A willingness to look past short-term noise and instead focus on a company's competitive advantages and stewardship serves as a core stock-picking advantage for Morningstar's Matt Coffina.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. It's Beat the Market Week on Morningstar.com and I'm joined today by Matt Coffina. He’s editor of the Morningstar StockInvestor newsletter, where he’s responsible for both the Tortoise and Hare portfolios, which have handily beat the market over their lifetime. We're going to talk to Matt about his process and how he thinks about investing in stocks.
Matt, thanks for joining me today.
Matt Coffina: Thanks for having me, Jeremy.
Glaser: Let's start with the big picture. What's your primary approach to investing? What attributes are you looking for in the stocks that you purchase for your portfolio?
Coffina: We invest in companies with strong competitive advantages. This would be a Morningstar Economic Moat Rating of wide, preferably wide, or narrow, as well as companies that are improving their competitive positions over time. That would mean stable or positive moat trends. Companies with strong management, exemplary stewardship ideally, companies that you can trust the management to use shareholders' capital wisely. And then also companies that are trading at reasonable prices relative to our analysts' estimates of their intrinsic value. So price to fair value ratios as low as possible and the higher the uncertainty underlying our fair value estimates, the greater the margin of safety that we would require in general.
Glaser: What do you see as the key risks to this process?
Coffina: I think the biggest challenge we face is just making sure that we're right about economic moats, moat trends, stewardship, and so on. Where we've gone wrong in the past is usually when we thought that a company had a very strong competitive advantage and then it turned out that it didn't for whatever reason. The competitors encroached on the territory. There were some kind of balance sheet issue where the company is overleveraged or other situations like that. I think the process itself is very sound, and the challenge is more in the execution and making sure that we're choosing companies that really do fit the criteria that we're looking for.
I can say the secondary challenges in a market environment like we've had in the last five years, where the market’s been very, very strong, it can be difficult for these relatively mature, slower-growing, very strong competitive position companies to keep up with a very rapid bull market.
Over the last five years, although we've beaten the market--beaten the S&P 500 slightly--it's been a much tighter spread than over the longer run, 10 years or since inception, because once you take out those 2001 to 2002 bear market and the 2008 bear market, that's where our really big outperformance is realized. It's a little harder to keep up with a very strong bull market, but over the long run, I think as long as we're successful about identifying companies with strong competitive positions, trading at reasonable prices, I think we should continue to do very well.
Glaser: We've been talking mostly in general terms, but can you give us a specific example of a stock that you purchased or a company that you purchased either recently or historically that you think really exemplifies your method of stock-picking?
Coffina: Reaching back into the StockInvestor archives, our best investment of all time was MasterCard. We bought this stock shortly after the IPO at a split-adjusted price of $4.40. The stock is north of $70 now, so we've made a better than 1,500% return on MasterCard.
This, again, was a situation where at the time investors were very worried about short-term issues like the legal issues that MasterCard was facing, they were ignoring the very, very strong competitive advantage, thanks to the network effect, that MasterCard enjoys, and the company's ability to grow revenue at a relatively rapid rate for many, many years into the future, as well as to achieve a high degree of operating leverage. So by looking past the short-term noise of the legal issues and the fact that this is a new business model to Wall Street when MasterCard came public and people maybe didn't know quite how to analyze it, we had a very, very successful investment there.
A more recent example might be Charles Schwab stock that I bought last year. In that case, it was very obvious that Charles Schwab's earnings are going to increase very materially whenever short-term interest rates begin to rise, but investors were again focused on the short term and seeing that the Fed was keeping the low-rate policy intact for the next couple of years at least. This tailwind of a higher short-term interest rates remained many years into the future or at least a few years into the future.
And investors weren't willing to be patient with a stock like Charles Schwab. It turned out that the stock has worked out much sooner than we might have expected, but I'm not that concerned about whether there's a catalyst for a company like Charles Schwab to outperform in the next one or two years. We're really interested in what this company's intrinsic value is going to be five and 10 years down the road and whether we can be pretty certain that its intrinsic value is going to be significantly higher than the current stock price, which is certainly the case a year or so ago when we bought the stock. I'm willing to just sit on the stock and be patient and wait for that intrinsic value to show through.
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Glaser: There are a lot of managers who talk about looking for great-quality companies or who are looking for companies that are trading for below their intrinsic value. What makes your process distinct, what makes it different from others out there?
Coffina: I think a lot of people do follow the same basic approach. But again, it's more in the execution. I think the main advantages that we have are, one, Morningstar staff of a hundred equity analysts, all looking at a very large universe of companies--more than 1,500 companies--through the same exact lens. So we're using a consistent discounted cash-flow valuation methodology.
We're using a consistent approach when it comes to economic moats and moat trends and stewardship. I think devoting so many resources to such a specific approach really is an advantage working in our favor. The other main advantage I think is more our patience and our willingness, again, to look past the next couple of years, be willing to accept a story that maybe doesn't have a catalyst on the immediate horizon, but it's fairly clear that the intrinsic value is going to be much higher five and 10 years from now.
A lot of money managers even following a similar approach to ours, they may not be willing to accept the situation where they think they might underperform for a few years at a time before the call really starts to work out. I think it's that very long time horizon and our willingness to look past the short-term noise and especially to remain disciplined that really serves as an advantage for us.
Glaser: Sometimes when a strategy has been successful over a long time, that success gets arbitraged away, other people come in with a similar strategy, and returns fall back to Earth. Would you expect that to happen here, or do you think that this is a process that could work over the long term?
Coffina: I think people increasingly recognize the benefits of the focus on high quality, but I don't think it's something that's easily arbitraged away, because, again, you need that very long investment horizon. You need to be very patient and disciplined, and also it takes a tremendous amount of resources to really look into these companies one by one. It's not like you can just screen for a specific factor, something like small cap stocks tend to outperform. Anyone can run a screen and see what the small-cap stocks are and invest in them.
Similarly, you could say momentum stocks tend to outperform, however you're defining that. Again, you could run the screen and decide which companies had momentum and invest in them. Those sorts of things are much easier, I think, to arbitrage away over time than really digging into the fundamentals of a company, taking a lot of time to really think it through, think about the competitive position, run discounted cash-flow analysis, make assumptions about the future.
Again, the greatest challenge that we face is more in the execution rather than our investment approach. I am very confident that if we're successful at picking companies with very strong competitive positions, trading at reasonable prices, I'm very confident that we'll have good results over time. The challenge is in making sure that the companies we buy really do have those strong competitive positions and really are trading at reasonable valuations.
Glaser: Matt, thanks for your insights into your process today.
Coffina: Thanks for having me, Jeremy.
Glaser: For Morningstar, I'm Jeremy Glaser.
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