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.

 
Jun 02, 2015
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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, 5/29/15 -- Reassessing Bank Moats

Over the past several weeks, Morningstar's bank analysts have been meeting with our economic moat committee (myself included) to review our bank coverage. Prior to the 2008-09 financial crisis, we were clearly too optimistic about many banks. We assigned wide moats to most large retail banks on the basis of cost advantages and customer switching costs, only to watch the stocks collapse during the crisis amid poor underwriting, insufficient capital, and excessive risk-taking. We downgraded many bank moats around this time.

While our reasoning for the downgrades was sound, I think the pendulum may have swung too far. Banking involves some inherent risks for investors, including opaque balance sheets and a high degree of financial leverage that magnifies the impact of bad decisions. The domestic banking market is especially challenging: Most international markets have consolidated around a handful of large banks, but the U.S. still has more than 6,000 banks competing aggressively for deposits and loans. Add in stricter regulatory scrutiny and higher capital requirements, and we still don't think the U.S. banking landscape is conducive to wide moats.

However, two domestic banks stand out: Wells Fargo WFC and U.S. Bancorp USB. We upgraded both companies' moat ratings to wide based on their combination of scale, low-cost deposit funding, sticky customer relationships, straightforward business models, conservative underwriting, and exemplary stewardship. These factors should support attractive returns on capital in most environments and on average through the business cycle. We also increased our fair value estimate for Wells to $61 from $58 and for U.S. Bancorp to $52 from $50. Wells remains a core long-term holding for the Tortoise, and if we ever decide to buy a second bank, U.S. Bancorp would be toward the top of my list.

Our country-by-country review of international banking markets revealed that some are more moat-worthy than others. We looked for markets with favorable macroeconomic, regulatory, political, and competitive conditions and found that Australia, Canada, Sweden, and Chile are relatively attractive. This led us to upgrade six foreign banks to wide moat: Toronto-Dominion TD, Bank of Nova Scotia BNS, Royal Bank of Canada RY, Banco Santander Chile BSAC, Banco de Chile BCH, and Sweden's Svenska Handelsbanken. I'm somewhat less likely to venture outside of our home market for a bank stock--it's harder to get comfortable with the potential macroeconomic risks when you're not in the country--but it's not out of the question.

Elsewhere, our investment in Union Pacific UNP is off to a rocky start, with the stock down about 6% since my purchase a few weeks ago. More importantly, we reduced our fair value estimate to $115 per share from $119. The main problem is Union Pacific's coal volume, which management revealed is down 24% so far in the second quarter. Coal demand has been under pressure across the country; with natural gas trading around $2.60/MMBtu, utilities are switching as much electricity generation as possible from coal to gas. However, I'm surprised that Union Pacific's coal volume has been hit so much harder than peers'; our analysts attribute it to a combination of milder weather compared with last year, excess inventory at Union Pacific's utility customers, and market share gains by Berkshire Hathaway's BRK.B Burlington Northern Santa Fe, which lost share last year because of weather-related service disruptions.

On the plus side, I don't think Union Pacific's coal headwinds will remain this strong indefinitely. In Eastern coal basins like Central Appalachia, there is a risk that both the mines and the power plants that burn the coal will close permanently. Similar closures are unlikely in Wyoming's Powder River Basin (the focal point for Union Pacific's coal franchise) or for power plants burning PRB coal given its lower cost to extract and lower sulfur content. Furthermore, coal will remain an essential part of the United States' electricity generation mix for the foreseeable future, and weak economics in Eastern basins could cause the coal-mining industry to regroup around the PRB. We don't need coal volumes to recover to justify Union Pacific's valuation--we just need the declines to slow. Our updated valuation model assumes a 15% decline in UP's coal carloads this year and 1% annual declines thereafter.

Note that coal represented about 18% of Union Pacific's freight revenue last year. Grain and aggregates volumes have also been down recently, but chemicals, intermodal units, and automotive have improved. Altogether, second-quarter volume is tracking about 4% below the previous year. Our full-year 2015 forecast now calls for a 2% revenue decline but roughly 5% growth in earnings per share.

Taking a step back, I'm actually rather happy to see Union Pacific's stock trading lower. We knew this was a cyclical business, which is why I started us off with a below-average 2.9% position weighting in the Tortoise. However, unlike some other cyclical businesses we've been involved with in the past (such as C.H. Robinson CHRW and Schlumberger SLB), I'm not concerned about the sustainability of Union Pacific's economic moat, the reasonableness of its valuation, or the risk of a prolonged industry-specific downturn. Since I eventually hope to buy more shares, I'd prefer if they were on sale.

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

Banks  |  Stephen Ellis

Following a major refinement to our bank economic moat methodology, we’ve upgraded eight banks to a wide economic moat: Wells Fargo, U.S. Bancorp, Svenska Handelsbanken, Toronto-Dominion Bank, Bank of Nova Scotia, Royal Bank of Canada, Banco Santander Chile, and Banco De Chile. The changes have resulted in higher fair value estimates across the group, as we assume excess returns persist over a longer time frame than before. Several of our new wide-moat banks are now undervalued, such as U.S. Bancorp, Banco Santander Chile, and Bank of Nova Scotia.

