FundInvestor PMS 185 U

Transcription

Cover_0108.qxp
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10:28 AM
Page 1
StockInvestor
January 2008
Volume
Number
7
7
Buying core holdings at a discount
Taking Stock of 2007
tion in either portfolio, went from roughly $27 to $20
in 2007, we are as confident as ever in our thesis.
If our projections of CarMax’s future cash flow are
correct, we should gain this back (and then some)
in the future.
The Tortoise and Hare have two goals—to beat the
S&P 500 Index, and to create positive returns regardless of the broad market environment. The portfolios managed to achieve the second goal in 2007, but
not the first. The Tortoise and Hare’s streak (on
a combined basis) of beating the market in successive
calendar years ended at three, and the portfolios have
now beaten the S&P 500 in five of the seven
calendar years the portfolios have been in existence.
Performance (%): Morningstar StockInvestor Portfolios vs. S&P 500
Period
2001*
2002
2003
2004
2005
2006
2007
Since Inception**
Since Inception***
Tortoise
Hare
Combined
S&P 500
9.1
-1.6
26.3
13.1
8.0
13.7
1.6
91.1
10.4
0.7
-23.9
26.2
26.9
3.2
22.0
5.2
62.7
7.7
4.9
-12.3
26.2
18.8
5.8
17.3
3.3
76.9
9.1
-4.8
-22.1
28.7
10.9
4.9
15.8
5.5
35.6
4.8
Data as of December 31, 2007. Returns include interest and dividends.
*Since Inception 6-18-01 **Total Cumulative Returns ***Annualized Returns
It was a close race until the end. The portfolios were
actually beating the market year-to-date until Dec. 12,
before limping to the finish line. I am not worried,
as whatever value the portfolios “lost” (and I use that
term very loosely) in the short term, we should only
get back in future years. Because the vast majority of
our fair value estimates for companies in the portfolios have been stable or rising (see Page 30 for more),
I view this near-term underperformance as a
mere “coiling of the spring” for 2008 and beyond. For
instance, even though CarMax KMX, the largest posi-
Another contributor to the underperformance was the
sector weightings. For example, the financial services
sector made up 40% of the Tortoise at the start of
the year, and this ended up being the worst-performing
sector in 2007. Meanwhile, we had comparatively light exposure to the energy sector, which was
yet again one of the top performers. We do not do
top-down projections of what sectors are going to be
hot or cold, but this sort of analysis does explain
some of the head winds our holdings face, as well as
what Mr. Market likes and dislikes at the moment.
As I like to do this time of year, here is a look back at
all the trades we have made in 2007.
Jan. 29, Sold 200 TC Pipelines TCLP
Sales Price: $36.15 12/31/07: $36.20
I started out the year by selling natural-gas pipeline
firm TC to raise cash for some more undervalued
ideas. I still think this is a decent little company, and
we recently raised our fair value estimate to $39
from $34. That said, I continue to think there are more
attractive and better-priced opportunities at
the moment. We realized a 12% gain (and a 23% total
return once you include partnership distributions)
over roughly a year and a half. (In this article, I will note
the realized gains for all of our closed positions.)
Jan. 29, Bought 100 eBay EBAY
Purchase Price: $32.02 12/31/07: $33.19
EBay remains the quintessential example of the
Continued on Page 28
Paul Larson
Equities Strategist and Editor
The Tortoise Portfolio
Our favorite conservative
picks, including Berkshire
Hathaway and Novartis
2
The Hare Portfolio
Our favorite aggressive picks,
including eBay and Paychex
4
Tortoise and Hare Focus
Bank of America and Vulcan
Materials
6
Bellwether Watchlist
8
Ratings and comments on more
than 150 wide-moat companies
InternationalInvestor
Canadian Review
17
Bulls vs. Bears
22
Debating Washington Mutual
Company Focus
24
Comcast, Starbucks, Zimmer, and
H&R Block
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2
The Tortoise Portfolio
The Tortoise certainly had a difficult 2007. The large
exposure to the financial services sector (39.5%
of the portfolio at the start of the year) was the
primary culprit. In some cases, such as Bank of
America BAC or J.P. Morgan Chase JPM, the weakness in the stock price has not been accompanied by
a change in our fair value estimate.
Morningstar Stock Portfolios | Paul Larson
From inception on June 18, 2001 through Dec. 31,
2007, the Tortoise has returned 91.1% compared with
a total return of 35.6% for the S&P 500 Index and
40.8% for the average large-cap blend mutual fund.
The Tortoise has outperformed 96.7% of U.S.
large-cap blend funds since inception, but it outperformed only 15.9% of these funds in 2007.
The Tortoise
Portfolio
Portfolio Holdings
Performance
and Transaction
Summary
Stock Name
Å 5 Shares added
Í 5 Shares sold
C 5 New holding
5 Not Rated
5 Under Review
Spec 5 Speculative
1Avg 5 Above Average
2Avg 5 Below Average
Avg 5 Average
NR
UR
Berkshire Hathaway BRK.B
Bank of America BAC
First American FAF
Novartis NVS
Wrigley Wm Jr WWY
Walgreen WAG
Johnson & Johnson JNJ
Lowe's Companies LOW
Anheuser-Busch BUD
Automatic Data Prcssing ADP
Wal-Mart Stores WMT
What is the goal of
the Tortoise Portfolio?
The Tortoise Portfolio has two
goals: to outperform the S&P
500 Index and to generate positive returns regardless of
the broad market environment.
Companies in this portfolio
tend to be large, moderate to
low risk, and slow growing.
We aim for all the companies
here to have an economic moat.
General Dynamics GD
But in others, most notably Washington Mutual WM,
there was indeed an impairment of the portfolio’s
capital, as we reduced our fair value estimate for the
company following the real estate/mortgage/credit
market mess that was the leading story of 2007.
Morningstar Ratings & Fundamentals
Star
Rating
Business
Risk
QQQ
QQQQQ
QQQQQ
QQQQQ
QQQ
-Avg
QQQQQ
QQQQQ
QQQQQ
QQQ
QQQQQ
Fair
Value ($)
Current
Price ($)
Consider
Buying
Consider
Selling
5000.00 4736.00 4260.50 6564.50
Size of
Moat
Dividend
Yield (%)
Stewardship
Wide
—
œ
∑
Avg
70.00
41.26
54.00
87.70
Wide
5.8
Avg
59.00
34.12
45.50
73.90
Narrow
2.6
∑
-Avg
73.00
54.31
62.20
95.80
Wide
2.0
—
-Avg
61.00
58.55
52.00
80.10
Wide
1.9
¥
Avg
56.00
38.08
43.20
70.20
Wide
0.9
∑
-Avg
80.00
66.70
68.20
105.00
Wide
2.4
¥
-Avg
39.00
22.62
33.20
51.20
Wide
1.2
∑
-Avg
57.00
52.34
48.60
74.80
Wide
2.4
œ
-Avg
53.00
44.53
45.20
69.60
Wide
2.2
∑
QQQQQ
QQQ
QQQQQ
QQQQQ
QQQQQ
-Avg
60.00
47.53
51.10
78.80
Wide
1.9
∑
Avg
87.00
88.99
67.10
109.00
Wide
1.2
œ
-Avg
47.00
33.62
40.00
61.70
Wide
1.2
œ
Avg
63.00
43.65
48.60
78.90
Wide
3.3
œ
-Avg
70.00
52.02
59.60
91.90
Wide
1.2
œ
-Avg
39.00
40.93
33.20
51.20
Narrow
3.2
œ
-Avg
60.00
61.37
51.10
78.80
Wide
2.2
¥
PepsiCo PEP
QQQ
QQQ
QQQ
-Avg
77.00
75.90
65.60
101.10
Wide
1.9
∑
Kinder Morgan Mngnt KMR
UR
-Avg
—
52.94
—
—
Wide
6.4
œ
White Mountains Ins WTM
QQQQQ Avg
700.00
514.05
539.80
877.00
None
1.6
œ
Home Depot HD
-Avg
44.00
26.94
37.50
57.80
Wide
3.3
¥
Washington Mutual WM
QQQQQ
QQQQQ
QQQQQ
QQQQQ
Broadridge Fin Solutions BR
Not Rated
Cintas CTAS
J.P. Morgan Chase & Co. JPM
American Express AXP
TransCanada TRP
Coca-Cola KO
Pfizer PFE
Moody's MCO
Avg
31.00
22.73
23.90
38.80
Wide
5.1
¥
-Avg
65.00
35.70
55.40
85.30
Wide
0.9
∑
Avg
43.00
13.61
33.20
53.90
Narrow
—
∑
—
—
22.43
—
—
—
0.8
—
Cash Holdings
Tortoise Portfolio Total
2.6
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Page 3
Morningstar StockInvestor
Median Price/Fair-Value Ratio
Subgroup
Med. P/FV Ratio
All Stocks
Wide Moat
Narrow Moat
No Moat
Below Avg. Risk
Average Risk
Above Avg. Risk
NYSE
NASDAQ
0.92
0.87
0.92
0.94
0.91
0.92
0.94
0.91
0.94
There were no trades in the Tortoise in December,
though activity in the portfolio materially increased in
2007. Turnover was 30.6% for the year, versus
an average near 9% over the previous three years. I
expect to maintain the higher level of portfolio
turnover as I continue to reallocate capital from lowerrated firms trading at modest discounts to fair value
to the higher-rated firms trading at deep discounts.
Portfolio Transactions
Ticker
Contact Paul Larson at [email protected]
Paul Larson personally owns shares of the following Tortoise stocks:
AXP, BAC, BRK.B, BUD, CTAS, FAF, GD, HD, JNJ, JPM, KMR, KO, LOW,
NVS, PFE, TRP, WAG, WM, WMT, and WWY.
15
25
Cost Basis/
2
Share ($)
Portfolio Performance Breakdown
Total
2
Cost ($)
Current
Value ($)
% Gain / % of
Loss
Portfolio
BRK.B 06-18-01
0
4
2153.25
8613.00
18944.00
120.0
10.5
BAC
04-25-07
0
270
50.43
13615.67
11140.20
-18.2
6.1
FAF
03-17-04
0
300
28.70
8610.99
10236.00
18.9
5.7
NVS
02-09-07
0
170
57.05
9697.79
9232.70
-4.8
5.1
WWY 04-18-06
0
150
45.97
6895.59
8782.50
27.4
4.8
10-11-07
0
230
39.37
9054.92
8758.40
-3.3
12-06-05
0
130
59.51
7736.38
8671.00
12.1
4.8
11-15-07
0
350
24.88
8707.44
7917.00
-9.1
4.435
BUD
10-20-03
0
150
48.70
7304.36
7851.00
7.5
4.3
ADP
06-14-02
0
175
27.84
4872.72
7792.75
59.9
4.3
WMT 07-19-02
0
150
47.43
7114.28
7129.50
0.2
3.9
GD
03-12-03
0
80
25.31
2025.06
7119.20
251.6
3.9
CTAS
05-16-07
0
200
37.61
7522.00
6724.00
-10.6
3.7
JPM
07-23-02
0
150
30.49
4574.16
6547.50
43.1
3.6
-0.7
5.5
4.8
NASDAQ Composite
2652.3
-0.3
10.7
4.7
35
0
06-01
06-02
06-03
06-04
Top Five Sectors (%)
a Financial Srvcs
s Consumer Goods
35.2
41
23
Lrg
10
8
0
Med
0
0
0
Sm
3682.50
6502.50
76.6
3.6
01-23-04
0
150
21.21
3181.88
6139.50
93.0
3.4
o Consumer Srvcs
i Healthcare
16.0
TRP
KO
10-01-04
0
100
40.63
4062.86
6137.00
51.1
3.4
p Business Srvcs
9.4
PEP
07-19-02
0
75
35.92
2694.25
5692.50
111.3
3.1
KMR
03-08-06
0
107
37.11
3970.77
5664.58
42.7
3.1
HD
09-24-01
0
150
21.85
3277.50
4041.00
23.3
2.2
PFE
09-24-01
0
150
35.21
5281.01
3409.50
-35.4
1.9
MCO
12-16-02
0
50
20.80
1039.75
1785.00
71.7
1.0
WM
12-05-01
0
125
31.05
3881.75
1701.25
-56.2
0.9
BR
06-14-02
0
43
11.92
512.56
964.49
88.2
0.5
Cash Holdings
7295.93
3
4.0
181319.50
4
100.0
12.3
p50 –100
p25 – 50
p10 – 25
p0 – 10
Morningstar ratings and fundamentals as of 12-31-07. Portfolio inception date: 6-18-01.
1
2.8
06-07
Value Blend Growth
19
29.46
44.7
06-06
16.4
125
5140.50
06-05
Style Breakdown (%)
0
3553.00
10.4
1468.4
07-18-01
355.30
1.6
S&P 500 Index
AXP
10
-2.3
70
-35
0
Since5
Inception
•Tortoise Portfolio • S&P 500 Index
0
WTM 11-05-01
12 Month
% Total Return
70
LOW
This
Month
Tortoise Portfolio
4.8
JNJ
Index
Level
Trailing Return (%)
105
WAG
Paul has bought the stock in the past month.
Paul has sold the stock in the past month.
© 2008 Morningstar, Inc. All rights reserved. Any opinions, recommendations,
or information contained herein: (i) is for educational purposes only; (ii) is not
guaranteed to be accurate, complete, or timely; (iii) has not been tailored to suit
any particular person’s portfolio or holdings; and (iv) should not be construed
as investment advice of any kind. Neither Morningstar nor any of its agents shall
have any liability with respect to such opinions, recommendations, or information.
Morningstar has not given its consent to be deemed an “expert” under the
federal Securities Act of 1933. Past performance is no guarantee of future results.
Before making any investment, consult with your financial advisor. Morningstar
employees may have holdings in the stocks recommended.
Portfolio Value
Date of First # of Shares
Purchase
+/– Change Total
3
Cintas, up a mere 5%. Beyond WaMu, there were no
other fair value estimate changes. œ
Looking at the reasons why the portfolio did so poorly
in December, WaMu was down 30% (and also had an
$8 decrease in its fair value estimate), while American Express AXP and Bank of America also dropped
more than 10%. The best performing stock was
Data through December 31, 2007.
January 2008
Master limited partnership units have
different tax characteristics than common
stocks and may not be suitable for taxdeferred accounts such as IRAs. Please
consult your tax advisor before buying.
2
Cost basis includes commissions.
Includes interest and dividends.
4
Includes capital gains.
5
Returns since inception are annualized
and include dividends.
3
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4
The Hare Portfolio
after an anemic December. The good news is that
the portfolio is in the best position in years to provide
oversized returns, as the stocks in the portfolio
are near an all-time best discount to fair value. Never
before has the Hare been so full of deeply undervalued five-star stocks.
Morningstar Stock Portfolios | Paul Larson
From its inception on June 18, 2001 through Dec. 31,
2007, the Hare portfolio has returned 62.7% compared
with a total return of 35.6% for the S&P 500 Index
and 28.7% for the average large-cap growth mutual
fund. The Hare has outperformed 94.4% of U.S.
large-cap growth funds since inception but only 12.9%
of these funds in 2007.
The Hare had a better year than the Tortoise, but still
fell just short of beating the S&P 500 for the year
The Hare
Portfolio
Performance
and Transaction
Summary
Å 5 Shares added
Í 5 Shares sold
C 5 New holding
5 Not Rated
5 Under Review
Spec 5 Speculative
1Avg 5 Above Average
2Avg 5 Below Average
Avg 5 Average
NR
UR
Portfolio Holdings
Stock Name
CarMax KMX
Compass Minerals Intl CMP
eBay EBAY
MasterCard MA
Vulcan Materials VMC
Paychex PAYX
Fastenal FAST
Western Union WU
International Game Tech IGT
Enterprise GP Holdings EPE
International Speedway ISCA
What is the goal of
the Hare Portfolio?
The Hare Portfolio has two
goals: to outperform the S&P
500 Index and to generate positive returns regardless of the
broad market environment.Companies in this portfolio tend to
either be small or fast growing,
or have a high risk/return
proposition. All companies here
have an economic moat.
Cemex CX
Sysco SYY
Discover Financial Svcs DFS
Microsoft MSFT
Dell DELL
Corporate Exec Board EXBD
Apollo Group APOL
Amgen AMGN
Expedia EXPE
IAC/InterActiveCorp IACI
Boston Scientific BSX
Looking at December, Amgen AMGN, CarMax KMX,
Corporate Executive Board EXBD, Discover
Financial Services DFS, and Vulcan Materials VMC
were all down in excess of 10%. CarMax, because of
its position size, was by far the largest drag on
near-term performance. Our fair value estimates for
all of these firms have not changed, and all five
look cheap enough to consider buying. Compass
Minerals CMP performed the best, up 12%.
Morningstar Ratings & Fundamentals
Star
Rating
Business
Risk
Fair
Value ($)
Current
Price ($)
Consider
Buying
Consider
Selling
Size of
Moat
Dividend
Yield (%)
QQQQQ
QQQQ
QQQQQ
QQ
QQQQQ
Avg
32.00
19.75
24.70
40.10
Narrow
—
∑
Avg
51.00
41.00
39.30
63.90
Wide
3.1
∑
-Avg
49.00
33.19
41.80
64.30
Wide
—
∑
Avg
184.00
215.20
141.90
230.50
Wide
0.3
¥
Avg
144.00
79.09
111.00
180.40
Wide
2.3
∑
QQQQQ
QQQQQ
QQQQQ
QQQ
QQQQQ
-Avg
46.00
36.22
39.20
60.40
Wide
2.8
œ
-Avg
63.00
40.42
53.70
82.70
Wide
1.1
œ
-Avg
32.00
24.28
27.30
42.00
Wide
0.2
¥
Avg
50.00
43.93
38.60
62.60
Wide
1.2
∑
Avg
54.00
37.02
41.60
67.70
Wide
4.0
∑
QQQQQ
QQQQQ
QQQQQ
QQQQQ
QQQ
Avg
63.00
41.18
48.60
78.90
Wide
0.2
¥
Avg
41.00
25.85
31.60
51.40
Narrow
2.9
—
-Avg
38.00
31.21
32.40
49.90
Wide
2.4
∑
Avg
35.00
15.08
27.00
43.90
Narrow
0.8
—
-Avg
35.00
35.60
29.80
46.00
Wide
1.2
œ
Avg
32.00
24.51
24.70
40.10
Wide
—
¥
Avg
93.00
60.10
71.70
116.50
Wide
2.7
¥
Avg
76.00
70.15
58.60
95.20
Wide
—
¥
Avg
66.00
46.44
50.90
82.70
Wide
—
†
Avg
38.00
31.62
29.30
47.60
Narrow
—
¥
QQQQQ Avg
QQQQQ Avg
39.00
26.92
30.10
48.90
Narrow
—
¥
21.00
11.63
16.20
26.30
Wide
—
¥
QQQQ
QQQQQ
QQQ
QQQQQ
QQQQ
Cash Holdings
Hare Portfolio Total
Stewardship
1.8
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10:49 AM
Page 5
We did have one set of positive ratings changes in
December. We upgraded the moat rating on Compass
from narrow to wide after taking a closer look at the
company’s sulfate of potash fertilizer business.
