moats april 2012
TRANSCRIPT
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StockInvestor
When it comes to selecting securities for the Tortoise
and Hare portfolios, my strategy is to first focus on
wide-moat firmsthose with some sort of competi-
tive advantage that should allow them to generate
excess economic profits for at least two decades.
Second, I only purchase these firms when there is a
margin of safety in the current stock price. I define
margin of safety as buying securities at a discount to
our fair value estimates, which are driven by long-
term fundamental analysis and expected cash flows.
But there is indeed a leap between selecting securi-ties to buy and actually managing a real portfolio
made up of a number of stocks that are constantly
changing in market value.
One thing I try to do is maximize the expected return
by minimizing the dollar-weighted price/fair value
ratio of each portfolio. Every month in the portfolio
recapson Pages 5 and 7 of this issueI state the
estimated intrinsic value of the portfolios based
on our fair value estimates. I simply take the shares
of each security owned and multiply by the fairvalue estimate, then sum the value of all the positions.
I am trying to move the intrinsic value of each port-
folio ever higher through the trades I make, trimming
positions as the stocks approach fair value, and
recycling the capital into stocks that trade at greater
discounts to fair value.
Focusing strictly on the price/fair value does have one
significant downsideit does not take into consider-
ation either risk or uncertainty. All stocks that trade at,
say, a 25% discount to fair value are not created equal.
Id much rather buy low-risk, low-uncertainty Coca-
ColaKO at a 25% discount than I would a company
with much greater uncertainty, such as Moodys
MCO orWeight WatchersWTW. Focusing strictly on
price/fair value would have us constantly swinging
for the fences when there might be lower-risk singlesand doubles opportunities that have a very high
probability of success.
To account for risk and uncertainty, I also try to maxi-
mize the dollar-weighted Morningstar star rating
of each portfolio. Our fair value uncertainty ratings are
one of just three inputs into the star rating, the
others being the fair value estimate itself and the
market price. A company with a high uncertainty
rating requires a 40% discount to fair value to attain
a 5-star rating, while a low uncertainty stock needsjust a 20% discount to become 5 stars.
Looking beyond the value considerations, there are
a couple of other things I try to do when managing
the portfolios. One is to keep the number of stocks in
each portfolio reasonable. I currently have 23 stocks
in the Tortoise and 26 in the Hare. In an ideal world,
Id like to get these numbers down to 1520 names in
each portfolio. I think more value can be added by
assigning a greater weight to our very best ideas than
the exceptionally marginal diversification benefit thatcan be had by owning our 40th to 49th best ideas.
Moreover, I will make a lateral trade in terms of
expected value if it means an upgrade in the economic
moat rating. Selling a narrow-moat firm trading at
a 25% discount to fair value in order to buy a wide-
moat firm trading at the same discount is a perfectly
logical move.
Tortoise Portfolio Our favorite wide-moat firms
with lower risk, including Abbot
Laboratories and Lowes
Hare Portfolio
Our favorite aggressive picks
with moats, including Oracle an
MasterCard
Pauls Favorites for New Money
Todays Best Ideas
Wide-Moat Watchlist
Ratings and comments on morethan 140 wide-moat companies
Stocks in Focus 1
Merck, Medtronic, and Bank of
New York Mellon
Spotlight 2
Compass Minerals: Competitive
Strengths Remain Intact
Spotlight 2
Express Scripts: Merger Creates
A Wide Moat
Spotlight 2
More Profitable Growth to Come
for Discover Financial
Stock to Sell 3
Walgreen
Economic Snapshot 3
Taking the Pulse of the Economy
Follow Paul on Twitter@StockInvestPaul
Buying core holdings at a discount
Paul Larson
Equities Strategist and Editor
Continued on Page 2
SM
Portfolio ManagementStrategy
April 2012
Volume 11Number 10
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2
Finally, I try to keep reasonable diversification within
the portfolios so that Im not sticking my neck out
too far on any given unpredictable macroeconomic
factor. Our analysts certainly have views regarding
things like electricity prices, housing prices, fertilizer
volumes, interest rates, and so on (all likely to rise
from here). But the future is inherently uncertain, and
a number of our projections simply will not come
to fruition. I believe our analysts are more likely to
be correct than not, which is why I own Exelon
EXC (electricity), St. JoeJOE (housing), Compass
Minerals CMP (fertilizer), and PaychexPAYX
(interest rates), but I would never put more than one
third of my portfolio into securities that share the
same primary macroeconomic influences.
So, to recap, I try to maintain a very large proportion
of wide-moat firms in the portfolios, while minimizing
the price/fair value ratio, and maximizing the star
rating of the portfolios as a whole. This strategy has
done quite well for us over the last decade-plus,
and I havent exactly lost sleep owning high-quality
companies like Berkshire Hathaway BRK.B or
Wal-MartWMT for long stretches of time.
How to Start Following the Tortoise and HareOne of the most common questions I receive from
subscribers is how to adopt the strategy of the Tortoise
and Hare. I do not think new subscribers should run
out and buy all of the securities in the Tortoise and
Hare at any given time, since the portfolios contain a
mix of todays best ideas as well as a number of
yesterdays ideas that are likely to soon be harvested.
I think a better strategy is to focus on companies
trading at the largest discounts to fair value, and then
add more securities as opportunities arise. In otherwords, dont dive in all at once, but rather merge into
traffic over time. My goal with the relatively new
feature on Page 8 (Pauls Favorites for New Money)
is to better highlight those stocks that are looking the
most attractive today.
About the Wide-Moat Focus Index
Following last months cover story, I received a record
number of email inquiries about the wide-moat focus
index. I plan on making the index a regular part of the
newsletter. And to answer the most common question
I received: Yes, Morningstar has partnered with
other companies that do (or soon will) use the index
in some tradable products. As they say, stay tuned!
To recap how the index is created, we start with all of
the U.S.-based corporations in our coverage universe
rated with an economic moat rating of wide. We then
rank this group by price/fair value ratios and take
the 20 cheapest to create the index. We reconstitute
the index once every quarter, and the positions are
rebalanced to be equal-weighted (all 5% weights) at
the point of reconstitution.
The index was reconstituted in mid-March, and thetable here shows the included companies until we
reconstitute and rebalance again in mid-June. There
were six new companies added this time, and the
six companies that fell out of the index were eBay
EBAY, Franklin ResourcesBEN, National Oilwell
VarcoNOV, St. JudeSTJ, StrykerSYK, and Zimmer
ZMH. The turnover within the index remains quite
high, on pace to easily exceed 100% again this year,
far above the high-teens annual turnover rate that
the Tortoise and Hare historically have experienced.
One company that is not part of the index is my newest
purchase in the Hare, Express ScriptsESRX. I
bought the stock on the day we upgraded the economic
moat rating to wide, which immediately followed
the closing of the companys purchase of competitor
Medco. In a nutshell, the pharmacy benefit manage-
ment industry is one where scale is a competitive
advantage, and Express Scripts is now the largest by
far. It also has a business model that requires very
little invested capital and is benefiting from several
secular tailwinds, including an aging population anda desire/need to control overall health-care spending.
Getting back to the index, the cutoff this time around
for wide-moat firms to make the index in terms
of the price/fair value ratio was 0.82. Express Scripts
currently trades at a ratio of 0.77. If we were recon-
stituting the index in early April instead of mid-March,
=Express Scripts would be part of the index. See
Page 26 for more on Express Scripts.
Portfolio Management Strategy
Continued From Front Cover
PaychexPAYX
Star Rating QQQQUncertainty Med.
Fair Value ($) 38.00
Current Price ($) 31.05Market Cap ($bil) 11.3
Dividend Yield (%) 4.1
Size of Moat Wide
Consider Buying ($) 26.60
Consider Selling ($) 51.30
1-Yr Hi/Low ($) 33.71/25.12
Stewardship Z
P/E 20.8
Berkshire HathawayBRK.B
Star Rating QQQQUncertainty Med.
Fair Value ($) 100.00
Current Price ($) 79.76
Market Cap ($bil) 187.3
Dividend Yield (%)
Size of Moat Wide
Consider Buying ($) 70.00
Consider Selling ($) 135.00
1-Yr Hi/Low ($) 83.72/65.35
Stewardship
P/E 18.4
Express ScriptsESRX
Star Rating QQQQUncertainty Med.Fair Value ($) 73.00
Current Price ($) 56.32
Market Cap ($bil) 27.3
Dividend Yield (%)
Size of Moat Wide
Consider Buying ($) 51.10
Consider Selling ($) 98.55
1-Yr Hi/Low ($) 60.89/34.47
Stewardship
P/E 22.3
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Morningstar StockInvestor April 2012 3
Master Limited Partnerships (MLPs) and
Qualified (IRA/401k) Accounts
Another very common question I receive is about the
tax treatment of MLPs. There are a number of MLPson the wide-moat watchlist; pipeline firms tend
to have wide moats. While returns on capital tend to
be modest (low teens), the excess returns they do
generate should last a very long time, often measured
in decades. Ive owned a number of MLPs in the Hare
over the years, including current holdings Energy
Transfer EquityETE , Enterprise Products Partners
EPD, and Magellan MidstreamMMP. This invest-
ment class also has increased in popularity in recent
years given its generally high yields from distributions
in a market parched for yield.
Regarding the tax consideration surrounding MLPs,
these investments are best held in a taxable account.
There are two main reasons for this. First, these
investments are inherently tax advantaged. If you own
these (or, say, muni bonds) in a qualified account,
you forgo those advantages. Here is the source of the
advantage for MLPs: These companies in most cases
pay out in distributions far more than the income they
generate that is considered taxable. The difference
is considered return of capital, which is not taxed
until one sells. As long as one doesnt sell, one can
defer this potential tax liability. (And if you happen
to continue to own these when you pass away, the
tax on this return of capital can be deferred forever,
since your heirs will have their cost basis stepped up.)
More importantly, while MLPs tend to not generate
much (if any) taxable income (especially in the first
few years after purchase), the income they do
generate is considered taxable, no matter what type
of account holds the investment. This is because
the income is considered unrelated business taxable
income (UBTI). If you generate more than $1,000 of
UBTI in your qualified account, you (or your accountant)will be stuck filling out form 990-T with the IRS and
likely having to withdraw from the account to pay for
taxes. Its just a sticky, tax-inefficient mess that I
recommend avoiding if at all possible. Just keep these
investments in your taxable accounts.
Upcoming Events
Again this year, I plan on attending Woodstock for
Capitalists, otherwise known as the Berkshire Hath-
away annual meeting. Among other things happening
that weekend in Omaha, I am slated to make a presen-tation at the 9th Annual Value Investor Conference
(www.valueinvestorconference.com) hosted by the
University of Nebraska Omaha, which is scheduled for
May 3 and 4. If you use economic moats in your invest-
ment process and love value investing, I cant recom-
mend these events highly enough. I guarantee you
will leave with a wealth of useful insights and enjoy
spending time with those that share a philosophy.
