Moats April 2012

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StockInvestor

When it comes to selecting securities for the Tortoise

and Hare portfolios, my strategy is to first focus on

wide-moat firmsthose with some sort of competi-

tive advantage that should allow them to generate

excess economic profits for at least two decades.

Second, I only purchase these firms when there is a

margin of safety in the current stock price. I define

margin of safety as buying securities at a discount to

our fair value estimates, which are driven by long-

term fundamental analysis and expected cash flows.

But there is indeed a leap between selecting securi-ties to buy and actually managing a real portfolio

made up of a number of stocks that are constantly

changing in market value.

One thing I try to do is maximize the expected return

by minimizing the dollar-weighted price/fair value

ratio of each portfolio. Every month in the portfolio

recapson Pages 5 and 7 of this issueI state the

estimated intrinsic value of the portfolios based

on our fair value estimates. I simply take the shares

of each security owned and multiply by the fairvalue estimate, then sum the value of all the positions.

I am trying to move the intrinsic value of each port-

folio ever higher through the trades I make, trimming

positions as the stocks approach fair value, and

recycling the capital into stocks that trade at greater

discounts to fair value.

Focusing strictly on the price/fair value does have one

significant downsideit does not take into consider-

ation either risk or uncertainty. All stocks that trade at,

say, a 25% discount to fair value are not created equal.

Id much rather buy low-risk, low-uncertainty Coca-

ColaKO at a 25% discount than I would a company

with much greater uncertainty, such as Moodys

MCO orWeight WatchersWTW. Focusing strictly on

price/fair value would have us constantly swinging

for the fences when there might be lower-risk singlesand doubles opportunities that have a very high

probability of success.

To account for risk and uncertainty, I also try to maxi-

mize the dollar-weighted Morningstar star rating

of each portfolio. Our fair value uncertainty ratings are

one of just three inputs into the star rating, the

others being the fair value estimate itself and the

market price. A company with a high uncertainty

rating requires a 40% discount to fair value to attain

a 5-star rating, while a low uncertainty stock needsjust a 20% discount to become 5 stars.

Looking beyond the value considerations, there are

a couple of other things I try to do when managing

the portfolios. One is to keep the number of stocks in

each portfolio reasonable. I currently have 23 stocks

in the Tortoise and 26 in the Hare. In an ideal world,

Id like to get these numbers down to 1520 names in

each portfolio. I think more value can be added by

assigning a greater weight to our very best ideas than

the exceptionally marginal diversification benefit thatcan be had by owning our 40th to 49th best ideas.

Moreover, I will make a lateral trade in terms of

expected value if it means an upgrade in the economic

moat rating. Selling a narrow-moat firm trading at

a 25% discount to fair value in order to buy a wide-

moat firm trading at the same discount is a perfectly

logical move.

Tortoise Portfolio Our favorite wide-moat firms

with lower risk, including Abbot

Laboratories and Lowes

Hare Portfolio

Our favorite aggressive picks

with moats, including Oracle an

MasterCard

Pauls Favorites for New Money

Todays Best Ideas

Wide-Moat Watchlist

Ratings and comments on morethan 140 wide-moat companies

Stocks in Focus 1

Merck, Medtronic, and Bank of

New York Mellon

Spotlight 2

Compass Minerals: Competitive

Strengths Remain Intact

Spotlight 2

Express Scripts: Merger Creates

A Wide Moat

Spotlight 2

More Profitable Growth to Come

for Discover Financial

Stock to Sell 3

Walgreen

Economic Snapshot 3

Taking the Pulse of the Economy

Follow Paul on Twitter@StockInvestPaul

Buying core holdings at a discount

Paul Larson

Equities Strategist and Editor

Continued on Page 2

SM

Portfolio ManagementStrategy

April 2012

Volume 11Number 10

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2

Finally, I try to keep reasonable diversification within

the portfolios so that Im not sticking my neck out

too far on any given unpredictable macroeconomic

factor. Our analysts certainly have views regarding

things like electricity prices, housing prices, fertilizer

volumes, interest rates, and so on (all likely to rise

from here). But the future is inherently uncertain, and

a number of our projections simply will not come

to fruition. I believe our analysts are more likely to

be correct than not, which is why I own Exelon

EXC (electricity), St. JoeJOE (housing), Compass

Minerals CMP (fertilizer), and PaychexPAYX

(interest rates), but I would never put more than one

third of my portfolio into securities that share the

same primary macroeconomic influences.