We now believe this particular business would have
a wide moat if all by itself, in addition to Compass’
other low-cost salt mines. We also increased the fair
value estimate from $41 to $51, reflecting very strong
commodity price increases. There were no other fair
value estimate changes during the month.
Paul Larson personally owns shares of the following Hare stocks:
AMGN, APOL-, CMP, CX, DELL, DFS, EBAY, EPE, EXBD, EXPE, FAST,
IACI, IGT, ISCA, KMX+, MA, MSFT, PAYX, SYY, VMC, and WU.
15
25
Total
2
Cost ($)
© 2008 Morningstar, Inc. All rights reserved. Any opinions, recommendations,
or information contained herein: (i) is for educational purposes only; (ii) is not
guaranteed to be accurate, complete, or timely; (iii) has not been tailored to suit
any particular person’s portfolio or holdings; and (iv) should not be construed
as investment advice of any kind. Neither Morningstar nor any of its agents shall
have any liability with respect to such opinions, recommendations, or information.
Morningstar has not given its consent to be deemed an “expert” under the
federal Securities Act of 1933. Past performance is no guarantee of future results.
Before making any investment, consult with your financial advisor. Morningstar
employees may have holdings in the stocks recommended.
Sign up for free Portfolio E-Mail Alerts
Want to find out about changes to our portfolios? Sign up for e-mail
alerts at http://msi.morningstar.com. We’ll let you know what
stock(s) we traded, and why, within 24 hours of any transaction.
Portfolio Performance Breakdown
Portfolio Value
Cost Basis/
2
Share ($)
5
I made no trades in December. Much like the Tortoise,
there was a meaningful increase in trading activity
in 2007. Turnover in the Hare was 37.5% for the year,
more than double the average turnover the previous
three years. Much like the Tortoise, I expect the
higher level of portfolio activity to continue in 2008. œ
Portfolio Transactions
January 2008
Ticker
Date of First # of Shares
Purchase
+/– Change Total
Current
Value ($)
% Gain / % of
KMX
01-20-04
0
1100
14.71
16181.44
21725.00
34.3
12.2
CMP
08-18-05
0
350
24.26
8490.48
14350.00
69.0
8.1
EBAY 04-20-06
0
330
33.08
10917.98
10952.70
0.3
6.2
MA
05-30-06
0
50
44.00
2199.99
10760.00
389.1
6.0
VMC
10-03-07
0
120
87.53
10503.68
9490.80
-9.6
5.3
Loss
Portfolio
Index
Level
Trailing Return (%)
This
Month
12 Month
Since5
Inception
-3.3
5.2
7.7
Hare Portfolio
S&P 500 Index
1468.4
-0.7
5.5
4.8
NASDAQ Composite
2652.3
-0.3
10.7
4.7
% Total Return
120
PAYX
06-24-02
0
250
28.55
7138.50
9055.00
26.9
•Hare Portfolio • S&P 500 Index
5.1
80
FAST
01-29-07
0
220
38.56
8482.65
8892.40
4.8
5.0
WU
10-02-06
0
365
17.74
6474.63
8862.20
36.9
40
5.0
IGT
06-27-05
0
200
28.35
5669.00
8786.00
55.0
4.90
EPE
05-29-07
0
235
37.74
8867.87
8699.70
-1.9
4.9
80
40
0
-40
ISCA
01-06-06
0
210
47.19
9910.09
8647.80
-12.7
4.9
CX
12-11-06
0
330
29.06
9588.98
8530.50
-11.0
4.8
SYY
10-09-03
0
250
31.98
7996.00
7802.50
-2.4
4.4
DFS
08-08-07
0
500
21.39
10694.45
7540.00
-29.5
4.2
MSFT 08-22-05
0
150
26.30
3945.63
5340.00
35.3
3.0
09-21-01
0
200
20.39
4078.00
4902.00
20.2
EXBD 07-10-07
0
80
67.76
5421.14
4808.00
APOL 08-02-04
0
60
66.81
4008.83
AMGN 06-11-02
0
75
38.80
2910.25
DELL
06-01
06-03
06-04
Top Five Sectors (%)
06-05
06-06
34.0
19.2
5
15
28
Lrg
d Ind Mtrls.
a Financial Srvcs
18.6
0
12
22
Med
2.8
0
0
Sm
2.7
g Utilities
13
-11.3
4209.00
5.0
2.4
3483.00
19.7
2.0
EXPE
01-11-05
0
100
22.73
2273.12
3162.00
IACI
01-11-05
0
100
28.39
2838.87
2692.00
-5.2
1.5
BSX
06-18-01
0
160
8.60
1376.00
1860.80
35.2
1.0
3676.99 3
178228.39
4
39.1
1.8
2.1
100.0
06-07
Style Breakdown (%)
o Consumer Srvcs
p Business Srvcs
Value Blend Growth
9.4
p50 –100
p25 – 50
p10 – 25
p0 – 10
5.0
Morningstar ratings and fundamentals as of 12-31-07. Portfolio inception date: 6-18-01.
1
Cash Holdings
06-02
Master limited partnership units have
different tax characteristics than common
stocks and may not be suitable for taxdeferred accounts such as IRAs. Please
consult your tax advisor before buying.
2
Cost basis includes commissions.
Includes interest and dividends.
4
Includes capital gains.
5
Returns since inception are annualized
and include dividends.
3
Focus_0108.qxp
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6:43 PM
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6
Bank of America BAC
Paul’s Position
Bank of America should survive the current turmoil.
Tortoise Stock Focus | Ganesh Rathnam
Rating
1-Yr High/Low
Fair Value
Current Price
Consider Buy
Consider Sell
QQQQQ
$54.21/40.61
$70.00
$41.26
$54.00
$87.70
Size of Moat
Business Risk
Market Cap
Dividend Yield Revenues
Wide
Avg
$183.1 bil
5.8%
Stewardship
∑
$72.6 bil
• Bank of America
% Change in Price
• S&P 500 Index
250
200
150
100
Morningstar’s Take
B of A’s retail operation—accounting for half of
profits—is the company’s standout performer. The
bank provides comprehensive retail services to
more than 38 million customers via 5,750 branches in
29 states. Because of this reach, non-interest-bearing
deposits constitute $175 billion, or 25%, of the
bank’s deposit base, dwarfing those of competitors.
The bank is also the premier credit card, smallbusiness, and home-equity lender in the country. We
believe B of A is the bank of choice for consumers
because of its array of products to fit every financial
need and its geographic reach that affords seamless
service to customers while traveling or relocating.
50
0
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
Profile
Bank of America provides commercial, retail, wealth-management,
and foreign banking services; originates home mortgage loans;
and operates full-service and discount securities businesses. It also
issues credit cards and provides computer banking services. The
company offers securities underwriting and other investment
banking services to corporations.
Management and
Stewardship
Chairman and CEO Ken Lewis succeeded his mentor, Hugh McColl,
in 2001. Although Lewis began by refocusing on profitable, internal
growth, he has taken the bank down an aggressive merger-growth
path, acquiring FleetBoston in 2004, MBNA in 2006, and LaSalle in
2007. In 2006, he earned $25.6 million in salary, bonus, and stock
compensation—high by any measure, but not out of line with other
large financial firms. Corporate governance appears relatively good,
but could improve. Our concerns center on the big compensation
packages—six other top executives earned $66.5 million collectively in 2006—and the fact that Lewis is both chairman and CEO.
But shareholders can use the services of a lead independent
director to air grievances, and insiders collectively own 46 million
shares, enough to align their interests with shareholders’.
Valuation
Our fair value estimate is $70 per share. We assume annual asset
growth will be about 6% during the next five years, mirroring
historical U.S. nominal GDP growth. In light of the turmoil in the
credit and mortgage markets, we’ve ratcheted up our charge-off
assumption to 0.86% of loans in 2007 and 1.11% of loans in 2008
from 0.71% in 2006. We expect charge-offs to average 0.82% of
loans thereafter until 2011. We forecast the net interest margin to
decline to 2.73% in 2007 from 2.96% in 2006 before recovering to
3.13% in 2011. We project modest gains in the efficiency ratio.
B of A’s corporate and investment bank and wealthmanagement business account for the other half
of profits, mainly via fee income. The investment bank
revolves around loan syndication. Number two in
loan volume, B of A is often lead underwriter for syndicated loans and collects commissions from both
borrowers and syndicate partners for performing due
diligence. This intimate contact with clients also
gives B of A opportunistic business in equity underwriting and merger and acquisition advisory.
Perhaps the biggest growth driver is the wealthmanagement business. Including its Columbia mutual
funds, B of A already has more than $500 billion in
assets under management. However, only 10% of B of
A’s estimated 8 million affluent customers currently
avail themselves of its wealth-management products.
B of A can rapidly increase fees in this division just by
roping in more of its checking account customers.
The bank is focusing on just this by motivating retail
employees to make referrals to the private bank.
Despite its size—nearly 10% share of domestic
deposits—the bank has been surprisingly agile in
pouncing on opportunities. It purchased LaSalle Bank
from ABN Amro ABN to become the top dog in
the competitive but attractive Chicago market. Opportunistic acquisitions such as this will only make
B of A a more formidable competitor. œ
Focus_0108.qxp
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6:43 PM
Page 7
Rating
1-Yr High/Low
Fair Value
Current Price
Consider Buy
Consider Sell
QQQQQ
$128.62/77.04
$144.00
$79.09
$111.00
$180.40
Size of Moat
Business Risk
Market Cap
Wide
Avg
$7.6 bil
2.3%
Stewardship
∑
$3.3 bil
• Vulcan Materials
• S&P 500 Index
310
7
Paul’s Position
Real estate construction volume is falling today, but
the story concerning pricing is very good.
Hare Stock Focus | Matthew Warren
% Change in Price
January 2008
250
190
130
When a contractor buys stone, sand, or gravel, it’s
motivated to use the nearest quarry. The economics
are simple: Stone aggregates cost about $8 per ton
at the plant site—a rough average that varies widely
based on regional scarcity—but incur an additional $0.10-$0.15 per ton for every mile in the back of
a truck. In general, transportation costs reduce a
quarry’s addressable market to a 50-mile radius.
(Markets lacking quarries are the exception, and they
are usually served by rail or water.) Vulcan sits in
a strong position, as it owns quarries in nine of the 10
fastest-growing cities in the nation.
70
10
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
Profile
Vulcan’s main business is aggregate quarries, which produce stone,
sand, and gravel for use mostly in concrete and asphalt. Aggregates make up about 70% of net sales while asphalt and ready-mix
concrete make up the balance. The public highway and infrastructure end markets consume nearly half of total production, with the
balance going toward commercial and residential construction.
Management and
Stewardship
Donald M. James has been chairman and CEO since 1997. He leads
a seasoned team that has shown skill in carving out a leading lowcost position. Management pay practices are in line with the
industry, and bonuses are tied to various metrics including
economic profit. We’re most impressed by management’s ability to
sniff out fast-growing markets and establish leading positions
there. The company has excelled with acquisitions, which is crucial
in an asset-driven business where resources are scarce and dwindling. Management and board members own 3.5% of the company
(including options), helping align their interests with those of
outside shareholders.
Valuation
We think Vulcan is worth $144. Impressive price increases in the
face of declining volume of late continue to dramatize Vulcan’s
moat. Homebuilding activity has slowed substantially, and it’s plausible that commercial construction could reverse recent growth
trends. However, infrastructure projects should prove much more
steady. Rapid industry consolidation makes us confident Vulcan will
continue to push through price gains ahead of cost inflation. We
model 8% compound annual sales growth over the next five years
(largely back-end loaded), despite lowered expectations for
volumes over the next year or two. We also have high operating
margin expectations, projecting a climb to 25% within five years.
Strategically located sites like these sustain their
competitive advantage as new quarry permits are
elusive at best. NIMBY—not in my back yard—objections are pervasive, as local governments are loath to
allow a quarry’s noise, dust, and truck traffic into their
communities. The resulting supply constraint creates a
favorable pricing environment. In fact, aggregate
companies have a history of pricing ahead of inflation.
Vulcan’s sheer size—it has a 10% share of the highly
fragmented aggregate market—has other advantages.
Management has significant leverage when negotiating with suppliers. With its financial strength and
operating experience, Vulcan and other large public
competitors are also able to ration new supply
to the market as needed, long before any new entrant
can gain a foothold. Plus, these industry behemoths control the long-haul markets, helping to maintain rational pricing and an impressive return on assets.
Aggregates exhibit much lower volatility than many
other construction supply businesses because
about half of total sales are tied to public infrastructure projects. These aggregate-intensive endeavors
are politically popular because of the numerous
jobs they create and the tangible benefits they provide
to constituents. They also receive dedicated federal
funding from gasoline taxes, which is matched and
supplemented on both the state and local levels. œ
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8
All the companies on this watchlist have wide economic
moats. Go to http://msi.morningstar.com to track changes
throughout the month.
Bellwether Watchlist
Company Name
Star
Rating
Bus.
Risk
Fair
Current Consider Consider
Yield
Value ($)* Price ($) Buying ($) Selling ($) Stew. (%)
P/E
Portfolio
Comment
QQQQQ -Avg 103.00
84.32
87.80 135.20 X 2.3 14.1
Abbott Laboratories ABT
QQQQ
-Avg
63.00
56.15
53.70
82.70 C 2.3 45.7
Debated in May 2006 “Bulls vs. Bears” feature. Now a
diversified health-care giant. Raised fair value in Dec.
Adobe Systems ADBE
QQQ
Avg
39.00
42.73
30.10
48.90 C
— 37.9
Network effect and switching costs create a superwide
moat. Featured July 2006.
Advisory Board ABCO
QQ
Avg
52.00
64.19
40.10
65.20 C
— 41.7
Similar to Corp. Executive Board, but focused on healthcare and education sectors. Highlighted in Sept. 2007.
Aflac AFL
QQQ
Avg
55.00
62.63
42.40
68.90 X 1.3 19.7
Alcon ACL
QQ
-Avg 112.00
143.04
Allergan AGN
QQ
Avg
57.00
64.24
44.00
71.40 C 0.3 40.8
Specialty pharmaceutical company that derives more than
one third of its revenue from Botox.
AllianceBernstein Hlding AB
QQQ
Avg
79.00
75.25
60.90
99.00 V 6.3 15.1
Top-tier asset manager experiencing robust growth from
rising international equity markets.
Altria Group MO
QQQ
+Avg
83.00
75.58
52.90 100.10 C 4.0 13.2
] 3M Company MMM
95.40 147.00 C 1.4 32.7
Innovation and manufacturing skills are the cornerstone of
its moat. Featured May 2007.
Wide-moat life insurers are very rare. Last featured in the
May 2006 issue.
Ophthalmic leader currently benefiting from Bausch &
Lomb’s problems.
Litigation environment stabilizing. Kraft spin-off
completed in April.
[ Amazon.com AMZN
Q
Avg
45.00
92.64
34.70
56.40 Z
] American Express AXP
QQQQQ -Avg
70.00
52.02
59.60
91.90 Z 1.2 14.9
Potential legal windfall from competitors. Earnings looked
decent, despite credit environment. Featured Sept. 2007.
] Amgen AMGN
QQQQQ Avg
66.00
46.44
50.90
82.70 V
Top-shelf biotech firm, but main drugs have come under
fire in 2007. Spotlighted August 2007.
Anheuser-Busch BUD
QQQ
-Avg
57.00
52.34
48.60
74.80 Z 2.4 19.1
Controls more than 50% of domestic beer market. New
Busch-family CEO in 2006. Debated in March 2006 issue.
Apollo Group APOL
QQQ
Avg
76.00
70.15
58.60
95.20 C
— 29.9
Largest for-profit education firm, with more than 300,000
students. Recovery looks complete. Debated in Feb. 2007.
QQQQQ Avg
25.00
17.76
19.30
31.30 C 1.3 14.8
Semiconductor equipment standard-bearer. Technological
lead and broad product portfolio. Raised fair value in Dec.
QQQ
Avg
50.00
49.76
38.60
62.60 C
AutoCAD software has high switching costs. Featured
Oct. 2006.
QQQQQ -Avg
53.00
44.53
45.20
69.60 X 2.2 23.6
Client turnover very low. Spun off Broadridge Financial in
April. Lower interest rates actually hurt earnings.
QQQ
Avg
44.00
39.53
33.90
55.10 X 1.9 29.8
Brands and direct-sales model lead to high and consistent
returns on capital. Debated in Sept. 2006 “Bulls vs. Bears.”
QQQQQ Avg
70.00
41.26
54.00
87.70 X 5.8
A retail-banking juggernaut. Bought in Tortoise in April
and June. Spotlighted in July.
Bank of New York Mellon BK
QQQ
Avg
53.00
48.76
40.90
66.40 X 1.9 21.7
Berkshire Hathaway BRK.B
QQQ
-Avg 5000.00 4736.00 4260.50 6564.50 Z
— 15.9
Buffett still going strong. Firm continues to create copious
amounts of value. Could benefit from credit turmoil.
Biogen Idec BIIB
QQQQ
Avg
73.00
56.92
91.50 X
— 34.3
Tysabri is back, and growth appears to be reaccelerating.
Company’s effort to sell itself put on ice in Dec.
[ Blackrock BLK
Q
Avg 168.00
216.80
129.50 210.50 C 1.2 32.4
Merged with Merrill Lynch’s asset-management business.
Featured April 2006.
[ Blackstone Group LP BX
Q
+Avg
17.00
22.13
10.80
20.50 V 1.4
] Boardwalk Pipeline Prtnrs BWP
QQQQQ -Avg
38.00
31.10
32.40
49.90 C 5.6 16.4
] Applied Materials AMAT
Autodesk ADSK
] Automatic Data Prcssng ADP
Avon Products AVP
] Bank of America BAC
56.30
— 106.4
— 16.8
— 34.1
9.4
—
Head and shoulders above the competition in online
retailing. Featured Jan. 2007.
