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About the Editor
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 Morningstar.com. 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.

 
Jul 28, 2017
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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 7/21/2017 -- A New Fair Value Estimate for Berkshire, Earnings Updates

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 Morningstar analyst notes below for American Express AXP, Bank of New York Mellon Corp BK (two separate notes -- one addressing the announced CEO change and other discussing earnings), Berkshire Hathaway BRK.B, BlackRock BLK, eBay EBAY, Novartis NVS, Unilever UL, and Visa V. Several Tortoise and Hare portfolio holdings were also tagged in a general note about efforts to repeal and replace the Affordable Care Act.

Best wishes,

David Harrell,
Editor, Morningstar StockInvestor

Amex's Renewed Focus on Growth is Encouraging, but Competition Remains Intense
by Jim Sinegal | Morningstar Research Services LLC | 07-19-17

We like that wide-moat American Express is turning its attention back toward revenue growth after the loss of a major client in 2016 and a period of emphasis on cost-cutting. A renewed emphasis on corporate spending, especially with small- and medium-size businesses, appears to be paying off. Additionally, a strengthening global economy is providing a tailwind for spending growth. However, evidence of an intense competitive environment continues to show up in results, and the company's plans to further differentiate its rewards offerings lack specifics. We are maintaining our $88 per share fair value estimate.

The competitive environment in the consumer space remains intense. Excluding the effects of last year's Costco business loss, total revenue expanded 8%, but rewards spending grew by 19% on the same basis. Card member services spending expanded by 24%. We think this indicates American Express is having to pass on a larger share of discount revenue to customers in order to maintain market share. Furthermore, though discount revenue as a percentage of billed business was stable during the quarter, American Express is passing on some economic benefits to merchants and acquirers through its OptBlue program. We see few signs that pressure from merchants and cardholders will let up any time soon.

American Express remains a payment method of choice for both large and small businesses, and the company's efforts to grow in this area are likely to pay off.  Although large companies are continuing to cut back on travel and entertainment expenses, American Express' global commercial business generated mid-single-digit billed business growth, driven primarily by small business volume. Business-to-business spending represents a multitrillion dollar opportunity, and we believe American Express benefits from high switching costs and a powerful brand asset in this arena.

American Express' online banking efforts are continuing to bear fruit. Management indicated that the company has passed on only about 25% of rate increases to savings account customers, and we don't expect competition to heat up any time soon. We doubt that many consumers will be inclined to lock in low rates until rates provide significantly higher nominal returns, and few banks seem desperate for deposit funds at the moment.

American Express' lending business is also performing well. Charge-offs remain very low--the company wrote off only 1.8% of loans during the quarter, and balances grew at a healthy 11% annualized rate during the quarter. We don't see any evidence that the company is chasing low-quality balances, and expect credit losses to remain manageable in a downturn. That said, losses are sure to increase over time as the portfolio seasons.

Marketing and promotion expenses grew by just 5% during the year as American Express turned its customer acquisition efforts to the digital realm, and other operating expenses fell by 4% on an adjusted basis over the same time period. We expect a renewed emphasis on expense control, combined with moderate growth in billed business and significant capital return, to result in healthy earnings per share growth over our five-year forecast period.

BNY Mellon's Surprise CEO Change Raises Questions About the Firm's Direction
by Greggory Warren, CFA | Morningstar Research Services LLC | 07-17-17

We were a bit surprised by today's announcement from wide-moat-rated BNY Mellon that chairman and CEO Gerald Hassell would be relinquishing his chief executive post immediately, and would also step down from his role as chairman at the end of the year, mainly because it wasn't clearly telegraphed to investors. That said, the choice of Charles Scharf, former CEO of wide-moat-rated Visa (with previous banking experience at Citigroup and JPMorgan Chase), to replace Hassell as CEO (and chairman at the end of the year) seems to be a solid choice for a firm that has been pressured by activist investors the past several years to cut costs and improve top-line growth, which has proved difficult to pull off in an environment of historically low interest rates. Hassell had planned to retire once the firm showed progress on a series of goals that were put forth by the firm in 2014, some of which were met last year. However, we had no indication that a management change was in the works. We expect to hear more from the firm (and to ask it plenty of questions) when BNY Mellon reports second-quarter earnings on Thursday, but would expect Scharf to be given at least six months to go through the business and put together a new strategy for the bank. That said, we're not big fans of past calls from some activist investors for BNY Mellon to spin off or sell its asset-management business, which had $1.7 trillion in AUM at the end of March 2017, making it one of the largest U.S.-based asset managers. This is a moaty business albeit not as moaty as its trust/custody operations. That said, it has served as a bit of a buffer for the firm during the past decade, offsetting some of the impact of historically low interest rates, and has provided some avenues for growth, especially internationally. We do not expect to make a change to our $49 per share fair value estimate for BNY Mellon as a result of the company's management change.