So, to recap, I try to maintain a very large proportion

of wide-moat firms in the portfolios, while minimizing

the price/fair value ratio, and maximizing the star

rating of the portfolios as a whole. This strategy has

done quite well for us over the last decade-plus,

and I havent exactly lost sleep owning high-quality

companies like Berkshire Hathaway BRK.B or

Wal-MartWMT for long stretches of time.

How to Start Following the Tortoise and HareOne of the most common questions I receive from

subscribers is how to adopt the strategy of the Tortoise

and Hare. I do not think new subscribers should run

out and buy all of the securities in the Tortoise and

Hare at any given time, since the portfolios contain a

mix of todays best ideas as well as a number of

yesterdays ideas that are likely to soon be harvested.

I think a better strategy is to focus on companies

trading at the largest discounts to fair value, and then

add more securities as opportunities arise. In otherwords, dont dive in all at once, but rather merge into

traffic over time. My goal with the relatively new

feature on Page 8 (Pauls Favorites for New Money)

is to better highlight those stocks that are looking the

most attractive today.

About the Wide-Moat Focus Index

Following last months cover story, I received a record

number of email inquiries about the wide-moat focus

index. I plan on making the index a regular part of the

newsletter. And to answer the most common question

I received: Yes, Morningstar has partnered with

other companies that do (or soon will) use the index

in some tradable products. As they say, stay tuned!

To recap how the index is created, we start with all of

the U.S.-based corporations in our coverage universe

rated with an economic moat rating of wide. We then

rank this group by price/fair value ratios and take

the 20 cheapest to create the index. We reconstitute

the index once every quarter, and the positions are

rebalanced to be equal-weighted (all 5% weights) at

the point of reconstitution.

The index was reconstituted in mid-March, and thetable here shows the included companies until we

reconstitute and rebalance again in mid-June. There

were six new companies added this time, and the

six companies that fell out of the index were eBay

EBAY, Franklin ResourcesBEN, National Oilwell

VarcoNOV, St. JudeSTJ, StrykerSYK, and Zimmer

ZMH. The turnover within the index remains quite

high, on pace to easily exceed 100% again this year,

far above the high-teens annual turnover rate that

the Tortoise and Hare historically have experienced.

One company that is not part of the index is my newest

purchase in the Hare, Express ScriptsESRX. I

bought the stock on the day we upgraded the economic

moat rating to wide, which immediately followed

the closing of the companys purchase of competitor

Medco. In a nutshell, the pharmacy benefit manage-

ment industry is one where scale is a competitive

advantage, and Express Scripts is now the largest by

far. It also has a business model that requires very

little invested capital and is benefiting from several

secular tailwinds, including an aging population anda desire/need to control overall health-care spending.

Getting back to the index, the cutoff this time around

for wide-moat firms to make the index in terms

of the price/fair value ratio was 0.82. Express Scripts

currently trades at a ratio of 0.77. If we were recon-

stituting the index in early April instead of mid-March,

=Express Scripts would be part of the index. See

Page 26 for more on Express Scripts.

Portfolio Management Strategy

Continued From Front Cover

PaychexPAYX

Star Rating QQQQUncertainty Med.

Fair Value ($) 38.00

Current Price ($) 31.05Market Cap ($bil) 11.3

Dividend Yield (%) 4.1

Size of Moat Wide

Consider Buying ($) 26.60

Consider Selling ($) 51.30

1-Yr Hi/Low ($) 33.71/25.12

Stewardship Z

P/E 20.8

Berkshire HathawayBRK.B

Star Rating QQQQUncertainty Med.