Getting out of retail banking to focus on securities
servicing. Mellon acquisition closed in July.
2007 IPO. Private-equity titan has generated fantastic
returns. Featured Oct. 2007.
Natural-gas pipeline company well positioned for growth.
Structured as a master limited partnership.
*Fair value based on Morningstar analyst estimates. Data through December 31, 2007. UR 5 Under Review –Avg 5 Below Average +Avg 5 Above Average ] 5 Stocks to consider buying [ 5 Stocks to consider selling
Bell_0108.qxp
1/3/08
6:44 PM
Page 9
Company Name
Bus.
Risk
Fair
Yield
P/E
Portfolio
9
Comment
QQQQQ Avg
21.00
11.63
16.20
26.30 C
— 32.3
Struggling with recent recalls and safety concerns, as
well as higher competition.
Bristol-Myers Squibb BMY
QQQ
Avg
29.00
26.52
22.40
36.30 C 4.2 24.8
Pharmaceutical firm experienced several management
miscues in recent years.
Brown & Brown BRO
QQQQ
Avg
30.00
23.50
23.10
37.60 Z 1.1 17.0
Stout returns on capital created by innovative incentive
structure and disciplined acquisitions.
QQQQQ -Avg
34.00
28.19
29.00
44.60 C 3.5 44.1
Owns general partner of Buckeye Partners LP. General
partner’s returns are leveraged.
Buckeye Partners LP BPL
QQQQ
-Avg
58.00
49.41
49.40
76.10 C 6.5 16.9
Pipeline firms tend to have moats because of their
geographic advantage. Buckeye is among our favorites.
Calamos CLMS
QQ
Avg
26.00
29.78
20.00
32.60 V 1.5 25.5
Asset management can be a fantastic business, as
evidenced by the firm’s 50% operating margins.
] Campbell Soup CPB
QQQQ
-Avg
42.00
35.73
35.80
55.10 C 2.4 16.9
Strong brands and market share in excess of 70%. Perfect
potential Tortoise stock. Featured Sept. 2007.
] Capital One Financial COF
QQQQQ Avg 115.00
47.26
88.70 144.10 X 0.2
QQQ
Avg
77.00
72.56
CH Robinson Worldwide CHRW QQQ
Avg
52.00
Checkfree CKFR
QQQ
Avg
Chicago Merc Exchange CME
QQQ
] Boston Scientific BSX
] Buckeye GP Holdings BGH
Caterpillar CAT
7.0
Strategy provides an advantage in customer targeting and
pricing risk appropriately. Featured Oct. 2007.
59.40
96.50 X 1.8 14.0
Sensitive to economic cycles, so near-term results may be
bumpy. A well-run firm nevertheless. Featured June 2006.
54.12
40.10
65.20 X 1.4 30.2
Leading truck brokerage with an interesting business
model. Benefits from scale advantages.
47.00
47.60
36.20
58.90 V
— 35.0
Leader in electronic bill payment and processing. In
process of being acquired by Fiserv. Featured Oct. 2006.
Avg 642.00
686.00
495.00 804.40 X 0.5 48.5
Hall of Fame member of Hare. Enjoys network effect,
leading to huge profit growth. CBOT purchase complete.
] Cintas CTAS
QQQQQ -Avg
47.00
33.62
40.00
61.70 Z 1.2 16.2
Economies of scale story. Purchased in Tortoise in May
2007. Spotlighted in June.
] Cisco Systems CSCO
QQQQQ Avg
37.00
27.07
28.50
46.40 X
Still 800-pound gorilla of networking. Retaking significant
market share. Featured Dec. 2006.
] Citigroup C
QQQQQ Avg
53.00
29.44
40.90
66.40 X 7.3
7.9
New CEO named in December. Taking SIV assets onto
balance sheet. Recently received dilutive capital infusion.
Coca-Cola KO
QQQ
-Avg
60.00
61.37
51.10
78.80 C 2.2 26.3
Perhaps one of the longest-lived moats around because of
its brands and business model.
Colgate-Palmolive CL
QQ
-Avg
71.00
77.96
60.50
93.20 X 1.8 24.7
Large overseas exposure, benefitting from the dollar’s
weakness. Recently sold from Tortoise Portfolio.
QQQQQ Avg
27.00
18.26
20.80
33.80 C
Unmatched ability to offer multiple services over one
connection. Featured this issue.
QQQQ
Avg
51.00
41.00
39.30
63.90 X 3.1 24.0
New addition. Low cost provider of salt. Near-monopoly
position in sulfate of potash fertilizer. In Hare portfolio.
] Corporate Exec Board EXBD
QQQQQ Avg
93.00
60.10
71.70 116.50 C 2.7 28.5
Collects and sells best-practices intelligence. Bought in
Hare in July. Spotlighted in August issue.
] Dell DELL
QQQQ
Avg
32.00
24.51
24.70
40.10 C
DeVry DV
QQQ
Avg
51.00
51.96
39.30
63.90 C 0.2 45.3
Dun & Bradstreet DNB
QQQ
-Avg
87.00
88.63
74.10 114.20 C 1.1 18.9
Eaton Vance EV
QQQ
Avg
42.00
45.41
32.40
52.60 X 1.1 42.9
Money-management firm with below-average customer
turnover. Featured Jan. 2006. Raised fair value in Dec.
QQQQQ -Avg
49.00
33.19
41.80
64.30 X
—
—
In Hare Portfolio. Great example of network effect. PayPal
going very strong. Featured Aug. 2006 and Feb. 2007.
Electronic Arts ERTS
QQQ
Avg
61.00
58.41
47.00
76.40 X
—
—
Profits ebb and flow with video game console cycle, but
strong long-term growth expected.
Eli Lilly & Company LLY
QQQQ
Avg
61.00
53.39
47.00
76.40 X 3.2 26.0
] Comcast CMCSA
C
Star
Rating
January 2008
Compass Minerals Intl CMP
] eBay EBAY
Stew. 5 Morningstar Stewardship Grade C 5 New Addition
5 Potential Tortoise Portfolio Holding
— 21.5
— 24.0
— 18.6
5 Potential Hare Portfolio Holding
Facing competitive pressures, but Michael Dell back in
charge. In Hare Portfolio. Reduced fair value in Dec.
For-profit education companies tend to be very profitable.
Featured March 2007. Raised fair value in Dec.
Database model characterized by high barriers to entry
and low incremental costs.
Leading maker of mental health drugs. Enjoys fastgrowing portfolio of new branded drugs.
Bell_0108.qxp
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6:44 PM
Page 10
10
Company Name
Star
Rating
Bus.
Risk
Fair
Yield
P/E
Portfolio
Comment
QQQQQ Avg
54.00
37.02
41.60
67.70 X 4.0 38.6
Owns general partners of TEPPCO and Energy Transfer.
Purchased in Hare Portfolio in May 2007.
Equifax EFX
QQQQ
Avg
42.00
36.36
32.40
52.60 C 0.4 17.9
Credit bureaus operate in an oligopoly. Like other database firms, enjoys high entry barriers.
Exelon EXC
QQQ
Avg
88.00
81.64
67.90 110.30 X 2.2 20.2
QQQQ
-Avg
53.00
44.68
45.20
ExxonMobil XOM
QQQ
-Avg
96.00
93.69
81.80 126.00 X 1.5 13.6
Fannie Mae FNM
Not Rated
+Avg
—
39.98
—
— V 4.5 24.1
QQQQQ -Avg
63.00
40.42
53.70
82.70 Z 1.1 27.5
Interesting distributor focused on the fastener market.
Spotlighted March 2007. In Hare Portfolio.
Federated Investors FII
QQQQ
Avg
48.00
41.16
37.00
60.10 C 2.0 19.5
Major player in the money-management industry.
Featured Dec. 2006.
Fiserv FISV
QQQ
Avg
62.00
55.49
47.80
77.70 C
The nation’s largest bank processing firm. Enjoys significant customer switching costs. Featured Sept. 2007.
Fortress Investment Group FIG
QQQ
+Avg
17.00
15.58
10.80
20.50 V 5.1
Forward Air FWRD
QQQQ
Avg
40.00
31.17
30.80
50.10 X 0.9 21.2
Franklin Resources BEN
QQQ
Avg 117.00
114.43
Freddie Mac FRE
Not Rated
] Enterprise GP Holdings LP EPE
] Expeditors Intl of WA EXPD
] Fastenal FAST
69.60 Z 0.6 37.9
— 20.8
0.0
90.20 146.60 Z 0.6 16.3
+Avg
—
34.07
—
— V 5.1 12.0
61.40 V 0.2 24.7
Recent watchlist addition. Large fleet of nuclear plants for
generating electricity give massive cost advantage.
Freight consolidation business model benefits from
network effect, scale advantages.
Largest, most efficient oil company on the planet.
We discussed oil in December issue.
Firm recently became current in filing financial statements, but now mortgage market woes loom.
Runs large hedge fund and private-equity shop. Featured
July 2007.
Has no rival with the same scale and service quality.
Owns some of the best-established brand names in the
mutual fund industry. Raised fair value in October.
Recently cut dividend and took on capital infusion to
shore up the balance sheet. Mortgage problems loom.
[ Gamco Investors GBL
Q
Avg
49.00
69.20
37.80
] Genentech DNA
QQQQQ Avg
91.00
67.07
70.20 114.00 X
General Dynamics GD
QQQ
Avg
87.00
88.99
67.10 109.00 Z 1.2 18.6
General Electric GE
QQQQ
Avg
45.00
37.07
34.70
56.40 X 3.1 16.6
Leader in large number of industries. Global infrastructure
buildout behind renewed growth. Featured Feb. 2007.
Genzyme GENZ
QQQ
Avg
75.00
74.44
57.80
94.00 X
Upgraded to wide moat because of improving operating
efficiency. Global salesforce.
Goldman Sachs Group GS
QQQ
Avg 220.00
215.05
— 26.2
— 161.3
169.60 275.60 X 0.7
8.8
Asset manager with $30B under management. Mario
Gabelli’s name excellent advertising for Gamco’s products.
One of our favorite biotech companies with strong
research and development capabilities.
Focused on cash generation and allocates capital with
discipline. In Tortoise Portfolio.
Simply the gold standard among investment banks. Strong
recent earnings despite material weakness at peer firms.
] Graco GGG
QQQQQ Avg
50.00
37.26
38.60
62.60 X 1.8 16.4
Standout among industrial firms, dominant in several
niche markets. Spotlighted in May 2007 issue.
] H & R Block HRB
QQQQQ Avg
26.00
18.57
20.00
32.60 C 3.0 16.4
Shuttered OptionOne mortgage business after sale failed.
Core tax business stil healthy. Featured this issue.
QQQQ
Avg
60.00
46.71
46.30
75.20 X 2.3 11.9
One of the strongest and most profitable brands on the
planet. Featured Feb. 2007.
] Hershey Company HSY
QQQQQ -Avg
52.00
39.40
44.30
68.30 C 2.9 29.4
Largest candymaker in the U.S., with a 30% share. Wide
portfolio of consumer brands. Featured July 2007.
] Home Depot HD
QQQQQ -Avg
44.00
26.94
37.50
57.80 C 3.3 10.7
One of only a handful of wide-moat retailers. Sale of
supply business complete. Featured Sept. 2007.
-Avg 120.00
108.10
Harley-Davidson HOG
IBM IBM
] IMS Health RX
Intel INTC
QQQ
102.30 157.50 X 1.4 16.2
Bread and butter is servicing rat’s nest of IT infrastructure
at core of most firms. Featured Feb. 2006.
QQQQQ Avg
32.00
23.04
24.70
40.10 C 0.5 16.3
Moat comes from hard-to-replicate database of global
pharmaceutical sales. Recent earnings spooked market.
QQQ
26.00
26.66
20.00
32.60 X 1.7 25.4
Facing competitive pressure from AMD, but still wide
moat. Featured May 2006.
Avg
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Page 11
Company Name
[ IntercontinentalExchange ICE
Star
Rating
Q
Bus.
Risk
Fair
Yield
+Avg 155.00
192.50
98.80 186.90 X
P/E
Portfolio
— 58.5
January 2008
11
Comment
2006 IPO. Electronic exchange focused on energy futures.
Benefits from network effect.
Avg
50.00
43.93
38.60
62.60 X 1.2 29.1
Slot machine manufacturer with about 70% share. In Hare
Portfolio. Featured April 2007.
QQQQQ Avg
63.00
41.18
48.60
78.90 C 0.2 30.5
Strong relationship with Nascar sanctioning body. Abandoning NYC and WA efforts. Featured in Nov. issue.
Intuit INTU
QQQ
Avg
33.00
31.61
25.40
41.30 X
— 24.7
Dominates small-business accounting, tax prep, and
personal finance software. Featured Sept. 2007.
Iron Mountain IRM
QQ
-Avg
33.00
37.02
28.10
43.30 Z
— 46.3
Document storage provides high switching costs and
recurring revenue stream. Raised fair value in Dec.
QQQQQ Avg
63.00
43.65
48.60
78.90 Z 3.3
International Game Tech IGT
] International Speedway ISCA
] J.P. Morgan Chase & Co. JPM
QQQ
9.5
Banking behemoth led by former winner of Morningstar
CEO of the Year award. In Tortoise. Featured April 2007.
Jack Henry & Associates JKHY QQQ
-Avg
25.00
24.34
21.30
32.80 X 1.1 20.8
Bank processing firm focused on smaller banks. Enjoys
high customer switching costs.
QQQ
-Avg
47.00
42.84
40.00
61.70 X 1.0 19.9
Publisher enjoys high returns on capital. Science and
technical franchises especially lucrative.
QQQQQ -Avg
80.00
66.70
68.20 105.00 C 2.4 18.8
John Wiley & Sons JW.A
] Johnson & Johnson JNJ
Health-care giant recently completed purchase of Pfizer’s
consumer business. Featured in June issue.
Kinder Morgan Energy Ptnr KMP UR
-Avg
UR
53.99
UR
UR Z 6.3
—
Largest master limited partnership focused on energy
transport and storage. Pipelines tend to have moats.
Kinder Morgan Mgmt KMR
UR
-Avg
UR
52.94
UR
UR Z 6.4
—
Different share class of KMP without MLP tax complexity.
Pays in shares instead of cash. Featured Feb. 2007.
KLA-Tencor KLAC
QQQ
Avg
52.00
48.16
40.10
65.20 C 1.1 20.1
Stock option backdating mostly in the rear view. Still
dominates certain niches of semiconductor industry.
Landstar System LSTR
QQQQ
Avg
51.00
42.15
39.30
63.90 Z 0.3 21.6
Recent Addition. Very similar to C.H. Robinson, benefitting
from network effect.
] Legg Mason LM
QQQQQ Avg 116.00
73.15
89.40 145.30 C 1.3 14.8
Now among the largest asset managers on the planet.
Featured Dec. 2006.
] Linear Technology LLTC
QQQQQ Avg
42.00
31.83
32.40
52.60 X 2.3 22.4
Among semiconductor companies, lower risk. Featured
Oct. 2006.
Avg 102.00
105.26
Lockheed Martin LMT
] Lowe’s Companies LOW
QQQ
QQQQQ -Avg
78.70 127.80 X 1.4 15.3
Improved efficiency and being sole provider of many key
defense items prompted recent moat upgrade.
39.00
22.62
33.20
51.20 X 1.2 11.4
Not many retailers have wide moats, but Lowe’s does.
Recently lowered outlook. Recently purchased in Tortoise.
Magellan Midstream Hldgs MGG QQQQ
-Avg
31.00
26.80
26.40
40.70 C 4.0 28.8
General partner of pipeline firm MMP. Higher growth but
slightly higher risk than MMP. Featured Oct. 2007.
Magellan Midstream Part MMP QQQ
-Avg
46.00
43.36
39.20
60.40 C 5.8 17.3
Long-haul oil pipelines and energy storage assets. Advantage period several decades.
QQQQQ Avg
44.00
26.47
33.90
55.10 X 2.9 18.7
Regulatory woes appear to be mostly behind this firm.
Featured Oct. 2007.
Avg 143.00
132.60
110.30 179.20 X 0.9 21.9
High transportation costs of low-value goods gives
geographic advantage. Spotlighted Nov. 2007.
Avg 184.00
215.20
141.90 230.50 C 0.3 35.7
One of three major global card systems. Benefits from
cash-to-plastic shift. In Hare. Featured Jan. 2007.
] Marsh & McLennan Cos MMC
Martin Marietta Materials MLM QQQ
MasterCard MA
QQ
QQQQQ Avg
46.00
26.48
35.50
57.60 X 2.6 19.3
Analog semiconductor expertise in short supply. Dropped
from S&P 500 in Sept. 2007.
McCormick MKC
QQQ
-Avg
37.00
37.91
31.50
48.60 X 2.2 22.4
More than 2 times larger than its next competitor in
spices and seasonings. Featured Jan. 2007.
McDonald’s MCD
QQQ
-Avg
54.00
58.91
46.00
70.90 Z 2.6 39.5
Brand and scale make Golden Arches unique. Spotlighted
in May issue.
] McGraw-Hill Companies MHP
QQQQQ -Avg
63.00
43.81
53.70
82.70 X 1.9 14.3
Publisher and parent of S&P has very wide moat. Debt
rating business under pressure. Featured Oct. 2007.
] Medtronic MDT
QQQQQ -Avg
62.00
50.27
52.80
81.40 X 0.9 20.3
Largest medical-equipment maker with wide product portfolio and technological lead. Featured July 2007.
] Maxim Integrated Prdcts MXIM
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Page 12
12
Company Name
Star
Rating
Bus.
Risk
Merck MRK
QQ
+Avg
50.00
58.11
31.90
60.30 C 2.6 23.6
Merrill Lynch & Company MER
UR
Avg
UR
53.68
UR
UR X 2.6 12.2
Massive write-down in recent earnings. Large army of
brokers make assets “sticky” to the firm.
Microsoft MSFT
QQQ
-Avg
35.00
35.60
29.80
46.00 Z 1.2 23.4
Gates to step down from day-to-day role to run charity.
New Vista software selling now. Featured Dec. 2006.
] Moody’s MCO
QQQQQ -Avg
65.00
35.70
55.40
85.30 X 0.9 11.7
Markets prefer fewer voices to many. Pressured from
subprime mess. In the Tortoise. Featured Nov. 2007.
] Morgan Stanley MS
QQQQQ Avg
70.00
53.11
54.00
87.70 C 2.0
Diversified investment bank, recently freed from conservative management.