Solid Net Interest Margin and AUM Gains Lift BNY Mellon's First-Half Results; Raising FVE to $53
by Greggory Warren, CFA | Morningstar Research Services LLC | 07-20-17

While there was little in wide-moat-rated BNY Mellon's second-quarter results that would alter our long-term view of the firm, we have increased our fair value estimate to $53 per share from $49 to reflect a greater increase in near-term net interest margin improvements, as well as assets under management, than we forecast previously. The company's second-quarter net interest margin of 1.14% was a large improvement over the prior-year period (0.97%) and a slight shift upwards from the first quarter (1.13%). We're now forecasting full-year results closer to the upper end (rather than the lower end) of our 1.10%-1.15% forecast range for the year.

Assets under custody/administration increased 1.6% sequentially and 5.4% year over year to $31.1 trillion. BNY Mellon had $1.8 trillion directly under management at the end of the second quarter, up 2.5% sequentially and 6.4% on a year-over-year basis. Shifting product mix, ongoing fee compression and changes in currency left investment management and performance fee revenue up 5.9% year over year (and 4.8% for the first half of 2017 when compared with the prior-year period). Total second-quarter (and first half) revenue increased 4.8% (3.9%) to $4.0 ($7.8) billion. Effective cost controls once again led to a low-single-digit increase in noninterest expenses during the period, allowing the firm to leverage ongoing share repurchases and post a 12.2% increase in second-quarter earnings to $0.88 per share.

BNY Mellon remains fairly well capitalized, with management committed to returning capital to shareholders. The bank's fully loaded common equity Tier 1 ratio at the end of June was 10.4%, up from the first quarter (10.0%) and beginning of the year (9.7%). The firm also recently announced an increase in its quarterly dividend to $0.24 per share from $0.19, which would imply a dividend yield of 1.8%. Through the first six months of 2017, BNY Mellon repurchased more than 13 million shares for around $734 million.

Berkshire Puts Growing Cash Hoard to Work; FVE Raised
by Greggory Warren, CFA | Morningstar Research Services LLC | 07-17-17

We've increased our fair value estimate for Berkshire Hathaway's Class A (B) shares to $290,000 ($193) from $280,000 ($187) to reflect changes in our assumptions about revenue, investment returns, and profitability since our last update. This fair value estimate change includes the impact of recent investments in Oakwood Homes, Store Capital, and Home Capital Group, Berkshire's exercise of its warrants to acquire 700 million shares of Bank of America's common stock, and the bid for Oncor Electric Delivery. It does not include the rumored $10 billion-plus investment Sprint reportedly solicited from Warren Buffett this past week, which we believe Berkshire would be willing to do at the right price (it has more than enough dry powder on hand). Our new fair value estimate is equivalent to 1.5 and 1.4 times our projected book value per share estimates for 2017 and 2018, respectively.

We use a sum-of-the-parts methodology to derive our fair value estimate. Our valuation for Berkshire's insurance operations increased 5% to $97,400 ($64) per Class A (B) share, primarily due to changes in market expectations for the investment portfolio. Our value for Kraft Heinz, which we value separately from the insurance operations, remains at $14,800 ($10) per Class A (B) share. While our estimate for BNSF increased 3% to $61,200 ($41) per Class A (B) share on slightly better coal volume through the first half of the year, we've lowered our valuation for Berkshire Hathaway Energy slightly to $25,400 ($17) per Class A (B) share, given the dilution from the Oncor bid. Our fair value estimate for Berkshire's manufacturing, service, and retail operations increased 3% to $82,000 ($55) per Class A (B) share, and we also made a slight increase in our value for the firm's finance and financial products division to $9,200 ($6) per Class A share after raising our long-term expectations and incorporating the Oakwood Homes and Home Capital Group deals into the segment.

