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.

 
Apr 18, 2015
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Matthew Coffina, CFA
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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, 4/17/15 -- Philip Morris Demonstrates Pricing Power

First-quarter earnings season is underway. As always, the growth rates below reflect adjusted, constant-currency numbers where available.

Wells Fargo WFC
Revenue Growth: 3%
Net Income Growth: -2%
EPS Growth: -1%

Low short-term interest rates remain a major headwind for Wells Fargo. The company has $1.2 trillion in deposits, up 9% year-over-year, on which it pays interest expense averaging just 0.09%. Deposit rates are unlikely to go below zero, but the interest income Wells can earn by lending out these funds has steadily declined due to the Federal Reserve's loose monetary policy. Wells' net interest margin fell to 2.95% in the first quarter, the lowest level in at least 20 years. Despite success in other areas--including loan growth, cost controls, underwriting, and maintaining a strong balance sheet--it is very difficult for Wells to grow earnings in the current interest rate environment. This doesn't bother me in the slightest: Most Tortoise holdings would be hurt by higher interest rates, so Wells provides valuable diversification. Our analyst indicated that a 10%-15% increase to our $52 fair value estimate may be in order, mostly to incorporate a lower cost of equity based on our new methodology. I consider Wells a core long-term holding.

Johnson & Johnson JNJ
Revenue Growth: 6%
Pre-Tax Income Growth: -5%
EPS Growth: -4%

J&J's consumer products segment is on the mend, posting operational sales growth (excluding divestitures and currency headwinds) of 4.7% in the most recent quarter. Unfortunately, the medical device business continues to struggle with competitive and reimbursement pressure, delivering operational sales growth of just 1.3%. The pharmaceutical division remains the growth engine, with operational sales growth of 10.2%. However, we expect J&J's pharma business to face increasing branded competition, patent expirations, and few new product launches over the next several years. Our analyst sees the company's drug development pipeline as among the weakest in Big Pharma. J&J also faces a relatively severe near-term currency headwind, which dragged down reported sales by more than seven percentage points in the first quarter. (The revenue growth rate cited above adjusts for divestitures and currency movements, but the pre-tax income and adjusted EPS growth rates do not.) With Johnson & Johnson's stock trading around our $99 fair value estimate, this is one of the first places I'd look to as a potential source of funds in the Tortoise.

Unilever UL
Revenue Growth: 3%

Unilever only provides a sales update after the first quarter, rather than a full earnings report. It showed 2.8% underlying revenue growth, consisting of 0.9% from volumes and 1.9% from pricing. Growth was well balanced across all of Unilever's product segments: personal care, food, refreshments, and home care. Considering economic challenges and sluggish consumer spending around the world, I think 2.8% is a respectable growth rate. Reported revenue was up 12.3%, helped by weakness in the euro (Unilever's reporting currency) relative to other global currencies. A falling euro isn't much consolation to U.S.-based investors, who must translate the stock price and dividends back to U.S. dollars, but Unilever's cost structure is still better aligned to recent foreign exchange volatility than most of our other multinational holdings. We raised our fair value estimate to $45 from $38 after lowering our cost of equity assumption to 7.5% from 10%, while also adjusting for current exchange rates. I expect to hold.

Philip Morris International PM
Revenue Growth: 9%
Operating Income Growth: 16%
EPS Growth: 24%

Philip Morris' stock jumped nearly 9% on Thursday after the company reported robust first-quarter earnings. The results underscore the strength and resilience of Philip Morris' business model. Despite an incredible 26 percentage point currency headwind, adjusted earnings per share declined only 2.5%. In constant-currency terms, adjusted EPS would have been up 23.5%. Cigarette volumes improved 1.4% year-over-year thanks to market share gains and inventory stocking. We primarily own Philip Morris for its pricing power, which was on full display with constant-currency revenue up more than 9%. Cost cutting and follow-on effects from last year's share repurchases accounted for the remainder of the EPS growth (buybacks are temporarily on hold as the company defends its dividend from currency headwinds). While the strength of the U.S. dollar creates major challenges, I'm as convinced as ever about Philip Morris' very wide moat and enduring competitive advantages. I plan to hold.

