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5 Key Pieces of the Stock-Picking Puzzle

Matthew Coffina, CFA
Jeremy Glaser

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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Glaser: How much of a discount do you demand? Does it depend on the market conditions or the individual stock?

Coffina: That's the third factor: An adequate margin of safety. Unfortunately, in the current market environment, there aren't significant margins of safety available. Most stocks we think are trading close to fair value or even modestly over fair value. I think, we have to adjust our expectations given the market environment.

But that said, I look at our star ratings. A 5-star rating would be ideal, meaning a very large discount to fair value, appropriate to the level of uncertainty underlying our fair value estimate. Not all fair values are created equal. A company like Coca-Cola or ITC Holdings that I just mentioned, those companies are much easier to value than a company like Facebook. So I would require a much smaller margin of safety when investing in a Coke than I would investing in a Facebook.

Also keep in mind that we have to be aware of the market conditions, and sometimes the market allows us to have greater discounts than other times. Right now, I'm pretty happy if I can find a high-quality company with a 4-star rating and even those are starting to get pretty few and far between.

Glaser: What about the fourth key?

Coffina: That would be moat trend. I want a company that doesn't only have a very strong competitive position, but we also want that competitive position to be strengthening further over time or at least staying the same. Morningstar has its moat trend rating, which could be either positive, stable, or negative. For the most part, I try to avoid companies with negative moat trends, meaning that the competitive position is weakening over time, and I look for companies with at least stable moat trends or ideally a competitive position that's strengthening, maybe the network effect is getting stronger as they're adding customers and suppliers to a network, maybe the intangibles advantage is getting stronger as they're investing in marketing and introducing new high-quality brands or investing in innovation, and so on.

Ideally, a strengthening competitive position, but at least stable.

Glaser: What's the final piece of this puzzle?

Coffina: The last piece would be stewardship, and Morningstar has its stewardship rating. We rate companies either Exemplary, Standard, or Poor. Again, for the most part, I try to avoid the companies with poor stewardship, and I look for at least standard. We view common stocks as representing an ownership interest in a real business, and so we need a management team that we can trust to allocate our capital appropriately and to execute on a good strategic vision.

Strategic execution and capital allocation are the two big things I look for here, when it comes to stewardship.

Glaser: How has this process worked over time or what's the performance looked like for the two portfolios you manage?

Coffina: Our process has certainly evolved over time, and things like the moat trend rating were only introduced in the last few years, which I think has really made our process better and better, and I'm hoping will show up in terms of improved returns going forward. But even historically, where we focus very much on wide moats and discounts to fair value, our track record has been terrific.

We've outperformed the S&P on a combined basis. Combining our two real-money portfolios, the Tortoise Portfolio and the Hare Portfolio, we've outperformed the S&P by about 4 percentage points per year, or over 100 percentage points cumulatively, over the last 12-plus years since our 2001 inception.

Glaser: Matt, thanks for joining me today.

Coffina: Thanks for having me, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser.

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