Looking more closely at Berkshire's insurance operations, we've kept our underwriting forecasts for each of the firm's four subsidiaries--Geico, General Re, Berkshire Hathaway Reinsurance Group, or BHRG, and Berkshire Hathaway Primary Group, or BHPG--in place, but have projected a slightly higher yield on the segment's investment portfolio (as interest rates increase over time). We’re also projecting stronger investment returns for the segment this year than we were projecting in our previous forecast. The net result is a 5% increase in our value for the insurance operations to $97,400 ($64) per Class A (B) share from $92,400 ($62) per Class A (B) share. We continue to be concerned with Geico's relentless pursuit of growth, given that it has come at the expense of profitability the past several years. The auto insurer's earned premium growth of 13.3% during the fourth quarter of 2016 was one of the strongest quarterly results Geico has ever put up, with management accelerating underwriting activity as its peers pulled back from the market in response to spiking loss ratios (driven by increases in both frequency and severity of claims). Geico continued to hit the gas pedal in the first quarter of 2017, generating earned premium growth of 13.1%. We don't expect the firm to maintain such an elevated rate of growth as we move forward, seeing earned premium growth averaging between 11%-12% during 2017-21--slightly above the 10.7% and 8.7% CAGRs that Geico generated during 2012-16 and 2007-16, respectively.

Geico's average loss ratio of 82.6% the past twelve calendar quarters was worse than the 78.7% average level seen during 2012-16 and the 77.0% level seen during 2007-16. That said, underwriting expenses continue to track down as the ever-increasing size and scale of Geico's business has allowed the auto insurer to generate an average expense ratio of 15.5% the past twelve calendar quarters, better than the 17.0% level seen during 2012-16 and the 17.5% level seen during 2007-16. Even so, the firm's overall combined ratio of 98.1% during the past three years puts profitability at levels not seen since 1999-2000. Going forward, we expect Geico's combined ratio to improve only marginally during the next five years, from 98.3% this year to 97.1% in 2021.

As for Berkshire's two reinsurance arms--General Re and BHRG--we're not expecting much in the way of growth, given that the industry continues to struggle with a weak pricing environment driven by excess capacity that has been driven by the entrance of new players (including hedge funds), as well as the growth of alternative capital (such as catastrophe bonds) and the lack of large-scale catastrophes (which makes it harder for reinsurers to justify raising their rates). While the firm expects reinsurance to be an unattractive business for at least the next decade, General Re and BHRG (unlike many of their peers) have the luxury of walking away from reinsurance underwriting when an appropriate premium cannot be obtained, with both firms showing no real inclination to pursue growth in the current pricing environment.

Given the pricing environment that reinsurers continue to face, we believe firms with more diverse insurance portfolios, and that serve multiple distribution channels, are much more likely to offset the negatives in the market, and should be able to target profitable opportunities as they arise. We feel that both General Re and BHRG fall into this category. That said, Berkshire's reinsurance operations are still dealing with a number of run-off contracts, so we expect the ability of the two firms to generate float (aside from one-off transactions like the AIG deal done earlier this year) to be limited. With more than two thirds of Berkshire's overall float coming from its two reinsurance arms--General Re (16%) and BHRG (52%)--we believe that further increases in the overall level of the company's insurance float (which stood at around $105 billion at the end of the first quarter of 2017) will be more difficult to come by.

For General Re, we continue to forecast low-single-digit annual declines in earned premiums during 2017-21, with expectations for an average combined ratio of 97.6% over the next five years. As for BHRG, we're not expecting much premium growth during the next five years, but do recognize that the more recent deal with AIG will lift earned premium growth into positive territory (from what continues to be a projection for low-single-digit annual declines in earned premiums during 2017-21). We also expect the firm to generate an average combined ratio of 99.2% over the next five years. In an environment where the two reinsurers are intentionally reducing underwriting (given that pricing is inadequate relative to the risk), about the best we can hope for is tight enough expense controls (and a lack of extremely adverse events), allowing both firms to keep their combined ratios below the 100% mark.