Fair Value ($) 100.00

Current Price ($) 79.76

Market Cap ($bil) 187.3

Dividend Yield (%)

Size of Moat Wide



1-Yr Hi/Low ($) 83.72/65.35

Stewardship

P/E 18.4

Express ScriptsESRX

Star Rating QQQQUncertainty Med.Fair Value ($) 73.00



Dividend Yield (%)

Size of Moat Wide



1-Yr Hi/Low ($) 60.89/34.47

Stewardship

P/E 22.3

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Morningstar StockInvestor April 2012 3

Master Limited Partnerships (MLPs) and

Qualified (IRA/401k) Accounts

Another very common question I receive is about the

tax treatment of MLPs. There are a number of MLPson the wide-moat watchlist; pipeline firms tend

to have wide moats. While returns on capital tend to

be modest (low teens), the excess returns they do

generate should last a very long time, often measured

in decades. Ive owned a number of MLPs in the Hare

over the years, including current holdings Energy

Transfer EquityETE , Enterprise Products Partners

EPD, and Magellan MidstreamMMP. This invest-

ment class also has increased in popularity in recent

years given its generally high yields from distributions

in a market parched for yield.

Regarding the tax consideration surrounding MLPs,

these investments are best held in a taxable account.

There are two main reasons for this. First, these

investments are inherently tax advantaged. If you own

these (or, say, muni bonds) in a qualified account,

you forgo those advantages. Here is the source of the

advantage for MLPs: These companies in most cases

pay out in distributions far more than the income they

generate that is considered taxable. The difference

is considered return of capital, which is not taxed

until one sells. As long as one doesnt sell, one can

defer this potential tax liability. (And if you happen

to continue to own these when you pass away, the

tax on this return of capital can be deferred forever,

since your heirs will have their cost basis stepped up.)

More importantly, while MLPs tend to not generate

much (if any) taxable income (especially in the first

few years after purchase), the income they do

generate is considered taxable, no matter what type

of account holds the investment. This is because

the income is considered unrelated business taxable

income (UBTI). If you generate more than $1,000 of

UBTI in your qualified account, you (or your accountant)will be stuck filling out form 990-T with the IRS and

likely having to withdraw from the account to pay for

taxes. Its just a sticky, tax-inefficient mess that I

recommend avoiding if at all possible. Just keep these

investments in your taxable accounts.

Upcoming Events

Again this year, I plan on attending Woodstock for

Capitalists, otherwise known as the Berkshire Hath-

away annual meeting. Among other things happening

that weekend in Omaha, I am slated to make a presen-tation at the 9th Annual Value Investor Conference

(www.valueinvestorconference.com) hosted by the

University of Nebraska Omaha, which is scheduled for

May 3 and 4. If you use economic moats in your invest-

ment process and love value investing, I cant recom-

mend these events highly enough. I guarantee you

will leave with a wealth of useful insights and enjoy

spending time with those that share a philosophy.

I am also slated to make a couple of presentations

at the MoneyShow in Las Vegas on May 1517.To receive your complimentary passes to the Money-

Show courtesy of Morningstar, please call

1-800-970-4355 and mention code 026640.

New Market Outlook Available

Your subscription includes access to our quarterly

market outlook. It has our economist Bob Johnsons

view as well as insights and ideas from each of our

sector teams. Please go to the StockInvestorwebsite

msi.morningstar.com to download the report.

Wide-Moat Focus Index Components (Q2, 2012)