American Express
AXP
Revenue Growth: 5%
Net Income Growth: 6%
EPS Growth: 11%

I have low expectations for American Express over the next couple of years as the company works through the loss of its Costco COST partnership, increasing competition for cardholders and co-brand relationships, and foreign currency headwinds. Against this backdrop, I thought the company's first-quarter results were pretty good, though the market came to a different conclusion (the stock was down 4.4% on Friday). On the negative side, spending on AmEx's corporate and international cards slowed in the first quarter. The company also incurred sharply higher expenses for card member services as it sought to differentiate its brand from the competition. On the plus side, credit losses are exceptionally low; American Express has a solid capital position and is aggressively returning cash to shareholders; and operating expenses unrelated to customer service, marketing, or cardholder rewards remain well controlled. With the stock under pressure but our fair value estimate holding steady at $95, I now consider American Express a favorite for new money in the Tortoise.

Charles Schwab SCHW
Revenue Growth: 3%
Net Income Growth: -7%
EPS Growth: -8%

I like Schwab's competitive position as a low-cost provider of investment advice, asset management, banking, brokerage, and other financial services. However, the main reason we own this stock is as a hedge against higher short-term interest rates. Few companies have more to gain from Federal Reserve rate increases than Schwab. Recent bond market activity has defied expectations for rising rates; the strength of the U.S. dollar, negative interest rates in much of Europe, low domestic inflation, and other macroeconomic data have made investors skeptical about the timing and extent of interest rate hikes. Low rates weighed on Schwab's first-quarter results, compounded by an 8% decline in trading revenue. (Although trading accounts for less than 15% of Schwab's overall revenue, it is volatile from quarter to quarter.) Expenses also rose, partly due to the launch of Schwab's "robo-advisor" offering, Schwab Intelligent Portfolios. The good news is that Schwab gathered another $34 billion of client assets and continued to improve penetration of its investment advisory and banking offerings, steadily building stickier and higher-value client relationships. Schwab Intelligent Portfolios attracted more than $500 million within three weeks of launch, demonstrating the power of Schwab's distribution platform. I plan to hold.

W.W. Grainger GWW
Revenue Growth: 4%
Operating Income Growth: -1%
EPS Growth: 1%

Grainger's first-quarter results were weak but unsurprising. The Canadian business remains the biggest drag due to both currency headwinds and declines in the oil and gas sector. Slowing industrial activity and zero inflation in the U.S. aren't helping either. Grainger reported revenue growth of 4% excluding acquisitions and currency movements, which is several percentage points below my long-run expectations. Subdued revenue growth also makes it very difficult for Grainger to expand margins--especially at a time when the company is also investing in its salesforce and distribution infrastructure--and management predicted that full-year earnings per share will be flat to up 6%. I'm willing to grant that this is an unusually difficult environment for Grainger, but our investment thesis relies on the company eventually returning to low-double digit or at least high-single-digit EPS growth. On the plus side, I'm enthusiastic about management's plan to repurchase $3 billion of stock over the next three years. This amounts to more than 18% of Grainger's current market capitalization, with $1.2 billion coming from cash flow and $1.8 billion from new debt. Grainger's balance sheet has historically been underleveraged, and I think the company can easily afford the incremental debt (the debt/EBITDA ratio is forecast to be in the range of 1.0-1.5 times). Long-term investors should hope that Grainger's share price remains as low as possible in the near term to maximize the number of shares that can be repurchased with these funds. We increased our fair value estimate to $272 per share from $264 to account for recent cash flows, and Grainger remains a favorite for new money.

BlackRock BLK
Revenue Growth: 2%
Operating Income Growth: 1%
EPS Growth: 10%

BlackRock's first-quarter revenue and operating income growth were held back by foreign exchange headwinds and lower performance and advisory fees versus the prior year. Earnings per share growth was driven by non-operating items and one-time tax benefits. BlackRock's quarterly results can be volatile, so I wouldn't read too much into this. Rather, I'm focused on BlackRock's impressive $70.4 billion of net asset inflows--representing an annualized organic growth rate of 6.5%--which were well balanced across asset types and strategies. BlackRock is closing in on $5 trillion of assets under management, yet its size seems to be an advantage rather than an impediment to gathering additional assets. For both institutional and retail investors, BlackRock offers low fees, diverse products, liquidity, advanced risk management capabilities, and a trusted brand. I think BlackRock has the widest moat among publicly traded asset managers, and the stock is a core long-term holding for the Hare.