As for the investment portfolio attached to the insurance operations (which includes not only the equity and fixed-income portfolios but the firm's cash balances), we are now projecting a 7%-8% annual increase in the overall value of these assets (which includes both market gains and additions to the portfolio), due primarily to mark-to-market changes made to the portfolio after a strong first half showing. Following the exercise of Berkshire's warrants to acquire 700 million shares of Bank of America common stock for $7.14 per share (which was paid for by exchanging the $5 billion 6% preferred stock Berkshire held in the bank), Berkshire became Bank of America's largest shareholder (outside of the major index-based products providers like Vanguard, State Street and BlackRock), with the bank becoming a top 5 stock investment holding for the firm. While the investment in Store Capital, a triple-net lease REIT, was much smaller at $377 million, Berkshire now holds a nearly 10% stake in the firm. Looking more closely at Kraft Heinz, which we value separately from the insurance operations (despite being held on their books), our fair value estimate remains at $14,800 ($10) per Class A (B) share.

With respect to Berkshire's other non-insurance operations, we've increased our fair value estimate for BNSF 3% to $61,200 ($41) per Class A (B) share on slightly better coal volumes through the first half of the year. Our new forecast has total unit volumes increasing at a 2.3% CAGR during the next five calendar years (up from 2.1% previously). While this is slightly higher than the 0.6% CAGR we saw during 2012-16, much of the improvement is coming from a quicker recovery in coal shipments (which were down 21.1% during 2016). We also envision pricing being slightly more robust overall for BNSF, with revenue per unit increasing at a 2.4% CAGR during 2017-21. We continue to expect pricing gains achieved during the next five years to outpace rail cost inflation, which should contribute to ongoing improvements in profitability. We believe that BNSF's operating ratio will improve from 66.3% during 2016 to 58.0% by the end of our five-year forecast period, putting the railroad's profitability more on par with its most comparable peer, Union Pacific, which we have projected to have a 56.0% operating ratio by the end of 2021.

We've reduced our fair value estimate for the insurer's 90% stake in Berkshire Hathaway Energy to $25,400 ($17) per Class A (B) share from $25,500 ($17), after incorporating the firm's purchase of Energy Future Holdings 80% equity stake in Oncor Electric Delivery (which we give a 50% chance of being closed before the end of 2017) into our model. The dilutive impact of the deal would have been greater had it not been for the buffer created by time value of money considerations. We still believe that the deal, which values Oncor at 26 times trailing earnings and 1.5 times (3.1 times goodwill adjusted) book value, to be a bit on the rich side, given that the median P/E multiple for our U.S. coverage is about 21 times trailing earnings, and the average P/B multiple for utilities is about 2.0 times in today's market. That said, the entry of Paul Singer and his hedge fund firm, Elliott Management, into the bidding process has lowered our overall confidence in the deal being completed, primarily because Buffett and Berkshire do not partake in bidding wars. However, BHE's announcement discussions with the Texas regulators regarding Oncor’s independence and financial integrity, as well as long-term investments in infrastructure and security, should still give it a leg up in bankruptcy court (even though Singer's hedge fund firm holds the majority of the EFH's debt).

Going forward, we continue to expect BHE's U.S. regulated utilities--PacifiCorp, MidAmerican Energy, and NV Energy--to continue to receive constructive rate-case outcomes and earn somewhere close to their current allowable returns on equity. This would leave annual EBITDA growth for these businesses in the 5%-6% range over the next five years. For Northern Powergrid, we expect ongoing price reviews to allow the firm to generate mid-single-digit annual EBITDA growth over the next five years. This is slightly higher than the rate of growth we are expecting for the firm's pipeline and renewables businesses, which assumes the near-term prospects for additional renewables projects coming on line will be limited due to the expiration of federal tax credits. Our fair value estimate for Berkshire's regulated utilities is also equivalent to 5.7 times our 2017 EBITDA estimate, putting it in line with our valuations for similar high-quality utilities with favorable regulatory structures and above-average growth opportunities. Our valuation also implies BHE's pipeline group is worth 10 times EBITDA, in line with peer multiples and indicative of the higher returns that pipelines are able to realize.