I am also slated to make a couple of presentations
at the MoneyShow in Las Vegas on May 1517.To receive your complimentary passes to the Money-
Show courtesy of Morningstar, please call
1-800-970-4355 and mention code 026640.
New Market Outlook Available
Your subscription includes access to our quarterly
market outlook. It has our economist Bob Johnsons
view as well as insights and ideas from each of our
sector teams. Please go to the StockInvestorwebsite
msi.morningstar.com to download the report.
Wide-Moat Focus Index Components (Q2, 2012)
Company Mkt Cap ($ Bil) Price ($) Fair Value ($) Price/Fair Value
C Amazon.com AMZN 87.3 191.87 225.00 0.85
Applied Materials AMAT 15.3 11.86 19.00 0.62
Bank of New York Mellon BK 28.0 23.34 35.00 0.67
Cisco Systems CSCO 107.5 19.96 26.00 0.77
CME Group CME 18.9 284.66 364.00 0.78
C Compass Minerals CMP 2.3 70.65 93.00 0.76
Exelon EXC 25.4 38.23 54.00 0.71
Expeditors Intl of Washington EXPD 9.7 45.85 61.00 0.75
General Electric GE 203.2 19.20 25.00 0.77
C Google GOOG 205.1 630.84 780.00 0.81
Martin Marietta Materials MLM 3.8 83.83 118.00 0.71
CMedtronic MDT 39.3 37.74 46.00 0.82
CMerck & Co. MRK 117.9 38.73 46.00 0.84
Northern Trust NTRS 11.1 46.22 58.00 0.80
Oracle ORCL 144.3 29.51 38.00 0.78
Pfizer PFE 166.2 22.05 27.00 0.82
C Schlumberger SLB 90.2 67.59 94.00 0.72
St. Joe JOE 1.6 17.33 26.00 0.67
Vulcan Materials VMC 5.4 42.02 63.00 0.67
Western Union WU 11.0 17.65 29.00 0.61
Energy Transfer EquityETE
Star Rating QQQQUncertainty Med.Fair Value ($) 54.00
Current Price ($) 40.05
Market Cap ($bil) 8.9
Dividend Yield (%) 6.2
Size of Moat Narrow
Consider Buying ($) 37.80
Consider Selling ($) 72.90
1-Yr Hi/Low ($) 47.34/30.78
Stewardship
P/E 29.0
C New addition for Q2.
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4
Performance and Transaction SummaryMorningstar Ratings & Fundamentals Portfolio Data
Stock NameStarRating
Fair ValUncert.
FairValue
CurrentPrice
ConsiderBuying
ConsiderSelling
Size ofMoat
Div Yield(%)
Stew.Grade
FirstPurchase
# of SharesChange Total
Cost Basis/Share Total Cost
Current-Value
Gain/Loss %
% ofPort
Abbott Laboratories ABT QQQQ Low 70.00 60.97 56.00 87.50 Wide 3.4 C 02-04-11 0 289 47.68 13778.65 17620.33 27.9 8.5
Lowes Companies LOW QQQ Med. 34.00 31.09 23.80 45.90 Wide 1.8 Z 11-15-07 0 500 25.07 12534.40 15545.00 24.0 7.5
ExxonMobil XOM QQQQ Low 91.00 83.88 72.80 113.75 Wide 2.2 07-11-08 0 178 76.68 13648.17 14930.64 9.4 7.2
Exelon EXC QQQQ Med. 54.00 38.23 37.80 72.90 Wide 4.0 10-06-09 0 370 46.55 17224.65 14145.10 -17.9 6.8
Berkshire Hathaway BRK.B QQQQ Med. 100.00 79.76 70.00 135.00 Wide 0.0 06-18-01 0 175 51.23 8965.58 13958.00 55.7 6.7
Pfizer PFE QQQQ Med. 27.00 22.05 18.90 36.50 Wide 4.0 C 09-24-01 0 470 22.60 10622.05 10363.50 -2.4 5.0
Novartis NVS QQQQ Low 69.00 54.72 55.20 86.25 Wide 4.5 X 02-09-07 0 185 56.80 10508.61 10123.20 -3.7 4.9
Automatic Data Prcssing ADP QQQ Med. 57.00 54.57 39.90 77.00 Wide 2.9 X 06-14-02 0 175 27.84 4872.72 9549.75 96.0 4.6
Wal-Mart Stores WMT QQQ Low 61.00 60.13 48.80 76.25 Wide 2.6 X 07-19-02 0 150 47.43 7114.28 9019.50 26.8 4.3
Johnson & Johnson JNJ QQQQ Low 77.00 64.92 61.60 96.30 Wide 3.5 C 12-06-05 0 130 59.51 7736.38 8439.60 9.1 4.1
General Dynamics GD QQQ Med. 75.00 70.82 52.50 101.30 Wide 2.9 Z 03-12-03 0 110 33.12 3643.34 7790.20 113.8 3.7
Kinder Morgan Mngmnt KMR QQQQ Med. 86.00 74.10 60.20 116.10 Wide 0.0 03-08-06 0 104 32.48 3377.93 7706.40 128.1 3.7
Cintas CTAS QQQ Med. 37.00 38.34 25.90 49.95 Narrow 1.4 C 05-16-07 0 200 37.61 7522.00 7668.00 1.9 3.7
American Express AXP QQQ High 54.00 57.16 32.40 83.70 Wide 1.4 X 07-18-01 0 125 29.46 3682.50 7145.00 94.0 3.4
Sysco SYY QQQQ Med. 36.00 29.11 25.20 48.60 Wide 3.7 X 04-28-08 0 235 29.01 6817.73 6840.85 0.3 3.3
JPMorgan Chase JPM QQQ High 51.00 43.89 30.60 79.10 Narrow 2.7 Z 07-23-02 0 150 30.49 4574.16 6583.50 43.9 3.2
TransCanada TRP QQQ Low 44.00 42.93 35.20 55.00 Narrow 4.1 Z 01-23-04 0 150 21.21 3181.88 6439.50 102.4 3.1
Procter & Gamble PG QQQQ Low 72.00 66.81 57.60 90.00 Wide 3.1 X 05-12-09 0 75 50.86 3814.74 5010.75 31.4 2.4First American Financial FAF QQQQ High 25.00 16.55 15.00 38.80 Narrow 1.9 06-02-10 0 300 12.21 3662.97 4965.00 35.6 2.4
PepsiCo PEP QQQQ Low 72.00 65.35 57.60 90.00 Wide 3.2 Z 07-19-02 0 75 35.92 2694.25 4901.25 81.9 2.4
CoreLogic CLGX QQQQ Med. 21.00 15.60 14.70 28.40 Narrow 0.0 X 03-17-04 0 300 16.49 4948.02 4680.00 -5.4 2.3
3M MMM QQQQ Low 100.00 86.33 80.00 125.00 Wide 2.7 X 01-23-08 0 50 74.93 3746.49 4316.50 15.2 2.1
Molson Coors Brewing Co TAPQQQQ Med. 55.00 41.17 38.50 74.25 Narrow 3.1 V 02-25-10 0 70 40.80 2856.15 2881.90 0.9 1.4
Walgreen WAG QQQ High 35.00 32.56 21.00 54.25 Narrow 2.8 X 10-11-07 -110 0 39.37 4330.61 0.00 -14.0 0.0
Tortoise Portfolio
Cash Holdings 7581.52 3.6
Tortoise Portfolio Total 2.9 208204.99
C
Goal of the Tortoise
The Tortoise Portfolio has two goals: to outperform the S&P 500 Index and togenerate positive returns regardless of the broad market environment. Companies
in this portfolio tend to be large, with moderate to low risk, and slow-growing.We aim for all the companies here to have an economic moat, preferably wide.
Legend:
Shares added
Shares sold
New holding
UR Under Review
NR Not Rated
Footnotes:
Morningstar ratings and fundamentalsas of 04-09-12. Portfolio inception
date: 06-18-01. *March 7 to April 9.
Morningstar Investment Services,Inc. is a registered investmentadvisor and wholly owned subsidiaryof Morningstar, Inc.
Cost basis includes commissions. Returns since inception are
annualized and include dividends.
**Invest in the Tortoise ApproachThe Hassle-Free Way.Did you know that Morningstar Investment Services now offers a customizableportfolio patterned after StockInvestor s Tortoise portfolio? To learn more, call1-866-765-0663.**
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Morningstar StockInvestor April 2012 5
Portfolio Roundup
Tortoise Performance Breakdown
150
120
90
60
30
0
-30
Cumulative Total Return Comparison (%)
pTortoise Portfolio pS&P 500 Index
Top Five Sectors (%)
d Healthcare 23.2
y Financial Srvcs 16.3
o Energy 14.5
s Cons Defensive 14.3
p Industrials 13.1
p51100
p2650
p1125
p010
Style Breakdown (%)
Value Blend Grth
Lrg
Med
Sm
51 27 8
5 4 0
5 0 0
Total Return (%) Index Level This Month 12 Month Since Inception
Tortoise Portfolio 2.5% 7.7% 7.6%
S&P 500 Index 1382.2 3.5% 6.3% 3.2%
*
From inception on June 18, 2001,throughApril 9, 2012,
the Tortoise has produced a total return of 119.5%
compared to 40.3% for the S&P 500 Index and 40.7%
for the average large-cap blend mutual fund. Total
returns include dividends for both the Tortoise and the
benchmarks. During the last 12 months, the Tortoise
has outperformed 89.4% of large-cap blend funds and
is still beating 99.4% of them since inception.
The Tortoise did not have the best month in March,
with the S&P 500 jumping ahead 3.5% since lastissue. Im not worried; the Tortoise still posted a posi-
tive absolute return, and I continue to expect our
periods of outperformance will come in bear markets,
not what weve experienced in recent months.
I made just one trade in the Tortoise this month, closing
outWalgreenWAG on April 3 at $33.99, realizing
a 14% capital loss on a position initiated in 2007. The
reason I sold Walgreen dovetails with the reason
I bought Express ScriptsESRX in the Hare. Namely,
the recent spat between the two companies showsthat the balance of power lies with the pharmacy
benefit managers and their clients (that care more
about lowering overall health-care costs) than it does
with the pharmacies (that offer convenience).
There were four fair value estimate changes since
last issueone reduction and three increases. We
trimmed ExelonEXC by $4 per share following its
merger with Constellation Energy, and we also cut
ExxonMobilXOM by $8 per share. On the other side
of the coin, we raised Kinder Morgan by $13 per
share and Berkshire HathawayBRK.B by $11.