Company Mkt Cap ($ Bil) Price ($) Fair Value ($) Price/Fair Value

C Amazon.com AMZN 87.3 191.87 225.00 0.85

Applied Materials AMAT 15.3 11.86 19.00 0.62

Bank of New York Mellon BK 28.0 23.34 35.00 0.67

Cisco Systems CSCO 107.5 19.96 26.00 0.77

CME Group CME 18.9 284.66 364.00 0.78

C Compass Minerals CMP 2.3 70.65 93.00 0.76

Exelon EXC 25.4 38.23 54.00 0.71

Expeditors Intl of Washington EXPD 9.7 45.85 61.00 0.75

General Electric GE 203.2 19.20 25.00 0.77

C Google GOOG 205.1 630.84 780.00 0.81

Martin Marietta Materials MLM 3.8 83.83 118.00 0.71

CMedtronic MDT 39.3 37.74 46.00 0.82

CMerck & Co. MRK 117.9 38.73 46.00 0.84

Northern Trust NTRS 11.1 46.22 58.00 0.80

Oracle ORCL 144.3 29.51 38.00 0.78

Pfizer PFE 166.2 22.05 27.00 0.82

C Schlumberger SLB 90.2 67.59 94.00 0.72

St. Joe JOE 1.6 17.33 26.00 0.67

Vulcan Materials VMC 5.4 42.02 63.00 0.67

Western Union WU 11.0 17.65 29.00 0.61

Energy Transfer EquityETE

Star Rating QQQQUncertainty Med.Fair Value ($) 54.00



Dividend Yield (%) 6.2

Size of Moat Narrow



1-Yr Hi/Low ($) 47.34/30.78

Stewardship

P/E 29.0

C New addition for Q2.

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4

Performance and Transaction SummaryMorningstar Ratings & Fundamentals Portfolio Data

Stock NameStarRating

Fair ValUncert.

FairValue

CurrentPrice

ConsiderBuying

ConsiderSelling

Size ofMoat

Div Yield(%)

Stew.Grade

FirstPurchase

# of SharesChange Total

Cost Basis/Share Total Cost

Current-Value

Gain/Loss %

% ofPort

Abbott Laboratories ABT QQQQ Low 70.00 60.97 56.00 87.50 Wide 3.4 C 02-04-11 0 289 47.68 13778.65 17620.33 27.9 8.5

Lowes Companies LOW QQQ Med. 34.00 31.09 23.80 45.90 Wide 1.8 Z 11-15-07 0 500 25.07 12534.40 15545.00 24.0 7.5

ExxonMobil XOM QQQQ Low 91.00 83.88 72.80 113.75 Wide 2.2 07-11-08 0 178 76.68 13648.17 14930.64 9.4 7.2

Exelon EXC QQQQ Med. 54.00 38.23 37.80 72.90 Wide 4.0 10-06-09 0 370 46.55 17224.65 14145.10 -17.9 6.8

Berkshire Hathaway BRK.B QQQQ Med. 100.00 79.76 70.00 135.00 Wide 0.0 06-18-01 0 175 51.23 8965.58 13958.00 55.7 6.7

Pfizer PFE QQQQ Med. 27.00 22.05 18.90 36.50 Wide 4.0 C 09-24-01 0 470 22.60 10622.05 10363.50 -2.4 5.0

Novartis NVS QQQQ Low 69.00 54.72 55.20 86.25 Wide 4.5 X 02-09-07 0 185 56.80 10508.61 10123.20 -3.7 4.9

Automatic Data Prcssing ADP QQQ Med. 57.00 54.57 39.90 77.00 Wide 2.9 X 06-14-02 0 175 27.84 4872.72 9549.75 96.0 4.6

Wal-Mart Stores WMT QQQ Low 61.00 60.13 48.80 76.25 Wide 2.6 X 07-19-02 0 150 47.43 7114.28 9019.50 26.8 4.3

Johnson & Johnson JNJ QQQQ Low 77.00 64.92 61.60 96.30 Wide 3.5 C 12-06-05 0 130 59.51 7736.38 8439.60 9.1 4.1

General Dynamics GD QQQ Med. 75.00 70.82 52.50 101.30 Wide 2.9 Z 03-12-03 0 110 33.12 3643.34 7790.20 113.8 3.7

Kinder Morgan Mngmnt KMR QQQQ Med. 86.00 74.10 60.20 116.10 Wide 0.0 03-08-06 0 104 32.48 3377.93 7706.40 128.1 3.7

Cintas CTAS QQQ Med. 37.00 38.34 25.90 49.95 Narrow 1.4 C 05-16-07 0 200 37.61 7522.00 7668.00 1.9 3.7

American Express AXP QQQ High 54.00 57.16 32.40 83.70 Wide 1.4 X 07-18-01 0 125 29.46 3682.50 7145.00 94.0 3.4

Sysco SYY QQQQ Med. 36.00 29.11 25.20 48.60 Wide 3.7 X 04-28-08 0 235 29.01 6817.73 6840.85 0.3 3.3

