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David Harrell is the editor of the Morningstar StockInvestor, a monthly newsletter that focuses on a wide-moat stock investing strategy. For illustration purposes, issues highlight activities pertaining to Morningstar, Inc. portfolios invested in accordance with a strategy that seeks to focus on companies with stable or growing competitive advantages. David served in several senior research and product development roles and was part of the editorial team that created and launched He was the co-inventor of Morningstar's first investment advice software.

David joined Morningstar in 1994. He holds a bachelor's degree in biology from Skidmore College and a master's degree in biology from the University of Illinois at Springfield.

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Matthew Coffina, CFA, is the portfolio manager for Morningstar Investment Management LLC’s Hare strategy. 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.

Michael Corty, CFA, is the portfolio manager for Morningstar Investment Management LLC’s Tortoise strategy. Before focusing his attention on the Tortoise, Michael co-managed five equity strategies offered by Morningstar Investment Management LLC and Morningstar Investment Services LLC since December 2013. Michael was previously a senior equity analyst on Morningstar Inc.’s equity research team covering companies in the media, business services, and consumer industries. Michael also spent several years on Morningstar’s moat committee, which assigns economic moat and moat trend ratings to their global coverage.

Prior to joining Morningstar in 2004, Michael worked at a public accounting firm and in the business lending arm of a major commercial bank. He has an undergraduate accounting degree from Loyola Marymount University, an MBA from Cornell University and is a CFA charterholder.

About the Editor David Photo
David Harrell
Editor, Morningstar StockInvestor
David Harrell is the editor of the Morningstar StockInvestor, a monthly newsletter that focuses on a wide-moat stock investing strategy. For illustration purposes, issues highlight activities pertaining to Morningstar, Inc. portfolios
Featured Posts
Roundup 8/17/2018 -- Results and News for Berkshire Hathaway

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.

Please see new analyst notes below from Morningstar Research Services for Berkshire Hathaway BRK.B (two notes), Booking Holdings BKNG, General Electric (two notes), and PepsiCO PEP. General Dynamics GD was tagged in a general note about defense stocks which is also included below. (These notes were published during the last two weeks -- as noted in the August 3rd update, there was no weekly update last week.)

Matt Coffina made two trades in the Hare portfolio this week, selling the portfolio's stake in Compass Minerals CMP on Tuesday and adding to its Tencent position on Thursday.

Best wishes,

David Harrell,
Editor, Morningstar StockInvestor

Berkshire's Purchase of Additional Apple Shares Keeps Tech Giant at Top of Firm's Equity Holdings
by Greggory Warren, CFA | Morningstar Research Services LLC | 08-14-18

There were few surprises in wide-moat-rated Berkshire Hathaway's second-quarter 13-F filing. The sale of Monsanto, which was acquired by Bayer for $128 per share in early June, netted the firm around $2.4 billion, and the insurer's sale of 4.5 million shares of Wells Fargo (for an estimated $240 million) was part of efforts to keep Berkshire's ownership stake in the bank below the 10% threshold. The insurer also reduced its stake in Phillips 66 by 24%, selling 11.0 million shares (for an estimated $1.1 billion). This followed a sale of $3.3 billion of stock back to that company during the first quarter. Berkshire also eliminated the rest of its holdings in Verisk Analytics (for an estimated $30 million), having blown out 80% of its holdings in the firm during the March quarter, and trimmed its stake in Charter Communications (netting an estimated $215 million for 0.7 million shares).

The company used the sale of 1.3 million shares of American Airlines (for an estimated $60 million) and 1.0 million shares of United Continental (for an estimated $70 million), as well as proceeds from the sales mentioned above, to purchase another 10.1 million shares of Delta (for an estimated $525 million) and 8.9 million shares of Southwest (for an estimated $480 million), which moved Berkshire's ownership stake in each of the domestic airlines to around 10%.

