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By Jason Stipp | 06-16-2011 01:15 PM

How Downside Protection, Patience Pay Off

Equities strategist Paul Larson says a simple wide-moat, low-turnover, valuation-conscious approach helped the StockInvestor portfolios handily beat the market and similar fund peers over the last 10 years.

Jason Stipp: I am Jason Stipp for Morningstar. It's the 10-year anniversary of Morningstar StockInvestor newsletter's Tortoise and Hare portfolios.

Here with me to talk about the performance of those portfolios, what's behind it, and some of his favorite ideas today is Morningstar StockInvestor editor, Paul Larson.

Thanks for joining me, Paul.

Paul Larson: Thanks for having me.

Stipp: So 10 years, looking back, can you talk a little bit about what the performance has been and then we'll dig into the portfolio strategies?

Larson: Sure. We've been blessed with some good performance over the last 10 years. On a combined basis the Tortoise and the Hare have returned 92.5% on a cumulative basis, and then that's versus the S&P, which is up a little more than 26%. On annualized terms on a combined basis the Tortoise and Hare is up 6.7% versus 2.3% for the S&P.

Stipp: So definitely some great outperformance versus that broad market benchmark. We also look at your performance against mutual funds that invest in a similar style. How have you stacked up on that front?

Larson: Sure. Thankfully it's also been quite good. Versus the large-blend category the Tortoise portfolio has beaten 99% of those funds in terms of performance since inception and then the Hare is beating a little under 98% of the large-growth category, which is the best category that it stacks up against.

Stipp: So certainly stacking up pretty well.

Can you talk a little bit about your strategy and what you think were the primary factors behind that performance? What are you doing in the portfolio that's different than a lot of your rivals out there?

Larson: My strategy is pretty simple, frankly. The first thing I do is I focus on companies that have wide economic moats, and a little bit less than 10% of our coverage universe here at Morningstar actually attains that wide economic moat rating. So, right off the bat I am focusing on what I would call the top 10% of companies in terms of business quality.

Then the second stage of my strategy is I only buy with a margin of safety, or as I define it, I only buy when these stocks are trading at a fairly significant discount to our estimate of their intrinsic value or our fair value estimate.

Stipp: So you're looking at a relatively small universe of stocks; you're also being patient and waiting. So it doesn't sound like there's a lot of activity in the portfolios necessarily?

Larson: No and that's actually something I'm quite proud of is, I'm not racking up the commissions and the other trading costs of the bid-ask spread and taxes and such.

Average annual turnover is actually around 17% versus the average mutual fund, which is closer to a 100%. So, my implied average holding period is measured in years--a little bit over five years.

So I think that this is important because when I'm buying stocks, I like to have that long-term focus, and knowing that my intentions are to hold a stock for a number of years, I'm much more careful buying it, [whereas] if I had a shorter-term timeframe, I might be a little bit sloppier on the vetting process with the idea that maybe I can get out in three months if something doesn't work out.

Stipp: So, certainly an interesting counter to the notion that you've got to be in the market trading every day and taking advantages of these small windows of opportunity. Yan can actually take a much more patient approach and get much further.

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