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Investment Strategy
What is the goal of the Tortoise Portfolio? The Tortoise Portfolio aims to outperform the S&P 500 index over time. Companies in this portfolio tend to be mature, relatively slow-growing, and with moderate to low risk. New purchases must have an economic moat, preferably wide. We attempt to tilt the portfolio toward companies with at least stable competitive advantages (stable moat trends).

What is the goal of the Hare Portfolio? The Hare Portfolio aims to outperform the S&P 500 index over time. Companies in this portfolio tend to be faster-growing, with both higher risk and higher return potential than those in the Tortoise. New purchases must have an economic moat, preferably wide. We attempt to tilt the portfolio toward companies with growing competitive advantages (positive moat trends).

Investment Strategy
Morningstar StockInvestor invests in companies with established competitive advantages and generous free cash flows, trading at discounts to their intrinsic values. These are core holdings, with more conservative ideas appearing in the Tortoise Portfolio and more aggressive ideas in the Hare Portfolio. We expect both portfolios to beat broad U.S. stock index benchmarks, such as the S&P 500, over rolling three-year periods.
About the Editor
As editor of Morningstar's StockInvestor newsletter, Matthew Coffina manages the publication's two real-money, market-beating model portfolios — the Tortoise and the Hare. Matt was previously a senior healthcare analyst, covering managed care and pharmaceutical services companies. Matt also developed the discounted cash flow model used by Morningstar analysts to assign fair value estimates to most of the companies in its global coverage universe.

Matt joined Morningstar in 2007. He holds a bachelor's degree in economics from Oberlin College and also holds the Chartered Financial Analyst (CFA) designation.

Jul 24, 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, 7/22/16 -- Structured Data and StubHub Accelerate EBay's Growth

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.

Second-quarter earnings season is picking up steam, with reports this week from eBay EBAY, PayPal PYPL, Visa V, American Express AXP, Discover Financial Services DFS, Novartis NVS, Johnson & Johnson JNJ, Unilever UL, and Union Pacific UNP. In other news, Visa and PayPal announced a new partnership, and Unilever agreed to acquire Dollar Shave Club.

Structured Data, StubHub Drive EBay's Solid Results, but Industry Dynamics Temper Long-Term Optimism
-by R.J. Hottovy, CFA

In our view, there were two clear highlights coming out of eBay's second-quarter update. The first was that eBay's structured data listing requirements are yielding positive results for its Marketplaces segment. This was evident in the number of listings (live listings crossed the 1 billion mark) and improved conversion rates (helping to accelerate constant-currency GMV growth by one point to 5% versus the previous quarter), and we expect further improvement during the back half as more listings are brought under the structured data fold. While we believe management deserves a good deal of credit for improving its buyer/seller marketplace experience, we still harbor concerns that Amazon's push for small/individual sellers (which was clear from its Prime Day marketing) may keep top-line trends from accelerating meaningfully from here.

The second takeaway was ongoing strength of StubHub and eBay classifieds that saw year-over-year currency-neutral revenue increase 40% and 15%, respectively, owing to a combination of new seller tools and other listing innovations and a strong slate of events and new verticals. We believe StubHub in particular and eBay classifieds to some extent have both carved out differentiated networks of sellers and buyers within the broader e-commerce industry, which continue to give us comfort with our narrow moat rating. That said, we expect StubHub growth to slow in the back half of the year as it laps last year's pricing changes.

We plan to raise our $25 fair value estimate by a few dollars based on the better-than-expected results from Marketplaces and StubHub, and we view raised 2016 guidance--revenue of $8.85 billion-$8.95 billion, adjusted operating margins of 31%-33%, and adjusted EPS of 1.85-$1.90--as realistic. While eBay presents investors with a compelling capital allocation story--especially with a new $2.5 billion share repurchase authorization--we view shares as fairly valued and find more compelling value in wide-moat Amazon.

Digging deeper into eBay's Marketplaces transformation, we're encouraged by early results from the structured data initiative (now covering 60% of all manufactured goods sold on its global marketplace), which has led to 15 million structured data product pages (which should expand to over 100 million pages by the end of the year and should help from a search-based customer acquisition standpoint). We also find other marketplace enhancement initiatives intriguing, including expanded eBay Valet offerings and drop-off sites (including all U.S. FedEx locations) as well as greater investments in machine learning and artificial intelligence (via the SalesPredict acquisition). Nevertheless, as management pointed out several times during its update, the competitive landscape in the North American e-commerce landscape has not died down. Although management noted that "Prime Day was a really good day," we still expect the Marketplaces segment to settle into a low- to mid-single-digit normalized top-line growth trajectory as the company laps the initial structured data ramp-up beyond 2016, particularly as Amazon puts a greater emphasis on individual/small business sellers. While we acknowledge that there are some natural cross-selling opportunities between marketplaces and StubHub, we still expect customer acquisition efforts will keep longer-term adjusted operating margins in the low-30s versus recent peaks around 34%.