Berkshire also increased its stake in Apple, acquiring another 12.4 million shares (for an estimated $2.2 billion), lifting its ownership stake to just over 5% of the technology company's outstanding shares. Other major purchases included the acquisition of another 2.3 million shares of Goldman Sachs (for an estimated $540 million) and 9.8 million additional shares of US Bancorp (for an estimated $500 million). Berkshire also made smaller additions to Bank of New York Mellon, Teva Pharmaceutical, General Motors, Liberty Global and Axalta Coating Systems during the second quarter.

Improved Insurance Results Lift Berkshire's 2Q Earnings; Book Value Hits $217,677 per Class A Share
by Greggory Warren, CFA | Morningstar Research Services LLC | 08-04-18

As wide-moat Berkshire Hathaway reported second-quarter results that were basically in line with our expectations, we are leaving our $330,000 ($220) per Class A (B) share fair value estimate in place. Second-quarter (first-half) revenue, which now includes both unrealized and realized gains/losses from Berkshire's investments and derivatives portfolios, increased 19.3% (decreased 2.9%) to $68.6 ($119.0) billion. Excluding the impact of investment and derivative gains/losses and other adjustments, second-quarter (first-half) operating revenue increased 8.4% (decreased 0.8%) to $62.2 ($120.7) billion.

Operating earnings, excluding the impact of investment and derivative gains/losses, rose 67.3% (58.7%) year over year to $6.9 ($12.2) billion during the second quarter (first half) of 2018. When including the impact of the investment and derivative gains/losses, Berkshire's operating earnings rose 181.8% (30.7%) to $12.0 ($10.9) billion during the same period(s). With no share repurchase activity during the past year, net earnings per Class A equivalent share rose a similar amount to $7,301 ($6,610) for the second quarter (first half) of 2018.

Book value per share, which serves as a fairly good proxy for measuring changes in Berkshire's intrinsic value, increased 3.1% sequentially to $217,677 (from $211,184 at the end of the first quarter of 2018), which was better than our forecast of $216,464. The company closed out the June quarter with $111.1 billion in cash and cash equivalents, up from $108.6 billion at the end of March. This should have left Berkshire with around $86 billion in dry powder that can be committed to investments, acquisitions, share repurchases, and dividends. There were no meaningful commitments to acquisitions during the second quarter, and the firm did not commit any capital to share repurchases or dividends.

Booking in a Near-Term Transition Phase, but Long-Term Competitive Positioning Appears Intact
by Dan Wasiolek | Morningstar Research Services LLC | 08-09-18

While we continue to see Booking as the best-positioned travel network (the source of its narrow moat) for long-term growth, we see its shares in a near-term transition period as the firm tries to balance growth and profitability, leading to booking deceleration in 2018. We plan to reduce our $2,300 fair value estimate by a mid-single-digit percentage for lower 2018 bookings growth, mitigated by lower near-term marketing expense, leaving shares undervalued. We reiterate that Expedia shares are at an attractive margin of safety.

Bookings grew 15% versus our 16% estimate and guidance of 10%-14%. On a two-year stacked basis, bookings rose 31%, down from 45% last quarter, a deceleration last seen in early 2017 and 2013. Further, management expects third-quarter bookings to rise only 3%-6%, implying a two-year stack rate of 22.4% at the midpoint. While we view this guidance as conservative, we think the deceleration is due to both a prudent pullback in performance marketing (which we reiterate is temporary) and potential maturation.

Booking saw marketing leverage for the third straight quarter, moving down 517 basis points to 36.8%. While this aids profitability, it can also hinder bookings. We reiterate our view that the industry pullback in performance channels will prove temporary (given the traffic and improving conversion of networks like narrow-moat TripAdvisor), which should aid TripAdvisor's growth. We also think that Booking might be bumping up against maturing growth in its core European market, around 50% of total bookings, although it will take more than one quarter for us to assess whether this is a lasting trend.

We plan to reduce our 2018 and 2019 bookings growth estimate to around 12% and 12.5%, respectively, from 17% and 13.5%, while maintaining our out-year forecast. Meanwhile, we look to lower our marketing spending as a percentage of sales about 150 basis points in 2018 to around 35%, while keeping our out-year forecast largely intact.