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In other news, regulators in the European Union decided to file formal antitrust charges against Google GOOG. For now, the case focuses on whether Google unfairly favors its own online shopping service over those of rivals in search results, but it could expand to include Android and other Google applications. While Google's business practices create challenges for competitors (why visit a third-party website when you can find the information you're looking for directly in search results?), I think regulators will be hard pressed to demonstrate harm to consumers. On the other hand, at this early stage it's impossible to predict the outcome of regulators' inquiry, which has political and protectionist dimensions to it. In a worst-case scenario, Google could be subject to billions of dollars in fines and be forced to separate its products in a way that would make it harder to compete, especially on mobile devices.

Regardless of the outcome, I think it's unlikely that this antitrust case will have serious negative consequences for our investment in Google given (1) the inherent popularity of its services with consumers, including roughly 90% market share in European search; (2) Google's ability to reformulate its business practices without necessarily hurting revenue, for example by making it easier for competitors to pay for superior placement in search results; and (3) various other levers Google can pull such as cutting back on investment spending or putting its cash to better use. In some ways, the antitrust investigation just reinforces the fact that Google has a very wide moat. Google remains a favorite for new money, and I'm considering adding to the Hare's already sizable position.

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I've received several subscriber emails about my Schlumberger SLB sale earlier this week. Here are my answers to the most common questions:

Question: What does this mean for our position in National Oilwell Varco NOV?

Answer: National Oilwell Varco is also heavily exposed to oil and gas prices--arguably more so than Schlumberger because of the very long life of certain rig equipment and NOV's dependence on deepwater drilling. However, I think that NOV's valuation does a better job accounting for the current oil price environment: NOV is trading at a deeper discount to our fair value estimate and at a materially lower price/earnings ratio. Additionally, my Schlumberger sale reduced the Hare's energy sector exposure to just 3.3%, removing any urgency to also sell National Oilwell Varco. However, if NOV's stock price approaches our fair value estimate and I conclude that the risk/reward tradeoff is no longer favorable, I won't hesitate to throw in the towel.

Question: Aren't we supposed to be long-term investors? Why did you sell Schlumberger after less than a year?

Answer: When we buy a stock, ideally I hope to hold it for many years--preferably forever. However, it's also critically important that we adapt to changing circumstances and don't anchor to out-of-date opinions. Circumstances in the energy sector have changed dramatically in the past year with the plunge in both oil and natural gas prices. If I thought this was a temporary cyclical setback, I would have no problem holding Schlumberger until the cycle turned. But in this case, the long-run supply and demand outlook for energy has also deteriorated due to the revolution in U.S. shale drilling. I didn't feel that Schlumberger's stock price adequately compensated us for the risk of a sustained downturn. We know from history that oil prices can stay low for decades. If you search for a 100+ year chart of oil prices, you'll find that the rapid price increases during the 2000s were a historical anomaly. Aside from a similar jump during the 1970's and early 1980's, the long-run trend for oil prices has generally been flat to down, especially if you adjust for inflation. Human ingenuity usually wins out over apparent natural limitations.

Question: Shouldn't we maintain our energy exposure for diversification reasons?

Answer: I agree that there are diversification benefits to investing in energy, including areas with greater commodity-price sensitivity like oilfield services or exploration & production (that is, not just midstream, which is relatively insulated from commodity prices). Energy is an important input to most other parts of the economy, so owning stocks that benefit from higher oil and gas prices provides a hedge against the possibility of rising costs elsewhere. For this reason, I hope to eventually bring the Hare's energy sector weighting back in line with the S&P 500 (around 8%). However, our energy holdings also have to stand on their own: Modest long-run hedging benefits don't justify taking on unfavorable risk/reward tradeoffs with more imminent downside potential. Although energy is the worst-performing sector over the past year, it has rebounded sharply in the past month. Oil prices have recovered from the lows too, but remain more than 40% below where they were last summer. For the most part, I don't think energy stocks--especially the more conservative, large-cap names that would be of interest to us--are down nearly enough given the drop in oil and gas prices.

Question: What's your take on Schlumberger's first-quarter earnings?

