A Closer Look at Morningstar's Four Stock Portfolios
Their philosophy, portfolio strategy, and portfolio composition.
by Haywood Kelly |
Nothing focuses the mind like the prospect of being hanged in a fortnight, and nothing focuses the investment mind like the prospect of allocating capital between two or more investments. That's one reason we now have four stock portfolios--the Tortoise and Hare portfolios, the Growth Portfolio, and the Dividend Portfolio--based on the research produced by Morningstar's team of equity analysts.
In these portfolios, we sift through our high-rated stocks and make decisions about which ideas are most compelling, and how much of a portfolio's capital to allocate to each holding. Now, there's nothing wrong with simply picking stocks from our 5-star list. The issue is that we currently have 79 5-star stocks--a lot to choose from, and certainly more stocks than most investors want to own or monitor. Plus, stocks enter and leave our 5-star list every trading day. Finally, those 79 stocks represent only 5% of our coverage universe of almost 1,700 stocks; the market isn't particularly cheap these days. If the market slid, you could easily see hundreds of 5-star stocks, which would make building a portfolio out of the 5-star stocks an even tougher challenge.
Different Circles of Competence…
Each portfolio focuses on a particular kind of stock, which allows each portfolio manager to exploit a different circle of competence. To uncover and analyze a small, rapidly growing company requires different techniques than analyzing a dividend-payer, for example.
For the Tortoise and Hare, published in the Morningstar StockInvestor newsletter managed by Paul Larson, the focus is on wide-moat companies--companies with established, clearly defined, and long-lasting competitive advantages. The investing strategy is simplicity itself: Monitor such companies and back up the truck whenever they become cheap. This strategy has clearly worked thus far. Since inception in mid-2001, the Tortoise Portfolio is up 65%, while the Hare has risen 28% versus only an 11% increase for the S&P 500 during this period.
For the Growth Portfolio in the Morningstar GrowthInvestor newsletter run by Mike Trigg, the focus is on companies with the potential for rapid, sustained growth. These tend to be smaller firms whose best years are (we hope) well off in the future. For these types of firms, you need a different set of analytical tools. Current and historical results count for little. What matters is the potential market opportunity.
For the Dividend Portfolio in Morningstar DividendInvestor managed by Josh Peters, the focus is on (what else) dividend-paying stocks, but more specifically on those companies that offer sustainable and growing dividends. One of the worst mistakes you can make is buying stocks based solely on a high current dividend yield. The analytical challenge is determining that the dividend is secure, which involves a combination of balance-sheet analysis, competitive analysis, and an assessment of corporate governance--whether management really will return money to shareholders through dividends. (We launched both the Dividend and the Growth portfolios in 2005, so we don't have much of a performance record to point to yet.)
Occasionally the different approaches will lead to the same destination. So, for example, you'll find IAC/InterActive Corp IACI in both the Growth and Hare portfolios, and Coca-Cola KO in both the Dividend and Tortoise portfolios. But the analysis that led us to those stocks differed in each case.
…But the Same Principles
While the circle of competence may differ, the underlying portfolio-building principles are exactly the same, and can be summarized as follows:
Buy stocks at a healthy margin of safety.
Don't dilute good ideas with mediocre ones.
Keep an eagle-eye on trading costs.
Forget sector or style targets; go where the opportunities are.
It's no accident that these principles are also those of the money managers whom we think do the best job by shareholders--managers like Chris Davis, Marty Whitman, and Bob Rodriguez. Below are some of the key stats of each Morningstar portfolio, as taken from Morningstar's Portfolio X-Ray.
Morningstar Portfolio Statistics
Tortoise
Hare Dividend Growth
# of Holdings 21 17 20 13
Top Holding First American FAF CarMax KMX Compass Minerals CMP Avid Technology AVID
Top Holding (%) 9 11 6 7
Forward P/E 16.80 19.58 14.46 22.56
Price/Book 3.12 3.42 2.83 3.03
ROA 8.17 10.47 6.61 11.07
ROE 31.69 22.01 21.15 22.31
Dividend Yield (%) 1.61 1.16 4.16 0.30
Median Market Cap 28,840.08 12,867.00 16,045.72 3,888.90
Data as of
Are We Value Investors?
As we never tire of pointing out, value and growth are not two ends of a spectrum. Valuation is a necessary component of any investing decision, whether one analyzes a fast-growing company or a slow-growing company. But as a shortcut in discussing portfolios, we often talk of value and growth as if they lay on a spectrum, and display this in the form of the Morningstar style box.
The chart shows how each of our four portfolios spreads out by the nine squares of the style box. I bolded the largest allocation in each. Two of the portfolios invest mainly in "growth," and only the Dividend Portfolio invests mainly in "value." And as you'd expect from a portfolio looking for tomorrow's leading companies, the Growth Portfolio allocates the bulk of its capital to mid- and small-cap stocks.
Morningstar Portfolios by Stock Style
Tortoise Hare Dividend Growth S&P 500
Large Value 23.38 0.00 35.58 0.00 33.50
Large Core 44.08 17.72 27.96 0.00 35.36
Large Growth 11.52 46.15 0.00 15.66 22.07
Mid-Cap Value 9.67 5.55 11.79 0.00 3.89
Mid-Cap Core 6.53 17.61 0.00 24.05 3.12
Mid-Cap Growth 4.09 0.00 0.00 39.08 1.98
Small Value 0.00 5.56 18.12 0.00 0.04
Small Core 0.00 7.41 6.54 3.99 0.03
Small Growth 0.00 0.00 0.00 17.22 0.00
Data as of
Just to reiterate: These allocations aren't set by any investment committee. They just happen to be where the portfolios fall now, given the opportunities available.
This is even clearer when you examine the sector allocation of each portfolio, where the allocations vary widely versus the market (as captured in the S&P 500). The Tortoise and Hare currently have a large chunk of capital invested in the service sector, the Dividend Portfolio's biggest overweighting versus the market is in manufacturing, and the Growth Portfolio overweights both the information and service economies.
Morningstar Portfolios by Sector
Tortoise Hare Dividend Growth S&P 500
Information 0.00 16.17 4.60 26.28 20.71
Software 0.00 7.32 4.60 19.82 3.84
Hardware 0.00 8.84 0.00 6.46 9.79
Media 0.00 0.00 0.00 0.00 3.89
Telecom 0.00 0.00 0.00 0.00 3.19
Service 71.88 70.91 49.02 57.26 45.76
Health Care 5.13 16.60 5.54 5.68 13.35
Consumer Services 9.05 31.80 4.22 43.94 8.60
Business Services 16.16 16.97 0.00 7.64 3.65
Financial Services 41.55 5.54 39.27 0.00 20.16
Manufacturing 28.12 12.92 46.38 16.46 33.52
Consumer Goods 16.61 0.00 19.34 8.57 9.04
Industrial Materials 3.11 7.41 10.89 7.89 12.19
Energy 8.39 5.51 16.15 0.00 8.82
Utilities 0.00 0.00 0.00 0.00 3.47
Data as of
From the Bottom Up
How might these allocations change over time? It's impossible to say. We don't believe anyone can predict the performance of the stock market, and we certainly don't try. We also don't try to predict which sectors will outperform, or which styles one should rotate into. Our buy decisions are simply a function of the stocks our analysts think are undervalued at any given time. A side effect of this strategy is that our performance will, at times, deviate sharply from that of the market. But unlike so many in the investment business, we don't define risk in terms of how much a portfolio departs from the market.