General Electric Now Trades in 4-Star Territory as Shares Oversold Under Fresh Take
by Joshua Aguilar | Morningstar Research Services LLC | 08-12-18

Shares of narrow-moat-rated General Electric traded down on Aug. 10 on news that the company was looking to sell power-conversion unit Converteam at a price for $1.5 billion. Converteam is based in Massy, France, and specializes in high-efficiency electric power conversion components, including motors and generators. The rumored price represents over a 50% discount to the previous sales price GE paid for the assets in 2011. We're not surprised by the news, and we're still maintaining our $15.70 fair value estimate. At a current market price of $12.77 at the time of writing, shares now appear oversold to us at what we peg to be about a 19% discount to our updated estimate of intrinsic value.

We now consider Jeff Immelt's tenure marked as a period of poor stewardship. The latest news is yet another example of a capital allocation misstep that mistimed the oil and gas markets. Our previous analyst, Daniel Holland, furthermore, presciently opined to The New York Times that GE overpaid for the deal in 2011. We estimate that at a minimum 80% of GE's acquisitions under Immelt were value-destructive and therefore include goodwill in our computation of returns on invested capital for the firm (which we estimate average about 9% during our forecast period).

We're also not surprised by Flannery's actions. The credit rating agencies have long warned GE of a potential downgrade if they fail to see a return to improved profitability in Power. Management is targeting a return to 10% segment profit margins for the unit, but we see only a 3-point improvement from end of 2017 levels (5.6%) between 8% and 9%. We see the firm's latest moves as GE's attempt to shed underperforming units with the aim of improving profitability. Bottom line, while shares are not a pound-the-table bargain, in our view, they do represent decent value in a market that is getting harder to find discounted deals, particularly in the industrials space.

The Great Unwind Continues; GE Pares Down Energy Financial Services
by Joshua Aguilar | Morningstar Research Services LLC | 08-08-18

In a move that surprised no one, GE continues to pare down assets in GE Capital, specifically in Energy Financial Services. As such, we are leaving our $15.70 fair value estimate intact. EFS, among other things, provides underwriting for Power, Renewable Energy, and Oil & Gas.

As part of the deal, Barry Sternlicht's Starwood Property Trust agreed to purchase GE's debt financing business for $2.56 billion, which includes unfunded loan commitments of $400 million. The remaining portion of the deal includes approximately $2.1 billion worth of 51 loans. Assets backing these loans include pipelines, power plants, and wind farms, among others. GE previously telegraphed its intention to pare down its exposure to GE Capital, in addition to efforts it has undertaken in the past to shrink Capital (including exiting real estate debt and what today is Synchrony Financial in 2015).

Recently, in an 8-K filing dated June 22, 2018, the John Flannery-led conglomerate reiterated its commitment to make GE Capital smaller and more focused on its core industrial businesses, following up to his commitments in a special call on Jan. 16, 2018. In the June 22 8-K filing, the company specified tactics to derisk the balance sheet, including targeting a total $25 billion worth of sales between EFS and its Industrial Finance businesses. While the timing of these asset sales is inherently uncertain, we had previously modeled this derisking plan in our model for both businesses. We are projecting EFS assets will reach an asset level of about $7.8 billion total by the end of 2018, down from $10.9 billion by the end of 2017 (and greater than the delta from the most current round of sales).

Pepsi's Long-Term Strategy Should Remain Intact Following Its CEO Transition
by Sonia Vora | Morningstar Research Services LLC | 08-06-18

We're maintaining our Exemplary stewardship rating for wide-moat PepsiCo after the company announced that CEO Indra Nooyi, 62, will step down on Oct. 3 after 24 years with the company, including 12 years in its top spot. Nooyi will be succeeded by Ramon Laguarta, who has been president of the company since 2017 and has experience as the CEO of Pepsi's Europe Sub-Saharan Africa business and president of its Eastern Europe region. We weren't surprised by Laguarta's appointment, given that each of the firm's previous five CEOs have been chosen from within the organization, which we view as evidence of its deep bench.