Taking all of these changes into consideration, the
estimated intrinsic value (shares held times fair value)
of the Tortoise is now $240,583, a 0.5% increase
from $239,345 last month. This increase is because
of the net increase in the fair value estimates as
well as dividends that have accrued. The Tortoise
now trades at a 13.5% discount to its estimated fair
value, a slight decrease from the 15.1% seen lastmonth, largely because of stock prices that increased
more than the net increase in the fair value esti-
mates. The dollar-weighted average star rating is also
now 3.65, a moderate decrease from 3.79 last month,
thanks again to recent price appreciation. While there
are a large number of mildly undervalued stocks avail-
able today, the pickings are still pretty slim regarding
table-pounding opportunities.
by Paul Larson
Contact Paul Larson at [email protected]. Paul Larson personally ownsshares of the following Tortoise stocks:ABT, AXP, BRK.B, CLGX, CTAS, EXC, FAF, GD, JNJ, JPM, KMR, LOW, MMM, NVS,
PFE, PG, SYY, TAP, TRP, WAG, WMT, XOM.
Paul has increased his position in the stock in the past month.
Paul has reduced his position in the stock in the past month.
2012 Morningstar, Inc. All rights reserved. Any opinions, recommendations,or information contained herein: (i) is for educational purposes only; (ii) is notguaranteed to be accurate, complete, or timely; (iii) has not been tailored to suitany particular persons portfolio or holdings; and (iv) should not be construed asinvestment advice of any kind. Neither Morningstar nor any of its agents shallhave any liability with respect to such opinions, recommendations, or information.Morningstar has not given its consent to be deemed an expert under the federalSecurities Act of 1933. Past performance is no guarantee of future results. Beforemaking any investment, consult with your financial advisor. Morningstar employeesmay have holdings in the stocks recommended.
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
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6
Performance and Transaction SummaryMorningstar Ratings & Fundamentals Portfolio Data
Stock NameStarRating
Fair ValUncert.
FairValue
CurrentPrice
ConsiderBuying
ConsiderSelling
Size ofMoat
Div Yield(%)
Stew.Grade
FirstPurchase
# of SharesChange Total
Cost Basis/Share Total Cost
Current-Value
Gain/Loss %
% ofPort
St. Joe JOE QQQQ High 26.00 17.33 15.60 40.30 Wide 0.0 06-08-10 0 1050 22.56 23683.38 18196.50 -23.2 8.1
Compass Minerals CMP QQQQ Med. 93.00 70.65 65.10 125.60 Wide 2.8 08-18-05 0 200 25.40 5080.74 14130.00 178.1 6.3
MasterCard MA QQQ High 394.00 439.29 236.40 610.70 Wide 0.3 C 05-30-06 0 30 44.00 1319.99 13178.70 898.4 5.9
Energy Transfer Equity ETE QQQQ Med. 54.00 40.05 37.80 72.90 Narrow 6.2 10-13-10 0 325 37.94 12331.44 13016.25 5.6 5.8
Express Scripts ESRX QQQQ Med. 73.00 56.32 51.10 98.55 Wide 0.0 04-03-12 +220 220 56.95 12527.99 12390.40 -1.1 5.5
eBay EBAY QQQQ Med. 42.00 36.30 29.40 56.70 Wide 0.0 Z 04-20-06 0 330 33.08 10917.98 11979.00 9.7 5.3
Paychex PAYX QQQQ Med. 38.00 31.05 26.60 51.30 Wide 4.1 Z 06-24-02 0 350 28.65 10026.38 10867.50 8.4 4.8
Google GOOG QQQQ High 780.00 630.84 468.00 1209.00 Wide 0.0 C 07-14-11 0 17 530.59 9019.99 10724.28 18.9 4.8
Autodesk ADSK QQQ Med. 39.00 40.54 27.30 52.70 Wide 0.0 C 11-18-08 0 250 19.43 4857.50 10135.00 108.7 4.5
Discover Financial DFS QQQ High 34.00 32.65 20.40 52.70 Narrow 1.2 08-08-07 -200 300 21.39 6416.67 9795.00 52.7 4.4
Strayer Education STRA QQQQ High 130.00 88.29 78.00 201.50 Narrow 4.5 Z 10-19-11 0 110 88.72 9759.29 9711.90 -0.5 4.3
CME Group CME QQQQ High 364.00 284.66 218.40 564.20 Wide 3.1 X 01-13-12 0 30 235.13 7053.91 8539.80 21.1 3.8
Zimmer Holdings ZMH QQQ Med. 71.00 64.15 49.70 95.90 Wide 1.1 Z 11-17-10 0 125 50.34 6292.36 8018.75 27.4 3.6
International Speedway ISCA QQQ V.High 26.00 28.25 13.00 45.50 Wide 0.7 C 01-06-06 0 280 40.18 11251.49 7910.00 -29.7 3.5
National Oilwell Varco NOV QQQQ Med. 97.00 78.21 67.90 131.00 Wide 0.6 C 10-18-11 0 100 64.03 6402.94 7821.00 22.2 3.5
Oracle Corp ORCL QQQQ Med. 38.00 29.01 26.60 51.30 Wide 0.8 01-13-12 0 250 26.99 6747.25 7252.50 7.5 3.2
CarMax KMX QQQ High 33.00 32.78 19.80 51.20 Narrow 0.0 X 01-20-04 -150 200 14.71 2942.08 6556.00 122.8 2.9
Western Union WU QQQQQ Med. 29.00 17.65 20.30 39.20 Wide 2.3 10-02-06 0 365 17.74 6474.63 6442.25 -0.5 2.9Cloud Peak Energy CLD QQQQQ High 29.00 15.30 17.40 44.95 Narrow 0.0 03-15-11 0 400 19.97 7989.96 6120.00 -23.4 2.7
Magellan Midstream MMP QQ Low 68.00 71.49 54.40 85.00 Wide 4.6 X 04-28-08 0 75 35.83 2687.24 5361.75 99.5 2.4
Vulcan Materials VMC QQQQQ Med. 63.00 42.02 44.10 85.10 Wide 0.1 10-03-07 0 120 87.53 10503.68 5042.40 -52.0 2.2
Cisco Systems CSCO QQQQ Med. 26.00 19.96 18.20 35.10 Wide 1.6 X 01-21-11 0 250 20.84 5209.98 4990.00 -4.2 2.2
Microsoft MSFT QQQQ Med. 35.00 31.10 24.50 47.25 Wide 2.6 Z 08-22-05 0 150 26.30 3945.63 4665.00 18.2 2.1
Enterprise Products EPD QQQ Med. 55.00 50.24 38.50 74.25 Narrow 4.9 X 05-29-07 0 75 23.26 1744.64 3768.00 116.0 1.7
International Game Tech IGT QQQ High 19.00 16.40 11.40 29.45 Narrow 1.5 X 06-27-05 0 200 28.35 5669.00 3280.00 -42.1 1.5
Cemex CX QQQQ V.High 11.00 7.25 5.50 19.30 Narrow 0.0 12-11-06 +17 443 23.48 10402.92 3211.75 -69.1 1.4
Hare Portfolio
Cash Holdings 1691.27 0.8
Hare Portfolio Total 2.4 224795.00
Invest in the Hare ApproachThe Hassle-Free Way.Did you know that Morningstar Investment Services now offers a customizableportfolio patterned after StockInvestor s Hare portfolio? To learn more,call 1-866-765-0663.**
Goal of the Hare
The Hare Portfolio has two goals: to outperform the S&P 500 Index, and to generatepositive returns regardless of the broad market environment. Companies in thisportfolio tend to either be small or fast-growing, or have a high risk/return proposi-tion. We aim for all companies here to have an economic moat, preferably wide.C
C
Legend:
Shares added
Shares sold
New holding
UR Under Review
NR Not Rated
Footnotes:
Morningstar ratings and fundamentalsas of 04-09-12. Portfolio inceptiondate: 06-18-01. *March 7 to April 9.
Morningstar Investment Services,Inc. is a registered investmentadvisor and wholly owned subsidiaryof Morningstar, Inc.
Cost basis includes commissions. Returns since inception are
annualized and include dividends. Master limited partnership units
have different tax characteristicsthan common stocks and may not besuitable for tax-deferred accountssuch as IRAs. Please consult your taxadvisor before buying.
**
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Morningstar StockInvestor April 2012 7
Portfolio Roundup
Hare Performance Breakdown
150
120
90
60
30
0
-30
Cumulative Total Return Comparison (%)
pHare Portfolio pS&P 500 Index
From inception on June 18, 2001, through April 9,2012,
the Hare has produced a total return of 105.3%
compared to 40.3% for the S&P 500 Index and 40.5%
for the average large-cap growth mutual fund. Total
returns include dividends for both the Hare and the
benchmarks. During the last 12 months, the Hare has
outperformed just 22.1% of large-cap growth funds
but is still beating 98.3% of them since inception.
A couple of stocks in the Hare had a relatively tough
time since last issue, namely StrayerSTRA (off 8.5%)and Cloud PeakCLD (off 9.1%), the same stocks
that were drags on performance in February. On the
other hand, IGTIGT, International SpeedwayISCA,
and AutodeskADSK all appreciated more than 10%.
There were a number of fair value estimate changes.
On one hand, we trimmed OracleORCL by $3.
We also published a new $54 fair value estimate for
Energy Transfer EquityETE, down $4 from before
we put the stock under review. On the other hand, we
added $36 to the GoogleGOOG fair value estimate,and also added $4 to DiscoverDFS.
I made three trades in the Hare since last issue, all on
April 3. I trimmed Discover (200 shares at $33.37)
and CarMaxKMX (150 shares at $34.70) to make the
position sizes more accurately reflect the remaining
opportunity in these names. I then purchased a new
position, buying 220 shares of Express ScriptsESRX
at $56.90. Read further into this issue for much more
on Express Scripts.
Following all of these changes, the estimated intrinsic
value of the Hare is now up to $279,959, a signifi-
cant 3.6% jump from last issue. The net fair value
estimate increases as well as the trades were both
responsible for the increase in overall estimated
value. The Hare now trades at a 19.7% discount to
this estimated fair value, slightly better than the
18.4% discount seen last issue, thanks largely to
the fair value estimate increases that were of greater
magnitude than the market price increases. The
dollar-weighted average star rating is now 3.73, upslightly from 3.70 last issue.
by Paul Larson
Contact Paul Larson at [email protected]. Paul Larson personally ownsshares of the following Hare stocks:ADSK, CLD, CME, CMP, CSCO, CX, DFS, EBAY, EPD, ESRX, ETE, GOOG, IGT,ISCA, JOE, KMX, MA, MMP, MSFT, NOV, ORCL, PAYX, STRA, VMC, WU, ZMH.
Paul has increased his position in the stock in the past month.
Paul has reduced his position in the stock in the past month.
