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.

 
Dec 19, 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, 12/18/14 -- PetSmart Acquired
Over the weekend, PetSmart PETM agreed to be acquired by a group of private equity investors for $83 per share--a 43.6% premium to our purchase price in June of this year. Dumb luck deserves the credit for our timing here: I didn't invest in PetSmart expecting it to be acquired, but an activist investor took an interest in the company just a month after we initiated our position. The deal is expected to close in the first half of 2015, and already has board approval and fully committed debt financing. The only downside is that we will end up with a short-term capital gain. I plan to hold PetSmart until January to push this gain into next year, at which point I intend to sell.

Express Scripts' ESRX chief financial officer decided to leave the company after less than a year on the job. Express Scripts insists that the departure has nothing to do with its accounting policies, and it reaffirmed its 2014 earnings guidance. However, frequent turnover in the CFO position is concerning, especially in light of the Medco integration challenges. Express Scripts turned to an external hire from a private beverage distributor to fill the CFO role on an interim basis, and I'm disappointed that the company hasn't done more to develop talent internally. On the other hand, Express Scripts continues to generate plentiful free cash flow and trade at a relatively attractive price/earnings multiple. I plan to hold for now.

Coca-Cola KO predicted 4%-5% constant-currency earnings per share growth in both 2014 and 2015, below the company's long-term target of high-single-digit growth. Worse, at current exchange rates, currency headwinds will wipe out more than 100% of the underlying EPS growth. Management also provided more details on its plan to refranchise Coke's North American bottling operations. It looks like the company will merely recover its original $12 billion investment without earning a meaningful return on this capital. The best we can say is that Coke's decision to consolidate the bottlers in 2010 may have accelerated innovation around packaging sizes and improved national account management. I'm discouraged by Coke's recent performance, and I view this as one of the Tortoise's most troubled positions. Most of the recent challenges are outside of management's control--especially currency headwinds and consumers' increasing health consciousness--but I suspect that the company could be doing a lot more to cut costs and return capital to shareholders. If a substantially better opportunity comes along, Coke is one of the first places I'd look to raise funds in the Tortoise.

We revisited our financial model for Lowe's LOW following the company's recent analyst day. We believe management's goals are largely attainable, and we increased our fair value estimate to $62 from $57. While Lowe's is growing earnings faster than any other Tortoise holding (and most Hare holdings too), it is also one of the Tortoise's most economically sensitive names. I actually don't mind that, since it adds diversification to an otherwise very defensive portfolio. I plan to hold for the long run.

Lastly, Oracle reported quarterly results that were well-received by investors:

Oracle ORCL
Revenue Growth: 7%
Operating Income Growth: 7%
EPS Growth: 5%

Excluding currency headwinds, Oracle's fiscal second quarter showed marked improvement. Revenue was up 7%, compared to last quarter's 2%, with better growth in just about every area: new software licenses, software product support, cloud computing, and hardware. While Oracle's cloud computing revenue is still a small portion of the total, it advanced 45% year over year. The adjusted operating margin also held steady at an impressive 46%. Overall, these results reassured investors that Oracle will be able to navigate the transition to cloud computing, which is the key to preserving its wide economic moat. I plan to hold.

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This week's roundup comes to you a day early because tomorrow I'll be traveling to spend the holidays with family. It will be our 6-month-old's first time on an airplane--apologies in advance to our fellow passengers!

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

We are increasing PetSmart’s fair value estimate to $83 per share after the firm accepted an $8.7 billion cash bid (representing a 9.1 multiple on trailing 12-month adjusted EBITDA) from a private-equity consortium led by BC Partners (with the participation of La Caisse and Stepstone). We believe the proposed deal is a good value for shareholders, since it represents an approximate 14% premium to our $73 stand-alone fair value, and a 39% premium to the July 2 trading price before the activist, Jana Partners, first intervened. The transaction represents a modest premium to retailer leveraged buyout multiples over the past few years, which have averaged between 8-9 times, but we believe the higher valuation is supported by low-cost financing and PetSmart’s own narrow economic moat. Though near-term results have been soft, we still believe the company benefits from intangible assets in the premium pet market, and relative insulation from e-commerce because of the high cost to ship bulky pet consumables.