JPMorgan Chase JPM QQQ High 51.00 43.89 30.60 79.10 Narrow 2.7 Z 07-23-02 0 150 30.49 4574.16 6583.50 43.9 3.2

TransCanada TRP QQQ Low 44.00 42.93 35.20 55.00 Narrow 4.1 Z 01-23-04 0 150 21.21 3181.88 6439.50 102.4 3.1

Procter & Gamble PG QQQQ Low 72.00 66.81 57.60 90.00 Wide 3.1 X 05-12-09 0 75 50.86 3814.74 5010.75 31.4 2.4First American Financial FAF QQQQ High 25.00 16.55 15.00 38.80 Narrow 1.9 06-02-10 0 300 12.21 3662.97 4965.00 35.6 2.4

PepsiCo PEP QQQQ Low 72.00 65.35 57.60 90.00 Wide 3.2 Z 07-19-02 0 75 35.92 2694.25 4901.25 81.9 2.4

CoreLogic CLGX QQQQ Med. 21.00 15.60 14.70 28.40 Narrow 0.0 X 03-17-04 0 300 16.49 4948.02 4680.00 -5.4 2.3

3M MMM QQQQ Low 100.00 86.33 80.00 125.00 Wide 2.7 X 01-23-08 0 50 74.93 3746.49 4316.50 15.2 2.1

Molson Coors Brewing Co TAPQQQQ Med. 55.00 41.17 38.50 74.25 Narrow 3.1 V 02-25-10 0 70 40.80 2856.15 2881.90 0.9 1.4

Walgreen WAG QQQ High 35.00 32.56 21.00 54.25 Narrow 2.8 X 10-11-07 -110 0 39.37 4330.61 0.00 -14.0 0.0

Tortoise Portfolio

Cash Holdings 7581.52 3.6

Tortoise Portfolio Total 2.9 208204.99

C

Goal of the Tortoise

The Tortoise Portfolio has two goals: to outperform the S&P 500 Index and togenerate positive returns regardless of the broad market environment. Companies

in this portfolio tend to be large, with moderate to low risk, and slow-growing.We aim for all the companies here to have an economic moat, preferably wide.

Legend:

Shares added

Shares sold

New holding

UR Under Review

NR Not Rated

Footnotes:

Morningstar ratings and fundamentalsas of 04-09-12. Portfolio inception

date: 06-18-01. *March 7 to April 9.

Morningstar Investment Services,Inc. is a registered investmentadvisor and wholly owned subsidiaryof Morningstar, Inc.

Cost basis includes commissions. Returns since inception are

annualized and include dividends.

**Invest in the Tortoise ApproachThe Hassle-Free Way.Did you know that Morningstar Investment Services now offers a customizableportfolio patterned after StockInvestor s Tortoise portfolio? To learn more, call1-866-765-0663.**

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Portfolio Roundup

Tortoise Performance Breakdown

150

120

90

60

30

0

-30

Cumulative Total Return Comparison (%)

pTortoise Portfolio pS&P 500 Index

Top Five Sectors (%)

d Healthcare 23.2

y Financial Srvcs 16.3

o Energy 14.5

s Cons Defensive 14.3

p Industrials 13.1

p51100

p2650

p1125

p010

Style Breakdown (%)

Value Blend Grth

Lrg

Med

Sm

51 27 8

5 4 0

5 0 0

Total Return (%) Index Level This Month 12 Month Since Inception

Tortoise Portfolio 2.5% 7.7% 7.6%

S&P 500 Index 1382.2 3.5% 6.3% 3.2%

*

From inception on June 18, 2001,throughApril 9, 2012,

the Tortoise has produced a total return of 119.5%

compared to 40.3% for the S&P 500 Index and 40.7%

for the average large-cap blend mutual fund. Total

returns include dividends for both the Tortoise and the

benchmarks. During the last 12 months, the Tortoise

has outperformed 89.4% of large-cap blend funds and

is still beating 99.4% of them since inception.

The Tortoise did not have the best month in March,

with the S&P 500 jumping ahead 3.5% since lastissue. Im not worried; the Tortoise still posted a posi-

tive absolute return, and I continue to expect our

periods of outperformance will come in bear markets,

not what weve experienced in recent months.