StubHub is rightfully getting a lot of attention in the wake of its impressive second-quarter results, but the unit still represents relatively small part of the overall business (we forecast roughly 11% of total eBay revenue for the year). While StubHub's growth trajectory will likely slow in the back half of the year as it laps more difficult comparisons and last year's price increases, we've raised our longer-term outlook for this segment and now believe this segment is on pace to deliver high-20s GMV growth this year and mid-teens growth the next five years (versus earlier expectations around 10%), especially when factoring in recent bolt-on acquisitions (TicketBis and TicketUtils) that expand its international reach and offer enhanced seller tools.

Despite our concerns about the competitive environment, eBay remains in strong financial flexibility (including $10.4 billion in cash--$1.3 billion after stripping out $9.1 billion in debt), and we believe income-oriented investors may find eBay's capital-allocation activity (including $2.8 million remaining on its share repurchases authorization) attractive. We would also not be surprised to see other capital allocation moves in the years to come, including the initiation of a dividend within the next several years or increased mergers and acquisitions activity such as technology- or geographic-related acquisitions.

Visa Deal Eliminates a Big Risk for PayPal; Mobile Growth Accelerates Again in 2Q
-by Jim Sinegal

Narrow moat-rated PayPal’s quarter was highlighted by a newly announced agreement with Visa, whose management team had been vocally antagonistic toward PayPal in recent quarters. Visa’s concerns were addressed by a greater incorporation of the Visa brand and technologies within the payment system. PayPal also agreed to pass on transaction data--a key battlefield for merchants, payment companies, and banks. Most importantly from PayPal’s perspective, the company agreed not to push customers toward ACH and away from the networks, which could drastically reduce the profitability of such transactions. PayPal experiences very little in the way of transaction costs to process ACH transactions, while it pays processing fees to networks and interchange fees to card issuers when its customers use traditional payment brands. However, Visa has agreed to provide economic incentives for volume processing, as it typically does with other partners. This will no doubt drive higher transaction expenses, but we have long believed that digital wallet providers have no choice but to offer complete customer choice, and PayPal has already cut back on its efforts to promote the use of ACH. We think the benefits, including the elimination of retaliation risk from Visa, outweigh the costs. We are maintaining our $48 per share fair value estimate.

Overall, the firm generated 29% growth in payment volume, and a 19.5% increase in revenue, though the number of user accounts expanded by only 11%. As payment processing increasingly is handled by mobile devices, we think PayPal has plenty of room to benefit from both market and share growth in the years to come. We note that management has already raised its revenue growth guidance for the year as a result of these trends.

We see the Visa deal as further evidence that PayPal is focused on becoming a partner to merchants and other payment firms rather than a potential competitor, giving up some profitability in exchange for a larger piece of the total payment pie. We think PayPal’s strategy in this respect is underestimated. While user payment credentials can indeed be stored on a mobile operating system, providers of this software are not typically entrenched in merchant environments. The number and size of companies using PayPal for mobile payment processing is already impressive, and mobile payment volume grew at an astounding 56% annualized rate during the quarter.

PayPal is also benefiting from the operating leverage inherent to the business. Expenses outside of transaction processing and credit losses expanded by 10% during the year, and accounted for only 40% of revenue versus 42% a year ago. We think this leverage can counteract some of the margin pressure occurring as PayPal serves larger merchants and gives up some economics as it did in the Visa deal.

Visa Controls Core Costs in a Quarter of Many Moving Pieces
-by Jim Sinegal

Wide-moat Visa’s fiscal third-quarter results were affected by the closing of its merger with Visa Europe. Previously, Visa Europe was owned by its European bank members.  However, key performance indicators continue to demonstrate the strength and growth prospects of the company’s business. We continue to believe the company represents an attractive value at a 20% discount to our $104 fair value estimate.

Supporting our valuation, the company announced plans to increase share repurchase authorization to $7.3 billion—around 4% of total market cap and slightly in excess of management’s 2016 free cash flow guidance. When combined with the company’s $0.14 per share quarterly dividend, the repurchases will represent an attractive—and likely fast-growing—effective cash return on the current stock price.

