A Wide-Moat Approach to Active Investing

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. It's Active/Passive Investing Week at Morningstar.com. I'm here today with Paul Larson. He is the editor of Morningstar StockInvestor, and we'll look at his take on active investing.

Paul, thanks for talking with me today.

Paul Larson: Thanks for having me.

Glaser: So, Paul, a lot of people when they think about active investing, they think that it must mean a lot of buying and a lot of selling--almost day trading. But your strategy is pretty different from that?

Larson: That's absolutely right. I do have a long-term focus, but I still am an active investor in that I'm active in looking for high-quality stocks, selecting out the stocks that have a wide economic moat from those in the market that don't have an economic moat and then also focusing on the stocks that are trading at a discount to our fair value estimates as opposed to those that may be fairly valued or even trade at a premium.

Glaser: What are you looking for in a company to kind of assess if it truly has a competitive advantage, if it's going to be able to beat the other firms in its sector over time?

Larson: Well, the first thing that we look for is some sort of qualitative sustainable competitive advantage. And once we do find some sort of qualitative factor, such as a patent, strong brand, low costs, or something like that, the real proof is going to be in the pudding, looking at the company's profitability, namely its returns on invested capital and also if you prefer higher returns on equity and returns on assets. We're not necessarily looking for the absolute level of profitability. You can have, say, a fashion retailer that has very high profitability, but that's not necessarily sustainable. What we're looking for is that excess profitability to last for long periods of time.

Glaser: So then if we look at valuation, how do you determine if a stock is cheap enough for you to buy?

Larson: Well, the thing that I primarily use is our Morningstar fair value estimates, and that's really our estimate based on the company's expected cash flow of the intrinsic value of the stock. And then what I do is, I simply take the market price relative to that fair value estimate, and I look for the ones that are trading at the greatest discount to our fair value estimate. And those are the ones that are really going to pop to the top of my list in terms of allocating new money.

Glaser: Now, in times of a lot of volatility you might see 50 or 75 stocks that might have competitive advantages and look reasonably cheaper, trading at some kind of discount. How do you make a decision to bring things into a portfolio? How do you really bring all of these different parts together to actually have a basket of stocks that you really own?

Larson: Well, beyond the moat and the priced fair value, I also use uncertainty because with a stock that has a relatively certain, low-uncertainty situation, I'm going to require less of a discount to buy that as opposed to a high-uncertainty situation which is going to have higher risk. And the cone of possibilities in the future is certainly going to be wider. So, I'm going to be a little bit more careful with the high-uncertainty situations.

Glaser: So, in a portfolio, about how many stocks you do want to own in your active strategy?

Larson: Well, I actually manage two different portfolios, and they each have a little more than 20 names. I think that's a pretty good number. If I were running only one portfolio, I would have indeed maybe only 20 or 25 names. I think that's enough to get the benefit of diversification but not too wide to necessarily dilute some of my best ideas.

Glaser: So, your hope is that these 20-25 stocks will beat the broader market because the valuation levels are so attractive that the portfolio will get some excess performance as the stocks come up to their fair value estimate levels?

Larson: That's right. When you're looking at the number of stocks in a portfolio, it's a balancing act between concentrating on your best ideas and also trying to get that diversification. I think that 20-25 number seems to be a pretty good spot.

Glaser: Well, Paul, I really appreciate you sharing your strategy with us and thanks for talking with me today.

Larson: Thanks for having me again.

Glaser: For Morningstar, I am Jeremy Glaser.