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Stock Strategist

The Ultimate Stock-Picker's Portfolio Bides Its Time

We're waiting to select our new pick.

As I mentioned a couple of weeks ago, I was planning to replace The Ultimate Stock-Picker's Portfolio's position in  Anheuser-Busch (BUD) with a new stock from my most recent watch list of the following 20 investment managers.

 Investment Manager List
 Alleghany Y
 Ariel Appreciation CAAPX
 Berkshire Hathaway BRK.B
 Clipper CFIMX
 Fairholme FAIRX
 Harbor Large Cap Value HAVLX
 Jensen JENSX
 Legg Mason Value Trust LMVTX
 Longleaf Partners LLPFX
 Markel Gayner Asset Management MKL
 Matrix Advisors Value MAVFX
 Mutual Shares TESIX
 Oakmark OAKMX
 Oak Value OAKVX
 Sequoia SEQUX
 Third Avenue Value TAVFX
 Torray TORYX
 Tweedy, Browne Value TWEBX
 Weitz Value WVALX
 Wintergreen WGRNX

I initially focused my search on  Bank of America (BAC),  Medtronic (MDT),  eBay (EBAY), and  Capital One Financial (COF). Although each of these businesses generates high returns on capital for owners--and as such, have each received a wide moat rating from Morningstar--presently, two of them have caught my eye more than the others.

In the case of eBay, I continue to be impressed with the prospects of the firm's online payment network, PayPal. I was initially led to examine PayPal during my analysis of the portfolio's last addition,  American Express (AXP). Similar to Amex, PayPal operates a payment system, but unlike Amex, PayPal utilizes the Internet to facilitate its transactions. Although PayPal doesn't have as strong a system as Amex since PayPal absorbs the costs of its customers funding their accounts with either a credit card or an online bank wire, it still captures more of the value chain in an online transaction than a typical credit card firm (think  MasterCard (MA)) or a bank would.

Further, my colleague John Owens has indicated that more and more online merchants are starting to accept PayPal as a method of payment, primarily as a result of its strong acceptance by eBay's entrenched user base. Even better, John notes in his  analysis that PayPal's addressable market off of eBay is about 10 times larger, indicating that the unit's growth prospects are still very strong. As a result, it appears that eBay is able to leverage its existing network into an adjacent high-return business--the equivalent of investment nirvana for potential shareholders.

When I look at buying businesses, I tend to gravitate toward those that have earned high returns on capital, and also have the potential to earn even higher incremental returns on each dollar of additional capital deployed in the business. Our wide moat rating on eBay takes this into account, and further, based on John's fair value estimate, the shares appear poised to offer potential investors very pleasing long-term returns.

Capital One
In addition to eBay, I've been intrigued by Capital One's transformation from a monoline credit card issuer to a more full-service financial services company. I really can't illustrate my thoughts on Capital One better than my colleague Michael Kon did in his recent  Analyst Report, where he states: "Several acquisitions transformed Capital One into a collection of good businesses that operate alongside one another. More than 70% of the profits come from the consumer lending segment, which includes the legacy U.S. credit card business, auto finance, mortgage banking, and credit card businesses in the United Kingdom and Canada. We think Capital One's scale and brand name are major competitive advantages that will benefit the firm in the long run. Capital One is one of the top five credit card issuers and auto lenders in the U.S. The firm also ranked among the top 20 mortgage originators in 2006. Thanks to its national scale and an ingenious marketing campaign, its brand is one of the most recognized in the financial services sector. In addition, having national scale allows Capital One to extract valuable information on consumer spending trends. With this information, Capital One can make better decisions regarding cross-selling initiatives, new product introductions, pricing strategies, and market opportunities and risks. Only a few firms in the country have access to such information, and Capital One is fortunate to be one of them."

In addition to these solid prospects for its business, Michael currently believes the shares are very attractively priced based on his most recent fair value estimate.

Decision Analysis
So then, which one of these am I going to choose to eventually replace Anheuser-Busch, which has lately dropped back into 4-star territory?

Examining my first criteria for selecting an investment off of our watch list, I quickly recognize that each stock is held by the same number of investment managers from the list above, making it difficult to differentiate them on this basis.

When I look at Morningstar's proprietary metrics for these stocks, the discount to fair value (P/FV) is slightly lower for eBay than for Capital One, slightly tipping the scale toward eBay. However, since these are still both growing firms, I think it's also reasonable to compare the three-year annual expected returns for each stock. You'll note that since this calculation incorporates our cost of equity assumption--think discount rate--into my analysis, it helps adjust for the risk our analysts think resides in each investment. Comparing these expected return metrics, it's basically a dead heat between the two at this point.

When I think about portfolio construction across different sectors as illustrated by's portfolio X-Ray tool, I tend to lean toward selecting eBay, as the model portfolio already has a sizable percentage of its assets in a couple of large financial stocks, American Express and  Berkshire Hathaway (BRK.B). That said, I try to remain agnostic toward asset allocation in managing this portfolio, instead focusing my efforts on where the highest expected returns are at any one time, irrespective of each stock's particular industry.

Given these evenly matched stocks by my most recent appraisal, I'm willing to be patient and wait for one of them to become more attractively priced before pulling the trigger for the model portfolio.

 eBay vs Capital One
Name Price Fair Value Cost of
Fair Value

Exp. Ret.

eBay (EBAY) $32.18 $49 10.0% 0.66 27%
Capital One Financial (COF) $78.44 $115 11.5% 0.68 27%
Data as of 06-29-07

I'll further note that since my last article, Anheuser's price has modestly dropped, pushing it back into 4-star territory based on Morningstar's rating for stocks. As you may recall, I indicated that I would sell stocks when they reach 3 stars, unless the business materially changed or the position reached too large a size in the portfolio. In the case of Anheuser, nothing has really changed with its business in the near term--it's still a steady-Eddie beer maker--and it's not an overly large position in the model portfolio. As such, I'm willing to wait for Anheuser's valuation to improve, which will give me the dual benefit of keeping my eye on both eBay and Capital One in the interim to see if one becomes more attractively priced. I may also use some of the model portfolio's current liquidity to take a small position in one of these stocks down the road should valuations change.

Position Update
The table below includes the portfolio's holdings through the end of the second quarter, June 29, 2007, as well as the Morningstar rating for each stock.

 The Ultimate Stock-Picker's Portfolio
Wal-Mart (WMT)
Berkshire Hathaway (BRK.B)
Time Warner 
American Express (AXP)
Sprint Nextel 
Expedia (EXPE)
Johnson & Johnson (JNJ)
Anheuser-Busch (BUD)
Pulte Homes (PHM)
Data as of 06-29-07  

On the first trading day of the third quarter, the portfolio's holdings in  Tyco  recently split into three different parts: Tyco Electronics (TEL), Covidian , and Tyco International . As I mentioned previously, I intend to sell the less-moat-worthy of these businesses, if the respective valuation is appropriate. This is yet another reason why I've decided to hold off on adding eBay and Capital One, as the Tyco transaction will likely free up some additional capital for either one or both of these names. Stay tuned for an update on both Tyco and a new position(s) in the coming weeks. And if you haven't already, please sign up for my e-mail alerts now so you can be among the first to see my new pick.

Justin Fuller has a position in the following securities mentioned above: AXP, DELL, PHM, MDT, COF, EBAY. Find out about Morningstar’s editorial policies.