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By Matthew Coffina, CFA and Jeremy Glaser | 10-28-2013 02:00 PM

5 Key Pieces of the Stock-Picking Puzzle

A company's long-term competitive advantages, discounts to its fair value, and adequate margin of safety are a few of the traits StockInvestor editor Matt Coffina looks for in a stock before making a purchase.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm joined today by Matt Coffina. He's the editor of Morningstar StockInvestor. He is going to tell us about the five keys in his process to selecting stocks for his portfolios.

Matt, thanks for joining me.

Matt Coffina: Thanks for having me, Jeremy.

Glaser: Matt, you've distilled your process into these five points. What's the first thing that you look at when you are assessing different securities?

Coffina: First and foremost, StockInvestor only invests in companies with sustainable competitive advantages, what Morningstar calls "economic moats." I will occasionally buy a company with a narrow moat, but the vast majority of our holdings have wide economic moats. These are advantages that we think can last multiple decades into the future.

Morningstar has identified five sources of a moat. These would include cost advantage. For example, a company like Wal-Mart has greater scale than any other retailer, gives it a cost advantage when negotiating with suppliers, or distribution cost advantages.

Switching costs would be another example. A company like Oracle, that its software is very closely tied into its customers' businesses and they can't readily swap it out.

And then a few other sources of moats, things like the network effect. An example here would be MasterCard. With efficient scale effect, a limited market is effectively served by a small number of companies. A holding we have in this category would be ITC Holdings. They own electricity transmission and infrastructure, and it just doesn't make sense to build a second set of wires between Point A and Point B.

And the last one would be intangible assets. So, things like brands or regulatory licenses. Probably the typical example here would be Coca-Cola, a very strong brand that consumers seek out and are willing to pay a modest premium for.

Glaser: After you've ascertained if a company has a competitive advantage or not, what's the next step?

Coffina: The second thing I look for is a discount to fair value. We only want to buy stocks if they're reasonably priced. Even the highest-quality companies can be overvalued. What I look at here is the price to fair value ratio. How does the company stock price compare to what our analysts think that the company is worth based on its ability to generate cash flows for years into the future? The greater the discount, the greater the margin of safety in that stock price.

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