By Robert Barker Morningstar, nearly synonymous with mutual-fund analysis, badly wants to be known for stock research as well. To help win that attention, the Chicago-based company has just unveiled a pair of actively managed stock portfolios -- the Tortoise and the Hare -- that it expects to beat the Standard & Poor's 500.
The Tortoise includes value stocks, while the Hare has more expensive and more volatile issues. To find out how Morningstar made its picks, I reached the manager of the portfolios, Mark Sellers, by phone the other day. Edited excerpts of our conversation follow.
Q: Why did you guys come up with these portfolios?
A: We wanted to be held accountable for the stock picks that we give, unlike a certain segment of Wall Street and the investment community. You'll see a lot of stock picks all over the financial press and on television, but you don't ever get a follow-up as to how they do.
Q: Well, sometimes there are follow-ups. You're throwing the financial press in the tank, too, for having conflicts of interest or hidden sources?
A: It varies. Some do and some don't. Obviously, Morningstar is independent, so we don't have investment-banking ties and ulterior motives to our recommendations. We're not always right, but we at least say how we feel about stocks.
Q: Even so, why should an investor look at your portfolios and say, "These guys know what they're doing -- I should pay attention."
A: We have a team of 23 analysts. Obviously, we're independent. We're honest, whether we like a stock or we don't. We follow up with telling people when to sell a stock.
Q: How many stocks would one of your analysts typically be responsible for following?
A: Around 40. The highest-profile companies in any particular industry are generally covered by a specialist within that industry.
Q: I see. And what's your background?
A: I have an accounting degree. I worked for GE Capital.
Q: We won't hold that against you.
A: [Laughs.] Great learning experience, although I wouldn't buy the stock (GE) right now. And I had a little hedge fund that I ran for a while.
Q: How did your hedge fund do?
A: It had its ups and downs, but it was during the Internet craze, so you know we did fairly well. But on a risk-adjusted basis it might not be [as good] because we did have some significant positions in some risky stocks.
Q: What process do you use to come up with fair value for a stock?
A: Our analysts specialize in particular industries as a general rule. They'll take their companies and do a discounted cash flow analysis, modeling the future earnings or the future cash flows of a company, and discounting them back to today. We use that as our fair value. We think the stock is over- or undervalued based on that.
Q: So you're applying that to how many stocks currently?
A: We do that for our largest 500. But then we sometimes see an interesting stock and we'll bring that under coverage as well as we find more interesting companies out there in the universe of 8,000 publicly traded U.S. companies.
Q: What else?
A: We have these four principles of profitable investing. We try to apply those in our model portfolios. And that is, [first], we look for companies with "economic moats."
Q: A moat being a sustainable competitive advantage?
A: Companies that we feel are able to sustain maybe cyclical downturns because they have some sort of competitive advantage that's going to allow them to survive while maybe their competitors' don't. Second, we also look for companies that are pretty far under fair value.
Q: O.K., so cheap stocks with moats. What else?
A: Also, we exploit the magic of compounding, so that we don't pay a lot of taxes and commissions and bid-ask spreads. So, we're going to try to be long-term investors in these stocks. [Finally,] knowing when to sell.
Q: What do you mean?
A: Some of the stocks we bought for turnaround reasons. And if they hit a price target that we have internally, we may lighten up or sell the whole position....Service Corp. (SRV), Office Depot (ODP), Knight Trading (NITE), Kemet (KEM) -- they're not necessarily stocks we would want to hold for 15 years or 10 years, but we'll hold them long enough till we think they get up to what we see as their fair value.
Q: So, just as a practical matter, how did you pick 'em?
A: Well, we actually have a portfolio committee of six.... [But] the actual pulling the trigger on each stock is my decision.
Q: So you're in a risky spot here!
A: Yeah, somebody's going to blame me if something goes wrong. And I'm hoping they're going to give me the kudos if things go right.
Q: I saw that you put Sears (S) in the portfolio at a hair under $40, but the fair value is listed at $40. What's going on?
A: In that case, I used to actually be the retail analyst for Morningstar, so I'm very familiar with Sears. I thought that the stock was a little more undervalued than our analyst on staff did.
Q: So you overrode the analyst and said, "I know this company, and I know it has a higher fair value," right?
A: In some cases, we did do that. Actually, our analysts are not required to have a positive opinion on the stocks within the portfolios. However, if the analyst has a strongly negative opinion on a stock that will cause us either to not add it or we'll have to...
Q: ...fire the analyst, right?
A: [Laughs.] We have to see if we can convince him, and if he has better reasons for not liking than we have for liking it, then we'll defer to the analyst.
Q: How much time should we give you to decide whether the portfolios are successful?
A: I don't think you can look at it at anything under a year. Our goal is three to five years. I don't think that there's any sort of predictability that goes along with anything under a year, and possibly not for three to five years. That said, if the market goes up 50% next year or for the rest of this year and we're only up 10%, I'm not going to sit here and tell you that you've got to give it more time. That's a significant underperformance.
Q: How can an investor follow your portfolios?
A: To subscribe to Morningstar Stock Investor would be the way. It's $89 a year. We have an e-mail alert service that's free of charge to subscribers, and what that means is if we ever make a trade in the portfolios, they find out right away.
Q: When is right away?
A: We never make trades on the open [of the day's trading]. It's always at the close. So we send an alert out before the market opens the next morning. Now, how fast people read their e-mail is up to them.
Editor's Note: Robert Barker will be on vacation for the next two weeks. The next Barker Online is scheduled to appear on Aug. 17. Barker covers personal finance in his Barker Portfolio column for BusinessWeek. His barker.online column appears every Friday, only on BW Online