We believe all of the bids have already been considered and do not expect a larger offer to emerge, since media reports have indicated that PetSmart has already held discussions with a number of private-equity prospects. Jana has also mentioned that the firm has personally visited private-equity prospects to gauge interest in a deal, so we think all of the interested parties have been flushed out by now. Additionally, long-time shareholder Longview Asset Management, which owns approximately 9% of shares, has agreed to the deal and plans to participate in the buyout with approximately a third of its holdings.

We believe the deal will pass near the proposed price but would not be surprised to see shares trade at a larger-than-typical discount due to regulatory uncertainty. Media reports indicate that regulators have adopted a stricter view on the banking sector’s leveraged lending guidelines and have criticized several deals as problematic. In particular, loans are considered to be “special mention” if the company cannot amortize or repay all senior debt from free cash flow, or half of its debt, in five to seven years, or if debt/adjusted EBITDA exceeds 6 times. PetSmart was not specifically mentioned, and its financing details have not yet been revealed, but the proposed takeover would require the firm to leverage itself over 6.5 times adjusted EBITDA, unless the bidders would increase the equity mix meaningfully above the typical 20% commitment. Additionally, the proposed transaction will be the largest private-equity deal of the year, and could draw increased regulatory attention as a result. Media reports indicate that several bankers have backed out due to the uncertainty, as these guidelines are new grounds for the banking sector, and there still exists a great deal of uncertainty among industry participants on what is allowed.

However, even if regulators scrutinize the transaction, we believe the various participants can restructure the deal to make it work near the current price. Additionally, it is possible that the private-equity firms can use their own financial forecasts (which will almost certainly incorporate substantial cost savings from restructuring plans) to justify the debt levels.

Our $73 stand-alone fair value does not incorporate the impact of management’s recently announced restructuring plans, which aims to reduce $200 million of annual expenses by 2016. However, we believe the proposed steps, while representing substantial upside, were also aggressive and could cause downside risks if the firm cut into muscle, as well as fat in the process. Consequently, while the buyout bid may reduce some upside if management succeeded in achieving these plans, we believe the increased certainty of a bid adequately compensates shareholders.

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Oracle ORCL  |  Peter Wahlstrom, CFA

Oracle posted fiscal second-quarter results that were modestly ahead of our expectations, and the firm is on track to meet our full-year outlook. While management continues to beat the cloud conversion drum and is admittedly making good progress, we don't think the story has fundamentally changed when we take a look through our long-term lens.  Oracle is still a well-positioned wide-moat firm that benefits from deep switching costs. We plan to update our financial model following the quarter's results and management's outlook (specifically as it relates to currency headwinds) but do not anticipate a change to our $42 fair value estimate. With the shares trading in 3-star territory, we'd seek a wider margin of safety.

Consolidated second-quarter revenue was up 3.5%, led again by the software license updates and product support (up 5.6%) and the small but quickly growing SaaS/PaaS and IaaS businesses (up 39% and 60%, respectively, off of $100 million-plus bases, but not in the billions). Legacy hardware and services revenue during the quarter illustrated a continuation of recent trends (flat and down slightly, respectively) and isn't a tremendous concern as we think about our wide moat rating. Non-GAAP operating margin in the quarter was flat year over year at 45.7%, but management was quick to point out that it continues to see the cloud transition as one that will benefit the firm's overall profit profile in the long run. We think there are several puts and takes that go into this view and the market is still evolving, but it's a good bogey to keep in mind. All in, Oracle reported non-GAAP diluted earnings per share of $0.69, up nominally (1%) year over year.

The company still generates ample cash flow, $14 billion in our current model, representing a 7.5% yield. Plus, with $16 billion in cash and equivalents on the balance sheet, Oracle is in a solid position to self-fund its investments, repurchase its shares ($4 billion year to date) and offer shareholders a modest $0.12 per share quarterly dividend (1.1% annualized yield). All of this is good news, particularly when the firm is facing stiff currency headwinds, as are many other global enterprises. Management went so far as to only provide constant currency guidance for the quarter, which, given the current volatility, seems prudent. Revenue could face a 4%-5% headwind in the coming quarter, depending on geographic mix, and this also obscures somewhat the underlying non-GAAP EPS guidance of $0.69-$0.74. So, while it may be a choppy quarter, and Oracle still struggles with some of the same challenges facing other legacy tech players, the firm is gaining traction in the cloud space, which is a positive and should help solidify its position in the marketplace.

