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.

 
Aug 22, 2014
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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, 8/22/14 -- Lowe's and PetSmart Earnings as Expected
Aside from my purchase of Schlumberger SLB on Monday, this week's biggest news consisted of earnings reports from two of our three retailers. While this remains a very difficult environment for retailers, our holdings continue to stand out.

Lowe's LOW
Revenue Growth: 6%
Operating Income Growth: 13%
EPS Growth: 18%

Most of the outdoor product sales that Lowe's lost in the first quarter because of harsh winter weather were recovered in the second quarter. Same-store sales were up 4.4% from the prior year, and the operating margin expanded 67 basis points to 11.0%. Aggressive share repurchases also helped to sustain high-teens earnings per share growth. However, overall first-half results were a bit weaker than expected, prompting management to trim its full-year revenue growth outlook by half a percentage point to 4.5%. The outlook for 2014 EPS was maintained at $2.63. Lowe's continues to lag behind larger peer Home Depot HD, which enjoyed 5.8% same-store sales growth and 23% EPS growth in the most recent quarter. As I've said in the past, Home Depot and Lowe's tend to trade market share back and forth over multiyear stretches, and Home Depot has had the upper hand for the past five years. On the flip side, Lowe's arguably has more room to expand operating margins as the housing recovery continues. Both Lowe's and Home Depot now appear fairly valued, and I plan to hold the Tortoise's large position in Lowe's. However, I would be an enthusiastic buyer of either home improvement chain at an appropriate discount to our fair value estimate.

PetSmart PETM
Revenue Growth: 1%
Operating Income Growth: 4%
EPS Growth: 10%

PetSmart has been busy responding to recent investor criticisms. In conjunction with its second-quarter earnings release, the company also announced the acquisition of Pet360 to bolster its online presence, a comprehensive cost-reduction plan, and management's intent to explore all strategic alternatives, including a possible sale of the company. While I didn't buy PetSmart expecting it to be acquired, I continue to believe this would be the best outcome for shareholders (assuming a healthy premium). In the meantime, total sales were up just 1.4% in the most recent quarter on a modest decline in same-store sales. PetSmart still managed to increase operating income by 4% through cost discipline, and earnings per share were up 10% thanks to share repurchases in prior periods (buybacks are temporarily on hold during the strategic review). Recall that our original investment thesis for PetSmart required only low-single-digit annual operating income growth, since the stock was offering an 8% free cash flow yield at the time of purchase. I plan to hold while PetSmart sorts out its long-term plans.

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Elsewhere, rumors have surfaced that eBay EBAY is again considering spinning off its PayPal unit. Such a transaction was first proposed by activist investor Carl Icahn early this year, though management vehemently objected based on synergies between the Marketplaces and PayPal segments. At the time, I was inclined to agree with management. However, I see a potential spin-off in a different light after eBay's recent execution issues, especially the data security breach in the Marketplaces segment. There may be more risk than benefit in keeping these businesses together; for example, if PayPal data had also been compromised, it could have significantly eroded consumers' confidence in the service. I also believe that recurring challenges in the Marketplaces segment are weighing on investors' perceptions (and valuation) of the faster-growing PayPal unit. Assuming synergies could be preserved through a continued close partnership between eBay and PayPal, I suspect a spin-off would unlock significant value for eBay shareholders. I'm interested to see what management decides, and I plan to hold.

Lastly, Enterprise Products Partners EPD completed its 2-for-1 unit split. We now own twice as many units (360), each of which is worth half as much (our new fair value estimate is $43). I would still like to add to our Enterprise stake, but I'm holding out for a slightly better price. If the distribution yield increases to about 4%--implying a unit price around $36--I will probably buy more.

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

PetSmart PETM  |  Liang Feng

Narrow-moat PetSmart reported soft second-quarter results, as falling transaction counts (down 2.6%) continued to drag same-store sales (down 0.5%). However, shares popped up over 4% in after-hours trading, after management announced that it will explore the potential sale of the company; acquire online media and specialty pet retailer Pet360 for $160 million (including $30 million of potential performance incentives); and enact various initiatives both to reduce costs and boost traffic, which management will go in greater detail about next quarter.