When I have doubts about a holding, I generally prefer to sell before earnings rather than after. Schlumberger reported first-quarter results on Thursday, and they were a bit better than consensus expectations. On a sequential basis, revenue was down 19% and adjusted earnings per share were down 29%. Results looked better on a year-over-year basis, with revenue down 9% and EPS down 12%. Falling sales and earnings were expected given dramatic cuts in capital expenditures across the oil and gas sector. Schlumberger benefits from its concentration of international customers, especially relative to North American-focused peers like Halliburton HAL. Schlumberger's international revenue was down 16% sequentially, compared to a 25% decline in North America. Schlumberger is also doing an admirable job adjusting its cost structure to lower revenue, with its first-quarter operating margin down a manageable 255 basis points sequentially. Earnings declines will likely accelerate as the year progresses and more contracts roll off or are repriced. Overall, I think Schlumberger's performance supports our view about its wide moat and strong financial position, but valuation is the sticking point--the stock would have to fall at least 25% for me to get interested again.

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


Philip Morris International PM  |  Philip Gorham, CFA, FRM

Philip Morris International comfortably beat consensus on the top line, but first-quarter results put the firm on track to meet our full-year projections. Management modestly raised its full-year guidance to $4.32-$4.42 in earnings per share from $4.27-$4.37, and although our estimate is now at the lower end of that range, we are unlikely to make material changes to our forecasts. We are reiterating our $92 fair value estimate and our wide economic moat and stable trend ratings. We continue to view Philip Morris as a high-quality business that is temporarily hampered by foreign exchange headwinds. As we stated in our fourth-quarter earnings note, looking through the reported numbers and stripping out the impact of foreign exchange, the business is performing quite well.

First-quarter revenue of $6.6 billion was 4.4% lower than last year on a reported basis, but 9.2% higher on a currency-adjusted basis. The upside was healthy and broad-based, with every region contributing positive growth. Particularly encouraging was the rebound in the European Union, which delivered 7.8% currency-neutral growth. While favorable trade inventory movements boosted volume around 1% in some key markets by our estimation, sell-through to the consumer accelerated in the first quarter in Europe, and Philip Morris made modest share gains in most major EU markets.

Only currency spoiled another strong performance in the Eastern Europe and Latin America segments. Despite strong performances last year, with both segments generating double-digit currency-neutral revenue growth, sales accelerated to 13.9% and 14.2%, respectively, mostly driven by pricing. It is this pricing power in a still fairly challenging environment that gives us confidence that the business model and competitive advantages of Philip Morris International remain firmly in place.

The first quarter is the smallest for Philip Morris, and we temper our enthusiasm for these results with some caution that risks relating to the macroeconomic environment and regulatory environment remain. Nevertheless, with the headwinds in Europe beginning to subside, we believe there is value in Philip Morris stock, and we continue to recommend it to value investors looking to hold high-quality businesses.

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BlackRock BLK  |  Greggory Warren, CFA

There was little in wide-moat BlackRock's first-quarter earnings that would alter our long-term view of the firm. We are leaving our $385 per share fair value estimate in place. BlackRock closed out the March quarter with a record $4.774 trillion in managed assets (just shy of our forecast of $4.776 trillion), which represented a 2.6% sequential (and an 8.5% year-over-year) improvement in its AUM. Long-term net inflows of $70.4 billion lifted organic growth over the past four quarters to 5.5%, above management's annual target of 5% and our own long-term forecast of 3%-4%. That said, the firm has seen two straight exceptional quarters of long-term organic AUM growth, something that we think will be difficult to sustain, especially if equity markets falter or interest rates start rising in the near term. We do, however, expect the firm's AUM to expand at a high-single-digit rate this year, with BlackRock closing out 2015 with more than $5 trillion in managed assets.

While the firm's quarterly average AUM was up 8.7% year over year, first-quarter revenue increased just 2.0% when compared with the prior year's period. This was due not only to a reduction in management fee rates (as a result of shifting product mix, ongoing fee compression, and adverse currency exchange), but also lower performance and distribution fees year over year. Given these conditions, and with BlackRock's AUM likely to increase at a mid- to high-single-digit rate in 2015, we expect the firm to generate mid-single-digit revenue growth in the year ahead. With regard to profitability, the company reported a 20-basis-point decline in operating margins (to 39.2% of revenue) when compared with first quarter 2014. While compensation expense was basically flat year over year, higher distribution and servicing costs, as well as higher general and administrative expenses, contributed to the decline in margins. We still see the firm closing out 2015 with operating margins in excess of 40% of revenue.