With regards to Berkshire's manufacturing, service and retail operations, our fair value estimate increased 3% to $82,000 ($55) per Class A (B) share, most of which was tied primarily to time value of money considerations. Our long-term forecast models past behavior by including bolt-on acquisitions to our future revenue projections, with revenue increasing at a mid- to high-single-digit rate the next five years. As for profitability, we see operating margins expanding by 20 basis points annually over the 7.0% level the segment reported in 2016. With regards to company's finance and financial products division, which includes Clayton Homes (manufactured housing and finance), CORT Business Services (furniture rental), Marmon (rail car and other transportation equipment manufacturing, repair and leasing) and XTRA (over-the-road trailer leasing), we've increased our fair value estimate for this unit slightly to $9,200 ($6) per Class A (B) share after raising our long-term expectations and incorporating the Oakwood Homes and Home Capital Group deals into the segment. Oakwood Homes, a private home building firm in Colorado and Utah, was purchased by Clayton Homes. It is the largest of the four site-build home building operators that Clayton has acquired the past several years. We've also assumed that the CAD 2 ($1.6) billion line of credit that Berkshire has extended to the struggling Canadian mortgage lender, Home Capital Group, which also came with a CAD 400 ($316) million investment in the company's stock, is being financed out of this division (which had $11.5 billion in cash and cash equivalents in tis books at the end of the first quarter).

Berkshire's book value per Class A equivalent share at the end of the first quarter of 2017 was $178,073. We think the firm can continue to grow its book value per share at a high-single-to-double-digit rate going forward, much as we've seen since the start of the new millennium. This would leave book value per Class A equivalent share at $191,800 at the end of this year and $210,700 at the end of 2018. Depending on the timing of U.S. corporate tax reform, Berkshire will likely see a one-time step up in its book value, as the deferred tax liability associated with its investment portfolio (which amounted to $27.7 billion at the end of 2016) and other assets gets written down to reflect a lower statutory U.S. federal income tax rate. Our best guess is that this would result in at least a 5% increase in book value per share. This is important, as Berkshire tends to trade on book value per share, with the company's shares trading at 1.4 times book value on average the past five and 10 years (and 1.5 times over the past fifteen years). The shares traded as high as 1.6 times book value in 2014 and 1.5 times book value last year.

While Berkshire closed out the first quarter of 2017 with $96.5 billion in cash on its books, a portion of that capital has already been spoken for. For starters, Buffett has been fairly explicit about his desire to keep around $20 billion in cash on hand as a backstop for the insurance business. We believe rest of the firm's operations are also likely to require at least 2% of annual revenue on hand as operating cash, which would amount to around $5.2 billion based on our top-line forecast for 2017. Toss in another $5.3 billion as starter cash for capital spending projects (which are likely to approach $13 billion this year), and Berkshire likely had $66.0 billion in dry powder at the end of the first quarter that could be used toward acquisitions and other investments, as well as share repurchases and dividends. Since that time, we've seen the firm commit $9 billion to the Oncor deal, another $1 billion to stock purchases, and around $1.6 billion as a line of credit for the struggling Home Capital Group. This would reduce that dry power amount to around $54 billion. That said, the firm likely pulled in another $4 billion in free cash flow during the second quarter, so we're likely looking at dry powder in the $55-$60 billion range, which would be more than enough to provide a capital infusion to Sprint--that is, of course, assuming that Berkshire gets high interest paying preferred stock and warrants to purchase shares down the road in return for the Buffett seal of approval.

Strong Organic Growth and Market Gains Lift BlackRock's 2Q AUM Higher; FVE Raised to $475 per Share
by Greggory Warren, CFA | Morningstar Research Services LLC | 07-17-17

We've increased our fair value estimate for wide-moat-rated BlackRock to $475 per share from $460 after updating our valuation for changes in assets under management, revenue, and profitability since our last update. BlackRock closed out the June quarter with a record $5.689 trillion in managed assets. This was about $175 billion higher than our forecast, with more than $70 billion of the difference due to more favorable currency exchange, another $50 billion coming from stronger active, institutional index and iShares flows, and the remainder due to greater market gains than we were forecasting.

Long-term net inflows of $93.5 billion were similar to results from the first quarter of 2017 and the fourth quarter of 2016, when BlackRock recorded $80.3 billion and $87.8 billion in total long-term inflows, respectively. While iShares remains the largest driver of BlackRock's inflows, picking up another $72.8 billion in AUM during the second quarter, the firm also saw positive flows from its retail ($8.6 billion) and institutional ($12.1 billion) platforms. BlackRock's organic growth rate of 7% over the past four calendar quarters was comfortably above management's annual target rate of 5%. We now expect organic growth of 5%-7% for the full year (compared with 4%-6% previously).

