay's structured data approach as a worthwhile endeavor that improves the buyer experience/conversion rates, search engine optimization, and dynamic pricing; these should keep marketplace GMV and revenue growth in the low single digits for the foreseeable future. For comparison, constant-currency marketplace GMV grew 4% in the quarter, a slight deceleration versus 5% growth in the prior quarter, while marketplace revenue grew 5%, a slight acceleration versus earlier quarters due to the reduced promotional activity. However, this still implies a sizeable gap to current industry trends. Certainly, StubHub and Classifieds, where constant-currency revenue increased 32% and 14%, respectively, should help to fill this gap and give us greater comfort with our narrow moat. That said, these platforms will take time to grow into material cash flow contributors (relative to the marketplace) and could face increased competition.

We're not planning to change our $28 fair value estimate, outside of adjustments for the sale of its stake in MercadoLibre (expected to yield gross proceeds of $1.2 billion). eBay's updated 2016 guidance--revenue of $8.95 billion-$9.0 billion, adjusted operating margins at the low end of 31%-33%, and adjusted EPS of $1.85-$1.90--appears feasible, especially after factoring in reduced contra-revenue factors and increased brand marketing spend.

Union Pacific Delivers Solid 62.1% Operating Ratio Despite Weak Volume, but Core Price Gains Were Weak
by Keith Schoonmaker, CFA | 10-20-16

Union Pacific produced a 62.1% third-quarter operating ratio, as carloads declined 6% and revenue dropped 7%; EPS slipped 9%. Coal and industrial volumes declined 14% and 11%, respectively, but agriculture increased 11%. International intermodal units were down 11% and domestic down 2% (flat excluding the impact of Norfolk Southern's discontinuing its Triple Crown product last year). However, total carloads improved 8% from the second quarter.

Most concerning to us is the mere 1.5% core price improvement. Management called out coal and international intermodal as particular price weak spots, but gave scant detail. Last year UP improved core price 3.5% or 4% every quarter, but in 2016 just 2.5% in the first quarter and 2% in the second.

Pricing exceeding inflation is key to our valuation and UP indicated labor inflation was 3% this period. Management expects full-year labor inflation to run about 2% and 2016 total inflation to be about 1.5%. For 2017, CFO Rob Knight indicated total inflation may exceed Global Insight’s 2.5%, but long run we expect 2.0%-2.5%.

This is a single quarter’s result, and, importantly, is still an increase. It's also in line with management’s full-year inflation expectations. Price is such a critical factor for the rails because we expect slow net volume growth over the long run (sub-GDP for most commodities, with coal declining and intermodal slowly expanding).

Should this low price improvement continue or inflation accelerate, we will revisit our long-run pricing assumptions. For now, we lowered our price assumptions for 2017 from 3% to 2% across the board except for 0% in coal, then kept 3% broadly thereafter. However, offsetting this are the time value of money since our last update, the beneficial impact of repurchases below our fair value, and decreased capex in 2016-17. As a result, we increase our fair value estimate by 2% to $100. Shifting our 3% price assumptions beyond 2017 to 2% per year would drop our valuation 3%.

Less Volatile Markets and Improved Flows Lift BlackRock's Third-Quarter AUM
by Greggory Warren, CFA | 10-18-16

There was little in wide-moat-rated BlackRock's third-quarter earnings that would alter our long-term view of the firm, and we are maintaining our $385 per share fair value estimate. BlackRock closed out the September quarter with a record $5.117 trillion in managed assets (which was $102 billion higher than our own forecast for the period, with most of the difference due to better market performance on both the equity and fixed income side of the business). This represented a 4.6% sequential (and 13.6% year-over-year) improvement in its assets under management.

Long-term net inflows of $55.2 billion were a marked improvement on the June quarter's $1.5 billion in total inflows and were slightly higher than our forecast for $51.2 billion in inflows for the period. This leaves organic growth over the past four calendar quarters at 3.5%, below management's annual target rate of 5% but in the middle of our own long-term forecast of 3%-4%. Based on our expectations for market performance and flows throughout the remainder of the year, we expect the firm to close out 2016 with more than $5 trillion in total AUM, driven by organic growth in the 3%-4% range.