] News Corporation NWS
QQQQ
-Avg
25.00
21.25
21.30
32.80 V 0.5 15.5
Purchase of Dow Jones complete. Recently launched
FoxBusiness channel. Featured in May issue.
QQQ
Avg
65.00
64.24
50.10
81.40 X 1.5 19.4
Strong brands translate to high returns. Featured August
2007.
Q
Avg
56.00
76.58
43.20
70.20 C 1.3 22.1
Focused on large institutions and the wealthy. Sold from
Tortoise in June. Reduced fair value in December.
133.61
Nike NKE
[ Northern Trust NTRS
Fair
Yield
P/E
6.1
75.80 143.50 X 0.2 60.2
Portfolio
Comment
Vioxx mess explains above-average risk. Sold completely
from Tortoise last year. Featured Sept. 2006.
NYMEX Holdings NMX
QQQ
+Avg 119.00
ONEOK Partners OKS
QQQQ
-Avg
70.00
61.25
59.60
91.90 C 6.5 16.6
Pipeline firm changed name from Northern Border Partners. Like most pipelines, very long advantage duration.
Oracle ORCL
QQQ
Avg
22.00
22.58
17.00
27.60 X
While wide moat is being tested, maintains enviable position in the database market.
QQQQQ -Avg
46.00
36.22
39.20
60.40 Z 2.8 25.1
QQQ
-Avg
77.00
75.90
65.60 101.10 X 1.9 20.4
QQQQQ Avg
31.00
22.73
23.90
38.80 C 5.1 22.5
Lipitor facing significant competition from generics.
Featured Feb. 2007. In Tortoise Portfolio.
Pitney Bowes PBI
QQQ
Avg
43.00
38.04
33.20
53.90 X 3.5 14.3
Long and dominant history in the postage meter industry,
but facing challenges from alternatives to direct mail.
Procter & Gamble PG
QQQ
-Avg
77.00
73.42
65.60 101.10 X 1.9 23.2
QQQQQ Avg
28.00
19.16
21.60
35.10 Z
Qualcomm QCOM
QQQQ
Avg
48.00
39.35
37.00
60.10 Z 1.4 20.2
Intellectual property powerhouse in wireless industry.
Patents provide very high-margin revenue stream.
Renaissance Re Holdings RNR
QQQQ
+Avg
80.00
60.24
51.00
96.50 X 1.5
6.2
Highly technical underwriting skills. Benign hurricane
season in 2006 and 2007 benefited all insurers.
Schering-Plough SGP
QQQQ
+Avg
38.00
26.64
24.20
45.80 X 0.9 21.0
Not as attractive a business as other pharmaceutical
companies, but still wide moat.
SEI Investments SEIC
QQ
-Avg
27.00
32.17
23.00
35.40 X 0.2 24.1
Strong technology platform to offer investmentprocessing services to private-banking and trust clients
] St. Joe JOE
QQQQQ Avg
50.00
35.51
38.60
62.60 X 1.4 80.7
Recent addition to the watchlist. Owns huge amounts of
undeveloped land in Florida. Featured in July issue.
] Starbucks SBUX
QQQQQ Avg
36.00
20.47
27.80
45.10 X
Strong brand creates large barrier to success in industry.
Spotlighted in the July issue.
[ State Street STT
Q
Avg
62.00
81.20
47.80
77.70 X 1.1 21.3
Majority of revenue and profits come from the bank’s feebased businesses.
Stericycle SRCL
QQ
Avg
52.00
59.40
40.10
65.20 X
Medical waste is a noncyclical business, and Stericycle
has a dominant share.
Strayer Education STRA
QQQ
Avg 174.00
170.58
Stryker SYK
QQ
-Avg
] Paychex PAYX
PepsiCo PEP
] Pfizer PFE
] Progressive PGR
61.00
74.72
— 24.8
— 10.5
— 23.5
— 43.3
134.20 218.00 Z 0.8 40.2
52.00
80.10 C 0.4 32.9
Exchange dominates trading in energy markets.
Payroll processor focused on small businesses that are
uneconomical for rivals to steal. Featured Aug. 2006.
Dominant salty snack company. Boasts 16 brands with $1
billion-plus in sales. New CEO. Featured March 2006.
Has 22 brands that generate more than $1 billion in
sales annually. Featured in June issue.
Can apply greater underwriting insight more finely and
much faster than competitors. Featured Oct. 2007.
Very profitable for-profit education company with
admirable management team. Featured Aug. 2006.
Demographics are on its side for this orthopedic device
maker. Cash piling up on the balance sheet.
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Page 13
Company Name
Star
Rating
Bus.
Risk
Fair
Yield
P/E
Portfolio
January 2008
13
Comment
QQQQQ Avg
35.00
24.08
27.00
43.90 X 3.4 13.0
Spun off Total Systems, leaving decent bank, but one with
only a narrow moat. Will drop from list next month.
] Sysco SYY
QQQQQ -Avg
38.00
31.21
32.40
49.90 X 2.4 18.8
Wide-moat distributors are rare, but this one dominates.
In Hare Portfolio.
[ T Rowe Price Group TROW
Q
Avg
46.00
60.88
35.50
57.60 Z 1.2 27.0
Asset manager with excellent fund lineup and
ethical reputation.
QQQQ
-Avg
43.00
38.33
36.60
56.50 X 7.2 14.2
Pipeline company enjoys significant barriers to entry and
very stable cash flows. Featured Aug. 2006.
] Time Warner TWX
QQQQQ -Avg
25.00
16.51
21.30
32.80 C 1.4 13.4
Controls some of the most prominent media franchises.
Featured May 2007.
] Time Warner Cable TWC
QQQQQ Avg
42.00
27.60
32.40
52.60 C
Recent addition to watchlist. Possesses communications
capabilities competitors cannot match.
QQQ
Avg
26.00
28.00
20.00
32.60 C 1.0 19.8
Handles applications, billing, collections, and customer
service for credit card issuers.
QQQQQ -Avg
88.00
70.72
75.00 115.50 X 2.4 18.2
Scale and network density give strong cost advantage.
Very strong balance sheet. Featured July 2006.
QQQ
-Avg
78.00
76.54
66.50 102.40 Z 1.5 18.8
Diversified company operating efficiently in several industrial markets. Featured Feb. 2007.
QQQQQ -Avg
41.00
31.74
34.90
53.80 Z 5.1 12.2
Strong competitive position in terms of geographic reach
and earnings growth prospects.
QQQ
54.00
54.80
41.60
67.70 C 4.4 17.0
Strong brands, owns 90% share of market for premium
smokeless tobacco. Featured Sept. 2006.
] Vulcan Materials VMC
QQQQQ Avg 144.00
79.09
111.00 180.40 X 2.3 15.8
High transportation costs of low-value goods gives
geographic advantage. In Hare. Spotlighted Oct. 2007.
] Wal-Mart Stores WMT
QQQQQ -Avg
60.00
47.53
51.10
78.80 X 1.9 15.4
Retailing goliath enjoys enormous cost advantages.
Debated in March 2006 and featured in Oct. 2007.
] Walgreen WAG
QQQQQ Avg
56.00
38.08
43.20
70.20 X 0.9 18.5
Impressive and consistent growth. Purchased in Tortoise
in October. Spotlighted in Nov. issue.
] Walt Disney DIS
QQQQQ -Avg
40.00
32.28
34.10
52.50 X 1.1 14.4
Owns outstanding brands and extensive media library.
Featured March 2007.
791.43
Í ] Synovus Financial SNV
TEPPCO Partners TPP
Total System Services TSS
] United Parcel Service UPS
United Technologies UTX
] US Bancorp USB
UST UST
Avg
— 25.8
724.30 1116.00 X 1.0 25.2
Washington Post Co WPO
QQQ
-Avg 850.00
Waters WAT
QQQ
-Avg
76.00
79.07
64.80
99.80 Z
Weight Watchers Intl WTW
QQQQ
Avg
54.00
45.18
41.60
67.70 X 1.6 18.6
Worldwide leader in weight-loss services, with a highly
recognizable and respected brand.
Wells Fargo WFC
QQQQ
Avg
39.00
30.19
30.10
48.90 X 3.9 11.4
Boasts top-three deposit market share in 15 of its 23
states. Attractive lending spreads.
QQQQQ -Avg
32.00
24.28
27.30
42.00 C 0.2 22.7
The Hare received shares in spin-off from First Data, then
we bought more in Hare. Featured extensively Nov. 2006.
Wrigley Wm Jr WWY
QQQ
-Avg
61.00
58.55
52.00
80.10 C 1.9 26.9
Dominant gum company around the globe. In Tortoise
Portfolio. Featured May and June 2006.
Wyeth WYE
QQQQ
Avg
52.00
44.19
40.10
65.20 C 2.4 13.6
Excellent growth-oriented drug portfolio complemented by
consumer product and animal health businesses.
QQQQQ -Avg
87.00
66.15
74.10 114.20 Z
] Western Union WU
] Zimmer Holdings ZMH
— 32.7
— 21.0
Talented management guiding namesake newspaper and
Kaplan. Educational business now nearly half of sales.
Large share in analytical instruments important in drug
discovery, research, manufacturing.
Government crackdown on industry leads to mild fine.
Demographic trends on firm’s side. Featured July 2006.
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Page 14
14
Morningstar Bellwether Watchlist Recommendations
Stocks to Consider Buying
3M MMM
Allied Irish Banks AIB *
American Express AXP
Amgen AMGN
Applied Materials AMAT
ARM Holdings ARMHY *
Automatic Data Prcss ADP
Bank of America BAC
Bank of Montreal BMO
Barclays BCS*
Boardwalk Pipeline LP BWP
Boston Scientific BSX
Buckeye GP Hold. LP BGH
Cadbury Schweppes CSG*
Campbell Soup CPB
Capital One Financial COF
Cemex CX*
Cintas CTAS
Cisco Systems CSCO
Citigroup C
Comcast CMCSA
Corporate Exec. Board EXBD
Credit Suisse Group CS*
Dell DELL
Diageo DEO*
eBay EBAY
Enterprise GP Hold. LP EPE
Expeditors Intl. of WA EXPD
Fastenal FAST
Genentech DNA
Graco GGG
H & R Block HRB
Hershey HSY
Home Depot HD
IMS Health RX
International Speedway ISCA
J.P. Morgan Chase JPM
Johnson & Johnson JNJ
Legg Mason LM
Linear Technology LLTC
Lloyds LYG
Lowe’s LOW
Marsh & McLennan MMC
Maxim Integrated MXIM
McGraw-Hill MHP
Medtronic MDT
Moody’s MCO
Morgan Stanley MS
News Corporation NWS
Novartis NVS*
Paychex PAYX
Pfizer PFE
Progressive PGR
St. Joe JOE
Starbucks SBUX
Synovus Financial SNV
Sysco SYY
Time Warner TWX
Time Warner Cable TWC
United Parcel Service UPS
US Bancorp USB
Walgreen WAG
Wal-Mart Stores WMT
Walt Disney DIS
Western Union WU
Zimmer Holdings ZMH
Stocks to Consider Selling
Amazon.com AMZN
Blackrock BLK
Blackstone Group LP BX
Gamco Investors GBL
IntercontinentalExchange ICE
Northern Trust NTRS
State Street STT
T Rowe Price TROW
Above are all the firms trading below their Consider Buying price as well as those trading above their Consider Selling price.*Stocks from the International Stalwarts list. See Page 18 for more.
Cost Advantage: Companies that
thrive on being the low-cost
provider in a commodity industry
can offer lower prices to
customers and still make a profit.
These companies create difficulty
for higher-cost competitors.
Types of Economic Moats
What separates a bad company
from a good one, in large part,
is the size of the economic moat, or
competitive barrier, a firm builds
around itself. Here are four main
types of economic moats along with
explanations of how they work:
High Customer-Switching
Costs: If a company sells products
that customers can’t get elsewhere—at least not easily—it
has high customer-switching costs.
This creates a situation in which
customers are willing to pay higher
prices for products because
of convenience.
Bellwether
Watchlist Review
Citigroup C
Citigroup announced it will bring the assets and liabilities of its structured investment vehicles (SIVs)
onto its balance sheet. With the prospects of the Super
SIV failing, we were not surprised to see Citigroup
take this action and do not expect it will have a major
impact on the company’s profitability. Consequently,
we are maintaining our fair value estimate.
Citigroup C
Star Rating
QQQQQ
Business Risk
Avg
Fair Value ($)
53.00
Current Price ($)
29.44
Market Cap ($bil)
146.6
Dividend Yield (%)
7.3
Size of Moat
Wide
Consider Buying ($)
40.90
Consider Selling ($)
66.40
1-Yr Hi/Low ($) 56.28/28.80
Stewardship
∑
P/E
7.9
An SIV is an off-balance-sheet arrangement
that allowed Citigroup to buy a series of asset-backed
securities—such as mortgage-backed securities,
corporate debt, and student loan debt—and fund them
through medium-term notes and short-term assetbacked commercial paper. However, as the subprime
mortgage market blew up in midsummer and
several SIVs were reported to hold this type of debt, the
asset-backed commercial paper market dried up.
Intangible Assets: Some
companies have an advantage over
competitors because of unique
nonphysical assets such as intellectual property rights (patents,
trademarks, and copyrights),
government approvals, brand
names, a unique company culture,
or a geographic advantage.
The Network Effect: A common
trait among companies that
exploit the network effect is
that they are the first, or one of
the first, to create a standard
in an emerging industry. These
companies can sometimes
create monopolies.
Because the SIVs were constantly issuing new commercial paper to fund their securities, the lack of a
market quickly put them into a liquidity crunch. It was
about this time when talks began of a Super SIV to
add liquidity to the market and bail out the struggling
SIVs. However, nothing could be decided upon, and
the rumored $80 billion Super SIV was reduced to $30
billion. Basically, the Super SIV did not look like it
was going to work. During the same period, Citigroup
worked to reduce the size of its SIVs from $87
billion to $49 billion in a fairly orderly manner (meaning
it took no large losses), and the Federal Reserve
announced a new form of short-term funding available
to the banks. We believe these three factors, in
addition to a threatened downgrade of Citi’s SIV debt,
convinced newly appointed CEO Vikram Pandit to
bring the SIVs onto Citi’s balance sheet.
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Page 15
Comcast CMCSA
Star Rating
QQQQQ
Business Risk
Avg
Fair Value ($)
27.00
Current Price ($)
18.26
Market Cap ($bil)
56.1
Dividend Yield (%)
—
Size of Moat
Wide
Consider Buying ($)
20.80
33.80
1-Yr Hi/Low ($) 30.18/17.37
Stewardship
¥
P/E
24.0
Goldman Sachs Group GS
Star Rating
QQQ
Business Risk
Avg
Fair Value ($)
220.00
Current Price ($)
215.05
Market Cap ($bil)
85.5
Dividend Yield (%)
0.7
Size of Moat
Wide
Consider Buying ($)
169.60
275.60
1-Yr Hi/Low ($) 250.70/157.38
Stewardship
∑
P/E
8.8
The consequences of this move are both good and
bad. On the good side, Citi strengthens the SIVs’ debt
position by explicitly guaranteeing the debt will
be repaid. Also, investors now have a clear picture of
what type of assets the SIVs were holding. Most
of the assets are relatively safe—97% are rated AA
or above—but 6% of the assets are collateralized debt
obligations or similar securities. We believe the
risk that Citigroup will need to take a large write-down
from these assets is limited.
On the bad side, adding the SIV assets to Citigroup’s
balance sheet uses up precious capital. The company
estimates its regulatory Tier 1 capital ratio will
decline 16 basis points. While this is not a significant
amount, it is meaningful to a company struggling
to rebuild its capital ratios. Management assures
investors that this move will not prevent the company
from reaching its capital goals by mid-2008. We
are inclined to believe management. However, we will
continue to watch its capital and announcements
carefully for signs of further deterioration.
Analyst: Jaime Peters, CFA, CPA
Comcast CMCSA
Comcast warned that revenue and profit growth for
2007 will be a bit lower and capital spending
will be higher than management had forecast. After
reviewing comments made in conjunction with the
warning by co-CFO Michael Angelakis at an investor
conference and looking over our valuation model,
we are leaving our fair value estimate unchanged. We
believe Comcast shares are attractive at their
current price.
The fact that management revised its 2007 forecast at
this point was surprising. The prior forecast had
been issued only a little more than a month before,
with three quarters of the year in the bag. We
were less concerned about the changes to revenue
and profit growth than the increase in capital
spending. Cable revenue, adjusted for acquisitions, is
expected to grow 11% instead of at least 12%,
and operating income before depreciation and amortization is expected to grow 13% versus 14%. We’ve
been expecting a sharp slowdown in revenue growth
over the next couple of years, and it seems that
January 2008
15
economic issues, which affect customer additions at
the margin, have conspired to pull growth down.
Given the strength of Comcast’s platform and upside
in the business services market, we think the firm
will still be able to meet our long-term growth forecast.
Also, we think the steps the firm has outlined to
deal with a more difficult economy, such as introducing
more service tiers for Internet access, make sense.
We’ve also been pleased with the firm’s margins this
year, given the heavy investment in expanding
the business services unit (2,100 people hired thus far
in 2007).
Based on the new expectation for 2007, capital
spending in the fourth quarter will come in at $1.5
billion versus the $1.2 billion previously forecast.
We had thought the original estimate looked too low,
given spending in recent quarters and the belief
that demand for advanced set-top boxes is likely to be
strong around the holidays. Angelakis said much
of the increase was tied to stronger demand for new
revenue-generating services. It’s important
to remember that revenue from these new services
doesn’t show up in full until the following quarter.
Still, we would prefer to see capital spending slow
with revenue growth. Another factor affecting capital
spending—and more of a concern—is an increase
in customer defections, which force the firm to spend
without an increase in revenue. We’ve increased
our capital-spending estimates somewhat to account
for this effect.