Looking more closely at the firm's fund flows, BlackRock generated better inflows with its equity operations (which account for 53% of its total AUM) than even we were forecasting, picking up $20.9 billion in total inflows, compared with our forecast for $13.7 billion in inflows. Active equity was the biggest surprise during the first quarter, picking up $500 million in inflows (which were the first positive flows for the segment since the fourth quarter of 2013), compared with our forecast for $5.5 billion in outflows. As we've noted in prior periods, continued improvements in this piece of BlackRock's business would be additive to revenue growth longer term, as the firm's active equity funds charge meaningfully higher fees (of just over 50 basis points on average) than its passive offerings (with equity ETFs at 34 basis points and the company's institutional index products at 5 basis points).

BlackRock's fixed-income platform continues to benefit not only from the growth of ETFs, but from the outflows that continue to plague PIMCO (following the departure of Bill Gross), with the firm picking up $36.3 billion in total inflows during the first quarter. This was about $12 billion lower than our forecast for the period, with most of the shortfall coming from the company's iShares operations, which we had expected to post $30.7 billion in inflows (compared with the $18.6 billion that BlackRock reported). The company also reported close to a $1 billion of outflows from its institutional index business, which we had expected to generate $7.9 billion in inflows. The saving grace here is that BlackRock's active fixed-income business posted $18.5 billion in positive flows, close to $9 billion more than our expectations. While we expect the firm to continue to benefit from the uncertainty surrounding PIMCO, as well as the more rapid growth of bond ETFs, we're not expecting annual organic growth for the fixed-income segment to reach the 7.8% level seen during 2014 (noting that organic growth for BlackRock's fixed-income operations was 0.9% in 2013 and negative 5.4% in 2012).

Generating $35.5 billion in net inflows during the first quarter, iShares accounted for half of the long-term inflows generated by BlackRock during the period. This compares with all of 2014, when the ETF business accounted for 56% of the company's long-term inflows. We view this as a sign of progress, especially since it is the firm's actively managed funds that are contributing more than they have in past periods to organic growth. While we continue to expect iShares to be the spearhead for BlackRock's long-term growth, the firm will get an added boost to its revenue if its actively managed funds generate positive performance and organic growth on a more consistent basis. Any incremental gains on the top line that the company can generate would also lead to much higher margins than we are currently forecasting, due to the amount of operating leverage in its operations.

Based on our current forecasts for the firm, we see BlackRock generating around $3.7 billion in free cash flow this year. The company has already spent $275 million during the first quarter on share repurchases, and expects this to be a good run rate for quarterly purchases going forward. This would lift full-year share repurchases to $1.1 billion (from a previous forecast of $1.0 billion annually). The firm also increased its quarterly dividend to $2.18 per share back in January, reflective of a 13% increase and leavings it current yield at 2.4%. With the stock trading at 95% of our $385 per share fair value estimate, it is difficult to make the case for buying the shares at these levels. That said, BlackRock still offers one of the better and more stable organic growth profiles in our coverage universe, and has the potential to generate high-single-digit growth in its operating income, and double-digit earnings growth, in each of the next five years--something that cannot be said for most of the other asset managers.

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W.W. Grainger GWW  |  Kwame Webb, CFA

We are increasing Grainger’s fair value estimate to $272 from $264 to reflect benefits from the time value of money and a recent share repurchase announcement, which are modestly offset by a diminished 2015 sales outlook. In the first quarter, Grainger faced headwinds from an oil and gas slowdown and currency translation. Both should persist through the year, and Grainger reduced its 2015 outlook to 1%-4% sales growth and EPS of $12.25-$12.95, down from 3%-7% sales growth and EPS of $12.60-$13.60. With a weaker outlook, Grainger has chosen to get more offensive and has decided to double its salesforce hiring plans in 2015, which will weigh on 2015 margins but should accelerate growth in 2016. We believe Grainger’s competitive advantage remains intact and we reiterate our wide moat rating.