These initiatives will look to address some of the complaints that activist JANA Partners (which owns a 9.7% stake) has filed. However, since JANA recently accused management of pursuing short-term results at the expense of long-term value--largely based on an internal presentation and letter that was anonymously sent to JANA, but has not yet been publicly released--we do not expect JANA will disappear into the background anytime soon.

We do not plan to incorporate a takeout premium into our $71 base-case fair value estimate and results fell largely within our expectations, so we do not currently anticipate a significant change to our fair value. That said, PetSmart laid out quite a few goals and updates in the earnings release, and we may revise our estimates after learning more from today’s call and follow-up conversations with management.

Sales grew 1.4% to $1.73 billion, as the net addition of 51 stores over the past year (to 1,352) offset the comps decline. Operating margins still expanded 20 basis points to 9.4% due to the past year’s cost reduction initiatives, which combined with share repurchases contributed to a 10% increase in earnings (to $0.98). However, management continues to expect soft sales going into the third quarter (calling for flat to slightly down comps), and maintained its full-year guidance, calling for low-single-digit sales growth, and earnings per share between $4.29 and $4.39.

Management announced a broad cost-reduction program in the earnings release, which will “fundamentally restructure the cost base of the company," by targeting (in order of magnitude) cost of goods sold, logistics, sourcing, store operating costs and overhead. We believe management is looking to preempt complaints brought to the forefront by JANA that the executive team is managing expenses inefficiently, since the firm is reportedly generating lower EBITDAR margins than its smaller peer Petco (18.5% in 2013, compared with 20% for privately held Petco, according to S&P’s debt rating reports cited by JANA).

We don’t think this comparison is completely fair, for several reasons. First, adding back rent presents an incomplete picture, since Petco operates a larger portion of its store-base in urban locations, where rent represents a higher portion of expenses. Second, we believe PetSmart operates a larger service business that took time to gain sales leverage, and includes minority-owned Banfield Hospitals, which is captured using the equity method. Third, PetSmart commands almost double Petco’s domestic share and has attracted a broader audience by building strong relationships with the industry’s top specialty-pet brands, while Petco has more willingly embraced lesser-known brands, which the firm may command significant purchasing power against, but may not effectively reach as broad an audience. That said, we acknowledge that inefficiencies have accumulated, and we look forward to hearing more details regarding management’s plans.

Additionally, management announced that it will once again broaden its offering of grocery and mass brands to drive new customers to the store, after several years of “consumables resets” that have looked to replace these items with more premium channel-exclusive items. It appears that management believes that it has taken a step too far with the consumables reset, and is blaming its current traffic weakness on its dearth of mass brands. Our first impression is that these initiatives could help alleviate the traffic issue, but management must strike a delicate balance to retain its progress on the premium front, while targeting customers that may have left due to an increasingly competitive market among grocery and mass merchants for pet items that are not channel-exclusive.

Management will also look to integrate Pet360, as part of the firm’s broader initiatives to improve its online and omni-channel capabilities. From our view, the most valuable portions of the Pet360 acquisition are the firm’s online information offerings and audience, as the firm is composed of nine websites (such as PetMD.com) that reach over 12 million pet owners per month, and not the firm’s online retail channel (petFoodDirect.com, for instance), which we doubt was meaningfully profitable, if at all.

Taking a step back, we continue to believe that it is difficult for any online firm (including PetSmart) to undercut brick-and-mortar pricing while shipping pet consumables profitably due to the high cost of shipping low-value bulky products. Consequently, unless PetSmart can meaningfully grow its online hardgoods presence, we do not expect the firm’s online business to generate meaningful profits. To the extent that we are wrong about this, it would undercut PetSmart’s narrow-economic moat because it would imply that other online businesses could profitably capture share by undercutting brick-and-mortar prices. That said, we like the strategic rationale of the Pet360 acquisition and the firm’s overall efforts to boost its online and omni-channel capabilities, since most customers research products online even if they don’t order online, so it is important to control the information access points. PetSmart is still the most highly trafficked online pet store, but the firm has lagged competitors in many online capabilities (for instance, the firm has only recently supported buy-online/pick-up in store, and prices for online items can be very uncompetitive). Even if online sales never generate meaningful profits, the online site can still influence consumer perceptions regarding the retailer's overall brand and value proposition, so management should carefully manage its online presence to protect its brand intangible asset and ability to cross-sell additional services.