Analyst: Michael Hodel, CFA
Goldman Sachs GS
Goldman Sachs wrapped up a stellar 2007 with solid
fourth-quarter results. The results were materially
in line with our expectations, and we are leaving our
fair value estimate unchanged. For the quarter,
Goldman reported earnings of $7.01 per diluted share
versus $6.59 in the year-ago period. In a year
marked by turmoil in the fixed-income, mortgage, and
real estate markets, Goldman managed to post a
32.7% return on equity. Unlike most other major financial institutions, Goldman avoided major losses
related to subprime mortgage securities. In fact, it
profited from the drop in value of subprime-related
mortgage securities by shorting the asset class
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16
Page 16
Bellwether Watchlist Review
Continued from Page 15
News Corporation NWS
Star Rating
QQQQ
Business Risk
-Avg
Fair Value ($)
25.00
Current Price ($)
21.25
Market Cap ($bil)
66.4
Dividend Yield (%)
0.5
Size of Moat
Wide
Consider Buying ($)
21.30
32.80
1-Yr Hi/Low ($) 25.78/20.31
Stewardship
†
P/E
15.5
Walgreen WAG
Star Rating
QQQQQ
Business Risk
Avg
Fair Value ($)
56.00
Current Price ($)
38.08
Market Cap ($bil)
37.8
Dividend Yield (%)
0.9
Size of Moat
Wide
Consider Buying ($)
43.20
70.20
1-Yr Hi/Low ($) 49.10/35.80
Stewardship
∑
P/E
18.5
with its own capital. Goldman played the market in
2007 almost perfectly; however, we believe there
will be periods when Goldman will show some weakness and it too will suffer losses.
The firm had problems at a few hedge funds this
summer—including Global Alpha and Global Equity
Opportunities—as their trading strategy suffered
during the market dislocation. These problems did not
have a material effect on Goldman’s earnings;
nevertheless, the firm is likely to have a similar experience at some point with its own capital, which
will produce material losses. That said, we believe
Goldman is clearly a wide-moat firm, continues
to produce strong returns on capital, and is one of the
world’s premier financial institutions. We would
happily pick up its shares at a sufficient margin of
safety to our fair value estimate.
Analyst: Ryan Lentell
News Corp. NWS
Dow Jones’ shareholders formally approved the sale
of the company to News Corporation. Dow Jones
common stock has ceased trading, and shareholders
will receive $60 in cash for each share. Approximately 60% of the outstanding voting power of the
company was cast in favor of the merger; 78%
of the outstanding shares of common stock and 54%
of the outstanding shares of Class B common
stock (mostly held by the Bancroft family) were voted
in favor of the transaction.
Rupert Murdoch finally has control of the asset that he
has prized for many years, and he wasted no time
making changes. The company has already announced
that Leslie Hinton will become CEO of Dow Jones,
replacing current CEO Richard Zannino. Hinton was
formerly the executive chairman of News International, News Corp.’s U.K. newspaper group, and has
spent his entire 40-year career in Murdoch’s media
empire. The company also announced that Robert
Thomson will become the publisher of The Wall Street
Journal, replacing Gordon Crovitz. Thomson was
previously the publisher of The Times of London, a
News Corp. property.
We expect Murdoch to push for considerable changes
to the business itself as well. He has already
expressed his interest in converting WSJ.com into a
free, ad-supported Web site. He believes that a
free Web site would attract enough user traffic and
ad dollars to offset the lost subscription revenue.
Murdoch also believes The Wall Street Journal should
provide more extensive coverage of international
news and politics. In addition, we expect Murdoch to
leverage the Dow Jones content on News Corp.’s
far-reaching media assets, especially the recently
launched FoxBusiness Network.
Analyst: Larry Witt, CFA
Walgreen WAG
Our expectations weren’t high for Walgreen’s fiscal
first quarter, so we were pleased to see the company
deliver on its promise to contain expense growth.
Though Walgreen faced a tough comparison period in
which large generic introductions, most notably
Zoloft, elevated gross profits, it managed to increase
operating profits a bit more than 8% year over
year. This is a significant improvement from the 4.4%
decline in operating profits in the prior quarter.
We are maintaining our fair value estimate and believe
the current share price represents a compelling
entry point for long-term investors.
Total sales for the quarter increased 10.4%,
with comparable-store sales up 5.4%. Like all industry
participants, the company was hurt by cycling the
launch last year of Medicare Part D and poorer overall
traffic trends in recent months. Front-end sales
growth suffered from weakness in seasonal sales and
photo and a slow start to the cough, cold, and flu
season. In its first earnings conference call, held Friday,
the firm indicated that more modest cost savings
are achievable, new stores’ returns on invested capital
today are just as high as in the recent past, and a
total footprint of 13,000 stores is achievable. Walgreen
currently has about 6,100 stores. Though the
current rough patch will last a bit beyond this quarter,
we believe the firm’s long-term prospects remain
compelling. œ
Analyst: Mitchell Corwin, CFA, CPA
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Special InternationalInvestor Insert
Canadian Review
InternationalInvestor | Allan Nichols, CFA
Allan Nichols, CFA
International Equities
Strategist
Thomson TOC
Star Rating
QQQQ
Business Risk
Avg
Fair Value ($)
50.00
Current Price ($)
40.75
Market Cap ($bil)
26.1
Dividend Yield (%)
2.4
Size of Moat
Narrow
Consider Buying ($)
38.60
62.60
1-Yr Hi/Low ($) 47.26/36.93
∑
Stewardship
P/E
28.9
Biovail Corp Intl BVF
Star Rating
QQQQQ
Business Risk
+Avg
Fair Value ($)
27.00
Current Price ($)
13.46
Market Cap ($bil)
2.2
Dividend Yield (%)
11.1
Size of Moat
Narrow
Consider Buying ($)
17.20
32.60
1-Yr Hi/Low ($) 26.48/13.20
Stewardship
¥
P/E
10.4
In December 2006, I wrote about Canada. Since then,
the country and its stock market have continued to
perform well. The S&P/Toronto Stock Exchange Equity
Index has had a total return of 10.4% from Dec.
15, 2006, through the end of 2007 versus the S&P 500’s
return of 4.9%. Behind this rally, the country has
benefited from the strength of its natural resources
economy. Oil is near an all-time high, which has
created huge demand for its oil sands projects. (I’ll
get to these in a second.) Besides oil, Canada has
large swathes of timber and other minerals, which are
in demand from China and other emerging countries
where economies have been on fire.
In addition to its natural resources, Canada has benefited from a conservatively run government
and economy. The Economist magazine estimates the
country in 2007 will run a positive current account
balance of 1.7% of gross domestic product and have a
federal budget surplus of 1% of GDP. The United
States, on the other hand, is expected to run a negative
current account balance of 5.5% and a budget
deficit of 1.2%. The better fiscal position in Canada
allows lower interest rates and lower inflation
rates than in the U.S., which in turn lowers the cost of
capital for firms as they make investment decisions.
I want to review Compton Petroleum CMZ, a firm I’ve
discussed previously. But first, I want to highlight
what I think are two of the most intriguing Canadian
firms right now: Biovail BVL—the focus stock in
last month’s issue—and Thomson Corporation TOC.
Thomson Corporation
Thomson Corporation of Canada is not to be confused
with Thomson TMS of France, which I’ve previously
written about and continue to like. Thomson Corporation is a provider of information to professionals
in law, finance, tax, accounting, scientific research,
and health care.
The crown jewel of the firm is its Westlaw division.
Westlaw and its competitor, LexisNexis (owned
by former stalwart Reed Elsevier ENL), dominate
online research for law-related information. When
attorneys want to search case law, past rulings, or
minutiae of the law, they turn to these databases.
However, because each database’s information is
often different, most large law firms subscribe to both
services. The importance of the service is evidenced
by its renewal rate of more than 80%.
Thomson’s second-biggest division is financial
services. Although it is only the third-largest provider
of financial information behind Bloomberg and
Reuters RTRSY, it has some interesting assets. It owns
one of the most extensive databases of international
financial prices as well as First Call and I.B.E.S, the
leading providers of corporate earnings estimates by
analysts working for investment banks.
In the spring of 2007, Thomson entered an agreement
to acquire Reuters, which—if successful—will
make it a solid number two. The two firms fit together
nicely as Thomson is well-known in North America,
while Reuters is strong in Europe and Asia. The deal
is still pending approval of regulators. But considering the lack of overlap geographically, we expect the
deal to be approved, though some small asset sales
may be required. Our analyst James Walden thinks
Thomson is paying a fair price for Reuters, so the deal
won’t accrete any immediate value to Thomson,
but it does put it in a better position to compete against
Bloomberg over the long-term.
The other divisions are significantly smaller, but again
are leaders in their respective fields. Each division
is growing in the midsingle digits organically,
with additional growth from small add-on acquisitions. Thomson is undergoing a cost-reduction
program, which is ahead of schedule and helping to
increase margins and cash flow in each division.
I expect the firm will continue to increase its revenue
and margins. I think the merger with Reuters will
further strengthen its moat, and if it drops back below
our Consider Buying price, I would be all over
the stock.
Continued on Page 20
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A watchlist of our 50 favorite international stocks with
moats. Go to http://msi.morningstar.com to track changes
throughout the month.
International Stalwarts
Company Name
Star
Rating
Bus.
Risk
Fair
Current Consider Consider Size of
Value ($)* Price ($) Buying ($) Selling ($) Moat
QQQQQ Avg
74.00
45.94
57.10
America Movil AMX
QQQQ
+Avg
83.00
61.39
Arcelor Mittal MT
QQQ
Avg
75.00
QQQQQ +Avg
QQQQ
] Allied Irish Banks AIB
Comment
Ireland’s economy slowing, but conservative lending and
diversification should protect it. Highlighted Dec. 2007.
4.4
6.8
52.90 100.10 Narrow
0.6
27.7
Its 137 million wireless customers are the most of any
telecom in Latin America. Highlighted Jan. 2007.
77.35
57.80
94.00 Narrow
1.7
14.6
Largest steel producer in the world. Leading industry
consolidation.
12.00
7.40
7.60
14.50 Wide
1.0
36.5
Sells chip designs to the semiconductor industry, used in
electronics, and autos.
Avg
50.00
42.82
38.60
62.60 Wide
4.1
11.1
Firm is No. 1 in gastrointestinal (ulcer) drugs. MedImmune
acquisition will further enhance pipeline.
QQQQQ Avg
79.00
56.60
60.90
99.00 Wide
4.5
13.6
Canadian banking market very attractive. Agreed to
acquire two Wisconsin banks. Highlighted Dec. 2007.
QQQ
Avg
55.00
50.50
42.40
68.90 Wide
3.4
14.0
25% of earnings from international operations. Highlighted Nov. 2006.
QQQQQ Avg
68.00
40.37
52.40
85.20 Wide
6.4
7.3
Took GBP 1.3 billion loss on subprime investments. Highlighted Dec. 2007.
BP BP
QQQ
Avg
77.00
73.17
59.40
96.50 Narrow
3.5
11.0
Still one of the world’s best oil firms. CEO stepped down
early. Featured Feb. 2007.
British Amer Tbco BTI
QQQ
+Avg
78.00
78.56
49.70
94.10 Wide
3.0
21.6
Successfully taking cigarettes into emerging markets.
Cash cow.
British Sky Brdcsting BSY
QQQQ
Avg
57.00
48.92
44.00
71.40 Wide
2.6
21.8
Dominant pay television provider in the U.K. and Ireland.
James Murdoch moved up to chairman from CEO.
Avg
37.00
35.67
28.50
46.40 Narrow
1.3
18.8
Owns and manages offices, residential developments,
and hydro plants.
QQQQQ -Avg
60.00
49.37
51.10
78.80 Wide
2.4
24.6
Confirmed would spin off beverages rather than sell them.
Featured Oct. 2007.
Canadian Imp Bk Of Cmrc CM
QQQQ
Avg
90.00
71.43
69.40 112.80 Wide
4.4
7.7
Canadian banking is highly insular. Despite Enron-related
woes, it boasts an excellent retail bank.
Canon CAJ
QQQ
Avg
50.00
45.83
38.60
62.60 Narrow
1.9
15.0
Leading consumer electronics firm, with specialties in
photography and printing.
QQQQQ Avg
41.00
25.85
31.60
51.40 Narrow
2.9
8.1
World’s best cement company. Global diversification
offsetting weak U.S. sales. In Hare Portfolio.
China Mobile CHL
QQ
+Avg
75.00
86.87
47.80
90.50 Wide
1.2
38.6
Wireless phone company with 340 million subscribers.
Featured April 2007. Upgraded to wide moat.
Companhia de Bebidas ABV
QQQ
+Avg
77.00
71.03
49.10
92.90 Wide
2.6
28.7
Dominates Brazil beer market; strong in other markets and
soft drinks. Highlighted June 2006.
+Avg
UR
32.67
UR
1.0
24.3
Largest exporter of iron ore—key to steel production.
Sizable position in nickel and other metals.
QQQQQ Avg
83.00
60.10
64.00 104.00 Wide
3.7
9.5
One of two top Swiss banks. Strong asset management
and private bank. Highlighted Dec. 2007.
QQQ
62.00
58.75
47.80
77.70 Wide
0.8
26.6
French product-life management and 3D design software
firm. Featured Jan. 2007.
QQQQQ -Avg 112.00
85.83
95.40 147.00 Wide
3.0
21.6
Largest spirits producer in the world. Exclusive distribution
competitors can’t match. Featured this issue.
E. ON EONGY
QQQ
Avg
65.00
70.35
50.10
81.40 Narrow
2.2
19.1
Large electric utility in Germany. Large cash war chest.
Featured June 2007. Fair value increased $3.
Enel ENSTY
QQQQ
Avg
67.00
59.05
51.70
83.90 Narrow
5.8
16.1
Large electric utility in Italy. Won bidding war for Endesa
of Spain.
Fomento Eco Mex FMX
QQQQ
Avg
46.00
38.17
35.50
57.60 Narrow
1.1
75.8
Top producer/distributor of beer and Coke in Mexico.
Featured May 2007.
] ARM Holdings ARMHY
AstraZeneca AZN
] Bank of Montreal BMO
Bank of Nova Scotia BNS
] Barclays BCS
Brookfield Asset Mngmnt BAM QQQ
] Cadbury Schweppes CSG
] Cemex CX
Companhia Vale Do Rio Doc RIO UR
] Credit Suisse Group CS
Dassault Systemes DASTY
] Diageo DEO
Avg
*Fair value based on Morningstar analyst estimates. Data through Dec. 31, 2007. UR
5 Under Review
–Avg
92.70 Wide
Div.
Yield (%) P/E
UR Narrow
5 Below Average
+Avg
5 Above Average ] 5 Stocks to consider buying [ 5 Stocks to consider selling
siii_0108.qxp
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10:51 AM
Page 19
Company Name
Star
Rating
Bus.
Risk
Fair
Current Consider Consider Size of
Value ($)* Price ($) Buying ($) Selling ($) Moat
GlaxoSmithKline GSK
QQQ
Avg
57.00
50.39
44.00
71.40 Wide
4.1
13.4
Strong drug portfolio despite recent negative safety data
on Avandia. Featured March 2007.
Danone GDNNY
QQQ
Avg
16.00
18.05
12.30
20.00 Narrow
1.5
22.0
Top global producer of yogurt. Lost control of Chinese J.V.
Wahaha Brand. Featured Nov. 2006.
Grupo Aero del Norte OMAB
QQQQ
+Avg
31.00
25.12
19.80
37.40 Wide
1.4
29.9
Wide-moat firm with airport monopoly in central and
northern Mexico.
Grupo Aero Pacifico PAC
QQQQ
Avg
52.00
44.63
40.10
65.20 Wide
4.2
30.6
Airport monopoly in west-central Mexico, including
Guadalajara. Highlighted Dec. 2006.
Grupo Aero Sureste ASR
QQQ
+Avg
61.00
61.22
38.90
73.60 Wide
1.1
38.0
Completed third terminal at Cancun airport. Highlighted
Sept. 2006.
HSBC HBC
QQQQ
Avg 103.00
83.71
79.40 129.00 Wide
5.2
12.1
2006 results hurt by subprime mortgage lending. Highlighted March 2007.
Imperial Tbco Grp ITY
QQQ
+Avg 100.00
107.28
63.70 120.60 Wide
2.3
20.2
Appears to have won bidding for Spanish-French cigarette
firm Altadis. Cash cow.
Infosys Technologies INFY
QQQQ
] Lloyds TSB Group LYG
Div.
Yield (%) P/E
Comment
Avg
54.00
45.36
41.60
67.70 Narrow
0.6
30.2
Largest offshore IT outsourcer. Cutting costs to offset
strength in Indian rupee. Highlighted June 2007.
QQQQQ Avg
53.00
37.65
40.90
66.40 Wide
7.4
9.6
Shareholder-friendly. Increased already-large dividend.
Highlighted Dec. 2007.
114.50
1.2
22.0
World’s largest food and beverage company. 26 brands
produce CHF 1 billion in annual sales. Fair value raised $3.
Nestle NSRGY
QQQ
-Avg 121.00
Nokia NOK
QQQ
Avg
34.00
38.39
26.20
42.60 Narrow
1.5
25.0
Market leader. Best profits in industry. Highlighted March
2007. Fair value increased 29%.
QQQQQ -Avg
73.00
54.31
62.20
95.80 Wide
2.0
18.4
2007 addition to Tortoise Portfolio. Robust drug pipeline.
Highlighted Jan. 2007.
] Novartis NVS
103.10 158.90 Narrow
Novo Nordisk NVO
UR
Avg
UR
64.86
UR
UR Wide
1.0
33.1
Leader in diabetes treatments. Rivals also attracted to
growing diabetes market.
Royal Bank of Canada RY
QQQQ
Avg
58.00
51.04
44.70
72.70 Wide
3.3
12.0
Largest bank in Canada by assets. Acquiring Alabama
National Bank corporation.
Royal Dutch Shell RDS.A
QQQ
-Avg
87.00
84.20
74.10 114.20 Narrow
3.3
10.7
One of the three largest integrated oil companies. Largest
retail distribution network.
SABMiller SBMRY
UR
—
UR
28.55
UR
1.7
26.3
Leading wide-moat international brewer. Combining U.S.
assets with Molson Coors. Offered to buy Grolsch.
Sanofi-Aventis SNY
QQQ
Avg
50.00
45.53
38.60
62.60 Wide
2.6
21.1
Plavix patent upheld. Still strong pipeline. Featured July
2007.
SAP SAP
QQQ
Avg
56.00
51.05
43.20
70.20 Narrow
1.2
23.0
German software firm dominates enterprise resource
planning market. Buying Business Objects.
Taiwan Semiconductor TSM
QQQ
+Avg
11.00
9.96
7.00
13.30 Narrow
4.5
13.1
Largest independent semiconductor foundry. Roughly 50%
market share.
Teva Pharmceutical Ind TEVA
QQQ
Avg
43.00
46.48
33.20
53.90 Narrow
0.7
67.6
World’s largest generic drug firm. Competition from big
pharma is a looming threat.
Toronto-Dominion Bank TD
QQQ
Avg
69.00
69.95
53.20
86.50 Wide
2.8
12.6
High return on equity in Canada, expanding into U.S.