2012 Morningstar, Inc. All rights reserved. Any opinions, recommendations,or information contained herein: (i) is for educational purposes only; (ii) is notguaranteed to be accurate, complete, or timely; (iii) has not been tailored to suitany particular persons portfolio or holdings; and (iv) should not be construed asinvestment advice of any kind. Neither Morningstar nor any of its agents shallhave any liability with respect to such opinions, recommendations, or information.Morningstar has not given its consent to be deemed an expert under the federal
Securities Act of 1933. Past performance is no guarantee of future results. Beforemaking any investment, consult with your financial advisor. Morningstar employeesmay have holdings in the stocks recommended.
Total Return (%) Index Level This Month 12 Month Since Inception
Hare Portfolio 1.9% 2.1% 6.9%
S&P 500 Index 1382.2 3.5% 6.3% 3.2%
*
p51100
p2650
p1125
p010
Top Five Sectors (%)
a Technology 18.4
y Financial Srvcs 17.0
o Energy 13.4
r Basic Mtrls. 12.8
t Cons Cyclical 11.9
Style Breakdown (%)
Value Blend Grth
Lrg
Med
Sm
4 10 30
2 20 9
3 22 0
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
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8
Todays Best Ideas
Here is a new monthly feature in which Paul highlights some of the stocks fromthe Tortoise and Hare that look the absolute most attractive to him today.The companies are ranked here by their attractiveness. Data as of April 9, 2012.
Pauls Favorites for New Money
eWestern Union WU | QQQQQFair Value Est. Current Price The risks the company faces from technological disruption are over-
blown as the technical hurdles to connect one countrys telecom
and payment infrastructure to another countrys are immense. Plus,
Western Union is in a very good position to utilize whatever
the next payment standard is. Meanwhile the stock trades at just
9 times earnings and with a free cash flow yield near 10%.$29.00 $17.65
rSt. Joe JOE | QQQQFair Value Est. Current Price St. Joe moves down the list from the top spot after appreciating
since last month. Progress has been made developing the area
around the new Panama City airport and Port of St. Joe. Mean-
while, the stock continues to be priced at dirt-cheap levels. Theimplied valuation on the companys land is near a mere $2,500 per
acre, dramatically undervaluing the significant number of acres
around the airport and along the beach. Meanwhile, limiting the
downside, the company has just $54 million in debt balanced
against $186 million in cash and Treasuries.
$26.00 $17.33
tExelon EXC | QQQQFair Value Est. Current Price Owning the largest nuclear power plant fleet in the country, Exelon
is a low-cost generator of electricity. While exceptionally low
natural gas prices have been a headwind thus far, a major tailwind
is emerging in the form of tightened EPA emissions standards for
its competitors that stand to raise the price of electricity. While we
wait for this positive catalyst to unfold, we can collect a juicy
5.5% yield on the shares (adjusted for the Constellation merger).$54.00 $38.23
uVulcan Materials VMC | QQQQQFair Value Est. Current Price This firm has suffered through terrible cyclical headwinds during
the last four years, and those headwinds should become
tailwinds sooner than later. Home construction activity should
normalize to roughly match new household formation. Not
only will recovering volumes help revive revenue, but there is also
significant operating leverage built in as currently underutilized
assets become more efficiently used. The Martin Marietta MLM
merger proposal looks inferior.
$63.00 $42.02
iEnergy Transfer Equity ETE | QQQQFair Value Est. Current Price We recently published a new $54 fair value estimate. ETE is like an
asset manager in that it can grow its earnings by increasing the
profits from its underlying businesses or by managing more assets.
Both are likely to occur. The merger with Southern Union is likely to
keep distribution growth from happening for a couple of quarters,
but the current yield of 6.1% is relatively rich.$54.00 $40.05
oExpress Scripts ESRX | QQQQFair Value Est. Current Price The newest addition to the Wide-Moat Watchlist is also now in the
Hare portfolio. The merger with Medco created a wide-moat firm.
Meanwhile, the company trades at just 13 times forward consensus
EPS estimates despite having the secular tailwinds of an aging
population (more overall prescription drug use), more generic drugs
available, and societys need to lower overall health-care spending.$73.00 $56.32
pCompass Minerals CMP | QQQQFair Value Est. Current Price An exceptionally warm winter has opened up an opportunity to
buy one of the relatively few wide-moat firms with a positive
moat trend. While near-term results from its highway salt business
should be very weak, the long-term competitive advantages are
only growing stronger as the company increases capacity and
reduces unit costs at its two flagship facilitiesGoderich and
Great Salt Lake. See Page 22 for more.$93.00 $70.65
aCME Group CME | QQQQFair Value Current Price The company has a wide moat thanks to the network effect, which
is one of the most potent sources of competitive advantage.
Reflecting the moat, this company is exceptionally profitable, as
operating margins routinely top 80% and aftertax margins
approach 40%. We can buy the shares at just 14 times 2012
estimated earnings. Meanwhile, CME just bumped its dividend
(new yield: 3.1%) and initiated a special annual dividend ($3 per
share for this year).
$364.00 $284.66
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Morningstar StockInvestor April 2012 9
Stew. GradeMorningstar Stewardship Grade CNew Addition aTortoise Holding bPotential Tortoise Holding cHare Holding dPotential Hare Holding
Company Name Star Rating
FairValue-Uncert.
Fair-Value
CurrentPrice
Consider-Buying
MoatTrend
Stew.Grade
Yield(%) P/E
Port-fol io Comments*
3M MMM QQQQ Low 100.00 86.33 80.00 k X 2.7 14.5 a
Abbott Laboratories ABT QQQQ Low 70.00 60.97 56.00 k C 3.4 20.2 a
Adobe Systems ADBE QQQ Med. 33.00 33.22 23.10 l C 0.0 21.2 d
Advisory Board ABCO Q Med. 58.00 86.82 40.60 k C 0.0 66.7 d
Allergan AGN QQQ Med. 92.00 ] 93.94 64.40 l 0.2 31.3 d
AllianceBernstein AB QQQ High 15.00 14.74 9.00 l V 3.3 d
Altria MO QQ Med. 24.00 31.16 16.80 k C 5.3 19.0 d
Amazon.com AMZN QQQ High 225.00 191.87 135.00 k X 0.0 d
Ambev ABV QQQ High 36.00 40.83 21.60 k 3.8 28.4 b
American Express AXP QQQ High 54.00 57.16 32.40k
X 1.4 14.0 a
Amgen AMGN QQQ Med. 68.00 67.02 47.60 l V 2.2 16.6 d
Anheuser-Busch InBev BUD QQQ High 70.00 70.67 42.00 l 1.9 23.7 b
Applied Materials AMAT QQQQQ Med. 19.00 11.86 13.30 k C 3.0 10.2 d
AstraZeneca AZN QQQQ Med. 53.00 44.05 37.10 l C 8.9 6.0 d
Autodesk ADSK QQQ Med. 39.00 40.54 27.30 k C 0.0 33.2 c
Automatic Data Prcssng ADP QQQ Med. 57.00 54.57 39.90 k X 2.9 20.2 a
Bank of New York Mellon BK QQQQ High 35.00 23.34 21.00 k C 2.2 11.5 b
Berkshire Hathaway BRK.A QQQQ Med. 150000 ] 119700 105000 k 0.0 19.3 b
Berkshire Hathaway BRK.B QQQQ Med. 100.00 ] 79.76 70.00 k 0.0 18.3 a
Biogen BIIB QQ Med. 107.00 126.61 74.90 k C 0.0 25.1 d
BlackRock BLK QQQ Med. 216.00 202.74 151.20 j C 3.0 16.4 d
Innovation basis of moat. Two thirds of sales outside U.S.
CEO Buckley stepping down, replaced by Inge Thulin.
Diversified firm with patent-protected drugs and a leading
diagnostics operation. Splitting into two.
Acrobat and Photoshop are industry standards.
HTML5 gradually displacing Flash.
Similar to Corp. Executive Board but focused on health-care
and education sectors. Sensitive to economic conditions.
Specialty pharmaceutical company that derives more than
one third of its revenue from Botox.
Top-tier asset manager. Conditions in capital markets can
both help and hurt results.
Focused on U.S. tobacco market. Marketing ban raises
barriers to entry. High taxes actually yield pricing power.
Head and shoulders above competition in online retailing.
Increasing competition with Apple and Google.
Dominates Brazil beer market; strong in other markets, soft
drinks. Currency volatility with Brazilian real has moderated.
Large payment network combined with lending operation.Loan losses have continued to fall.
Top-shelf biotech. Anemia drugs contending with
reimbursement pressures and biosimilars.
Controls 25% of global beer market. Cut overhead expenses
and marketing to help pay for merger.
Semiconductor equipment standard-bearer. Technological
lead and broad product portfolio. Very cyclical.
Number one in gastrointestinal (ulcer) drugs. Hefty late-stage
pipeline. Expanding biologic presence.
AutoCAD software is close to a standard and has very high
switching costs. Recovery in demand continues.
Payroll processing leader. Minimal client turnover. Low
interest rates hurt earnings, as does anemic labor market.Mammoth in asset custody and management. Benefits from
large scale. Featured this issue.
Buffett still going strong. Bought big stake in IBM. Started
buying back shares. Woodstock for Capitalists around corner.
B-share value is now worth 1/1500th of A-share. Investments
during crisis paid off handsomely. History could be repeating.
Multiple-sclerosis leader with two leading treatments,
Avonex and Rituxan. Tysabri has good efficacy and potential.
After several mergers, now the largest asset manager in the
world, with more than $3 trilli on under management.
Wide-Moat Watchlist More Wide-Moat Watchlist Information!If you wish to read more about any of the companies on the Wide-Moat Watchlist,please visit msi.morningstar.com. We have made available the analyst reportsfor each of the companies on the watchlist.
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10
*Fair value based on Morningstar analyst estimates. Data through April 9, 2012. URUnder Review ]Fair Value Increased [Fair Value Decreased jPositive kStable lNegative
Wide-Moat Watchlist (continued)
Company NameStarRating
Fair ValueUncert.