We don't foresee a material shift in Pepsi's strategy with Laguarta at the helm, given his 22-year tenure at the firm, extensive knowledge of its operations, and key role in setting its strategy as president. Under Nooyi's leadership, the company bolstered its portfolio of healthier offerings, which now contribute roughly half of sales compared with about 38% in 2006, and better aligned its portfolio with evolving consumer tastes (with above 5% compound sales growth over this period). As such, we posit that this bent toward more natural and wholesome fare will continue. We expect Pepsi will reinforce its brand-related investments, with combined expenditures on advertising and research and development approximating 7% of sales over the next 10 years, in line with historical rates. We contend that these investments will help the company develop and bring new products to market, ensuring that its competitive advantage remains unwavering. In this context, we're reiterating our $123 fair value estimate, which calls for 3% top-line growth and operating margin around 18% on average over our forecast period.

Tencent's Weak 2Q No Threat to Its Wide Moat Rating and Long-Term Growth Outlook
by Jennifer Song | Morningstar Research Services LLC | 08-16-18

We remain positive on wide-moat-rated Tencent for its long-term growth outlook, but near-term uncertainty has risen because of the lack of visibility over the launches of new gaming titles. However, we had already factored in slower growth in 2018 due to the delays in approval for game monetization, and our earnings forecast is 10% below market consensus. We think the delay merely pushes off growth to 2019, when we expect game approvals to resume. Hence, we make little change to our key assumptions, but lift our full-year net profit forecast to CNY 74.6 billion from CNY 66.6 billion, to factor in noncash items classified in other gains. However, we lower our fair estimate to HKD 590 per share from HKD 641, after taking into account an 8% depreciation in the Chinese yuan against the Hong Kong dollar. We think the recent share price weakness present an attractive buying opportunity, with the current price level not fully reflecting Tencent's monetization opportunities, supported by the company's strong network effect built on its massive user base and ecosystem.

Recent market jitters were driven by net revenue growth slowing to 30%--the slowest pace since third-quarter 2015--and a 2% year-over-year (23% quarter-on-quarter) decline in net profit. The slowdown reflects a lack of new game launches, which is leading to concern that the Chinese government is clamping down on gaming. While this is not confirmed, we would not be surprised to see no or slow approvals for 2019 because of an ongoing restructure of the administrations governing this space. While the approval process of new game titles remains cloudy in the near term, we think revenue could be less impeded going forward because Tencent has a pipeline of 15 games approved for launch, of which five are expected in the third quarter. Tencent has a chance to see its gaming revenue pick up.

Investors are Hungover on Defense Stocks but the Spending Party Hasn't Even Started Yet
by Chris Higgins | Morningstar Research Services LLC | 08-10-18

Over the past several months, defense stocks have stalled, underperforming the S&P 500, but we believe that industry growth rates will accelerate through 2019 as recent increases in the Department of Defense budget translate into outlays to the industry. Our regression analysis tying industry revenue growth to U.S. defense outlays predicts double-digit revenue growth for some industry names by second-quarter 2019.

In addition, we think the midterm elections slated for early November 2018 could provide an entry point into defense stocks, as uncertainty rises ahead of elections. Over the longer term, we see defense budget growth stalling out in 2020 and beyond due to persistent budget deficits and rising national debt. The 2020 Presidential election also represents a potential risk to defense spending. We continue to appreciate the sturdy moats in the U.S. defense industry and we note nearly all the defense names we cover possess wide moats. Stricter Department of Defense regulation of contract pricing, particularly in the wake of tax reform represents the only threat to moats in our view.

Although it's tough to find cheap stocks in the defense sector, we like General Dynamics, trading at a price/fair value ratio around 0.88. The company isn't a defense pure play because of its business jet unit, but with the CSRA acquisition, defense and government-related activities now account for roughly 75% of consolidated revenue. For investors preferring a defense pure play, we'd point them to Raytheon or Northrop Grumman, with both trading at discounts to our fair value estimates.


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David Harrell may own stocks from the Tortoise and Hare Portfolios in his personal accounts.

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