Much like we saw during the first quarter, BlackRock turned 15.5% average AUM growth in the second quarter into 7.5% revenue growth, as mix shift and fee compression weighed on the firm's top line. Revenue growth of 7.4% through the first six months of 2017 is right in line with our forecast for mid- to high-single-digit revenue growth for the full year. With regards to profitability, BlackRock reported a 190-basis-point increase in adjusted operating margins (to 41.3% of revenue) when compared with the first half of 2016. We expect full-year adjusted operating margins of 41%-43%, with the firm's free cash flow approaching $3.5 billion.

Looking more closely at the firm's fund flows, BlackRock's ability to put together three straight quarters with inflows in excess of $80 billion speaks to the strength and diversification of its operations. Total equity inflows of $38.4 billion during the second quarter were driven by the firm's iShares ($51.8 billion) operations. Active equities remain in net outflow mode, with another $7.6 billion flowing out during the period, and institutional equity index portfolios saw $5.8 billion in outflows. Given the meaningfully higher fees BlackRock charges for its active equity operations (of 57 basis points relative to 28 basis points for iShares equity offerings and 5 basis points for institutional index funds), the firm would go a long way toward enhancing organic AUM and revenue growth if it ever got the performance of its actively managed funds back on track. BlackRock closed out the June quarter with 62%, 78%, and 66% of their fundamental equity funds above the benchmark or peer median on a 1-, 3-, and 5-year basis, respectively, which was much better than what we saw at the end of the March quarter. That said, we believe it is more prudent to stay conservative on any sort of recovery, especially with active asset managers' fees and performance under a much larger microscope than they've even been before, following in the aftermath of the Department of Labor's fiduciary rule.

BlackRock's fixed-income platform shrugged off the dual headwinds of a rising U.S stock market and rising rates (with the Federal Reserve increasing the federal-funds rate near the end of both the March and June quarters this year), posting $42.9 billion in inflows during the second quarter. Flows were driven primarily by iShares ($20.9 billion) and the firm's institutional index ($18.0 billion) operations, with positive flows from its actively managed fixed-income operations (of $4.0 billion) being an added bonus. At the end of the March quarter, 75%, 77%, and 88% of BlackRock's actively managed taxable bond funds were beating their benchmark or peer medians on a 1-, 3-, and 5-year basis, respectively, while 53%, 54%, and 68% of tax-exempt offerings were doing the same. We expect iShares fixed-income operations to continue to be the more consistent and substantial organic growth vehicle for BlackRock. The $63.6 billion of net inflows produced by the ETF platform during the past year was reflective of a 20.9% organic growth rate. While the company continues to battle Vanguard for ETF flows, the two firms are still capturing more than two thirds of industry's inflows, which has allowed iShares to maintain its market share at 38%-39% the past five years (while Vanguard's has risen from 18% to 25%).

Based on our current forecasts for the firm, we see BlackRock generating close to $3.5 billion in free cash flow this year. The company remains committed to buying back $275 million of its common stock each quarter, which it did again during the second quarter of 2017. As we noted last period, the company increased its quarterly dividend to $2.50 per share, reflective of a 9% increase in the dividend. And based on our updated earnings estimate for 2017, the payout ratio for the company's $2.50 per share quarterly dividend is around 46%--within management's targeted range of 40%-50%--with the current yield being 2.4%. BlackRock is now trading at around a 12% discount to our revised fair value estimate of $475 per share.

EBay Platform Enhancements Driving Improved Fundamentals, but Shares Strike Us as Fairly Valued
by R.J. Hottovy, CFA | Morningstar Research Services LLC | 07-21-17

Our thesis on eBay is intact following its second-quarter update, with platform enhancements driving improved results but also appropriately valued by the market. The firm has clearly improved its competitive position since the May 2014 data breach/password reset issues and changes in Google's search engine algorithm through new user experiences and homepage supported by structured data/AI efforts, mobile platform upgrades, a more aggressive brand campaign, new delivery speed search functionality, and adoption of promoted listing advertising for sellers. These measures helped to drive constant-currency marketplaces GMV growth of 6% (a slight acceleration from the 5% posted the prior two quarters and offsetting a 5% decline in StubHub GMV due to a weak U.S. events market), active-user growth of 4%, and a second straight quarter of acceleration in the number of sellers on eBay (with contribution from large brands called out). In our view, this validates the network effect underpinning our narrow moat rating.