FairValue
CurrentPrice
ConsiderBuying
MoatTrend
Stew.Grade
Yield(%) P/E
Port-foli o Comments*
Boardwalk Pipeline Prtnrs BWP QQQQ Low 29.00 26.85 23.20 l C 7.9 24.6 d
Bristol-Myers Squibb BMY QQ Med. 30.00 33.04 21.00 l C 4.1 15.3 d
British Amer Tbco BTI QQ Med. 82.00 101.07 57.40 k X 5.5 20.4 d
Buckeye Partners LP BPL QQQQ Low 67.00 59.88 53.60 k X 6.9 50.0 d
Campbell Soup CPB QQQQ Low 36.00 33.24 28.80 k C 3.5 14.1 b
Capella Education CPLA UR High UR 34.68 UR k X 0.0 10.2 d
Caterpillar CAT QQQ High 111.00 103.57 66.60 l X 1.8 14.0 b
CH Robinson Worldwide CHRW QQQQ Med. 73.00 64.00 51.10 k X 2.1 24.4 d
Cisco Systems CSCO QQQQ Med. 26.00 19.96 18.20 l X 1.6 15.6 c
CME Group CME QQQQ High 364.00 284.66 218.40 k X 3.1 10.5 c
Coca-Cola KO QQ Low 69.00 72.87 55.20 k X 2.8 19.8 b
Colgate-Palmolive CL QQ Low 92.00 97.04 73.60 k X 2.6 19.6 b
Comcast CMCSA QQQ Med. 30.00 29.33 21.00 l C 2.2 19.6 d
Compass Minerals CMP QQQQ Med. 93.00 70.65 65.10 j 2.8 15.9 c
Corporate Executive Board EXBD QQQ Med. 38.00 40.39 26.60 l C 1.7 24.2 d
CoStar Group CSGP QQQ High 64.00 68.49 38.40 j X 0.0 d
Dassault Systemes DASTY QQ Med. 72.00 89.59 50.40 k C 0.7 30.0 d
Diageo DEO QQ Med. 79.00 96.27 55.30 k X 2.2 22.9 b
Dun & Bradstreet DNB QQQ Med. 85.00 81.55 59.50 k X 1.9 15.5 d
Eaton Vance EV QQQ High 28.00 27.45 16.80 k C 2.8 14.4 d
eBay EBAY QQQQ Med. 42.00 36.30 29.40 k Z 0.0 14.7 c
Eli Lilly LLY QQQ Med. 40.00 39.72 28.00 l C 4.9 10.2 d
Equifax EFX QQQ Med. 41.00 43.21 28.70 k C 1.7 23.1 d
Exelon EXC QQQQ Med. 54.00 38.23 37.80 l 4.0 10.2 a
Expeditors International EXPD QQQQ High 61.00 45.85 36.60 k Z 1.1 25.6 d
Natural gas pipeline company that is well-positioned for
growth. Large cost overruns on projects in recent years.
Major patent losses in 2011 offset by strong pipeline.
Focusing on core pharmaceutical business.
Cash-cow firm. Successfully taking cigarettes into emerging
markets. High taxes yield pricing power.
Pipelines tend to have moats because of their geographic
advantage. Bought general partner. Buying storage assets.
Strong brands and market share in excess of 70%. Very
defensive business. Volumes weak recently.
High amount of scrutiny around for-profit education lately.
We are highly likely to downgrade moat rating.
Sensitive to economic cycles, so results may be bumpy.
Company benefiting from commodity boom.
Leading truck brokerage with an interesting business model.
Benefits from network effect and scale advantages.
Still 800-pound gorilla of networking. Cash flow and hoard
provide buffer. Restructuring effort starting to bear fruit.
Largest futures exchange in the world benefits from network
effect. MF Global scandal has hit shares. Bought in Hare.
Extremely long-lived moat. Bought bottlers in North America
in an attempt to give flexibility with new products.
Has 44% worldwide market share in toothpaste. Large
overseas exposure. About 75% of sales outside U.S.
Unmatched ability to offer multiple services via one
connection. Bought NBC Universal from GE.
Low-cost producer of salt and sulfate of potash fertilizer.Weather is leading to near-term earnings weakness.
Collects and sells best-practices intelligence. Growth
stopped in recession, has now stabilized.
Controls info critical to commercial real estate industry.
Databases very costly for competitors to replicate.
French product-life management and design software firm,
focused on higher-end products. Significant switching costs.
Largest spirits producer in the world. Strong brands and
exclusive distribution that competitors cant match.
Database model characterized by high barriers to entry and
low incremental costs.
Money-management firm with below-average customer
turnover. Industry problems have stung less here.Classic network effect. PayPal going very strong, marketplace
growing again. GSI purchase working well thus far.
Leading maker of mental-health drugs. Steep patent losses in
coming years offset by decent pipeline.
Credit bureaus operate in an oligopoly. Like other database
firms, enjoys low costs and high barriers to entry.
Large fleet of nuclear plants gives cost advantage. Low nat.
gas prices sting. Constellation deal has been completed.
Freight consolidation business model benefits from network
effect, scale. Outstanding management.
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Morningstar StockInvestor April 2012 11
Stew. GradeMorningstar Stewardship Grade CNew Addition aTortoise Holding bPotential Tortoise Holding cHare Holding dPotential Hare Holding
Wide-Moat Watchlist (continued)
Company NameStarRating
Fair ValueUncert.
FairValue
CurrentPrice
ConsiderBuying
MoatTrend
Stew.Grade
Yield(%) P/E
Port-fol io Comments*
Express Scripts ESRX QQQQ Med. 73.00 ] 56.32 51.10 k 0.0 22.3 c
ExxonMobil XOM QQQQ Low 91.00 83.88 72.80 l 2.2 10.0 a
Fastenal FAST Q Med. 34.00 51.58 23.80 k Z 1.3 42.6 d
Federated Investors FII QQ High 19.00 22.42 11.40 k C 4.3 15.5 d
Fiserv FISV QQQ Med. 69.00 68.77 48.30 k C 0.0 20.2 d
Forward Air FWRD QQ Med. 32.00 35.41 22.40 l 0.8 22.1 d
Franklin Resources BEN QQQQ Med. 145.00 124.81 101.50 k 0.9 14.5 d
General Dynamics GD QQQ Med. 75.00 70.82 52.50 k Z 2.9 10.2 a
General Electric GE QQQQ Med. 25.00 19.20 17.50 l X 3.5 15.6 b
GlaxoSmithKline GSK QQQ Med. 49.00 45.02 34.30 l X 5.9 13.8 b
Google GOOG QQQQ High 780.00 630.84 468.00 k C 0.0 21.2 c
Graco GGG QQ Med. 48.00 53.54 33.60 k X 1.7 23.1 d
Grupo Aero del Norte OMAB QQQ High 16.00 15.87 9.60 k V 3.3 18.6 d
Grupo Aero Pacifico PAC QQQ High 43.00 37.35 25.80k
C 1.8 17.6 d
Grupo Aero del Sureste ASR QQ High 62.00 71.97 37.20 l V 3.6 17.6 d
Grupo Televisa TV QQQQ Med. 26.00 20.99 18.20 k C 0.7 24.9 d
Harley-Davidson HOG QQ High 39.00 46.92 23.40 l X 1.3 20.1 b
Hershey Company HSY QQ Med. 48.00 59.81 33.60 l C 2.5 21.8 b
Home Depot HD QQQ Med. 49.00 50.58 34.30 k X 2.3 20.5 b
IBM IBM QQ Low 182.00 204.94 145.60 k X 1.5 15.7 d
Imperial Tobacco Group ITYBY QQ High 69.00 78.90 41.40 k X 5.4 14.1 d
Intel INTC QQQ Med. 26.00 27.76 18.20 k X 3.0 11.6 d
IntercontinentalExchange ICE QQQ High 145.00 135.84 87.00 k X 0.0 19.7 d
International Speedway ISCA QQQ V.High 26.00 28.25 13.00 k C 0.7 20.5 c
Intuit INTU QQ Med. 46.00 59.11 32.20 k X 1.0 26.7 d
New addition to the watchlist following merger with Medco.
Roughly 40% share. Bought in Hare. Highlighted this issue.
Largest, most efficient oil company. Recent rise in oil prices
and refining margins should lead to near-term profit spike.
Distributor focused on fasteners. Past Morningstar CEO of
the Year winner at helm. Great execution, but a pricey stock.
Major player in the money-management industry. Potential
reforms to money market funds a major uncertainty.
The largest bank-processing firm. Enjoys significant
customer-switching costs as evidenced by 99% renewal rate.
Has no rival with the same scale and service quality
because of its wide transport network.
Owns some of the best-established brand names in the
mutual fund industry.
Defense firm focused on cash generation. Allocates capital
with discipline. Federal budget constraints a headwind.
Leader in large number of industries. Firm survived capital
markets freeze and recession. Reducing GECS exposure.
Strong drug portfolio despite recent negative safety data on
Avandia. Well-positioned in vaccines.
Majority share of search, expanding into other areas. Bought
Motorola for its patents. Rivalry with Apple increasing.
Dominant in several niche markets, such as paint sprayers.
Benefits from efficient scale phenomenon.
Airport monopoly in central and northern Mexico.
Benefits from efficient scale.
Airport monopoly in west-central Mexico, includingGuadalajara. Yet another efficient-scale situation.
Third major owner of Mexican airport concessions.
Completed third terminal at Cancun airport.
Dominates Mexican broadcast media industry, especially
programming.
Among the strongest and most profitable brands.
Demographics represent significant headwind.
Largest candymaker in the U.S. with a 30% share.
Trust still controls in excess of 80% of voting power.
Maintained profitability in cyclical trough. Same-store sales
quite strong recently thanks to warm winter weather.
Bread and butter is servicing complicated IT infrastructure at
core of most firms. Berkshire Hathaway bought 5% stake.Fourth-largest tobacco firm in world. Cash cow.
Nearly 50% share in U.K. market.
Semiconductor behemoth. Scale advantages. Antitrust issues
have resurfaced overseas.
Electronic exchange focused on energy futures. Benefits from
network effect. Regulation change still a risk.
Strong ties to NASCAR sanctioning body and also benefits
from efficient scale. Casino opened in Kansas.
Dominates small-business accounting, tax-prep, and personal
finance software. Large switching costs.
C
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12
*Fair value based on Morningstar analyst estimates. Data through April 9, 2012. URUnder Review ]Fair Value Increased [Fair Value Decreased jPositive kStable lNegative
Wide-Moat Watchlist (continued)
Company NameStarRating
Fair ValueUncert.
