Avoiding the portfolio potholes

Christine St Anne | 03 Nov 2014

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Christine St Anne is Morningstar's online editor. Follow her on Twitter @MstarChristine


It can take only one bad stock investment decision to bring down the value of an investment portfolio.

Diversification is, of course, the key to ensuring this event is avoided. But good, thorough disciplined processes are also crucial when it comes to selecting the good stocks and avoiding the bad ones.

Investors can look to the Morningstar Income Portfolio as an example of a long-term, quality investment strategy.

In fact, the Morningstar Income Portfolio has consistently outperformed the market since its inception in 2002. This period included the global financial crisis in 2007 and the recent sell-off in September and October 2014.

"The Income Portfolio is about sustainability of dividends. We want to make sure we have stocks in the portfolio that can deliver sustainable cash flow and that are quality businesses. We don't want potholes that destroy the value of the other stocks in the portfolio," Morningstar head of equities research Peter Warnes said at the recent Morningstar Individual Investor Conference.

Warnes was part of Morningstar's equity panel at the conference. For Warnes and his fellow panellists -- sector head of resources Mathew Hodge and head of equity and credit research Joel Bloomer -- a robust research process will help investors avoid potholes.

Morningstar's "ratings ecosystem" organises the process. Key elements include:

• Competitive advantage -- economic moat,

• What's it worth -- fair value, DCF (discounted cash flow) model,
• Risk -- fair value uncertainty,

• Capital allocation -- how the stewardship of the company approaches capital management,

• Attractiveness -- price/fair value, recommendation,

• Suitability -- sustainable yield,

• Peer analysis -- 120-plus analysts, global coverage of 1,500 companies, investment committee.

Crucial to this process is Morningstar's moat methodology. Putting his "school teacher hat" on, Warnes emphasized to the audience the importance of moat-rated stocks by using the illustration below.



(click image to enlarge)


"A moat rating ensures a company can generate returns for the long term," Warnes said.

"We want to play in this end of the market," he said, pointing to the "narrow moat" and "wide moat" parts of the illustration.

Moat-rated stocks will also ensure capital preservation. They can also provide some sort of protection if an investor buys a stock at the wrong time.

"We have all bought assets at wrong time, but there is more chance of getting your money back with stocks that have a moat rating," Warnes said.

Stocks with moats possess competitive advantages such as intangible assets, switching costs, a network effect, cost advantages and efficient scale, as outlined in the recent video titled Why moats matter.

The Income Portfolio typically holds 15 to 20 stocks. A common investment risk is "trying to find something better" and hence the portfolio trades infrequently and consolidates trades where possible, Warnes said.

The portfolio has a strong preference for narrow and wide-moat companies, with a focus on quality companies that trade at a discount to intrinsic value.

Stocks with lower valuation uncertainty -- that is, companies whose valuations are easy to understand, such as Woolworths (WOW) -- are strongly preferred.

These best-practice processes ensure Morningstar's Income Portfolio avoids potholes.

Premium subscribers have full access to the Morningstar Income Portfolio.

This report appeared on www.morningstar.com.au 2022 Morningstar Australasia Pty Limited

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