We still find management's 2017 guidance realistic, including organic revenue growth of 6%-8% ($9.3 billion-$9.5 billion, though management noted that this would likely come in ahead of the high end if foreign exchange rates don't change), operating margins of 29%-31%, and adjusted EPS between $1.98 and $2.03. While the market was looking for an increase in eBay's full-year outlook, we believe it factors in the competitive environment (where our analysis suggests Amazon is also seeing seller growth acceleration) and technology/brand investments. Traditional retailers looking for greater online distribution and new international opportunities (including Flipkart) could set the stage for upside, but we remain comfortable with our longer-term outlook calling for average annual revenue growth in the midsingle digits and operating margins of 32%. As such, we're not planning material changes to our $33 fair value estimate, and we view shares as fairly valued.

Novartis' 2Q Largely as Expected, With Strong New Product Sales Offsetting Generic Gleevec Pressure
by Damien Conover, CFA | Morningstar Research Services LLC | 07-18-17

Novartis posted second-quarter results largely in line with our and consensus expectations, and we don't expect any major changes to our fair value estimate. We continue to view the stock as modestly undervalued. Despite the increasing generic pressure on the branded drug segment, a strong pipeline gives us confidence in Novartis' wide moat.

In the quarter, new product launches helped offset generic competition, leading to flat operational sales growth, which we expect will continue through 2017 followed by a return to growth in 2018 of 3%. Generic Gleevec caused the majority of the headwinds in the quarter, and we expect this pressure will subside in 2018 as the patent loss annualizes. Importantly, the company's next-generation drug Tasigna continues to hold up well, and we project flat sales for it over the next three years. Helping to offset the generic headwinds, the company's recently launched drugs are posting steady gains. In particular, immunology drug Cosentyx and cardiovascular drug Entresto are together already contributing close to 5% of the top line, and we expect this to grow to over 12% by 2020 based on efficacy advantages over competitive drugs. Looking ahead at the late-stage pipeline, we are bullish on ophthalmology drug RTH258 based on superior dosing, but the filing isn't expected until the second half of 2018.

Outside the branded drug group, the remaining divisions of Sandoz (generics) and Alcon (eye care) are weighing on results, with operating income in both groups down 7% operationally year over year. At Sandoz, increasing competition in the United States is dragging down pricing, but we expect the strong position in biosimilars should return the group to growth in 2018. For Alcon, heavy reinvestment should continue to improve top-line growth and should moderate in 2018, shifting the group to positive operating income growth.

Solid First Half With Margin Expansion for Unilever; Raising FVE Slightly
by Philip Gorham, CFA, FRM | Morningstar Research Services LLC | 07-20-17

Unilever's first-half performance showed that our margin expansion thesis is intact, and strong sales growth in Asia meant that the company modestly exceeded our expectations on the top line. Significantly, this flowed through the income statement to earnings, and we are raising our fair value estimate a touch to EUR 52 per Amsterdam-traded ordinary share. Although organic growth remains below historical levels, Unilever's entrenched position in the supply chain of its retailers, the source of its wide economic moat, was again in evidence as growth exceeded that of its markets and the company took value share, in aggregate.

First-half underlying sales growth in the Asia segment of 5.5% took us by surprise, and was the only material variance from our forecasts. The second-quarter volume decline of 0.6% indicates that price increases of around 5%, implemented to offset commodity cost inflation, are sticking better than we had expected, with price elasticity proving to be quite low so far. The pricing also dropped to the bottom line, with the underlying EBIT margin expanding 180 basis points year over year, slightly ahead of our expectations.

We have raised our near-term forecasts for sales, EBIT, and earnings growth, and this accounts for more than half of our fair value increase (the remainder being the impact of the time value of money since our last update). This report has no impact on our medium- and long-term expectations, however, and we continue to forecast 4% organic sales growth and a 19% normalised medium-term EBIT margin.

While our sales growth assumes pricing pressure continues to weigh on organic growth, our EBIT margin assumption is aggressive, which is one of the key metrics underlying our valuation. Unilever is making structural changes to its operating model that we expect will facilitate more efficient internal capital allocation, and the operating margin expansion reflected solid progress in that regard.