Our new methodology includes analysis of regulatory, competitive, political, and economic elements in all 22 countries we cover. These elements support the sustainability of banks' economic returns over time. Our updated analysis for rating financial systems explains why bank moats differ across our global banking coverage despite similar business models or similar profitability. Accordingly, we note that our wide-moat banks are generally contained within high-quality systems such as Australia, Canada, Sweden, and Chile, which score well across the banking system criteria we’ve developed. However, some U.S. banks, such as Wells Fargo and U.S. Bancorp, also earn wide moats despite operating in a weaker system. These banks score well on other factors, including evaluations of a bank’s culture, balance sheet, its ability to fend off disruption, and its ability to generate excess returns.

As in the past, we see low funding costs as a key advantage for retail and commercial banks. However, we believe that switching costs play a key role in a bank’s ability to maintain low-cost funding (its cost-advantage-based moat source) and are consequently adding switching costs as a moat source. In addition, we’re delving deeper into moat sources for non-interest-earning banking businesses, which can contribute half or more of earnings at complex banks.

Investors see banking crises as the result of extraordinary circumstances, chiefly, unforeseeable economic shocks. They are therefore categorized as freak events. We strongly disagree as we believe that that banking crises are recurring and heavily influenced by nonmacro factors. We’ve observed over 150 banking crises since 1800 across our coverage of 22 countries.

As a result, we’ve made a major refinement in our bank moat methodology. We’ve introduced a deep analysis of the banking systems for all 22 countries we cover, as we believe that the more stable a given system is, the more confidence we can have in banks’ excess returns over time. Our research shows that a thorough understanding of a bank’s banking system, which includes regulatory, competitive, political and economic elements, informs how sustainable a bank’s economic returns are over time.

We believe there are several key benefits for our research. First, we can highlight the strengths and weaknesses of each system, and the system’s direct impact on the moatiness of banks. Second, we can explain why bank moats differ across our global banking coverage despite banks’ operating similar business models. Third, we can discuss the differences between the moaty qualities of an individual bank and the strength of a banking system. Accordingly, we note that our wide-moat banks are generally contained within high-quality systems such as Australia, Canada, Sweden, and Chile, which score well across the banking system criteria we’ve developed. For our U.S. banks, we’ve awarded wide economic moats to several banks despite our fair assessment of the system. We see the U.S. banking system as strong from economic and political perspectives, but weaker from competitive and regulatory fronts. In our opinion, a highly competitive environment with over 6,000 banks operating in the market and the complex regulatory structure allow for lax regulatory monitoring and regulatory arbitrage.

Other changes focus on better describing how competitive advantages are created and sustained at interest-earning and fee-based financial businesses. As in the past, we see low funding costs as a key advantage for retail and commercial banks. While spread-based businesses are the heart of most banks’ business models, investment banking, asset and wealth management, custody banking, and insurance can also play material or even dominate an individual firm’s business model. Each one of these segments offers a recurring fee revenue stream. We highlight extreme cases in which a bank generating low net interest margins, high operating costs, and high credit costs looks like more like an asset or a wealth manager at the pretax profit level. As a result, the moat sources of banks that operate in multiple businesses can include cost and switching costs, but also intangibles in some cases due to the unusual scale and scope of a bank’s expertise within a given niche that enables it to earn premium pricing. We believe firm-level economic moats are best assessed in this context and view a bank’s moat rating as a composite of its exposure to--and competitive advantages in--various markets and lines of business  

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Union Pacific UNP  |  Keith Schoonmaker, CFA

We've reduced our expectations for Union Pacific's 2015 volume growth and operating ratio improvement on the basis of year-to-date carload volume that is weaker than we anticipated and recent management comments concerning a sustained lag in adjusting network capacity to demand. Our wide moat rating is intact, but we've reduced our fair value estimate to $115 per share from $119. The shares are trading at $103, so we maintain our opinion that they are undervalued.

Most impactful is the 24% decline in second-quarter coal volume to date versus the year-ago period, as still-low natural gas prices, mild weather, and high utility coal inventories have suppressed demand. We incorporate a more severe full-year coal decline (down 15% versus our prior 7% estimate, in line with the 7% drop in the first quarter) and maintain our expectations of coal declines going forward, offset somewhat by growth in intermodal units.

During the first-quarter earnings call, management indicated 500 employees on furlough and since then has furloughed over 300 more, plus stored an additional "couple hundred" locomotives. Managing head count is complex: the rail has about 7% attrition and needs some head count for capital projects, so while this matter has management's full attention, flexing with demand takes time. We increased our projection of labor cost as a percentage of revenue by 100 basis points for 2015, but we still believe the rail will continue to make more effective use of manpower, fuel, and machine, attaining a 60% OR next year (2014 was 63.5% and we now model 62% for 2015).

Through May 23, UP's second-quarter volume had declined 4% in total, comprising a 10% year-over-year decline in carloads offset somewhat by a 4% increase in intermodal units. Among large-volume commodities, second-quarter volume has so far declined an astonishing 24% in coal, 22% in grain (tough comparisons), and 13% in crushed stone, gravel, and sand; chemicals and autos rose 1% and 10%, respectively.

For reference, first-quarter (per the Association of American Railroads as of March 28) total volume was down 2% via 2% and 3% drops in carloads and intermodal, respectively, including just 7% lower coal volume compared with the first quarter of 2014 and only a 2% decline in grain. Chemicals and autos were then strong with 3% and 8% growth.

UP's year-to-date total volume is off 3%, total carloads are down 5%, and intermodal units are flat compared with the prior-year period (intermodal was constrained during the first quarter due to the West Coast port labor strike). Among the most material categories, full year-to-date carloads are off 14% in coal, 9% in grain, and 2% in crushed stone, gravel, and sand; chemicals and autos are up 2% and 9%.

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