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Lowe's LOW  |  Jaime M. Katz, CFA

On the heels of Home Depot’s beat and raised second-quarter results yesterday, Lowe’s beat and lowered guidance appeared disappointing at first glance. However, management noted the outlook for the rest of the year remained intact, and that revised guidance was in response to performance during the completed first half. We plan to maintain our narrow moat rating and $49 fair value estimate, and think Lowe’s is still a market leader that we admire in the home improvement market. With shares trading around $50, we see the stock as fairly valued, and would wait for a wider margin of safety to invest.

Second-quarter sales rose 5.7%, thanks to 4.4% overall comp growth helped by 6.5% comps in the outdoor product category as weather improved. Average ticket increased 1.3% and transactions grew 3.1%, and all regions and all product categories delivered positive comps growth. Similar to Home Depot, pro services outperformed the company average, and we reiterate that we think this is a long-term tailwind Lowe’s can capitalize on (pro represents about 30% of sales), particularly if the housing market either improves or remains stable. Gross margin expanded moderately, by 20 basis points, and SG&A contracted 40 basis points, helping accomplish 67 basis points in operating margin growth. This gives us confidence that Lowe’s is on track to achieve its forecast operating margin expansion of 65 basis points for the 2014.

Management lowered its top-line outlook for 2014, taking revenue growth to 4.5% from 5%, and comp-store sales to 3.5% from 4%. However, the company noted this was in response to performance in the first half of the year, and not with regard to adjusted expectations for the second half, which implies comps around 4%, and continued operating margin leverage (by 50 basis points or more in the second half). Lowe’s also noted its 2015 goals were intact, which calls for EBIT margins of 9.7%, ROICs of 17% and EPS of $3.44 (we forecast EPS of $3.28 and EBIT of 9.2%).

Macroeconomic factors were noted as mixed for the company as improving employment, income, consumer spending, and home prices were offset by lower volume of existing home sales, a slightly cautious tone about the environment that was also sounded on Home Depot’s call yesterday. Both companies seem to be positioned well to weather any inconsistency in the metrics in upcoming months, particularly as they focus on becoming closer to the customer, turning inventory faster if seasonal can continue to match demand better in upcoming periods—although we are aware this can be more weather-dependent than we'd like in certain periods. The focus on better fulfillment/distribution and customer-led design experiences should improve operating margins performance as expenses remain controlled and productivity improves.

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Schlumberger SLB  |  Robert Bellinski, CFA

Barrons' cover story this week was a fittingly positive overview of Schlumberger's recent efforts to grow more operationally efficient and deliver multiyear double-digit earnings growth to shareholders. We are similarly bullish--currently, Schlumberger is Morningstar’'s most undervalued wide-moat stock. Based on our $145 per share, we see more than 35% upside.

New products at improved incremental margins will drive earnings growth. As we reported after the firm’s analyst day earlier this year, the company has rolled out a number of new technologies and performed bolt-on acquisitions to improve market share across all operating groups. All these moves add up to delivering new products at incremental margins of more than 40%, and drive our forecast for operating margin improvement from 19% in 2013 to 26% by the end of the decade.

Intangible assets and strong customer relationships continue to support Schlumberger’s wide moat. The firm spends more than any other oilfield service company on research and development, and combined with strategic acquisitions, it has built the broadest product offering in the industry. This has allowed the firm to increase the level of integrated services it sells, saving customers time and improving Schlumberger’s asset efficiency.

At current levels, we find Schlumberger's valuation very attractive. Our forecast calls for average annual EBITDA growth of more than 12% and earnings per share growth of more than 16%, over the next five years. We believe the firm should trade for 12 times our 2015 EBITDA estimate of $16.4 billion, and 21 times our 2015 EPS estimate of $6.94, or $145 per share. This is one valuation turn greater than the respective historical levels cited by Barron’s, but well-justified, in our opinion, given oil prices remain above $100/barrel for the foreseeable future, and oil supply will become increasingly reliant on more capital-intense forms of development (deep-water, unconventional, etc.).

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