Buying Commerce Bancorp.
Toyota Motor TM
QQQQ
Avg 135.00
106.17
1.0
11.6
World’s largest automaker in first quarter. Seems above
industry’s struggles. Highlighted Nov. 2006.
TransCanada TRP
QQQ
-Avg
39.00
40.93
33.20
51.20 Narrow
3.2
18.9
Dominant Canadian natural-gas pipeline firm that is in
the Tortoise Portfolio. Raised fair value $4.
UBS UBS
QQQQ
Avg
53.00
46.00
40.90
66.40 Wide
4.0
0.0
Vodafone Group VOD
QQQ
Avg
35.00
37.32
27.00
43.90 Narrow
3.8
-21.0
Stew.
5 Morningstar Stewardship Grade C 5 New Addition
UR
104.10 169.10 Narrow
Has taken about CHF 12 billion in write-offs on debt portfolio. World’s largest asset manager. Strong I-bank.
Largest wireless telephone carrier by revenues. Most
geographically diversified.
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Canadian Review
Compton Petroleum CMZ
Star Rating
QQQQ
Business Risk
+Avg
Fair Value ($)
13.00
Current Price ($)
9.20
Market Cap ($bil)
1.2
Dividend Yield (%)
—
Size of Moat
Narrow
Consider Buying ($)
8.30
15.70
1-Yr Hi/Low ($)
12.20/7.55
Stewardship
∑
P/E
9.6
Canadian Natural Res CNQ
QQQQQ
Star Rating
Business Risk
Avg
Fair Value ($)
96.00
Current Price ($)
73.14
Market Cap ($bil)
39.3
Dividend Yield (%)
0.4
Size of Moat
Narrow
Consider Buying ($)
74.00
120.30
1-Yr Hi/Low ($) 87.17/44.56
Stewardship
∑
P/E
15.4
Price/Fair-Value Ratio **
All International Stocks
Emerging Mkt Stocks
Developed Mkt Stocks
U.S. Stocks
**Median price to fair value ratios
among Morningstar’s coverage
universe. Data as of Dec. 31, 2007
.97
.99
.95
.92
Compton Petroleum Update
Compton has been a very frustrating stock. While
watching oil prices reach all-time highs, Compton’s
stock has performed the Chinese water torture
with a steady drop, drop, drop in the price. The firm
has been hurt by a couple of factors. First, it is
involved with natural gas and not oil. Although the
two products generally move in tandem over the
long term, this time natural-gas prices have stayed
flat, while oil has advanced about 50%.
Second, the high oil price has driven increased demand
for Canadian oil sands, which are primarily located
in Northern Alberta and are only economically viable
to explore, drill, and produce at high oil prices. The
reserves are large—one of the largest deposits in the
world—but difficult to extract.
This demand for extraction has in turn created a
demand for workers, which has driven up the price
companies have to pay to get employees to
come work in the harsh climate of Northern Alberta.
However, the wages being paid there have in turn
increased the wages in Southern and Central Alberta
where Compton’s projects are located. This is
causing Compton to get squeezed; it doesn’t benefit
from the high oil price, but it is having to pay the
higher wages to attract employees.
Finally, the provincial government in Alberta recently
changed the royalty structure for both oil and naturalgas production in Alberta. The new royalty structure
increases the royalties owed to the government based
on a sliding scale of prices. As the prices of oil and
natural gas increase, so does the government’s take as
a percentage of revenue. This caps the future upside
of Compton, because if natural-gas prices catch up to
oil prices, some of that increase will accrue to the
government instead of shareholders. This change in the
economics of drilling has caused the firm to cancel
plans to drill 80 wells in 2007.
Last month, Paul talked about reasons to consider
selling a stock. One was there has been a fundamental change in the story, and another was trading
one position for another that provides a better
opportunity. With Compton, both of these potentially
apply. While the assets in the ground haven’t changed
and are worth significantly more than Compton’s
current stock price, the economics of gaining access
to those assets have changed with higher costs
and higher royalties. There are also lots of interesting
alternatives for investing the funds. Although I
haven’t sold my Compton shares yet, I am reviewing
alternatives, and this stock is definitely on my
watch list to sell.
One final comment on Compton. The firm’s largest
shareholder—Centennial Energy Partners, with
a 19.8% stake—submitted a proposal to management
Dec. 17 to put the company up for sale. Management replied that now is not the time with natural-gas
prices low, drilling down, and the Canadian dollar
strong. So even though management is not likely to
sell soon, there is a large activist shareholder
that may help drive value. Just the announcement
drove the price up by more than 10%. My biggest fear
with Compton is it has become a value trap, and
the price won’t rise to our fair value estimate, just as
much of its natural gas is trapped in the ground and
may not be able to rise to the surface any time soon.
Canadian Natural Resources CNQ
An alternative to Compton is Canadian Natural
Resources, which was highlighted on Page 24
last issue. To review, it is a much larger company, and
like Compton, has extensive natural-gas holdings
because of the acquisition of Anadarko Petroleum’s
APC Canadian subsidiary in 2006. In addition, it owns
large oil assets. The largest of these is the Horizon
project. The first phase is a wholly owned oil sands
project that will come on line in 2008.
In addition to Canadian assets, the firm also has
assets in the North Sea and off the coast of
West Africa. These provide diversification and avoid
the high costs from the employee shortage in
Canada. Although there has been an increased demand
for workers worldwide, nowhere is the shortage
as severe as in Alberta. œ
Contact Allan Nichols at [email protected]
Allan Nichols owns the following companies mentioned
in this article: CMZ, and TMS
siii_0108.qxp
1/4/08
10:51 AM
Page 21
Diageo DEO
International Stock Focus | Ann Gilpin
340
Rating
1-Yr High/Low
Fair Value
Current Price
Consider Buy
Consider Sell
QQQQQ
$93.12/74.55
$112.00
$85.83
$95.40
$147.00
Size of Moat
Business Risk
Market Cap
Wide
-Avg
$62.9 bil
3.0%
280
220
220
160
160
100
100
40
40
-20
-20
-80
• Diageo
% Change in Price
280
1998
Stewardship
—
$7.5 bil
• S&P 500 Index
1999
2000
2001
2002
2003
2004
2005
2006
2007
Profile
The product of a merger between Grand Metropolitan and Guinness
in 1997, Diageo is the world’s leading producer of branded premium
spirits. It also produces and markets beer and wine. Brands include
Guinness stout, Smirnoff vodka, Tanqueray and Gordon’s gins,
Captain Morgan rum, Bailey’s Irish Cream, and Johnnie Walker
scotch. Diageo also owns 34% of upscale champagne and cognac
maker Moet Hennessy.
Management and
Stewardship
Paul Walsh, a veteran who started at Grand Metropolitan in 1982
and spent a decade running Pillsbury, stepped into the CEO role in
2000. Walsh has been the driving force behind Diageo’s strategy to
shed noncore businesses in order to focus on spirits. James Blyth,
retired chairman of Boots Company, became Diageo’s chairman in
July 2000 and presides over its 11-member board. Blyth will retire
in June 2008 and current board member Franz Humer will take his
place. We applaud the separation of the chairman and CEO roles
and the fact that Diageo’s board is composed of nine independent
members. We don’t see any red flags in corporate governance.
Compensation levels seem consistent with those at comparable
companies, and about 75% of compensation is variable, based on
both annual and longer-term performance. Management and shareholder interests appear well-aligned. The only gripe we have is that
directors do not stand for elections annually.
Valuation
Our fair value estimate for Diageo is $112 per ADR, and is based on
an exchange rate of GBP 0.495 per dollar. We expect Diageo’s
annual sales growth to average about 5.5%-6% during the next five
years as strong growth in emerging markets offsets low-single-digit
growth in Europe. Diageo will probably continue to invest heavily in
marketing and advertising in Asia Pacific, and we expect operating
profit growth to outpace sales growth. We forecast operating
profits to increase about 7.5%-8% annually for the next five years.
0.00
28.2900
49.8940
50.8234
42.0002
Allan’s Position
50.6338
I think Diageo’s strong brands and distribution
set it
51.8088
up to generate strong returns for many years.18.6689
13.7679
40.3896
Diageo is a highly profitable spirits maker. With
eight
45.9771
of the world’s top 20 brands and unrivaled global
47.7726
distribution, the firm has a wide moat, in our43.9748
opinion.
44.5795
Diageo is the world’s largest spirits maker, and the
48.0639
strength of its portfolio is unmatched. Brands such as
49.6778
Smirnoff, Guinness, Baileys, Tanqueray, Johnnie
39.1554
Walker, and Jose Cuervo are number one in the world
39.1554
in their respective categories, and the company
32.6847
continues to flex its marketing muscle to gain share in
34.1044
each of its 180 markets. One key strength of Diageo’s
34.1044
business is its distribution advantage. Diageo consoli34.1715
dated its distribution base in America to one exclusive
21.5862
agent per state; no other company has come close
5.6949
to matching its exclusive distribution scale in the U.S.
-0.2874
This exclusivity is highly profitable, as Diageo’s
oper1.7766
ating margins in North America are in excess of 33%.
1.7054
14.7847
We see three key markets for Diageo, each with
16.6901
different prospects. North America is extremely
prof20.0625
itable for the firm, and the trend of American
consumers trading up to premium and above17.5291
spirits
16.2598
brands, where the majority of Diageo’s products
are positioned, bodes well for sales growth. 19.2128
Europe is
29.7751
the firm’s biggest sore spot. Declines in on-site
(bar) consumption have led to flat to negative43.9984
volume
53.0559
growth, and margins have compressed as a result
of
more competitive pricing. International markets
32.7913
outside the U.S. and Europe are Diageo’s biggest
39.6168
opportunity for growth, and volume in these 41.4737
regions is
increasing at a double-digit clip. Operating margins
46.5385
there are somewhat lower than in the rest of53.3232
Diageo’s
business because of heavy marketing spending,
but
53.7065
we view this as an investment, given the brand
equity
42.8241
that must be built up in these newer markets.41.9528
48.1988
Diageo has the strongest position in the global market,
but industry consolidation has led to bigger competitors.
The sale of Allied Domecq vaulted Pernod Ricard to
number two, and the Swedish government’s pending
sale of V&S (maker of Absolut) could propel aggressive bidder Fortune Brands FO to the global arena. œ
0.00
7.040
12.381
13.404
11.272
15.656
14.314
-2.352
3.740
12.071
18.694
25.388
30.529
26.313
31.214
36.187
32.782
40.006
35.526
34.672
30.820
38.996
41.651
49.839
42.212
39.354
52.829
48.122
44.878
48.341
45.923
54.780
46.499
45.782
34.104
34.654
39.313
26.455
18.336
27.424
28.074
24.872
23.524
15.606
6.161
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Page 22
22
Debating Washington Mutual WM
Bull vs. Bears | Erin Swanson and Matthew Warren
Erin Swanson, CFA
Stock Analyst
Washington Mutual WM
QQQQQ
Star Rating
Business Risk
Avg
Fair Value ($)
43.00
Current Price ($)
13.61
Market Cap ($bil)
11.8
Dividend Yield (%)
—
Size of Moat
Narrow
Consider Buying ($)
33.20
53.90
1-Yr Hi/Low ($) 46.15/12.81
Stewardship
∑
P/E
5.1
Washington Mutual was far from the darling of Wall
Street in 2007, but I don’t believe all is lost for
this mortgage giant. Its diversified operating platform,
strong balance sheet, access to a broad array
of funding sources, and management experience will
prove to be a solid defense, in my opinion.
Credit concerns obviously abound in the residential
mortgage industry. However, I believe WaMu’s
management anticipated the slowdown and began
taking steps to position its balance sheet for tougher
times long before any signs of deterioration were
evident. During 2006, WaMu sold nearly all of its
subprime mortgage originations, tightened its underwriting standards, and reduced its subprime portfolio
by $2.4 billion. The firm has not stopped there; WaMu
recently announced its intentions to shut down all
lending through its subprime mortgage channel. Digging
further into WaMu’s balance sheet, I view the firm’s
$20 billion of subprime exposure, or 8% of its total loan
portfolio, as manageable. In addition, the fact that
nearly half of its subprime loans are fixed-rate is a huge
plus. These borrowers are not facing an imminent
increase in the interest rate charged on their mortgages,
and the chance of foreclosure is reduced.
if I assume WaMu charges off all loans originated
between the beginning of 2005 and October 2007 with
loan/value ratios in excess of 80%—a highly
pessimistic and unlikely scenario—my valuation model
still points far higher than the current stock price.
Beyond the mortgage mess, I believe the market has
also lost sight of the fact that WaMu operates a
diversified business platform, with nearly $150 billion
in core retail deposits. Retail banking is WaMu’s
crown jewel, and the firm is leveraging its strong retail
platform and customer relationships to diversify
its revenue stream. In 2005, it acquired Providian, a
leading credit card issuer to the middle market.
I believe this business is a great fit for WaMu, as it
allows the firm to cross-sell additional products to
its existing customers.
I think WaMu’s recent preferred equity issuance of
nearly $3 billion and the significant reduction in its
quarterly dividend give the company sufficient capital
in the near term. Finally, management experience
is an invaluable asset during tumultuous times such
as these. Kerry Killinger has guided the troops at
WaMu for more than 15 years, operating the business
through past cycles. I believe this knowledge and
experience will serve the firm, and ultimately shareholders, well this time around, too.
Mortgage originations and servicing are essential
businesses, and it stands to reason that WaMu—
which I believe is a likely survivor—possesses a great
opportunity to gain share in this consolidating market.
In my opinion, the market has taken into account
WaMu’s exposure to risky loans, and then some. Even
Paul Larson
Equities Strategist
The Editor’s View
Matt did not go into numerical detail concerning the
problems at WaMu, but if you believe his thesis that
the financial system surrounding mortgages is crumbling, WaMu is probably headed toward bankruptcy.
While I have a slightly less apocalyptic view of the
industry as a whole, there is no denying the industry
has a large hangover. At the height of the bubble, the
rates lenders were charging got way too small for the
risks they were taking. Underwriting standards also
went to pot, as it seemed anyone with a pulse
could get a loan. Now that the bubble has popped,
those borrowers who stretched their incomes too
far can no longer count on price appreciation to bail
them out. Loans are going bad at a frightening
pace, and the backstops on these loans—the actual
homes acting as collateral—are not nearly as
valuable as once before. It’s all so painfully obvious
with the benefit of hindsight.
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6:47 PM
Page 23
Matthew Warren
Stock Analyst
Fannie Mae FNM
Star Rating
Not Rated
Business Risk
+Avg
Fair Value ($)
—
Current Price ($)
39.98
Market Cap ($bil)
39.1
Dividend Yield (%)
4.5
Size of Moat
Wide
Consider Buying ($)
—
—
1-Yr Hi/Low ($) 70.57/26.38
Stewardship
†
P/E
24.1
Freddie Mac FRE
Star Rating
Not Rated
Business Risk
+Avg
Fair Value ($)
—
Current Price ($)
34.07
Market Cap ($bil)
22.5
Dividend Yield (%)
5.1
Size of Moat
Wide
Consider Buying ($)
—
—
1-Yr Hi/Low ($) 68.55/22.90
Stewardship
†
P/E
12.0
The Bear Position
I think there are structural flaws in the financial
system related to mortgages, and WaMu will
continue to be seriously injured as those flaws
become exposed.
Say you are a business school professor, and your
students have just turned in newly minted business
plans. While sitting on your Barcalounger enjoying
a cocktail, ready to start grading, one particular title
catches your eye: “Georgie Mack Makes it Happen.”
Georgie Mack’s business model involves a highly
leveraged financial institution that would borrow some
combination of short- and long-dated funds, then
proceed to loan them out (or guarantee similar loans
issued by other institutions) to individuals looking
to play the stock market. To mitigate some of the risk,
customers must post enough cash to their account
to cover at least 20% of the account value at origination. In fact, if asset values drop, the customers
would be forced to shore up the equity cushion by
introducing additional capital (what’s generally
referred to as a margin call) or face a forced sale.
What might appear to be a ridiculously risky business
model has simply been lifted from governmentsponsored entities Fannie Mae FNM and Freddie Mac
FRE. Of course, these companies—often associated
with apple pie—actually don’t require homeowners to
post new equity funds or face a forced sale when
home values decline, which makes the businesses even
riskier than my example suggests.
But, you might say, home prices don’t swing as wildly
as stock prices on the NYSE. Or do they? Ask anyone
So where does that leave us with WaMu today? I
happen to believe the company is in a bimodal situation. On one hand, WaMu stands a decent chance of
going bankrupt if mortgage charge-offs continue
rising. But if WaMu survives, the stock is likely to be
worth more than double what it is today. If I had
to place a bet concerning which stock in the Tortoise I
thought was going to do the best in 2008, I’d place
my bet on WaMu. Likewise, if the proposition were
which stock in the portfolio would do the worst,
January 2008
23
who followed the American dream and purchased a
new home in California, Florida, or Nevada over
the past couple of years, near the bubble’s peak, and
you’ll know this assumption is coming unglued. Ironically, it was the widely held convictions that
regional housing markets aren’t correlated and home
prices would never decline on a nationwide basis
that helped fuel the house price runup and subsequent
demise. Homeowners, brokers, banks, Wall Street
titans, rating agencies, and investors all fell under the
same spell, milking the stable-pricing premise to
its logical extreme. Underwriting standards deteriorated so much that the mere absence of rapid
home price appreciation was enough to shake out
some of the riskiest loans in short order.
In this unprecedented (at least in the past seven
decades) situation, the government-sponsored mortgage finance firms are facing declining home prices
across the nation, on average. Having long made oneway leveraged bets on prices inching ever higher,
they now find themselves in a situation they’d previously thought could occur only in a scenario at
odds so long it’d be plotted many standard deviations
from the mean.
Let’s take this comparison one step further. WaMu’s
home-lending unit—well stocked with exposure
to subprime, interest-only, negative amortization, and
home-equity loans—looks like the late Evel Knievel in
comparison with the more staid government-sponsored enterprises. If home prices continue declining,
expect WaMu’s future to resemble the bumpy landing
Evel experienced when jumping the fountains at
Caesars Palace.
WaMu would also be my first bet.
If Erin is right, the payoff odds with WaMu’s stock are
impressive. But the uncertainty is high, and my
confidence (read “edge” in the Kelly criterion) is quite
small. I just don’t know if anyone, myself included,
can accurately predict the ultimate size of the liabilities related to lending sins of the past. I’m planning
on holding my small position, but I believe WaMu is
very far from a fat pitch today. œ
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24
Comcast CMCSA
Paul’s Position
One of the more interesting things on the radar.