Top-line growth did slow substantially due in larger part to the strength of the U.S. dollar. Operating revenue only expanded by 3% during the year as reported growth was cut in half by currency fluctuations. Underlying trends were strong, though, with payment volume growth on a constant-dollar basis in the three months ended in June up 10% from the same period in the previous year. Cross-border volume on the same basis increased by 5% in that time frame, and the company processed 10% more transactions than the previous year. Though currency fluctuations and macroeconomic volatility will affect volumes in the short run, we think double-digit constant dollar growth in network volume is sufficient to stand by our valuation.

Client incentives rose to 18.8% of revenue, slightly higher than management’s 18.5% guidance for the full 2016 fiscal year. The company kept a tight hold on expenses in the first half of the year. Excluding transaction-related expenses, falling personnel and marketing costs highlighted the company’s ability to generate operating leverage even in a difficult top-line environment.

China was a significant detractor from cross-border payment, with growth rates in outbound payment volume falling from 50% last year to almost no growth this year. However, volatility in exchange rates benefited the company, which makes more money in such an environment. Management also reaffirmed its long-term accretion guidance for Visa Europe. We don’t see any reason why Visa would lose market share in Europe in the near term—instead, we think market share will remain somewhat stable as it has on a global basis over a long time period.

Visa also announced a new partnership with PayPal, which should support the traditional network model over time, heading off competition at the pass. The Visa brand and network will now be displayed and promoted by PayPal, which will receive economic encouragement to counter its historic incentive to push customers to ACH instead.

American Express Results Demonstrate Headwinds in the Card Business
-by Jim Sinegal

American Express’ second-quarter results were consistent with our expectations for the wide-moat firm, as well as its previously outlined guidance, and we are maintaining our $76 per share fair value estimate. The company appears to be doing a decent job retaining former Costco co-brand customers, but is spending heavily to do so. We think this supports our belief that while the American Express brand remains an advantage with customers looking for superior service that keeping up with competitors will be harder than it has been in the past.

Management indicated that a higher level of spending in the short term will be necessary to meet longer term efficiency goals. We don’t think that assertion is unreasonable as the firm invests in technology and automation. However, we’re not convinced that American Express will be able to cut off spending on discretionary projects related to customer acquisition, digital payments, and other growth-related initiatives in an increasingly competitive environment.

Similar to peers, American Express is benefiting from strong growth in consumer borrowing. Excluding portfolio losses and foreign exchange movements, loan balances expanded by 13% from the previous year. Unfortunately, the company’s issuing business depends far more on noninterest sources of income, and continued merchant pressure on pricing along with efforts to build acceptance through OptBlue are still pressuring discount rates. Overall, adjusted revenue--excluding lost business and foreign exchange movements--expanded by only 4% during the quarter, continuing a trend of low-single-digit growth.

Credit quality remains stellar. Past due loans make up only 1.1% of the total, and American Express wrote off just 1.5% of loan balances. Both figures were up slightly from the previous year, but credit performance remains a tailwind. Though losses are well below normal, we expect this to continue to some extent as long as U.S. employment remains robust.

Discover Is Skillfully Navigating a Competitive Environment
-by Jim Sinegal

Discover grew credit card loans at a 4% annualized rate during the second quarter, though Discover card sales volume grew only 2% over the past 12 months. The results were in line with our expectations for the narrow-moat company, and we are standing by our $56 per share fair value estimate.

Discover continued to improve its funding base, with direct-to-consumer and similar deposits growing by 16% during the past year. These lower-cost funding methods now fund 39% of balance sheet assets versus 35% a year ago. We think the continued improvement in funding mix and the secular trend toward online banking are good for the current business and set the stage for the company to diversify into other types of financial intermediation in the years to come.

Provisioning for credit losses grew from $306 million to $412 million over the last four quarters, though the increase was due more to loan growth and seasoning than any deterioration of the company’s portfolio. In fact, the charge-off rate declined slightly over that time frame. More concerning, competition remains intense in the rewards space.  Discover’s management team was not alone this quarter in indicating that rewards costs are rising across the card space. The rewards rate was 1.21% this quarter, several basis points ahead of management’s guidance for the year and consuming a full 58% of interchange revenue. Management’s discipline should pay off in returns, but the intensity of competition may continue to slow growth.

The company’s capital position remains exceptionally strong—Discover’s common equity Tier 1 ratio stood at 14.2% as of June 30.  As a result, the company obtained regulatory approval for an increased dividend—now $0.30 per share quarterly—and will repurchase up to $1.95 billion in shares over the next four quarters. Given that regulatory issues likely preclude mergers and acquisitions for some time, we think this is a fine use of capital in a competitive, low-growth environment.