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Express Scripts ESRX  |  Vishnu Lekraj

On Dec. 15, Express Scripts announced that CFO Cathy Smith will leave the firm in January and be replaced on an interim basis by James Havel, the current CFO of beverage distributor Major Brands.

Havel has significant consulting experience as the former head of Ernst and Young’s St. Louis office. While this news was somewhat abrupt, given that Smith was in her current position for only 11 months, this development has no impact on our long-term outlook for the firm and we are reiterating our $89 fair value estimate.

Express has seen some material turnover within its finance operations over the last few years and we believe the firm has struggled to some extent with managing an organization that has tripled in size over the past decade. However, we believe Express is still on track with its turnaround strategy, and the firm has reiterated its EPS outlook for 2014. We would also emphasize Express is well positioned for long-term success given the critical need for its services and market-leading position.

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Coca-Cola KO  |  Adam Fleck, CFA

We plan to maintain our $42 per share fair value estimate and wide moat rating for Coca-Cola following details gleaned from the firm’s business update call, though we will likely lower our near-term projections to account for ongoing currency headwinds. Following up on the cost savings plan announced in October, there are several additional transactions that will take place in 2015 with both positive and negative impacts; these include the continued refranchising of some of Coke’s wholly owned North American distribution assets, the sale of the firm’s energy drink portfolio to Monster Beverage, and the inclusion of Monster’s non-energy drinks. The key takeaway is that the combined impact is minimal for 2015--the company estimates that the headwind from giving up distribution rights will lead to a 1% hit to the top line and EPS, but Monster’s moving parts will drive revenue up 1% to 2% while not affecting the bottom line.

Over the long run, the company aims to complete half of its bottling refranchising by 2017 and the remainder by 2020, with a low-single-digit percentage headwind to EPS due to sacrificed gross margin in product sales from the additional layer formed between Coke and retailers. The revenue impact is also minimal (about 5% of sales, per management guidance for $2 per case impact and our forward estimates), since Coke plans to structure the agreements as sub-bottling contracts rather than outright sales, and will therefore receive a portion of the lost selling price back in quarterly payments.

In all, based on management’s outlook, operating margins should rise as a result of this transaction--this also makes sense considering that Coke’s historical business pre-bottling acquisition (in 2010) was higher margin. Importantly, ROICs should also increase. The company will shed $5 billion in assets by 2017, or nearly 10% of our estimated future invested capital base for the company, a rate higher than the low-single-digit reduction in earnings.

At first blush, the end financial results of the refranchising appear to offer Coke minimal return on its initial investment. The company acquired the North American bottlers in 2010 for about $12 billion, and spent an additional $1 billion for rights to distribute several of Dr Pepper Snapple’s brands. On top of the $5 billion in assets the firm will shed by 2017, management estimates that the remaining business to be refranchised by 2020 will be another $5 billion, and the manufacturing arm (which, for now, will stay with Coke) is worth roughly $2 billion. The company also estimates the total efficiency savings (including those planned for the manufacturing piece) at about $1 billion, good for a total of $13 billion--equal to the original purchase price.

That said, we believe there are benefits to having owned the bottlers, including enhanced product development (such as 8-ounce cans and 1-liter plastic bottles in North America) that helped increase price per ounce and offset substantial commodity cost inflation, better national account management, and improved employee incentives to drive growth across the systems. Admittedly, it’s worth questioning whether Coke needed to own the bottlers outright in order to enact these changes, but ultimately we think the future gains from increased package development, cost-cutting initiatives, better price/volume management, and variable incentive pay from the sub-bottlers (allowing Coke to capture some of the future growth upside) will help drive higher returns for the firm.

We also remain encouraged by management’s updated goals to again focus on its core beverage business, with plans to drive top-line growth back to the mid-single-digit level (such as incremental marketing spend and improved pricing in North America) while also cutting costs by 8% per year. In all, we’re still comfortable with our long-run forecast for 7% to 8% annual earnings per share growth.

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