Morningstar StockInvestor editor Matt Coffina discusses how interest rates, key industry trends, commodity prices, and evaporating margins of safety are impacting StockInvestor's moat-focused Tortoise and Hare portfolios.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.
2013 was a great one for equity investors, but what was driving those returns, and how did that impact other portfolios, like Morningstar StockInvestor's, Tortoise and Hare?
I'm here with Matt Coffina, editor of Morningstar StockInvestor, to look at some of these things.
Matt, thanks for joining me today.
Matthew Coffina: Thanks for having me, Jeremy.
Glaser: As I mentioned, the S&P 500 was up over 30% in 2013. How did your portfolios fare compared to that number?
Coffina: They performed pretty much as you would expect, which is to say that our relatively conservative Tortoise Portfolio underperformed the market with a 25.9% total return--the S&P was up 32.4%--but our relatively more aggressive Hare Portfolio outperformed the market with a 37.1% total return.
Last year was relatively challenging for interest-rate-sensitive, more-conservative issues, but a relatively strong year for riskier, more growthy kinds of companies, and that's exactly what we saw in our performance.
Glaser: Let's look at some of these themes. Like you mentioned, one of the big ones was interest rates. When was the Fed going to taper? That was a big question. We saw a pretty significant rise in interest rates starting in the spring. What impact did that have, both positive and negative, on your portfolios?
Coffina: I would put interest rates in both the positives and the negatives camp. On the positive side, we owned the number of companies that are specifically exposed to higher interest rates in a positive way. These would include Charles Schwab; ADP and Paychex, the payroll processors; and JPMorgan and Wells Fargo, two big banks. All of these companies would benefit from higher short-term interest rates in the long run, and investors' expectations of those higher rates led to those being relatively strong performers last year.
On the other hand, expectations of higher interest rates hurt more conservative higher-yielding companies like utilities, pipelines, consumer defensive firms, a lot of which we own in the Tortoise. That was one of the factors weighing on the Tortoise's performance last year.
Glaser: Switching gears a bit, social networking stocks had a great year, performance-wise. What was driving that, and how did it impact you?
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Coffina: I think one of the big trends in 2013 was that investors came around to the idea that mobile advertising can be just as profitable as desktop-based advertising. Going into 2013, a lot of investors were worried that the growing adoption of smartphones was going to lead to some headwinds for companies like Facebook, Google, or Baidu, all of which we own, and I think all of these companies proved during 2013 that mobile advertising can be just as profitable as desktop advertising, that their economic moats are going to survive this transition to more mobile computing, and that led all of these stocks to be relatively strong performers.
Glaser: Given the runup in stock prices, though, is this already priced in? Have these gone too far?
Coffina: For the most part, margins of safety have disappeared and most of these stocks are now trading at a premium to our fair value estimate. Actually, selling Facebook early last year was one of my biggest mistakes of the year by far. We had a very large position going into the year, about 7%, and I sold half of our Facebook in February of last year, and the stock subsequently doubled. I ended up selling the rest of it before the year was out for a much better total return. At the time, back in February, I was concerned about some correlated risk exposures between having all of these three companies, and in retrospect, I shouldn't have been so shy about putting our money where our mouth was and placing a big bet on mobile advertising. But that said, looking forward we think that the opportunity has been relatively tapped out at this point. And although I think this is a trend that still has a long way to go in terms of greater mobile advertising, the margins of safety just aren't there like they were a year ago.
Glaser: Are there any other industries that did well, but maybe didn't quite gather the same number of headlines?
Coffina: Another top performer for our portfolios was payment networks, and these are great businesses--they have been great businesses for decades--and I think they will be for decades going forward. We own MasterCard, American Express, and Discover Financial Services, and all three of these were among our stronger performers last year. The trend toward greater adoption of electronic payments is still in its relatively early stages, and again, I think it still has a long way to go.
Another factor that benefited American Express and Discover, in particular, was that the credit environment remained very benign in 2013. Loan losses are low. That probably will pick up at some point, but in the short term, it remains a tailwind.
Glaser: What didn't go well for you last year? What was a drag on performance?