Novartis Posts In-Line Q2 While Investing to Support Long-Term Growth; Shares Look Undervalued
-by Damien Conover, CFA

We don’t plan any significant changes to our $89 fair value estimate for Novartis after the firm reported second-quarter results largely in line with our expectations and updated full-year guidance slightly downward to reflect increased investments behind cardiovascular drug Entresto. We continue to view the stock as slightly undervalued, with the investment community likely focusing too much on near patent losses and Alcon margin pressures while not appreciating a strong pipeline. The continued innovation further supports our wide moat rating for the firm.

We expect this quarter’s flat sales and EPS growth to continue throughout the year, as generic pressures will not annualize until mid-2017 and Alcon and Entresto investments will also weigh on margins through the end of 2016. The increased Entresto spending likely led Novartis to decrease its full-year 2016 operating income growth guidance to a range between flat and a low-single-digit decline (from flat). However, we expect earnings to accelerate in the second half of 2017 as Entresto’s strong clinical data and endorsement by leading cardiovascular groups should offset payers' resistance to cover the drug. Also, the generic pressure to cancer drug Gleevec should taper off in mid-2017, and sales of Tasigna (a similar but slightly better version of Gleevec) are holding up well, up 15% in the quarter. Additionally, recently launched immunology drug Cosentyx is well positioned to drive peak sales well over $3 billion. Beyond 2017, Novartis is continuing to support innovation that should return the company to high-single-digit growth by 2018. We are encouraged by clinical data supporting potential blockbusters LEE011 for breast cancer, OAP030 and RTH258 in ophthalmology, RLX030 for heart failure, and AMG334 for migraines. Within the generic business, Sandoz is well positioned to launch more than five new biosimilars targeting branded drugs, with over $1 billion in annual sales apiece.

J&J Posts Solid 2Q as Immunology Drugs Buoy Growth, but Deceleration Longer Term Is Expected
-by Damien Conover, CFA

Driven largely by outperformance in its drug group, Johnson & Johnson reported second-quarter results exceeding both our and consensus expectations, and we plan to slightly raise our fair value estimate. Nevertheless, we continue to view the stock as slightly overvalued, with increasing concerns for generic or biosimilar competition for complex drugs Concerta, Invega Sustenna, Risperdal Consta, and Remicade, which collectively represent over $10 billion in annual sales. Despite these concerns, we remain confident in the company’s wide moat, driven by steady innovation in the drug and device group coupled with solid brand power in the consumer group.

While partly supported by reserve adjustments in the quarter, the drug group continues to lead the company, with 13% normalized growth supported by both mature and new drugs. However, we expect this growth to decelerate in 2017 as branded competition increases and generics launch on complex older drugs. On the branded side, new competing immunology drugs (Novartis’ Cosentyx, Eli Lilly’s Taltz, and Takeda’s Entyvio) are likely to take market share from Johnson & Johnson's largest drug segment of immunology drugs. Further, we expect biosimilar Remicade to cause close to 20% annual declines in J&J’s branded Remicade sales by 2018.

While older drugs face increased competition, new drugs are mitigating the pressures. In particular, recently launched cancer drugs Imbruvica and Darzalex are posting rapid growth supported by excellent clinical data. Further, we expect immunology drug guselkumab will help J&J maintain its leadership in immunology based on the drug’s superior efficacy profile to AbbVie’s Humira in psoriasis.

Further helping support the bottom line, cost-reduction programs in consumer and device divisions should lead to almost 500 basis points of margin expansion for the company. As the consumer group finally fixes its manufacturing issues, we expect strong leverage from this segment.

Unilever's In-Line Q2 Highlights Value of Its Moat and Emerging-Markets Footprint
-by Philip Gorham, CFA, FRM

Unilever's second-quarter organic sales growth of 4.7% was bang in line with our forecast and the first quarter, although we slightly underestimated the extent to which currency movements would drag down reported results. We are reiterating our EUR 40 and $44 respective fair value estimates for the Amsterdam-traded shares and their ADR counterparts, as well as our GBX 3,250 and $44 respective fair value estimates for the London-traded PLC shares and their ADR counterparts. Unilever's wide moat remains intact, and we believe its scale and financial flexibility provide it with defences against competitive threats.