Stock Focus | Michael Hodel, CFA
Rating
1-Yr High/Low
Fair Value
Current Price
Consider Buy
Consider Sell
QQQQQ
$30.18/17.37
$27.00
$18.26
$20.80
$33.80
Size of Moat
Business Risk
Market Cap
Wide
Avg
$56.1 bil
0.0%
Stewardship
¥
$29.9 bil
• Comcast
% Change in Price
• S&P 500 Index
234
190
146
102
58
14
1998
1999
2000
2001
2002
2003
2004
2005
2006
Competition for television customers has been tough
the past several years. Satellite competitors DirecTV
DTV and EchoStar DISH have taken virtually all of the
growth across the industry, hitting smaller and weaker
cable companies particularly hard. Comcast has fared
better than most, holding the number of customers
served roughly flat. Given the maturity of this business,
however, Comcast will probably continue to lose
TV market share over the next few years as phone
companies more aggressively offer the service.
2007
Profile
Comcast is the largest operator in the cable industry. The firm’s
networks reach nearly 50 million households, with 24 million
customers signing up for at least basic cable service. The firm also
offers high-speed Internet and phone service. The five largest
markets Comcast serves are Philadelphia, Chicago, San Francisco,
Seattle, and Boston. The firm also owns interests in a handful of
cable networks, including E!, The Golf Channel, and Versus.
Management and
Stewardship
The biggest issue we have with Comcast’s stewardship is that the
founding Roberts family owns all of the supervoting Class B shares,
thereby holding 33% voting control. Holders of Class A shares have
the remainder of voting power, while holders of Class A special
shares CMCSK are not entitled to vote on corporate matters. The
Roberts’ voting power can’t be diluted under the firm’s articles of
incorporation—the number of Class A votes per share adjusts to
maintain Class B voting power. We don’t like to see control of the
firm concentrated in this manner. President and CEO Brian Roberts
took the chairman spot as well in May 2004; we would prefer these
roles were separated. Roberts is well paid: His salary and bonus
totaled $10.9 million in 2006. Include the value of stock options and
other items, and Robert’s total compensation hit $26 million.
Valuation
Fears concerning increasing competition and future
capital-spending needs have made some investors
wary of Comcast. We believe that the strength of its
competitive position will enable attractive returns.
Our fair value estimate is $27. With customers increasingly
subscribing to additional services, including Internet access and
digital video recorders, we think revenue growth will be strong
through 2008. Beyond that, we expect that growth in subscriptions
to new services will slow and competition will limit price increases,
pushing revenue growth down to about 5% annually. We expect
margins to expand a bit as more customers subscribe to more than
one service and slowing growth turns management’s attention to
cost-cutting. We think the firm’s ability to use its scale to manage
programming costs will be a benefit.
What clearly sets Comcast apart from its rivals is the
capability of its networks, which can offer a full
complement of television, Internet, and phone services.
The phone companies are entering the TV business in response to the success Comcast and other
cable firms have had stealing phone customers—
nearly 10% of the households in Comcast’s territory
have signed on for its phone service, and that figure
is advancing rapidly. The phone companies are
upgrading their networks to match Comcast’s capability, but these efforts are time-consuming and
in many cases won’t produce networks superior to
Comcast’s. We believe Comcast’s network will
be able to evolve at a reasonable cost as technology
advances. In addition, nearly three fourths of the
firm’s current capital budget is dedicated to items that
directly generate additional revenue.
Comcast’s size is also an advantage. The firm’s cable
networks reach nearly 50 million U.S. homes—around
45% of the total—and serve 24 million customers,
about 45% more than its nearest pay-TV competitor.
Comcast also has deep experience creating content,
particularly on a local level. While Comcast’s relative
size will shrink some over the next couple of years,
we don’t expect it to lose its leadership position,
given the increased fragmentation in the industry. œ
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Starbucks SBUX
Rating
1-Yr High/Low
Fair Value
Current Price
Consider Buy
Consider Sell
QQQQQ
$36.61/19.89
$36.00
$20.47
$27.80
$45.10
Size of Moat
Business Risk
Market Cap
Wide
Avg
$15.0 bil
0.0%
Stewardship
∑
$9.4 bil
With more than 10,000 domestic locations, Starbucks
dwarfs its rivals in the specialty coffee retail
market. Caribou Coffee CBOU, with fewer than 500
U.S. stores, is a distant number two. Furthermore,
Starbucks is strengthening its position, with plans for
at least 1,700 domestic openings in fiscal 2008.
• Starbucks
% Change in Price
• S&P 500 Index
690
570
450
330
210
90
1999
25
Paul’s Position
While there are competitive threats to consider, Starbucks is the cheapest it has been in a very long time.
Stock Focus | John Owens, CFA, CPA
1998
January 2008
2000
2001
2002
2003
2004
2005
2006
2007
The company does face rising competition from fastfood chains. McDonald’s MCD now offers
premium coffee at around 14,000 U.S. restaurants. The
Golden Arches is also testing lattes, cappuccinos,
and other specialty drinks in several U.S. markets. This
has created considerable fear that Starbucks will
lose customers to McDonald’s, which offers even more
convenient locations and cheaper prices.
Profile
Starbucks’ 14,000-plus stores sell coffee, espresso, tea, and cold
blended drinks. They also offer food, whole bean coffee, coffeemaking equipment, music CDs, and other merchandise. The firm
sells its coffee (under the Starbucks, Seattle’s Best, and
Torrefazione Italia brands) and Tazo Tea to grocery stores and warehouse clubs. Through joint ventures and other agreements, the firm
produces and sells branded bottled Frappuccino and espresso
drinks, ice creams, and liqueurs.
Management and
Stewardship
Howard Schultz founded Starbucks in 1985 and has served as its
chairman since inception; he was also CEO until 2000. CEO James
Donald joined Starbucks in 2002 as president of North America and
was promoted to his current role in 2005. In fiscal 2006, Schultz
and Donald earned salary plus bonus of $3.6 million and $3 million,
respectively. Both received very generous option grants worth an
estimated $9.3 million each. Shareholders also had to dole out
nearly $1 million for the chairman’s personal use of the company
aircraft, security services, and other benefits in fiscal 2006. This
may seem like rich compensation, but shareholders have enjoyed
robust long-term returns. Schultz, with 4.1% beneficial ownership,
has ample incentive to increase shareholder value.
Valuation
Our fair value estimate is $36 per share. We project that annual
revenue growth will average 15% over the next 10 years, trailing
off from 22% last year to about 8% by 2016. We see Starbucks
expanding to more than 37,000 stores worldwide while still generating annual comparable sales growth in the low single digits
domestically and in the midsingle digits overseas. We forecast the
operating margin to dip slightly in 2007 as a result of rising labor
and occupancy costs. Thereafter, we expect profitability to improve
modestly year over year, as Starbucks spreads its fixed expenses
over a larger sales base.
In our view, both Starbucks and McDonald’s can
succeed in this fast-growing business. According
to the National Coffee Association, U.S. coffee sales
through restaurants, cafés, and other outlets could
reach $29 billion by 2011, 50% more than last year.
We believe McDonald’s, Dunkin’ Donuts, and other
fast-food chains compete more on price, while Starbucks caters to customers desiring a higher-end experience, with baristas handcrafting and customizing the
drinks. Another source of differentiation is Starbucks’
stylish cafés, with their comfortable sofas and chairs,
eclectic music, and Wi-Fi access, offering customers a
“third place” where they can relax or work.
Given its leadership in this fast-growing market, Starbucks could eventually expand to 20,000 domestic
stores by further penetrating urban and suburban areas
and expanding into smaller towns and off-highway
locations. The increasing use of drive-throughs, as
well as new breakfast and lunch offerings, should also
boost sales at existing stores. The firm could also
match its domestic potential internationally. It already
has more than 4,000 stores in 41 other countries.
As an example, Starbucks has been embraced in teadrinking China, which management believes could
become its second-largest market. œ
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26
Zimmer ZMH
Paul’s Position
This is another company worth investigating further.
Stock Focus | Julie Stralow, CFA
Rating
1-Yr High/Low
Fair Value
Current Price
Consider Buy
Consider Sell
QQQQQ
$94.38/63.00
$87.00
$66.15
$74.10
$114.20
Size of Moat
Business Risk
Market Cap
Wide
-Avg
$15.5 bil
0.0%
$3.8 bil
Stewardship
œ
• Zimmer
% Change in Price
• S&P 500 Index
250
200
150
100
50
0
2001
2002
2003
2004
2005
2006
2007
Profile
Zimmer is a leading provider of orthopedic medical devices.
The firm focuses primarily on joint reconstruction, where it leads
key niches including knee and hip implants. Reconstructive
implants accounted for 83% of the firm’s sales in 2006. The balance
was generated from related surgical tools, devices to treat traumatic injuries, and spinal column treatments.
Management and
Stewardship
We like that Zimmer has decided to separate its chairman and CEO
positions after Ray Elliott recently retired from both spots. We think
CEOs should have to report to a higher authority, namely shareholders, through the board, and it can be difficult for a board to
remain objective when the CEO also acts as the leader of the
board. David Dvorak is the new CEO, and retired Bristol-Myers
Squibb BMY executive John McGoldrick is now chairman. We also
like that Zimmer aims to remove the supermajority voting provision
that has blocked the board’s declassification in recent years. Hopefully, that change will enable more outside influence at the firm.
But there is still room for improvement. Compensation has been
lofty, with Elliott taking home about $12 million in total 2006 pay.
Valuation
We think Zimmer is worth $87 per share. Zimmer doesn’t appear to
be stealing as much market share with its gender-specific knees
as we’d originally anticipated, and new competitive hip-resurfacing
products look poised to steal demand from Zimmer’s traditional hip
implants. We still expect 10% sales growth in 2007 and 9%
compound annual sales growth through 2011. Without major new
product launches in the near term, we think the firm will have difficulty expanding its gross margin. Also, the Department of Justice
has sanctioned hefty monitoring fees related to surgeon consulting
arrangements. As a result, we think operating margins will average
about 33% through the next five years. We assume capital expenditures average 7% of sales during the next five years.
Zimmer stands out in a very attractive industry. It leads
several key orthopedic device categories that possess
high barriers to entry and sticky physician relationships. These positive attributes, combined with manufacturing and marketing prowess, will help the firm
generate excellent returns for the long run.
Zimmer claims a leading market position in reconstructive devices, including top spots in knee and hip
replacements. This leadership remains very stable
because orthopedic surgeons typically display high
levels of brand loyalty. With patient outcomes
dependent on the skills developed using a particular
manufacturer’s devices, surgeons have little incentive
to switch once they’re comfortable with a supplier’s
product set. Therefore, as long as Zimmer’s innovation
cycle doesn’t fall dramatically behind competitive
cycles, the firm should continue leading and benefiting
from growth in these key niches.
Long-term growth trends look promising, too. Joint
replacements are typically preceded by years of wear
and tear on the body. Aging and osteoarthritis can
lead to the painful breakdown of hips and knees. With
baby boomers entering their later years, procedure
volume should increase at a strong pace in the long
run. Two conflicting factors also should lead to
healthy procedure growth: more active lifestyles and
expanding waistlines. Many who are active in
sports expect to pursue higher-intensity activities for a
longer time than in previous generations. These
activities can place additional stress on joints and
lead to more, and earlier, replacements.
The vast majority of industry sales are paid for by
government entities, such as Medicare. These entities
might have to cut reimbursement rates for procedures,
which would pressure profits of industry customers
(hospitals) and could trickle down to industry participants in the form of lower prices. We think Zimmer is
in a great position to tackle these challenges through
its lean manufacturing operations as well as its
prowess in physician relationships and education. œ
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H&R Block HRB
Rating
1-Yr High/Low
Fair Value
Current Price
Consider Buy
Consider Sell
QQQQQ
$24.95/17.57
$26.00
$18.57
$20.00
$32.60
Size of Moat
Business Risk
Market Cap
Wide
Avg
$6.0 bil
3.0%
Stewardship
¥
$4.1 bil
Due to the current mortgage market, H&R Block’s
Option One mortgage operation has lost considerable
value. We believe that this business still represents
some economic value, but more importantly we
believe that Option One should not overshadow the
strong fundamentals of H&R Block’s tax business.
• H&R Block
% Change in Price
• S&P 500 Index
250
H&R Block has a wide moat due to its scale, brand
recognition, and market position. Its 20.3 million U.S.
clients represent 16.1% of the IRS’ estimate of total
individual income tax returns and bring in revenue
roughly 10 times that of its closest competitor. With
its scale and experience, H&R Block is able to
offer a wider variety of products, often at a lower cost.
200
150
100
50
0
1999
27
Paul’s Position
Significant management missteps have not been able
to destroy the wide economic moat.
Stock Focus | Todd Young
1998
January 2008
2000
2001
2002
2003
2004
2005
2006
2007
Profile
H&R Block is the leader in tax preparation and IRS refund loans,
which represent roughly two thirds of revenue. It also offers business consulting services through RSM McGladrey, the fifth-largest
U.S. accounting firm. The consumer financial segment offers
brokerage and investment planning through H&R Block Financial
Advisors and full-service banking through HRB Bank. It also operates a mortgage segment, Option One, which is being wound down.
Management and
Stewardship
Activist-investor Richard Breeden was elected chairman in late
2007, after winning three seats on the board. Breeden is a hedgefund manager and former SEC chairman. Breeden replaces Mark
Ernst, who stepped down as chairman and CEO. Alan Bennett is
serving as acting CEO and is a former CFO of Aetna. We applauded
the separation of the chairman and CEO roles and look highly upon
Breeden’s plan to focus the company on its core tax business and
exit the brokerage and banking industries. While things are
improving, H&R Block only receives a C Stewardship Grade. Block’s
accounting is complex, with various off-balance-sheet operations,
and it has restated earnings in the recent past. Additionally, a
shareholders’ rights plan makes any potential acquisition difficult.
Valuation
Our fair value is $26. The mortgage business represents less than
$2 of our $26 value. We estimate the value of Option One to be
approximately $400 million dollars, below the $873 million book
value. It includes impairments on the most risky pieces of the business and also accounts for the possible sale of the mortgageservicing business at a steep discount. For the core business, we
project 8% annual revenue growth and an operating margin
improvement from 16% in fiscal 2007 to an average of 17% over
the next five years. We expect growth to come from fee increases
and the growth of other services within the tax segment as well as
growth in the business and consumer financial services. We
believe the company will leverage its fixed costs as it grows.
Although tax client growth at brick-and-mortar
locations has been flat recently, there are many other
elements that should help spur growth. As some
customers move to online offerings and brick-andmortar competition intensifies, H&R Block has
struggled to bring in new clients. However, H&R
Block’s digital offerings have had significant growth.
With its brand recognition it should continue to
encroach on Intuit INTU, the online leader. H&R Block
is also offering various refund loan products and
has standardized the rate it charges. While still high
at 36% APR, it is well below industry rates, which
can be higher than 70%. Additionally, its prepaid
MasterCard offering is an innovative product that lets
customers transfer refunds directly to the card,
avoiding hefty check-cashing fees that many lowincome clients would otherwise have to pay.
H&R Block’s Option One mortgage subsidiary has been
a thorn in its side. H&R Block entered the mortgage
industry in 1997, creating significant income during
the real estate boom. Unfortunately, like many financial institutions that dealt in riskier subprime mortgages, the company took substantial losses this year.
H&R Block has stopped originating new loans and is
considering its next steps in regards to the mortgageservicing piece, which represents little risk. œ
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Page 28
Continued From Cover
2007 Total Return (%) While held in StockInvestor Portfolios
Tortoise Portfolio
-100%
-50
Hare Portfolio
S&P 500 (5.5%)
WM
MCO
HD
BAC
FAF
AXP
CTAS
WTM
LOW
PFE
JPM
NVS
WAG
0
50
KO
BRK.B
PEP
KMR
CL*
TRP
GD
BR
WWY
SLM*
BUD
NTRS*
WMT
JNJ
ADP
100%
S&P 500 (5.5%)
DFS
BSX
AMGN
IACI
KMX
CX
ISCA
VMC
SYY
EXBD
PAYX
IGT
DELL
-100%
MA
APOL
EXPE
NOK*
CMP
MSFT
BIIB*
FAST
FNF*
EBAY
WU
TCLP*
EPE
-50
0
50
100%
Total Return since Jan 1, 2007 or when first added to portfolio, whichever is later. *Return of closed positions until point of sale. p Decliners p Advancers
Moody’s MCO
Star Rating
QQQQQ
Business Risk
-Avg
Fair Value ($)
65.00
Current Price ($)
35.70
Market Cap ($bil)
9.2
Dividend Yield (%)
0.9
Size of Moat
Wide
Consider Buying ($)
55.40
85.30
1-Yr Hi/Low ($) 76.09/35.05
Stewardship
∑
P/E
11.7
Novartis AG NVS
Star Rating
QQQQQ
Business Risk
-Avg
Fair Value ($)
73.00
Current Price ($)
54.31
Market Cap ($bil)
127.5
Dividend Yield (%)
2.0
Size of Moat
Wide
Consider Buying ($)
62.20
95.80
1-Yr Hi/Low ($) 60.36/51.20
Stewardship
—
P/E
18.4
competitive advantage known as the network effect—
it has the most sellers, thereby attracting the
most buyers, and vice versa. Although there have been
concerns about the growth rates at the auction
business, PayPal continues to grow at very high rates.
Our fair value estimate was $45 when this purchase
was made, and we raised it to $49 during the year. I’m
not certain when Mr. Market will awake from his
slumber concerning the value of eBay’s cash flow, but
as long as the intrinsic value of the business continues
to rise, I will be happy.
Jan. 29, Bought 125 Fastenal FAST
Purchase Price: $35.70 12/31/07: $40.42
A matter of weeks after announcing Fastenal’s Will
Oberton as Morningstar’s 2006 CEO of the Year, I was
thrilled to be able to purchase this unique distributor at what I consider a very good price. We increased
our fair value from $53 to $63 during the year,
reflecting larger (and earlier) free cash flow growth
than we expected before. I still think Fastenal is
a fantastic long-term holding worth considering today.
Feb. 9, Sold 50 Moody’s MCO
Sales Price: $74.24 12/31/07: $35.70
This particular trade is an enigma, as it can be thought
of as both one of my best trades of the year, as well
as one of my worst decisions. I say this because I sold
only half of the Tortoise’s position. Considering
where the stock is today, selling back in February was
a great move, given what has happened in the
credit markets. Likewise, holding the other half of the
position was perhaps my worst decision of the year.
