Playing the Hand We're Dealt

My strategy in running the Tortoise and Hare model portfolios that are the centerpiece of Morningstar StockInvestor has two steps: 1) focus on companies with wide moats and 2) only buy when there is a sufficient margin of safety (ideally, 5-star stocks). This relatively simple strategy has served us well over the years, helping lead our portfolios to outperform the S&P 500 over the long term.

But some of my recent purchases in the portfolios seem to conflict with this strategy. I’ve initiated positions in stocks rated only 4-stars (witness  Facebook (FB)), bought narrow-moat stocks (witness  Cloud Peak Energy ), or stocks that have less-than-perfect characteristics (witness  Molson Coors (TAP)). Have I lost my marbles and started to stray from the basic strategy?

In a word, no. All I am trying to do is play the hand the market is dealing us. Managing two portfolios with 20-plus names in each (40–50 stocks between them), there are usually not quite enough wide-moat, 5-star names to fill out the complete roster. Consider the Wide-Moat Watchlist in StockInvestor, a list that contains all of the U.S.-traded companies that have wide moats, which is more than 140 companies. At this update, there are just four stocks from this list trading at a 5-star valuation. I’d love to have both portfolios hold nothing but wide-moat names trading at huge discounts to intrinsic value, but this ideal is rarely possible in reality. As such, I simply invest in what I think are the most compelling opportunities at any given time.

I’ve always been willing to buy higher-quality narrow-moat stocks such as  CarMax (KMX). And regarding the case of 2011 purchase  Energy Transfer Equity LP (ETE) (rated narrow moat when I bought), I believe mostpipeline companies sit on the wide/narrow moat borderline. The very high barriers to entry and limited competition are offset by regulation that keeps returns on invested capital at a modest level. I’m not going to split hairs regarding which side of the wide/narrow borderline ETE sits; it has an economic moat of sufficient width. With the stock trading moderately below its $54 fair value estimate and sporting a tax-advantaged yield from its partnership distributions in excess of 5%, I’m quite happy to continue holding ETE today.

Besides looking slightly beyond the wide-moat universe for investment opportunities, I am indeed guilty as charged regarding buying 4-star stocks. I'm also guilty of selling 2- and 3-star stocks, often well below our published Consider Selling prices. Let me explain what I am trying to do.

Beyond the two-step strategy, another tactic I employ is trying to maximize the aggregate dollar-weighted estimated fair value of the portfolio. In other words, I'm trying to minimize the aggregate dollar-weighted price/fair value ratio of the portfolios.

The Consider Selling prices—the prices at which a stock attains a 1-star rating—are a fair bit above our fair value estimates, and there is often the opportunity to recycle the capital into more undervalued names well before something reaches a lofty 1-star price. Here is just one example. This past August, I sold  MasterCard (MA) at an 8% premium to fair value and  Magellan Midstream Partners 21% above fair value. In isolation, these are not such horrific premiums to fair value that I felt the need to treat the stocks as hot potatoes, especially for such fantastic underlying companies. But by recycling the capital into Facebook, which was trading at a 40% discount to fair value at the time, I was able to increase the expected value of the Hare portfolio by about $4,464, or approximately 2%. 

In a nutshell, if someone on the street came up to you and offered six quarters for your $1 bill (50% premium to intrinsic value), of course we’d recommend taking the deal and offloading the dollar. But pragmatically, I think it also makes perfect logical sense to sell a dollar bill for $0.90 if we can turn around and buy other dollar bills for $0.60. Selling the dollar for $0.90 makes no sense in isolation, but it does when considering the opportunity cost. What I'm essentially trying to do with the Tortoise and Hare is minimize the opportunity costs while maximizing and growing the intrinsic value of the portfolios.

Adjusting for Uncertainty
There is one more twist to the strategy, however. In addition to trying to minimize the aggregate price/fair value ratio of the portfolios, I also take risk and uncertainty into account. Thankfully, Morningstar’s Rating for stocks has uncertainty embedded into it. A company with low uncertainty only needs to see its stock drop to 20% below fair value before attaining a 5-star rating, while a high-uncertainty company needs a 40% discount before reaching 5 stars. This should make intuitive sense; the more uncertain the situation, the greater the required margin of safety.

If I were to manage the portfolios solely by buying the stocks that trade at large discounts to fair value, chances are the portfolio would skew toward higher uncertainty situations. But by adding another layer—managing the portfolio to maximize the dollar-weighted average star rating—I can take uncertainty into account. In other words, looking at just the price/fair value ratio would have me—in baseball terms—often swinging for the fences. Yet the star rating reduces risk and gives a more balanced game that includes a fair number of lower-risk, more certain singles and doubles.

When I sold MasterCard and Magellan to add to Facebook, I brought the dollar-weighted average star rating of the Hare up by 0.12 “stars.” This one set of trades is obviously not hugely transformative for the portfolio, but if we continue to make select trades like this, eventually they will add up.

In a nutshell, I’m focusing on high-quality companies—either wide-moat or select narrow-moat firms. With these companies I am making trades to try to push the expected value and dollar-weighted star-rating north for both portfolios. I’m doing so while trying to be mindful of trading expenses and, more importantly, keeping a long-term perspective.

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