Volume growth of 1.8% and price/mix of 2.8% represented a slightly heavier skew to price/mix in Unilever's second quarter, as a slight weakening of deflationary pressures in Europe and emerging-market price increases helped drive organic sales. Underlying sales growth in emerging markets of 7.7% underlined Unilever's status as one of the strongest emerging-market plays among large-cap consumer staples firms. Organic growth at or above 6% in the Asia and Americas segments is a primary reason for Unilever's outperformance of Nestle in recent quarters. We expect Nestle's growth to again undershoot that of Unilever by several basis points in the second quarter.

Another reason for Unilever's solid performance is execution. Its gross margin was 80 basis points higher year over year in the first half of the year, ahead of our estimate of 60 basis points. Despite higher SG&A spending, partially affected by currency movements, respectable execution at the gross margin assisted the 50-basis-point improvement in the first-half EBIT margin.

In the long term, Unilever's greatest challenge comes from the emergence of new entrants, both as a result of the migration to modern channels and in emerging markets. We think Unilever's economic moat, stemming from its scale and ability to invest to drive top-line growth, should allow it to generate long-term excess returns.

Unilever's Acquisition of Dollar Shave Club Highlights Risks to Moats in Consumer Staples
-by Philip Gorham, CFA, FRM

Unilever is to acquire Dollar Shave Club, the online upstart in male grooming, for $1 billion, an acquisition that we think is more significant for its implications about the emerging threat from e-commerce in consumer staples than for its financial impact on Unilever. Nevertheless, we are reiterating our wide moat and stable trend ratings for Unilever, as we still believe that the competitive advantages of the large-cap consumer products manufacturers will help them defend their position against most online new entrants. We are also reiterating our EUR 40 and $44 fair value estimates for the Amsterdam-listed ordinary shares and ADRs, respectively. However, we are raising our fair value estimate for the London-traded ordinary shares to GBX 3,250 from GBX 3,100 to account for the recent depreciation in sterling against the euro. Our $44 fair value estimate for the London-traded ADRs remains unchanged.

Dollar Shave Club was formed in 2012 as an online supplier of low-cost men's razors, and has since expanded into adjacent categories in men's grooming. Its annual sales growth rate of around 30% is reflected in the multiple of 5 times sales Unilever is paying for the business. Dollar Shave Club generated $152 million in turnover in 2015, which represents less than 1% of the men's razor market by value, according to Canadean, and although profitability was not disclosed, we believe it remains a low-margin business. This deal, therefore, barely moves the needle on Unilever's annual sales in excess of EUR 52 billion, and on our valuation. It does, however, signal that the mega-cap consumer staples manufacturers are taking seriously the risk of share loss from the shift to e-commerce. This acquisition gives Unilever a business-to-consumer platform, as well as management experienced in expanding a business in this channel.

Union Pacific Delivers Respectable 65.2% Operating Ratio Despite 11% Volume Decline
-by Keith Schoonmaker, CFA

Freight haulers cannot conjure demand out of thin air, and with Union Pacific’s second-quarter total volume down a sharp 11%, driven by declines of 21% in coal and 22% in international intermodal, we count it a positive that the firm held its operating ratio to a mere 110 basis points of degradation, to 65.2%. UP endured volume headwinds similar to what other rails encountered and improved its core pricing just 2%, but we maintain most of our assumptions and wide moat rating because we believe UP’s long-run competitive advantages are undiminished. In fact, we increased our fair value estimate for UP to $98 from $95 per share as we incorporate the time value of money since our last update and because we reduced our long-run capital expenditure projection from 18% of revenue to 17% after management suggested that the firm could need only 15% due to excess locomotives on hand and declining positive train control investment requirements. We temper this to 17% to better align with the past decade mean of 16.6% of sales, and note the firm exceeded 17% only in 2012, 2014, and 2015.

Powerful levers to preserve railroad profitability are price increases and managing labor levels. This period’s 2% core price increase is lowest since the first quarter of 2014. In the interim, UP improved core price 2.5%-4% each quarter. During most of the next five years we assume the rail improves core price 3% on average, with this inflation-beating increase enabled by two of the rail’s efficient market structure and cost advantages over other transportation modes. Our long-run average assumption is not refuted by an occasional slower gains. Even though gross ton miles declined 11% in the period, the firm reduced its average workforce 12% in line with the 12% decline in revenue. Management expects volume to declined 6%-8% during full 2016 (we model slightly greater decline) and indicated it is unlikely to improve OR this year (we model 90 basis points worse than last year).


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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.

Matthew Coffina, CFA, and Michael Corty, CFA, may own stocks from the Tortoise and Hare in their personal accounts.

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