First-quarter sales rose 2% year over year to $2.4 billion, with acquisitions adding 100 basis points of growth while a strong U.S. dollar was a 300-basis-point headwind. U.S. sales grew 4% (79% of total sales). Canadian sales fell 8% (9% of sales), but increased 3% on a local currency basis. The other businesses segment which includes European and South American units along with Grainger’s online-only Zoro and MonotaRO businesses grew 8% on a reported basis and 21% on a local currency basis. Operating income declined 1% to $351 million as growth related spending for the European Zoro launch and restructuring expenses in Europe and Brazil weighed on profits.

Despite uninspiring performance during the quarter, Grainger’s ongoing investments in online platforms as well as the expanded salesforce should aid future growth. Recognizing the need to accelerate cash returns to shareholders, Grainger announced a $3 billion share repurchase program which at current prices reduces shares outstanding by 19% over the next three years. Pursuing this plan will take the current debt to EBITDA ratio to slightly above 1.0 times from under 0.5 times.

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Unilever UL  |  Erin Lash, CFA

The breadth of Unilever's expansive distribution network combined with its solid brand mix (which support the firm's wide moat) was evident in the firm's first-quarter trading update. After bumping up our fiscal 2015 sales outlook to nearly 8% growth from 1.4% previously to account for the benefit from favorable foreign currencies as well as recalibrating our cost of capital assumptions, we are raising our fair value estimate for the local shares to EUR 43 from EUR 33 and the other share classes (which also adjust for current spot rates) to GBX 3,061 from GBX 2,493 and $45 per ADR from $38. We view Unilever as fairly valued, but would look to any retreat in the stock price due to concerns about slowing global consumer spending or competitive pressures as an opportunity to build a position in this wide-moat name.

For the quarter, organic sales rose 2.8%, which was driven by nearly 2% higher prices and a 1% uptick in volume. But unlike last year, when unfavorable foreign exchange movements hampered the top line to the tune of 9%, FX was a pronounced positive, at almost 11%. Emerging markets (nearly 60% of sales) posted sales growth just north of 5% on 4% higher prices and 1% increased volume, and despite the contraction from a year ago, when sales popped about 7%, management highlighted that India and South Africa showed signs of improvement and China is stabilizing. From our vantage point, the firm's tenure in these regions (which dates back 50-100 years in some instances), subsequent grasp of consumer trends, and spending behind product innovation and marketing ensure the company is well positioned when growth resumes. Looking across Unilever's categories, growth was broad-based, with each segment posting 2%-3% underlying sales growth. We note, however, that the food business (up nearly 3%) benefited from an earlier Easter, and as such, we hesitate to view this quarter's performance as sustainable.

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Wells Fargo WFC  |  Jim Sinegal

Wells Fargo's net interest margin fell by 25 basis points to 2.95% over the past 12 months as the company added deposits and experienced lower interest income accruals from variable sources such as credit-impaired loans. However, we don't see this as a negative. In fact, we expect to raise our fair value estimate by approximately 10%-15% as we lower Wells Fargo's assigned cost of equity to 9% based on our new methodology and adjust our long-run charge-off assumptions, even as net interest margin remains a near-term headwind.

Total and core deposits both grew by 9% during the year, with Wells Fargo paying only 9 basis points of interest expense on its deposit funding. The company's low-cost deposit base growth remains its key source of competitive advantage, and we believe the company's narrow moat remains intact. The company's recently announced purchase of financial assets from General Electric demonstrates Wells Fargo's advantage, as such "shadow banks" may face fewer regulations, but also must deal with significantly higher wholesale funding costs.

Wells Fargo's conservative lending standards also help produce returns above the bank's cost of capital. The company charged off only 0.33% of loans during the quarter--considerably better than our current long-term forecasts.

On the efficiency front, Wells is subject to increased regulatory costs like many of its peers, but we are encouraged by the company's relative lack of legal expenses. The company's simple, domestically focused business is clearly not "too big to manage" as the company has thrived under the leadership of several CEOs. Though the company expects its efficiency ratio to be at the high end of its 55%-59% target for 2015, we don't view increases in headcount negatively. Along these lines, Wells Fargo's emphasis on cross-selling is associated with significant incentive spending. We see these expenses as worthwhile in building long-term customer relationships and consequently, switching costs.