This is the problem with doing things halfway—you
will always be only half right and half wrong.
The good news is I don’t think Moody’s will face meaningful legal liabilities related to its previous ratings,
and the firm’s moat appears to be intact. The bad news
is it may take years for the credit markets to
achieve the levels of activity seen at the height of the
real estate/mortgage/credit/LBO bubble. Our fair
value estimate of $65 reflects fairly conservative
assumptions (example: a 7% revenue decline in 2008),
but actual results could very well be worse.
I’m comfortable with the Tortoise’s small position.
Feb. 9, Bought 100 Novartis NVS
Purchase Price: $58.58 12/31/07: $54.31
With the proceeds of the Moody’s sale, I purchased
this leading pharmaceutical firm. Over the past
two years, we’ve had three different analysts cover this
company, and all three have really liked what
they have observed. With the stock even cheaper than
it was when I first purchased, I am that much more
bullish today.
April 25, Sold 125 SLM SLM
Sales Price: $53.65 12/31/07: $20.14
This was my best trade of 2007. At the time I sold,
there was a $60 per share buyout offer on the table.
Despite this, I thought Sallie Mae’s moat had
eroded due to slashed government subsidies, and I
believed the buyout stood a significant risk of not
happening. Turns out those risks I had identified came
true—we later downgraded the moat rating
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Bank of America BAC
Star Rating
QQQQQ
Business Risk
Avg
Fair Value ($)
70.00
Current Price ($)
41.26
Market Cap ($bil)
183.1
Dividend Yield (%)
5.8
Size of Moat
Wide
Consider Buying ($)
54.00
87.70
1-Yr Hi/Low ($) 54.21/40.61
Stewardship
∑
P/E
9.4
Cintas CTAS
Star Rating
QQQQQ
Business Risk
-Avg
Fair Value ($)
47.00
Current Price ($)
33.62
Market Cap ($bil)
5.3
Dividend Yield (%)
1.2
Size of Moat
Wide
Consider Buying ($)
40.00
61.70
1-Yr Hi/Low ($) 42.89/31.14
Stewardship
œ
P/E
16.2
Enterprise GP Holdings EPE
Star Rating
QQQQQ
Business Risk
Avg
Fair Value ($)
54.00
Current Price ($)
37.02
Market Cap ($bil)
5.2
Dividend Yield (%)
4.0
Size of Moat
Wide
Consider Buying ($)
41.60
67.70
1-Yr Hi/Low ($) 46.96/32.76
Stewardship
∑
P/E
38.6
from wide to narrow, and the buyout ultimately fell
through. A bad situation has recently gotten
downright ugly, and boy am I glad I avoided the mess.
Our realized gain was 41% over about three years.
April 25, Bought 150 Bank of America BAC
Purchase Price: $50.75 12/31/07: $41.26
It turns out I was early in buying BofA, as it clearly
would have been better to buy this banking behemoth
after the credit market problems came to the forefront. Thankfully, the pain BofA should feel from the
credit market problems will likely be relatively minor,
as it did not play in the subprime mortgage sandbox,
and it also had a limited amount of its earnings
derived from investment banking and securitizations.
As a nearly assured survivor, I think BofA is in a
great position today to take away share from competitors who bit off more than they could chew.
May 16, Sold 125 TransCanada TRP
Sales Price: $36.49 12/31/07: $40.93
I trimmed the Tortoise’s relatively large position in
Canadian pipeline firm TransCanada as the stock
approached its fair value estimate, but it turns out I
was early in this trade, too. The stock got all the
way up to near $44 this autumn as the U.S. dollar fell
to a point where it was worth only CAD 0.92. If
you are a U.S. dollar bear and/or a bull on the naturalresource-heavy Canadian economy, then the relatively steady TransCanada (with most of its earnings
generated in Canadian dollars) is a great investment
to keep on the radar.
May 16, Bought 200 Cintas CTAS
Purchase Price: $37.56 12/31/07: $33.62
Cintas’ stock has done little more than trickle down
since I added it to the Tortoise, but our thesis
and fair value estimate are unchanged. This may be a
classic time-arbitrage opportunity, where shortterm results are likely to be mildly anemic (due to the
economic environment), but the long-term positioning and expected cash flow are as good as ever. I
think Cintas is still worth considering today.
May 24, Sold 172 Fidelity National Financial FNF
Sales Price: $26.20 12/31/07: $14.61
I would argue that avoiding this bullet was my second
January 2008
29
best trade, after Sallie Mae. The stock rose for a
couple of days after I sold, but then fell well below the
Hare’s selling point. I said at the time of the sale
that I was not a fan of the management team, and their
moves later in the year solidified my negative
view. Namely, the company overpaid (in our opinion)
for Ceridian, a human resources firm that has no
discernable synergies with title insurance. I think our
F Stewardship Grade for this company says
it all. After a series of convoluted spin-offs, we still
managed to escape with over a 100% gain in a
three-and-a-half-year holding period.
May 24, Bought 170 Enterprise GP Holdings EPE
Purchase Price: $37.13 12/31/07: $37.02
We tend to like pipeline companies with their stable
competitive advantages created by simple geography, and we really like the general partners of the
master limited partnerships (MLPs) that usually
own these businesses. I think it’s useful to think of the
general partners as owning “super equity” stakes in
the pipeline firms, with above-average growth in their
distributions likely to continue for many years.
For investors looking for income, Enterprise is among
my favorite ideas. (Of course, there is the caveat
that one might encounter increased tax complexity with
this stock, as Enterprise GP itself is an MLP. But I
think we will be far more than fairly compensated for
the extra aspirin needed at tax time.)
June 13, Sold 150 Northern Trust NTRS
Sales Price: $63.44 12/31/07: $76.42
We generally like the asset management business—
returns on capital tend to be very high, as there
is very little invested capital. This is also a relationship
business, which creates customer switching costs.
Yet Northern Trust simply looked overvalued this
summer, and I thought there were better opportunities
elsewhere. I would gladly buy this stock back...at
the right price. Our realized gain (excluding dividends)
was 62% with an average holding period just under
five years.
June 13, Bought 120 Bank of America BAC
Purchase Price: $49.86 12/31/07: $41.26
June 13, Bought 70 Novartis NVS
Purchase Price: $54.57 12/31/07: $54.31
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Page 30
Percentage Fair Value Estimate Change in 2007
Hare Portfolio
Tortoise Portfolio
WM
WTM
FAF
ADP
-100%
-50
0
50
GD
TRP
MCO
BRK.B
KO
PFE
JNJ
PEP
WMT
WWY
JPM
100%
AMGN
BSX
CX
IACI
DELL
-100%
MA
EXPE
CMP
FAST
APOL
IGT
EBAY
PAYX
MSFT
KMX
-50
0
50
100%
Fair Value estimate change since Jan 1, 2007, or when first added to portfolio, whichever is later. p Decreases p Increases
Companies not shown had no fair value estimate change.
Corporate Exc Board EXBD
Star Rating
QQQQQ
Business Risk
Avg
Fair Value ($)
93.00
Current Price ($)
60.10
Market Cap ($bil)
2.1
Dividend Yield (%)
2.7
Size of Moat
Wide
Consider Buying ($)
71.70
116.50
1-Yr Hi/Low ($) 96.33/58.54
Stewardship
¥
P/E
28.5
Discover Financial DFS
Star Rating
QQQQQ
Business Risk
Avg
Fair Value ($)
35.00
Current Price ($)
15.08
Market Cap ($bil)
7.2
Dividend Yield (%)
0.8
Size of Moat
Narrow
Consider Buying ($)
27.00
43.90
1-Yr Hi/Low ($) 32.17/14.81
Stewardship
—
P/E
—
One of the things I did several times in 2007 was to
buy more of companies that were already in the
portfolios as capital was freed elsewhere and/or the
newer opportunities became more attractive. With
these two trades, I was able to increase the position
size of both stocks while also reducing the Tortoise’s
cost basis in each.
July 10, Sold 400 Nokia NOK
Sales Price: $28.88 12/31/07: $38.39
My timing was fairly poor in selling Nokia, as I got out
just as the party was getting started. Although
Nokia clearly has great execution, I am still no fan of
industries with very fast product cycles and a
dependency on guessing short-term fashion and technological trends. I would consider buying Nokia again,
but only at a very deep discount to fair value, given
these characteristics and its narrow moat rating. Our
realized gain was 131% over roughly three years.
July 10, Bought 80 Corporate Exec. Board EXBD
Purchase Price: $67.64 12/31/07: $60.10
With the proceeds freed from the Nokia sale, I initiated
a position in this consulting firm that has some of
the most impressive financial characteristics I have
seen. The firm has essentially no invested capital
(meaning, nearly infinite ROICs), and free cash flow
regularly averages over 30% of sales. I would buy
more of this stock, if I had more capital available.
July 10, Bought 95 Fastenal FAST
Purchase Price: $42.11 12/31/07: $40.42
July 10, Bought 65 Enterprise GP Holdings EPE
Purchase Price: $39.02 12/31/07: $37.02
These two trades were examples of where I actually
averaged up in my cost basis in order to take bigger
swings at some of the fat pitches that were available.
In my view, both remain good long-term investments.
Aug. 8, Sold 200 Biogen Idec BIIB
Sales Price: $58.08 12/31/07: $56.92
I had some well-timed sales in 2007, but this was not
one of them. Not long after I sold, the company
announced it was attempting to sell itself (after activist
investor Carl Icahn got involved), and the stock
popped to above $80. While the company’s efforts ultimately came up empty and the stock has come
back down to earth, it sure would have been nice if I
had waited a couple weeks to sell. Sometimes luck
is on your side, sometimes not. This trade reminds me
of one of my favorite thoughts/quotes I heard this
year: “Only liars sell at the 52-week high, and buy at
the 52-week low.” Our realized gain was 78%,
with an average holding period of four and a half years.
Aug. 8, Bought 300 Discover Financial DFS
Purchase Price: $24.02 12/31/07: $15.08
Here is another trade where I wish I had waited a tad
longer before pulling the trigger. Discover has done
nothing but go down since I bought a mere five
months ago, as anything remotely related to consumer
credit risk has become toxic waste on Wall Street. We
are aware of the credit issues, and have built into our
valuation model a significant increase in charge-offs,
going from 3.8% in the most recent quarter to our
projection of an average of 5.5% the next couple years.
Even with these projections, our fair value remains $35
today, the same as it was the day I first bought.
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Star Rating
QQQQQ
Business Risk
Avg
Fair Value ($)
144.00
Current Price ($)
79.09
Market Cap ($bil)
7.6
Dividend Yield (%)
2.3
Size of Moat
Wide
Consider Buying ($)
111.00
180.40
1-Yr Hi/Low ($) 128.62/77.04
Stewardship
∑
P/E
15.8
Walgreen WAG
Star Rating
QQQQQ
Business Risk
Avg
Fair Value ($)
56.00
Current Price ($)
38.08
Market Cap ($bil)
37.8
Dividend Yield (%)
0.9
Size of Moat
Wide
Consider Buying ($)
43.20
70.20
1-Yr Hi/Low ($) 49.10/35.80
Stewardship
∑
P/E
18.5
Intl Speedway ISCA
Star Rating
QQQQQ
Business Risk
Avg
Fair Value ($)
63.00
Current Price ($)
41.18
Market Cap ($bil)
2.2
Dividend Yield (%)
0.2
Size of Moat
Wide
Consider Buying ($)
48.60
78.90
1-Yr Hi/Low ($) 54.78/41.02
Stewardship
¥
P/E
30.5
Oct. 3, Bought 51 Vulcan Materials VMC
Purchase Price: $94.88 12/31/07: $79.09
If I was going against the grain with Discover, I was
really going against the grain in buying quarry
operator Vulcan, which derives about one quarter of
its sales from the housing market. Thankfully,
the weakness in volumes going toward residential
construction is being more than offset by very
strong price increases and synergies from the recent
Florida Rock acquisition. I have a high conviction
with this particular investment. For more, see Page 7
of this issue and Page 22 of the October issue.
Oct. 11, Bought 155 Walgreen WAG
Purchase Price: $39.12 12/31/07: $38.08
After the company reported weak quarterly earnings
that prompted a severe fall in the stock price, we
had the opportunity to buy into this top-shelf retailer.
In owning Walgreen, we get a company with first-rate
efficiency that is benefiting from the aging population
(increasing per-capita consumption of prescriptions)
as well as rising health-care inflation. It is no surprise
to me that Walgreen regularly reports impressive
same-store-sales growth in the high single digits. This
is a stock I remain very excited about today.
Oct. 26, Sold 100 Coca-Cola KO
Sales Price: $61.42 12/31/07: $61.37
Coke is one of the success stories in the Tortoise. With
this sale, the Tortoise realized a gain of roughly
50% in under three years. Not bad for a company with
an exceptionally low risk profile and one of the
longest-lived moats around.
Nov. 8, Sold 50 Mastercard MA
Sales Price: $200.31 12/31/07: $215.20
Nov. 8, Sold 65 Apollo APOL
Sales Price: $78.15 12/31/07: $70.15
Nov. 8, Sold 150 Microsoft MSFT
Sales Price: $35.69 12/31/07: $35.60
Before I made a series of trades to reallocate capital
from the Hare’s lower-rated stocks to those that were
more undervalued, these three stocks—all of which
had appreciated to the neighborhood of their fair
value estimates and rated 3 stars—represented more
than 22% of the Hare. After trimming, they represented 11%. I still like all three companies very much,
January 2008
31
but it did not make sense to have them at such large
proportions of the portfolio, given their valuations.
Nov. 8, Bought 200 Discover Financial DFS
Purchase Price: $17.35 12/31/07: $15.08
Nov. 8, Bought 202 Cemex CX
Purchase Price: $27.45 12/31/07: $25.85
Nov. 8, Bought 60 International Speedway ISCA
Purchase Price: $43.90 12/31/07: $41.18
Nov. 8, Bought 69 Vulcan Materials VMC
Purchase Price: $81.81 12/31/07: $79.09
With the capital raised from the three trades above, I
added to the Hare’s stakes in these four companies, all with 5-star stocks trading well below their
fair value estimates, all stocks where I had limited
amounts of capital to invest in them when I initiated
the positions. With the seven reallocation trades,
I was able to raise the Hare’s dollar-weighted priceto-fair value ratio from 0.80 to 0.76.
Nov. 15, Sold 150 Colgate-Palmolive CL
Sales Price: $77.98 12/31/07: $77.96
Colgate is another success story in the Tortoise, as we
realized a gain of over 70% in a position held an
average of just over four years. Much like the realized
gain in Coke, this is far from a grand-slam investment gain, but I still view this as a winner, given the
relatively low amount of risk we were taking.
Nov. 15, Bought 75 Walgreen WAG
Purchase Price: $39.62 12/31/07: $38.08
With more capital becoming available from the sale
of Colgate, I was able to add to the Walgreen position
to bring it to a size more appropriate for my level of
confidence in the opportunity. For more on Walgreen,
see Page 22 of the November issue.
Nov. 15, Bought 350 Lowe’s LOW
Purchase Price: $24.85 12/31/07: $22.62
The final trade of the year really went against the
grain. Sure, the real estate market is in a deep recession, and flipping houses may no longer be in style,
but people still need to maintain their homes. Lowe’s
is also still expanding across the country (and
Canada) at a handsome rate, and it remains a very
financially healthy firm.
Continued on Back Cover
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Volume 7, Number 7
Equities Strategist and Editor
Paul Larson
What really attracts me to Lowe’s is simple valuation.
We have what I consider to be entirely realistic
assumptions built into our discounted cash-flow model
(negative same-store sales in 2008, profit margin
compression, etc.), and we still show the stock to be
worth $39. It may be a bumpy year or two, but I
have no doubt the profits at Lowe’s will be very meaningfully higher in 2010 and beyond. Lowe’s is among
my favorite stocks in the Tortoise right now. For more,
see Page 24 of the November issue.
About the year’s best and worst performers...
By far, the worst performer in either portfolio was
Washington Mutual WM, down 70% in 2007, as the
company is a main player in the mortgage mess
the credit markets are working through right now. We
started the year with a fair value estimate of $52,
and our fair value is now $43. For more on WaMu, see
Page 22. Amgen AMGN was another big loser, as
the stock’s price declined 32%, and our fair value estimate went from $91 to $66 on new revelations
concerning the company’s anemia drugs. Amgen,
WaMu, and Boston Scientific BSX (fair value from
$25 to $21 in 2007) are great examples of why we run
portfolios of diverse stocks. No investor ever batted
1.000, and we have to expect some losers to go along
with the winners.
folio’s relative underperformance—even though our
fair value increased slightly, and the company
received a nod from Berkshire Hathaway BRK.B.
Home Depot HD is another one where our fair
value estimate has not changed, yet the stock is far
cheaper than it once was after falling 33%. With
time, these particular stocks should perform just fine.
MasterCard’s MA stock did the best in 2007, up
118%, while our fair value estimate went from
$105 to $184. There were also a large number of
stocks that had smaller fair value increases.
Director of Stock Analysis
Pat Dorsey
Stock Analysts
Ann Gilpin, Michael Hodel,
John Owens, Ganesh Rathnam,
Julie Stralow, Erin Swanson,
Matthew Warren, Todd Young
Copy Editors
Designer
Christopher Cantore
Design Intern
Meghan Tweedie
Data Team
Desiree Deleoz, Jeff Manczko,
Neelm Pradhan
The bottom line is I don’t think there is any need to
overhaul our strategy. The performance in 2007
may have been anemic, but the portfolios are now in
the best position in years in terms of expected returns.
Over the long term, I am highly confident the returns
from the Tortoise and Hare will be quite handsome. œ
Programmers
Eider Deleoz, Christine Tan
Publisher
Maureen Dahlen
Product Manager
Jeannie Bernier
Chief of Securities Analysis
Haywood Kelly
President, Securities Research
Paul Larson owns the following companies mentioned in this
article: -APOL, AMGN, BAC, BRK.B, CTAS, CX, EBAY, EPE, EXBD,
DFS, FAST, HD, ISCA, +KMX, KO, LOW, MA, MSFT, NVS, TCLP, TRP,
VMC, WAG, WM
15
25
Catherine Gillis Odelbo
© 2008 Morningstar, Inc.
All rights reserved. Reproduction by
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and opinions are subject to change
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Although many other stocks in the portfolio saw their
prices decline, our fair values have held up for
many of them. For instance, CarMax was down 26%
in 2007—by far the largest contributor to the port-
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FundInvestor PMS 185 U

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