FairValue
CurrentPrice
ConsiderBuying
MoatTrend
Stew.Grade
Yield(%) P/E
Port-foli o Comments*
Intuitive Surgical ISRG Q Med. 343.00 539.07 240.10 j X 0.0 43.7 d
Jack Henry & Associates JKHY QQ Med. 30.00 ] 33.23 21.00 k 1.4 20.0 d
John Wiley & Sons JW.A QQQ Med. 46.00 46.86 32.20 l X 1.7 14.9 d
Johnson & Johnson JNJ QQQQ Low 77.00 64.92 61.60 k C 3.5 18.6 a
Kinder Morgan KMI QQQ Med. 38.00 39.38 26.60 k 3.2 57.8 b
Kinder Morgan EnergyPtnr KMP QQQ Med. 86.00 82.22 60.20 k 5.6 b
Kinder Morgan Management KMRQQQQ Med. 86.00 74.10 60.20 k 0.0 a
KLA-Tencor KLAC QQQ Med. 51.00 53.28 35.70 k C 2.6 12.0 d
Landstar System LSTR QQQ Med. 53.00 57.38 37.10 k 0.4 24.1 d
Legg Mason LM QQQ High 30.00 ] 26.27 18.00 l 1.2 18.2 d
Linear Technology LLTC QQQ Med. 36.00 32.05 25.20 k X 3.1 15.1 d
Lockheed Martin LMT QQ Med. 71.00 88.74 49.70 k 4.5 11.3 b
Lorillard LO QQQ High 120.00 136.40 72.00 k X 4.6 17.1 d
Lowes LOW QQQ Med. 34.00 31.09 23.80k
Z 1.8 21.7 a
Magellan Midstream MMP QQ Low 68.00 71.49 54.40 k X 4.6 19.5 c
Martin Marietta MLM QQQQ Med. 118.00 83.83 82.60 k 1.9 49.5 d
MasterCard MA QQQ High 394.00 439.29 236.40 l C 0.3 29.6 c
Maxim Integrated Products MXIMQQQ Med. 27.00 27.78 18.90 l X 3.2 17.4 d
McCormick MKC UR Low UR 53.87 UR k 2.3 20.7 b
McDonalds MCD QQQ Low 100.00 98.88 80.00 k 2.8 18.8 b
McGraw-Hill Companies MHP QQ High 40.00 48.69 24.00 l C 2.1 17.7 d
Medtronic MDT QQQQ Med. 46.00 37.75 32.20 k 2.6 12.1 b
Merck MRK QQQQ Med. 46.00 38.73 32.20 l C 4.3 19.2 b
Microsoft MSFT QQQQ Med. 35.00 31.10 24.50 l Z 2.6 11.3 c
Monsanto Company MON QQQ Med. 83.00 ] 76.59 58.10 k 1.6 21.7 d
Currently has monopoly position in robotic surgery. One of
the widest moats in all of health care, if not entire market.
Bank processing firm similar to Fiserv, but focused on smaller
banks. Enjoys exceptionally high customer switching costs.
Publisher enjoys high returns on capital. Science and
technical franchises especially lucrative.
Diversified health-care giant. Reform legislation mild net
positive. Recalls hurt results. Exiting stent business.
Structured as regular corporation. Owns general partner of
KMP. Announced blockbuster merger with El Paso.
Large master limited partnership focused on energy transport
and storage. KMI purchase should lead to many dropdowns.
Different share class of KMP without MLP tax complexity.
Pays in shares instead of cash. Long-time holding in Tortoise.
Still dominates certain niches of highly cyclical
semiconductor supply industry.
Logistics firm very similar to C.H. Robinson, benefiting from
network effect.
Now among the largest asset managers on the planet. Still
smarting from damage done during financial crisis.
Among semiconductor companies, lower-risk. Has a
concentrated amount of industrys design talent.
Defense market now highly consolidated. Sole provider of
many key defense items, particularly in aerospace.
Dominates menthol tobacco category. FDA scrutinized
menthol products, but we think outright ban is unlikely.
Same-store sales bounced thanks to warm weather. Overallhousing market is showing signs of life.
Pipelines and energy-storage assets. Annuitylike with
inflation hedge. Great business, but units are not cheap.
High transport costs gives geographic advantage. Volumes
off significantly, pricing holding up. Bid for Vulcan.
Benefits from cash-to-plastic shift. Federal Reserve diluted
Dodd-Frank debit card rules. Positive operating leverage.
Leading analog chipmaker with concentration of industrys
engineering talent.
More than 2 times larger than its next competitor in spices
and seasonings. Very stable business, but not exactly cheap.
Brand and scale make Golden Arches unique. Same-store
sales holding up very well in anemic economy.Splitting publishing and S&P ratings businesses. Dodd-Frank
implementation a wild card. Few friends in D.C. today.
Largest medical equipment maker with wide product portfolio
and technological lead. Featured this issue.
Patents on pharmaceutical products basis for moat. Bought
Schering-Plough in bid to gain scale, diversity.
Windows is flat, but Office still selling well and growing.
Raised cash for unknown reason. Bought Skype.
Large technological lead in seeds. Roundup facing pricing
pressure from generics. Antitrust issues surfacing.
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Morningstar StockInvestor April 2012 13
Stew. GradeMorningstar Stewardship Grade CNew Addition aTortoise Holding bPotential Tortoise Holding cHare Holding dPotential Hare Holding
Wide-Moat Watchlist (continued)
Company NameStarRating
Fair ValueUncert.
FairValue
CurrentPrice
ConsiderBuying
MoatTrend
Stew.Grade
Yield(%) P/E
Port-fol io Comments*
Moodys MCO QQ High 35.00 41.60 21.00 l C 1.5 16.7 b
MSCI MSCI QQQ Med. 41.00 36.76 28.70 k C 0.0 26.0 d
National Oilwell Varco NOV QQQQ Med. 97.00 78.21 67.90 k C 0.6 16.6 c
Nike NKE QQQ Med. 100.00 ] 110.69 70.00 k 1.3 23.0 d
Northern Trust NTRS QQQQ High 58.00 46.22 34.80 k X 2.6 18.7 b
Novartis NVS QQQQ Low 69.00 54.72 55.20 k X 4.5 14.5 a
Novo Nordisk NVO QQ Med. 120.00 145.00 84.00 k X 1.3 29.0 d
ONEOK Partners OKS QQ Med. 46.00 54.06 32.20 k C 4.5 16.1 d
Oracle ORCL QQQQ Med. 38.00 [ 29.01 26.60 k 0.8 15.3 c
Paychex PAYX QQQQ Med. 38.00 31.05 26.60 k Z 4.1 20.7 c
PepsiCo PEP QQQQ Low 72.00 65.35 57.60 k Z 3.2 16.2 a
Pfizer PFE QQQQ Med. 27.00 22.05 18.90 l C 4.0 19.9 a
Philip Morris PM UR Med. UR 88.37 UR k 3.5 18.2 d
Potash Corp of Saskatchew POT QQQQ High 56.00 44.10 33.60k
1.3 12.6 d
Procter & Gamble PG QQQQ Low 72.00 66.81 57.60 k X 3.1 19.6 a
Qualcomm QCOM QQQ Med. 62.00 66.50 43.40 l Z 1.5 24.0 d
Ritchie Bros. Auctioneers RBA QQQ Med. 24.00 [ 22.33 16.80 j X 2.0 31.1 d
Roche Holding RHHBY QQQQ Med. 52.00 42.99 36.40 k C 0.0 16.2 b
SABMiller SBMRY QQ Med. 33.00 40.29 23.10 k C 1.0 24.0 b
Sanofi-Aventis SNY QQQQ Med. 46.00 37.02 32.20 k 4.7 13.2 b
Schlumberger SLB QQQQ Med. 94.00 67.59 65.80 k X 1.6 19.3 d
SEI Investments SEIC QQQ Med. 19.00 20.25 13.30 l C 1.5 18.2 d
Spectra Energy SE QQQ Low 32.00 31.17 25.60 k X 3.6 17.6 b
Spectra Energy Partners SEP QQQ Low 31.00 31.34 24.80 k V 6.1 19.2 b
St. Joe JOE QQQQ High 26.00 17.33 15.60 k 0.0 NA c
Pressured by mortgage and structured-finance mess. Could
be disrupted by implementation of Dodd-Frank legislation.
Owns numerous equity indexes, some of which are industry
standards. Licenses provide high-margin earnings stream.
A 2011 addition to watchlist after we upgraded moat rating.
Dominant share in drilling rig equipment. Bought in Hare.
Strong brands and global scale translate to high returns on
capital. Margins are a current concern.
Relatively conservative company. Focused on large
institutions and the wealthy.
Unique in that patented pharmaceutical business married to
large generics business. Swiss currency playing havoc.
Leader in diabetes treatments. Rivals also attracted to
growing diabetes market.
Like most pipeline firms, has very long advantage duration
and is relatively low-risk. Low nat. gas prices do not hurt.
Maintains enviable position in the database market. Sun
Micro integration proceeding.
Focused on small businesses. High customer switching costs.
HR services still growing faster than core payroll business.
Dominant salty-snacks company. Boasts 16 brands with more
than $1 billion in sales. Bought some of its bottlers.
Lipitor patent has expired, but firm should still earn more
than $2 per share in 2012. Stock is no longer a table-pounder.
Tobacco industry enjoys huge barriers to entry, and high
taxes actually lead to pricing power.
Largest fertilizer producer in world and part of cartel. Cashbid by BHP Billiton killed by Canadian regulators.
Has 24 brands that generate more than $1 billion in sales
annually. Reached new deal to sell Pringles.
Intellectual property powerhouse in wireless industry.
Patents provide very high-margin revenue stream.
Industrial equipment auctioneer based in Canada benefits
from network effect. We recently lowered our fair value est.
Largest biotech company in the world, with relatively large
number of biologics.
Has 15% of worldwide beer market. Near monopoly in
certain countries. Joint venture in N. America doing well.
Wide lineup of branded drugs and vaccines. Recently closed
on purchase of Genzyme.We recently upgraded moat rating. Intellectual property lead
in specialized oil services.
Strong technology platform to offer investment-processing
services. Very high switching costs.
Owns giant midstream natural gas business, as well as
general partner of Spectra Energy Partners.
Majority owned by Spectra Energy. Structured as MLP. Has
less attractive stock valuation than peers at moment.
Huge amounts of undeveloped land in Florida. Development
around new airport and seaport has started.
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14
Wide-Moat Watchlist (continued)
Company NameStarRating
Fair ValueUncert.