With Reckitt Benckiser having just sold its foods division for a whopping 21 times EBITDA, Unilever will no doubt be hopeful that it can realize a similar multiple for its spreads business. However, we estimate that first-half sales fell by 3.5% year over year, in contrast to the 5% growth achieved by RB's food segment in 2016, so we doubt that, even in the current climate, Unilever's assets will be valued at such a multiple. We continue to assume that at 10 times last year's EBITDA, the business would be worth around EUR 6 billion.

Smooth Sailing for Wide-Moat Visa in Fiscal 3Q
by Jim Sinegal | Morningstar Research Services LLC | 07-20-17

Wide-moat Visa continued to generate double-digit growth and high returns on capital in its fiscal third quarter, and we plan to maintain our $108 per share fair value estimate. The company's global network of financial institutions, consumers, and merchants constitutes an enormous competitive advantage over competitors. Visa's brand further represents global acceptance and transaction security to its customers, while its position as the world's largest consumer-to-business payment network provides economies of scale. The market for the company's services continues to grow with consumer spending and the global decline of cash, allowing the firm to grow quickly without much investment of capital. Visa returned 100% of fiscal third-quarter income to shareholders in the form of dividends and repurchases, while growing total transactions--including those processed by Visa Europe--at a 13% adjusted rate over the past 12 months.

Volatility in certain drivers helped the business during the quarter. Rebates and incentives came in at 20.1% of gross revenue due primarily to a delay in boosting these payments to customers in Europe. We don't read too much into quarterly changes in rebates and incentives payments, instead preferring to focus on long-term trends. We do think that customers will continue to demand a larger share of payment economics, but expect changes to be gradual and manageable. Management indicated that the company's ancillary offerings are becoming increasingly attractive to smaller issuers that may not have the same technical capabilities as the largest banks. We don't explicitly forecast much additional revenue from data-focused offerings, but see a moderation in pricing pressure as a clear benefit. Currency movements in European markets also boosted cross-border revenue.

Visa's efforts to open and expand its network also seem likely to moderate competitive pressures. In the last few days, Visa and PayPal expanded their partnership, allowing PayPal to issue Visa debit cards within Europe. This expands PayPal’s ambitions in traditional financial services--it will utilize a pre-existing banking license as it grows its retail banking business--and gives it access to point-of-sale payments. It also provides yet another source of additional transaction volume for Visa.

Political Reality too Much for GOP Healthcare Overhaul; Mixed Impact for Our Healthcare Coverage
by Vishnu Lekraj | Morningstar Research Services LLC | 07-18-17

The political reality of scaling back healthcare coverage for millions of constituents was too much for the U.S. Senate GOP to overcome in passing a major overhaul of the Affordable Care Act. With the loss of more than two “yes” votes for both the initial and revised Senate Republican plan, Senate majority leadership was unable to push a measure that would be appealing to both the moderate and libertarian wings of its caucus. Thus, we believe the probability of a substantive “repeal and replace” plan becoming law is now extremely low. On balance, we find this development positive for both the managed care and hospital sectors as volume increases due to expanded coverage will remain in place. On the other end of the spectrum, the elimination of various ACA fees and taxes for pharmaceutical and device companies is now off the table. Even though this development maintains a status quo operating environment, it does take away a potential positive financial impact for these firms.

From here we believe the Senate will take a step toward shoring up a weak public exchange marketplace in order to maintain a functioning private individual insurance market over the near term. This will likely require some meaningful level of bipartisan negotiation in both chambers of congress. Despite the rhetoric of letting these marketplaces fail, we believe it will be politically untenable for Republicans to allow this scenario to playout given they control every branch of the federal government and a significant percentage of affected voting districts are either Republican or tossup leaning. Additionally, we believe congressional GOP leadership is keen to move on from the political minefield of healthcare legislation and toward initiating a major overhaul of U.S. tax code.

Bottom line, we believe the ACA will likely remain in place for some time to come and its dominant affect upon healthcare-related firms will continue. However, we also believe there will need to be legislation to address long-term issues and concerns related to certain aspects of the law. Chiefly, lawmakers will have to formulate a long-term plan to stabilize the public exchange/individual markets (which comprise approximately a quarter of the private insurance space) in order to keep premium costs in check, incentivize robust health insurance company participation, and prevent a death-spiral scenario from developing.
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David Harrell may own stocks from the Tortoise and Hare Portfolios in his personal accounts.

 
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