Coffina: One drag on performance was certainly our bets on commodity prices. We had a number of companies like Exelon, PotashCorp, Compass Minerals, and Cloud Peak Energy. All of these are very leveraged to a specific commodity--for the most part natural gas or commodities that are linked to natural gas, like power prices and Powder River Basin coal. In Potash's case there is a special circumstance going on in Eastern Europe, where the pricing cartel broke down in the middle of 2013, and that's really pressured demand and prices for potash.
I think the takeaway here is that we need to be very careful buying into companies where the fair value estimates are very much leveraged to a specific commodity price forecast. We do our absolute best to come up with these commodity price forecasts, but it's very, very difficult to gain an edge here as there are just so many factors that are outside of the companies' control, outside of our control, that can influence commodity prices, and if the commodities don't move in the direction that you're expecting, you could end up not having much to show for your investment in those companies.
Glaser: You mentioned one of your biggest regrets was selling a little bit of Facebook too early. Do you regret any of the other positions you sold out of? Any that you wish you would have held on to?
Coffina: Well,a lot of sales looks bad in retrospect when you have such a strong bull market. The next best performer after we sold it was AbbVie. This is a case where I was concerned about the longer-run outlook. AbbVie relies on Humira for about 60% of sales, and this one drug is going to lose patent protection a few years from now. It's not on the immediate horizon, and the drug continues to grow strongly in the short run, but I didn't think that its risk profile was compatible with the Tortoise Portfolio, where we own the stock. That stock still did very well this year as investors focus their attention elsewhere and are not so much worried about the Humira patent loss, not yet at least.
Other companies that we sold, like 3M or Magellan Midstream Partners, are very high-quality companies that I sold primarily for practical reasons, because they were very small positions in our portfolios, but the stocks did well last year, and in retrospective, there is really no reason to sell such a high-quality business ever. Ideally, I would have made those larger positions rather than selling.
Glaser: Were there any that you were glad to see the other side of?
Coffina: Yes, early in the year we also sold St. Joe and Strayer Education. These are two companies that Morningstar thought had wide economic moats, but the competitive position steadily deteriorated over time. Even though we already had a large capital loss on Strayer, and we came out about even on St. Joe after a multi-year holding period, I think it's never too late to cut your losses and move on when you're faced with a company with a deteriorating competitive position. Their wide economic moats are no longer, and I think it was time to move on, and that certainly paid off in the market last year.
Glaser: We've looked at the trends that drove performance last year. Do you expect those to be the similar ones investors should be looking out for in 2014? What kind of performance are you expecting next year, or over the next few years?
Coffina: In some cases, these trends still have a very long way to go. Payment networks remain excellent businesses, and the shift toward more electronic forms of payment is ongoing and likely to last for the foreseeable future. Also the transition from advertising in traditional media to social media and mobile in particular--that's a trend that I think has a very long way to go and could continue to benefit companies like Google and Baidu that we continue to hold for multiple years into the future.
In other cases, something like rising interest rates, I think that's largely been baked into stock prices at this point. The companies that we made money on last year because of rising interest rates are, for the most part, fully valued at this point. And if anything, I am finding more opportunities in relatively conservative, more interest-rate-sensitive areas of the market like real estate investment trusts or pipeline companies at the current time, because I think the market has sort of overshot the headwinds from rising interest rates.
Other than that, I would say we really have our work cut out for us going into 2014. Going into 2013, both the Tortoise and Hare looked moderately undervalued--somewhere on the order of 15% undervalued. Going into 2014, they both look about fairly valued or maybe very slightly undervalued, and that's just a function of the market that we're in. There are very few opportunities out there, very few meaningfully undervalued stocks, particularly among high-quality stocks that we would be interested in.
That means we don't have a lot of opportunities, even if we wanted to, to swap out some of our more fully valued stocks where the opportunities have already been realized, because there aren't that many other opportunities out there. I think the market right now is characterized by being both fully valued, but also relatively homogenously valued. There are really very few stocks that stand out as being materially underpriced.
That said, the good news is that we own very high-quality companies, with strong and growing competitive advantages. I think when we look back five or 10 years from now, we'll find that all of these companies are earning a lot more, they have much higher dividends, and their intrinsic values have increased substantially from where they are today. Over the long run, we'll still do quite well, but in the short run, it's a little harder to be optimistic when there aren't the same margins of safety available now as there have been for most of the past five years.
Glaser: Matt, thanks so much for the update today.
Coffina: Thanks for having me.
Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.
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