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Charles Schwab SCHW  |  Michael Wong, CFA, CPA

Elevated expenses and lower trading dented Charles Schwab’s first-quarter results, but growth in asset-based revenue and the launch of the company’s robo-advisor solution, Schwab Intelligent Portfolios, mean that the company’s upward trend is still intact. We are maintaining our $32 fair value estimate and wide moat rating for Charles Schwab. Schwab previously said that advertising would be higher in the quarter from the launch of Schwab Intelligent Portfolios. Advertising expense was $69 million compared with $63 million a year ago and $58 million last quarter and had a $0.01 negative effect on EPS. The bump in advertising appears to have had its intended effect, with 274,000 accounts added in the quarter, 6% higher than the first quarter of 2014 and 16% higher than the trailing 12-quarter average. The company also said that its robo-advisory offering has more than $500 million in assets despite only launching on March 9. This compares to some of the currently leading robo-advisory firms that are several years old and have about $2 billion in client assets.

While relatively weak or strong trading revenue can influence quarterly results, we believe that investors should focus on the asset management and net interest revenue lines. Trading revenue makes up only 15% of net revenue at Schwab, and we forecast it decreasing to less than 10% over the next five years. Much of our forecast lower proportion of trading revenue is due to growth in other revenue lines, rather than an absolute decline in trading. Additionally, asset management revenue has become a partial substitute for trading revenue, due to initiatives like OneSource. Together, asset management and net interest income are about 80% of net revenue, and were up 6% from a year ago and 0.5% sequentially. Net interest revenue growth contributes approximately 75% of our net revenue growth forecast over the next five years, so it’s the most material and dynamic of the company’s revenue lines.

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American Express AXP  |  Jim Sinegal

Despite the effects of a strong U.S. dollar versus other currencies and the pending loss of its co-brand relationship with Costco, American Express posted an 11% increase in diluted earnings per share and a 29% return on average equity during the quarter. We think the company’s performance under these circumstances is indicative of its wide moat, and we do not intend to significantly alter our recently updated fair value estimate.

Management appears to be doing a reasonably good job steering the company through tough times in early 2015. American Express’ strong capital position allowed the company to repurchase shares, contributing to an 11% increase in earnings per share on a 6% increase in net income. The company also offset increasing rewards and services expenses by lowering operating expenses across the board. American Express is also expanding its network—a key source of its economic moat—by adding new merchants through its OptBlue program. Though the loss of the Costco co-brand relationship is a large blow, we don’t think American Express is down for the count. In fact, new relationships with companies like Charles Schwab are intriguing as the financial services landscape changes.

Helpfully, American Express is still benefiting from extraordinary credit quality, writing off only 1.5% of principal balances in the first quarter—and releasing $107 million in reserves. We think an improving economy and a greater emphasis on spending rather than lending among American Express’ competitors could lead to an extended period of low loan losses, boosting the company’s bottom line above and beyond “normal” levels. American Express' exceptional profitability, healthy capital levels, and pristine credit should provide the company quite a cushion to deal with temporary bumps in the road.
 
Most troubling during the quarter might have been the slowing pace of spending on the company’s corporate cards. Billed business fell 1% as reported and grew by only 4% as adjusted for the effects of foreign currencies. Income in this segment fell slightly to $180 million from $184 million. However, we believe this is due to volatility in corporate spending rather than increased competition, and expect American Express to maintain its stronghold in this area.

We also see evidence that American Express is having to pass on more economic benefits to cardholders as other issuers continue to vie for premium customers. Cardmember rewards grew by only 4% during the year, but services expense expanded by 18% as American Express redoubled its efforts to distinguish itself from peers.

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Johnson & Johnson JNJ  |  Damien Conover, CFA

Johnson & Johnson reported first-quarter results below our expectations but slightly ahead of consensus projections, as strong drug sales helped mitigate weak device sales. We don't plan to change our $99 fair value estimate based on the results, and we are holding firm to our wide moat rating despite increasing competitive threats to leading drugs and a relatively weak late-stage pipeline. We think the company's portfolio of patent-protected products and strong brand power in the consumer division support its wide moat.

Following the recent trend, J&J's drug group once again led growth in the quarter, and we expect this trend will continue, but at a decelerating rate. Several of the company's core drugs--including cardiovascular drug Xarelto, oncology drug Zytiga, and immunology drugs Simponi and Stelara--posted double-digit gains. However, increasing competition to all of these drugs is likely to slow growth over the next several quarters. Over the next two years, we expect generic competition to increase for several neuroscience drugs (Concerta, Invega Sustenna, and Risperdal Consta), which represent 5% of J&J's drug sales. The increasing competition combined with a weak late-stage pipeline is concerning. However, we project a strong growth trajectory for several new drugs (diabetes drug Invokana and cancer drug Imbruvica) will help mitigate J&J's headwinds.