FairValue
CurrentPrice
ConsiderBuying
MoatTrend
Stew.Grade
Yield(%) P/E
Port-foli o Comments*
*Fair value based on Morningstar analyst estimates. Data through April 9, 2012. URUnder Review ]Fair Value Increased [Fair Value Decreased jPositive kStable lNegative
St Jude Medical STJ QQQQ Med. 49.00 38.91 34.30 k 2.4 15.4 d
Starbucks SBUX QQ Med. 48.00 57.42 33.60 l 1.2 34.5 b
State Street STT QQQ High 50.00 43.82 30.00 k C 2.2 11.6 d
Stericycle SRCL QQ Med. 77.00 84.77 53.90 j X 0.0 31.5 d
Stryker SYK QQQQ Med. 63.00 54.15 44.10 k X 1.6 15.7 d
Sysco SYY QQQQ Med. 36.00 29.11 25.20 k X 3.7 14.9 a
T. Rowe Price TROW QQQ Med. 61.00 63.61 42.70 k X 2.1 21.8 d
Time Warner Cable TWC QQ Med. 70.00 79.93 49.00 l C 2.8 16.1 b
Total System Services TSS QQ Med. 19.00 22.54 13.30 l C 1.8 19.6 d
United Parcel Service UPS QQQ High 80.00 79.19 48.00 j X 2.9 20.6 b
United Technologies UTX QQQQ Med. 100.00 80.23 70.00 k Z 2.4 14.6 b
Verisk Analytics VRSK Q Med. 32.00 46.83 22.40 k C 0.0 28.7 d
Visa V QQQ High 105.00 119.50 63.00 l 0.7 31.5 d
Vulcan Materials VMC QQQQQ Med. 63.00 42.02 44.10 k 0.1 c
Wal-Mart Stores WMT QQQ Low 61.00 60.13 48.80 l X 2.6 13.2 a
Walt Disney DIS QQQ Med. 45.00 42.11 31.50 l X 1.4 15.9 b
Waters WAT QQQ Med. 96.00 90.08 67.20 k Z 0.0 19.2 d
Weight Watchers Intl WTW QQQ High 77.00 74.48 46.20 k C 0.9 18.1 d
Western Union WU QQQQQ Med. 29.00 17.65 20.30 k 2.3 9.6 c
Zimmer Holdings ZMH QQQ Med. 71.00 64.15 49.70 k Z 1.1 15.9 c
Part of implantable cardioverter defibrilator oligopoloy.
No longer just a fast-follower.
Brand creates large barrier to success for competitors.
Diversification of distribution channels working thus far.
Enviable position in custody and asset management. Balance
sheet was problem during credit crisis.
Medical waste is a noncyclical business, and Stericycle has a
dominant share. Mark Miller won CEO of Year for 2009.
Orthopedic devices benefit from demographic trends.
Government crackdown on industry relatively benign.
Wide-moat distributors are rare, but this one dominates
thanks to its scale. Food inflation a headwind to profitability.
Asset manager with excellent fund lineup and ethical
reputation.
Communications capabilities competitors cant match.
Spin-off from Time Warner complete.
Handles applications, billing, collections, and customer
service for credit card issuers.
Scale and network density give cost advantage. Strong
balance sheet. Expanding network in Europe by buying TNT.
Diversified company operating efficiently in several industrial
markets. Service contracts quite lucrative.
Became publicly traded in late 2009. Collects data essential
to insurance industry operations.
Enjoys advantages from network effect and scale. Federal
Reserve diluted Dodd-Frank debit card rules.
Volumes down by roughly half from peak. We recommendstanding pat on MLM bid for now.
Retailing goliath enjoys cost advantages. Anticyclical: Did
relatively well during recession, lagging during recovery.
Owns theme parks, movie studios, and TV properties. Very
strong brands, extensive media library.
Large share in analytical instruments important in drug
discovery, research, and manufacturing.
Highly recognizable and respected brand. Insurance
reimbursement could ignite growth.
Strong brand and large network of more than 400,000 agents.
Average transaction size now flat, volumes still growing.
Leading provider of orthopedic devices. Cyclical and
demographic trends on firms side.
WatchlistRecommendationsThese are all the Wide-Moat Watch-list firms trading below their ConsiderBuying price as well as those tradingabove their Consider Selling price.
Applied Materials AMAT
Vulcan Materials VMC
Western Union WU
Advisory Board ABCO
Fastenal FAST
Intuitive Surgical ISRG
Verisk Analytics VRSK
Stocks to Consider Buying Stocks to Consider Selling
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Morningstar StockInvestor April 2012 15
Wide-MoatStatistics
Wide-Moat Firms With the Highest Yield (%)
AstraZeneca AZN 8.9
Boardwalk Pipeline Partners BWP 7.9
Buckeye Partners BPL 6.9
Spectra Energy Partners SEP 6.1
GlaxoSmithKline GSK 5.9
Kinder Morgan Energy Partners KMP 5.6
British American Tobacco BTI 5.5
Imperial Tobacco Group ITYBY 5.4
Altria MO 5.3
Eli Lily LLY 4.9
Wide-Moat Firms With the Lowest Forward P/E Ratios
Western Union WU 9.1
Sanofi SNY 9.1
Caterpillar CAT 9.1
General Dynamics GD 9.1
Bank of New York Mellon BK 9.2
Pfizer PFE 9.4
ExxonMobil XOM 9.4
Novartis NVS 9.7
State Street STT 9.7
Cisco Systems CSCO 10.0
Wide-Moat Firms Trading at Best Price/Fair Value Estimate Ratios
Western Union WU 0.61
Applied Materials AMAT 0.62
St. Joe JOE 0.67
Bank of New York Mellon BK 0.67
Vulcan Materials VMC 0.67
Exelon EXC 0.71
Martin Marietta Materials MLM 0.71
Schlumberger SLB 0.72
Expeditors International of Washington EXPD 0.75
Median Price/Fair Value Estimates
Coverage Universe 0.95
By Moat Rating
Wide 0.99
Narrow 0.94
None 0.95
By Fair Value Uncertainty
Low 0.99
Medium 0.98
High 0.92
Data as of April 9, 2012
Performance: Morningstar StockInvestor Portfolios vs. S&P 500
Period Tortoise (%) Hare (%) Tortoise & Hare Combined (%) S&P 500 (%)
2001* 9.1 0.7 4.9 -4.8
2002 -1.6 -23.9 -12.3 -22.1
2003 26.2 26.3 26.2 28.7
2004 13.1 26.9 18.8 10.9
2005 8.0 3.2 5.8 4.9
2006 13.7 22.0 17.3 15.8
2007 1.6 5.2 3.3 5.5
2008 -22.2 -32.4 -26.8 -37.0
2009 19.4 45.6 30.5 26.5
2010 9.7 14.3 11.9 15.1
2011 7.3 1.4 4.5 2.1
Trailing 12 Months 5.9 3.9 4.9 6.3
Since Inception Cumulative 119.5 105.3 112.4 40.3
Since Inception Annualized 7.6 6.9 7.3 3.2
Data as of April 9, 2012. Returns include interest and dividends. *Since Inception June 18, 2001. Time-weighted, assuming equal investments at inception.**Morningstar Investment Services, Inc. is a registered investment advisor and wholly-owned subsidiary of Morningstar, Inc.
Invest Like the Tortoise
and Hare
Morningstar Investment
Services** offers customizable
separate account stock portfo-
lios patterned after these popular
StockInvestorstrategies.
Call 1-866-765-0663 to learn more, or
e-mail [email protected]
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16
Merck recently has become one of the more attractive
opportunities in health care.
Morningstars Take
Facing increased competition, patent losses, and a
pipeline of late-stage drugs with poor chances of
approval, Merck greatly improved its long-term outlook
by acquiring Schering-Plough. Without Schering,
Mercks prospects were muddled, despite its recent
success launching several new blockbusters. Now,
with the addition of Schering, we believe Merck is
favorably positioned for long-term growth. Mercks
new products during the last few years have helped
offset recent patent losses. Januvia for diabetes,Isentress for HIV, and the Gardasil vaccine against
human papillomavirus represent new blockbusters.
All the drugs enjoyed monopoly positions at the time
of launch. However, current and expected competition
from other big drug firms likely will create a drag
on these drugs growth during the next few years.
Still reeling from the patent loss on hypertension drugs
Cozaar/Hyzaar in early 2010, Merck faces the loss
of its next top drug in terms of revenue generation:
Singulair for respiratory ailments in 2012. Singulairrepresents more than 10% of the combined sales of
Merck and Schering. While losses in international
markets should not fade as fast as in U.S. markets,
the patent expirations create major roadblocks to
Mercks growth.
Mercks efforts to develop a reliable late-stage pipe-
line have yielded questionable results. The Food
and Drug Administration denied Merck approval for
cholesterol drug Tredaptive (formerly Cordaptive)
in early 2008. Subsequently, Merck reported poor clin-ical data on late-stage drugs Rolofylline for heart
disease and Telcagepant for migraines. Fur ther, key
late-stage drug anacetrapib for atherosclerosis is
chemically extremely similar to a drug (torcetrapib)
that failed to receive FDA approval, raising the risk
that anacetrapib might meet the same end. Deciding
not to wait for new internal pipeline drugs, Merck
significantly strengthened its operations by acquiring
Schering-Plough for about $40 billion. Schering brings
in a very strong pipeline of late-stage drugs with
Pauls PositionMerck MRKStock Focus | Damien Conover, CFA
80
60
40
20
0
-20
-40
Total Return
p
Merck (%)p
S&P 500 Index(%)
Fundamental Table
Fiscal Year Ended Dec-09 Dec-10 Dec-11 *Dec-12 *Dec-13 *Dec-14 *Dec-15
Sales ($ mil) 27,428 45,987 48,047 47,160 45,481 46,273 47,577
Operating Income ($ mil) 15,392 2,957 8,280 12,416 10,868 11,761 12,620
Net Income ($ mil) 12,899 861 6,272 8,978 7,788 8,466 9,116
Free Cash Flow ($ mil) 1,931 9,144 10,660 12,812 10,395 9,536 10,326
EPS $3.26 $3.42 $3.76 $3.76 $3.50 $3.59 $3.70
ROIC (with goodwill) 33.6% 5.7% 9.2% 15.1% 13.6% 14.1% 14.7%
*Morningstar Estimates, Base Scenario
Profile Management & Stewardship
Merck makes pharmaceutical products to treat
conditions in a number of therapeutic areas,
including cardiovascular disease, asthma, infec-tions, and osteoporosis. The company also has
a substantial vaccine business, with treatments
to prevent hepatitis B and pediatric diseases as
well as HPV and shingles. Following the Schering
acquisition, about 45% of the companys sales
are generated in the United States.
At the beginning of 2011, Ken Frazier took over
as CEO, replacing Dick Clark. With Clark nearing
the age of retirement, we view the new leader-ship as a continuation of Mercks past strategy
and not a red flag causing concern. Regarding
the new CEO, Fraziers almost two decades of
experience at Merck across most major divisions
should position him well to lead the company.
Also, Frazier deserves much of the credit for the
successful handling of the Vioxx litigation as
he held Mercks general counsel position during
the majority of the litigation. Mercks board is
packed with current and retired CEOs, which can
lead to quid pro quo compensation packages
for top executives, but lends valuable strategic-
planning experience.
Rating Fair Value Current Price Price/Fair Value Consider Buy Consider Sell
QQQQ $46.00 $38.73 0.84 $32.20 $62.10
Econ. Moat Moat Trend Uncertainty Credit Rating Stewardship Stock Style
Wide Negative Med. AA C 4
Market Cap PE Proj. Yield P/B P/S P/CF
$117.9 bil 19.2 4.3% 2.2 2.5 9.7
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
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Morningstar StockInvestor April 2012 17
blockbuster potential and faces only limited patent
losses during the next few years. Combining the
two entities should also yield more than $3 billion in
annual cost savings. While Merck historically has
chosen to grow through internal development, we
believe the Schering acquisition places Merck in
a stronger strategic position.