While BlackRock's quarterly average AUM was up 8.4% year over year, third-quarter revenue declined 2.5% when compared with the prior-year period, as product mix shifts, declining fee rates, and lower performance fees detracted from the company's top line. While revenue was down 3.2% through the first nine months of 2016, we continue to expect BlackRock to produce slightly better results for the full year (albeit still in negative territory).

With regards to profitability, the company's operating margins of 40.5% through the first three quarters of 2016 were around 80 basis points lower year over year but do include a restructuring charge during the first quarter that cost BlackRock close to 300 basis points in margin. We still envision the firm closing out the year with operating margins in the 40%-41% range.

Scharf Steps Down at Visa
by Jim Sinegal | 10-17-16

Visa announced that Charlie Scharf will resign as CEO effective Dec. 1, to be replaced by current board member Alfred Kelly. Scharf had been with Visa since 2012, and according to the company's filing, chose to resign in order to spend less time in San Francisco.

Alfred Kelly spent more than 20 years at American Express and currently sits on the Visa board of directors. He has served as the CEO of Intersection, a company attempting to bring wireless Internet to New York, since February 2016. His payment industry experience, combined with his knowledge of Visa's business, seems appropriate for the CEO role. In fact, he left American Express in 2010 in order to explore CEO possibilities.

That said, Visa is in the midst of considerable change. The company just completed the acquisition of Visa Europe, which will require considerable effort to integrate. The industry is dealing with heightened regulation around the world as well as new competitors as the role of mobile devices in processing payments grows. However, the company's wide moat--stemming from both its global network of banks, merchants, and consumers, and its trusted brand--gives new management plenty of time to adapt, as does the fast-growing market for electronic payments.

We do not plan to alter our standard stewardship rating or fair value estimate.


©2016 Morningstar, Inc. All rights reserved. The Morningstar name and logo are registered marks of Morningstar, Inc. The information contained in this document is the proprietary material of Morningstar, Inc. Reproduction, transcription, or other use, by any means, in whole or in part, without the prior written consent of Morningstar, Inc., is prohibited. All data presented is based on the most recent information available to Morningstar, Inc. as of the release date and may or may not be an accurate reflection of current data.  There is no assurance that the data will remain the same.

The commentary, analysis, references to, and performance information contained within Morningstar® StockInvestorSM, except where explicitly noted, reflects that of portfolios owned by Morningstar, Inc. that are invested in accordance with the Tortoise and Hare strategies managed by Morningstar Investment Management LLC, a registered investment adviser and subsidiary of Morningstar, Inc. References to "Morningstar" refer to Morningstar, Inc.

Opinions expressed are as of the current date and are subject to change without notice. Morningstar, Inc. and Morningstar Investment Management LLC shall not be responsible for any trading decisions, damages, or other losses resulting from, or related to, the information, data, analyses or opinions or their use. This commentary is for informational purposes only and has not been tailored to suit any individual.

The information, data, analyses, and opinions presented herein do not constitute investment advice, are provided as of the date written, are provided solely for informational purposes and therefore are not an offer to buy or sell a security. Please note that references to specific securities or other investment options within this piece should not be considered an offer (as defined by the Securities and Exchange Act) to purchase or sell that specific investment.

This commentary contains certain forward-looking statements. Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results to differ materially and/or substantially from any future results, performance or achievements expressed or implied by those projected in the forward-looking statements for any reason.

Investments in securities are subject to investment risk, including possible loss of principal.  Prices of securities may fluctuate from time to time and may even become valueless.  Securities in this report are not FDIC-insured, may lose value, and are not guaranteed by a bank or other financial institution. Before making any investment decision, investors should read and consider all the relevant investment product information. Investors should seriously consider if the investment is suitable for them by referencing their own financial position, investment objectives, and risk profile before making any investment decision. There can be no assurance that any financial strategy will be successful.

Common stocks are typically subject to greater fluctuations in market value than other asset classes as a result of factors such as a company's business performance, investor perceptions, stock market trends and general economic conditions.

All Morningstar Stock Analyst Notes were published by Morningstar, Inc. The Weekly Roundup contains all Analyst Notes that relate to holdings in Morningstar, Inc.'s Tortoise and Hare Portfolios.

David Harrell may own stocks from the Tortoise and Hare Portfolios in his personal accounts.

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