We expect the consumer group's strong resilience and the device group's struggles will continue. We believe the strong brand power supporting J&J's moat remains intact for the consumer group, which posted operational growth of 5%. While we expect the growth rate for consumer to accelerate as manufacturing issues are remedied, we believe the device segment (up 1% operationally) will continue to struggle as a result of poor pricing power and slow innovation trends.

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Google GOOG  |  Rick Summer, CFA, CPA

The European Commission sent a formal Statement of Objections to Google regarding the company's practices with its comparison shopping engine product, and simultaneously opened an antitrust investigation into the company’s business dealings with respect to the Android operating systems and other Google applications for the smartphone market. While we expect there to be changes to some of Google's business practices (similar to the outcome of past regulatory investigations), we do not expect Google's competitive position to weaken, nor do we believe the company's growth potential to hinge on the conclusion of this investigation. We are sticking with our wide moat rating and $715 fair value estimate, and we consider the shares undervalued, even accounting for the risk of further regulatory action in Europe.

Google's mobile assets have been a key pillar of our wide moat rating and the outcome of the antitrust investigation bears careful watching, as the wireless Internet continues to take share away from desktop-based activities. But, we don’t think the antitrust investigation will weaken Apple's or Google’s current smartphone market dominance.  We believe any move to weaken the Android ecosystem, as loosely controlled by Google, would only serve to increase Apple's competitive advantages and would be unlikely to drive more consumer choice or to increase competition in the mobile Internet. From our perspective, we believe the EC will have a hard time "leveling the playing field," as the Google Play application store is largely open, and parties such as Yelp, Expedia, and TripAdvisor are driving copious amounts of their business through the Android ecosystem. In terms of prebundled applications such as Maps and Search, it is possible that Google may not be able to force handset-makers to include these applications.

We believe smartphones without access to Google applications are generally in lower demand, however, and it is not clear how consumers would necessarily benefit. Also, in today’s environment, handset providers can already choose to use other forms of Android if they prefer to avoid using Google applications.

Regarding the investigation into Google's comparison shopping practices, we expect potential changes to be barely incremental to the company's revenues and profits. Google is the most widely used search engine in Europe (approaching 90% market share by some estimates), and the company's business and wide moat is driven by a) its ability to capture significant quantities of user information, and b) matching this information with a large liquidity pool of advertising. Being forced revise the presentation of organic search results (which it's not clear the company will have to do) will have minimal impact on its business model, in our view.

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Schlumberger SLB  |  Jason Stevens

While Schlumberger's first-quarter results underscore the magnitude and speed of the collapse in U.S. oilfield activity, we saw evidence of aggressive expense management and, thus far, strong margins overseas. Our $95 fair value estimate remains intact, though we have adjusted our near-term estimates downward. First-quarter revenue declined 19% sequentially, led by a 25% decline in North America. Total segment operating margins compressed by 260 basis points, with North America's margins down 670 basis points, implying only moderate pressure thus far on international margins. We don't think this will last, as spending cuts of 10%-15% internationally are likely to outstrip Schlumberger's willingness to cut costs and cede market position. We currently expect international margins to trend downward during 2015 from the current 22.4% to 17.9% for the fourth quarter. The company announced plans to cut another 11,000 positions on top of the 9,000 previously announced, a 15% head count reduction since last fall. In our view, that will help Schlumberger manage its margin better during this downturn than in 2009.

One of the more interesting items on Schlumberger's earnings calls was its emphasis on adopting a new services model, entering into closer collaboration with operators through performance-based contracts. This model would leverage Schlumberger's robust technical skills while allowing the company to share more in the risk--and the rewards--of deploying new oilfield technologies. In our view, if the firm is successful at moving down this path, it will create further differentiation from more commodified oilfield products and services, potentially supporting even higher full-cycle margins. There's only so much room to cut costs in the value chain, and if Schlumberger can instead succeed at increasing production per dollar of spend, and can share in that upside, performance-based contracts could become a powerful profits driver.

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