Mercks Economic Moat and Trend
While Mercks competitive advantage has been
eroding during the last several years, the company still
supports a wide economic moat. Patents, economies of
scale, and a powerful intellectual base buoy Mercks
business and keep it well shielded from the competi-
tion. As the bedrock of Mercks wide moat, patentprotection should continue to keep competitors at bay
while Merck strives to introduce the next generation
of drugs. Further, the companys enormous cash flows
support a powerful salesforce that not only sells
currently marketed drugs, but also serves as a deter-
rent for developing drug companies seeking to launch
competing products. As a result, Merck offers
a powerful partnership opportunity for externally
developed drugs. The cash flows also put the
company in the rare position of supporting the approx-
imately $800 million in research and developmentneeded on average to bring each new drug to the
market. Lastly, while not as powerful as in the 1990s,
Mercks research laboratories still hold a vast data-
base of knowledge that should help the company
maintain its leadership positions in drug discovery
and development.
Merck faces a deteriorating moat trend. While patent
protection still shields the majority of Mercks drugs
from competition, the company is not developing
enough new drugs to offset eventual patent losses. Inthe post-Vioxx era, the FDA has grown increasingly
risk-sensitive, tending to approve only very safe drugs
or drugs in highly needed areas such as cancer.
While diverse, Mercks pipeline still has sizable expo-
sure to primary-care indications, which carry high
hurdle rates required for approval. Exacerbating the
issue, insurance companies are steadily reducing
coverage for follow-on drugs, forcing drug firms to
push for true innovation and reducing the power
of their distribution networks. The U.S. government
also is evaluating comparative effectiveness programs
and more aggressive price negotiations, potentially
raising the bar for future innovation. Partially offset-
ting these issues, international markets remain
a bright spot for the company, and Merck is forging
ahead with more innovative development with a
particular focus on biologics. The acquisition of
Schering-Plough brings in a stable consumer health-
care business and a host of biologic drugs with
much stronger barriers to entry.
Valuation
Our fair value estimate is $46 per share. We believe
Mercks acquisition of Schering-Plough will yield
enough earnings growth to offset the steep purchaseprice. In particular, we expect several billion dollars
in annual cost savings. Scherings strong late-stage
pipeline should boost Mercks long-term growth rate.
On the patent side, Merck will face major generic
competition to its blockbuster drug Singulair in 2012.
Therefore, we anticipate a high degree of volatility
in sales growth as the patent expires. However,
we expect sales of marketed products and products
still under development eventually to offset sales
lost to the Singulair patent expiration, and the addi-
tion of Scherings pipeline further remedies Merckspatent cliff.
One of the key uncertainties facing Merck is the
success of its recently launched drugs. Given the low
trajectories of recently launched drugs, we have
projected relatively conservative estimates for several
new products including Saphris, Dulera, and Bridion.
However, under a more bullish scenario, we could see
our estimates double. In this bullish case, our fair
value estimate would increase to $50. Conversely,
side effects or payor pushback could cause all ofthese drugs to fail. Under this bearish scenario, our
fair value estimate would fall to $40.
Merck remains in strong financial health, even
with the additional $8.5 billion in debt needed for the
Schering acquisition. We expect the combined
company will generate a free cash flow of approxi-
mately $12 billion in 2011. Mercks strong and
stable cash flows should whittle away the debt rela-
tively quickly.
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18
Here is another relatively attractive health-care firm.
When the Wide-Moat Focus index was reconstituted
a few weeks ago, Medtronic became a member.
Morningstars Take
With its diversified portfolio and strategy to develop
products for a wide range of chronic diseases,
Medtronic is well positioned to take advantage of
new trends in disease management.
This wide-moat companys vision is to establish a
significant presence in chronic diseases, in addition
to its historical stronghold in heart disease. Invest-
ments in neuromodulation, diabetes, and spinal prod-ucts from the middle to late 1990s have paid off
in spades, offering new revenue streams and taking
some pressure off heart products. Revenue from
those three product areas increased from 25% of total
sales in fiscal 2000 to 40% in fiscal 2011. Medtronics
diversified medical technology portfolio allows
it to better weather glitches in the development or
approval process for any particular new device.
While several of the firms key markets have experi-
enced slowing growth (including implantable cardio-verter defibrillators and spinal procedures), the firm
has focused on its fundamental strategy of innovation.
The firm is often first to market with new products.
For instance, Medtronics new Revo MRI-compatible
pacemaker received Food and Drug Administration
approval last spring and is the first such pacer in the
U.S. market. Because an estimated one third to one
half of pacemaker patients will eventually need an
MRI, Medtronics technology addresses a key limita-
tion of early generations of pacemakers. We expect
Medtronic will apply the same engineering knowl-edge to introduce MRI-compatible ICDs in the coming
years. Additionally, Medtronic enjoys a dominant
position in the emerging neuromodulation market.
While Medtronics electrical devices have been
primarily used for subsegments of incontinence and
chronic pain patients, the general therapeutic
approach is being applied to a number of additional
conditions including epilepsy, Parkinsons, treatment-
resistant depression, and essential tremor.
Pauls Position
Rating Fair Value Current Price Price/Fair Value Consider Buy Consider Sell
QQQQ $46.00 $37.75 0.82 $32.20 $62.10
Econ. Moat Moat Trend Uncertainty Credit Rating Stewardship Stock Style
Wide Stable Med. AA- 1
Market Cap PE Proj. Yield P/B P/S P/CF
$39.3 bil 12.1 2.6% 2.3 2.4 9.6
Medtronic MDTStock Focus | Debbie S. Wang
60
45
30
15
0
-15
-30
Total Return
p
Medtronic (%)p
S&P 500 Index(%)
Fundamental Table
Fiscal Year Ended Apr-09 Apr-10 Apr-11 *Apr-12 *Apr-13 *Apr-14 *Apr-15
Sales ($ mil) 14,599 15,817 15,933 16,201 16,345 17,210 18,199
Operating Income ($ mil) 2,801 4,215 4,001 4,213 4,111 4,376 4,473
Net Income ($ mil) 2,074 3,099 3,096 3,195 3,019 3,172 3,257
Free Cash Flow ($ mil) 3,380 3,558 3,240 4,102 3,448 3,361 3,387
EPS $3.13 $3.44 $3.61 $3.44 $3.56 $3.52 $3.60
ROIC (with goodwill) 18.9% 21.6% 20.2% 17.9% 16.0% 16.4% 16.4%
*Morningstar Estimates, Base Scenario
One of the largest medical device companies,
Medtronic develops and manufactures thera-
peutic medical devices for chronic diseases. Itsimplantable products include pacemakers,
defibrillators, heart valves, stents, insulin pumps,
and spinal fixation devices. The company
markets its products to health-care institutions
and physicians in the United States and
overseas. Foreign sales account for about 41%
of the companys total sales.
Medtronic gets good marks for its stewardship.
In 2011, Omar Ishrak left GE Healthcare to lead
Medtronic as CEO and chairman. While Ishrakhas had little direct experience with the cardiac
market or the device industry, he was consid-
ered a rising star at GE. We note Ishrak was the
pioneer behind GE Healthcares successful
entrance into the China markethe led efforts
to expand the product portfolio in order to
compete head-to-head with local imaging compa-
nies, which gave GE a substantial leg up in
the Chinese midmarkets. Considering Medtronic
has been making a number of investments
in China and has identified emerging markets as
a strategic source of growth, we think Ishrak
can bring valuable perspective.
Profile Management & Stewardship
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
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Morningstar StockInvestor April 2012 19
Medtronic has pinned its hopes for growth on atrial
fibrillation, transcatheter heart valves, and drug-
resistant hypertension. The firm recently bulked up its
technology in these three areas with a series of
acquisitions. There is a growing body of clinical
evidence to support the efficacy of these therapeutic
approaches, especially for calcified aortic stenosis
and uncontrolled hypertension. We note that these
remain health conditions for which there are few
good treatment options. As favorable data comes out
of the clinical trials, Medtronic is appropriately armed
to expand these therapies into sizable new markets.
We expect to see Medtronic delve more deeply into
emerging markets, especially as new CEO OmarIshrak brings extensive experience with the Chinese
market. Medtronic was one of the earliest medical
device companies to establish a beachhead in China,
and that investment is beginning to pay off. Although
emerging markets continue to account for a small
portion of the firms current revenue base, we expect
that to expand steadily over the next 10 years. Impor-
tantly, the firm has concentrated on fundamental
building blocks that plant the seeds for a moat later
on. In China, for example, Medtronic has focused
on establishing itself as a resource for doctors, bothin terms of providing medical training on its products,
but also to help in creating a stream of patients.
Even the most innovative companies may stumble on
occasion, though. Medtronics late start in developing
a drug-coated stent has been a disappointment. The
firm received domestic regulatory approval for its own
stent in 2008, long after rivals Boston ScientificBSX
and Johnson & JohnsonJNJ established footprints
in that market. Further exacerbating the situation,
Medtronics first-generation stent technology wasntas impressive as that of rivals. There is the possibility
for a more favorable foray into this market with
Medtronics next-generation Resolute stent, especially
as J&J exits the market. But it is a market that is
not as moaty as some of the others that Medtronic
operates in.
Economic Moat and Trend
Medtronics wide moat is rooted in its dominant
presence in highly engineered medical devices to
treat chronic diseases, including those beyond its
historical stronghold in heart disease. Medtronics
moat is mainly related to several intangibles, including
intellectual property and carefully nurtured relation-
ships with physicians. Thanks to its persistent ability
to innovate, Medtronic is often first to market with
new products in various therapeutic areas. We expect
Medtronic to continue its record of innovation, based
on its extensive patent portfolio. According to inde-
pendent intellectual property evaluation publications
Device Linkand The Patent Board, Medtronic holds
the strongest intellectual property position based on
the number and technological strength of its patents.
Further, Medtronics diversified medical technologyportfolio allows it to better weather occasional
glitches in the development or approval process for
any particular new device. For example, even though
Medtronic trailed competitors by four years in
launching its drug-coated coronary stent, it hardly
skipped a beat as the cardiac rhythm management,
spinal, and neuromodulation businesses more than
compensated for its tardiness in stents. Another
element of Medtronics wide moat is its highly trained
salesforce and relationships with medical practitio-
ners. Doctors often rely on medical device sales repsfor their deep device knowledge as well as their
experience with device usage in a wide range of
patients. As a result, Medtronics reps play the role of
highly specialized experts who advise practitioners
on implantation, programming, and maintenance of
Medtronic devices and create sticky relationships
with medical practitioners.
Valuation
Our fair value estimate is