I made just one trade in the Tortoise this month, closing

outWalgreenWAG on April 3 at $33.99, realizing

a 14% capital loss on a position initiated in 2007. The

reason I sold Walgreen dovetails with the reason

I bought Express ScriptsESRX in the Hare. Namely,

the recent spat between the two companies showsthat the balance of power lies with the pharmacy

benefit managers and their clients (that care more

about lowering overall health-care costs) than it does

with the pharmacies (that offer convenience).

There were four fair value estimate changes since

last issueone reduction and three increases. We

trimmed ExelonEXC by $4 per share following its

merger with Constellation Energy, and we also cut

ExxonMobilXOM by $8 per share. On the other side

of the coin, we raised Kinder Morgan by $13 per

share and Berkshire HathawayBRK.B by $11.

Taking all of these changes into consideration, the

estimated intrinsic value (shares held times fair value)

of the Tortoise is now $240,583, a 0.5% increase

from $239,345 last month. This increase is because

of the net increase in the fair value estimates as

well as dividends that have accrued. The Tortoise

now trades at a 13.5% discount to its estimated fair

value, a slight decrease from the 15.1% seen lastmonth, largely because of stock prices that increased

more than the net increase in the fair value esti-

mates. The dollar-weighted average star rating is also

now 3.65, a moderate decrease from 3.79 last month,

thanks again to recent price appreciation. While there

are a large number of mildly undervalued stocks avail-

able today, the pickings are still pretty slim regarding

table-pounding opportunities.

by Paul Larson

Contact Paul Larson at [email protected]. Paul Larson personally ownsshares of the following Tortoise stocks:ABT, AXP, BRK.B, CLGX, CTAS, EXC, FAF, GD, JNJ, JPM, KMR, LOW, MMM, NVS,

PFE, PG, SYY, TAP, TRP, WAG, WMT, XOM.

Paul has increased his position in the stock in the past month.

Paul has reduced his position in the stock in the past month.

2012 Morningstar, Inc. All rights reserved. Any opinions, recommendations,or information contained herein: (i) is for educational purposes only; (ii) is notguaranteed to be accurate, complete, or timely; (iii) has not been tailored to suitany particular persons portfolio or holdings; and (iv) should not be construed asinvestment advice of any kind. Neither Morningstar nor any of its agents shallhave any liability with respect to such opinions, recommendations, or information.Morningstar has not given its consent to be deemed an expert under the federalSecurities Act of 1933. Past performance is no guarantee of future results. Beforemaking any investment, consult with your financial advisor. Morningstar employeesmay have holdings in the stocks recommended.

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

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6

Performance and Transaction SummaryMorningstar Ratings & Fundamentals Portfolio Data

Stock NameStarRating

Fair ValUncert.

FairValue

CurrentPrice

ConsiderBuying

ConsiderSelling

Size ofMoat

Div Yield(%)

Stew.Grade

FirstPurchase

# of SharesChange Total

Cost Basis/Share Total Cost

Current-Value

Gain/Loss %

% ofPort

St. Joe JOE QQQQ High 26.00 17.33 15.60 40.30 Wide 0.0 06-08-10 0 1050 22.56 23683.38 18196.50 -23.2 8.1

Compass Minerals CMP QQQQ Med. 93.00 70.65 65.10 125.60 Wide 2.8 08-18-05 0 200 25.40 5080.74 14130.00 178.1 6.3

MasterCard MA QQQ High 394.00 439.29 236.40 610.70 Wide 0.3 C 05-30-06 0 30 44.00 1319.99 13178.70 898.4 5.9

Energy Transfer Equity ETE QQQQ Med. 54.00 40.05 37.80 72.90 Narrow 6.2 10-13-10 0 325 37.94 12331.44 13016.25 5.6 5.8

Express Scripts ESRX QQQQ Med. 73.00 56.32 51.10 98.55 Wide 0.0 04-03-12 +220 220 56.95 12527.99 12390.40 -1.1 5.5

eBay EBAY QQQQ Med. 42.00 36.30 29.40 56.70 Wide 0.0 Z 04-20-06 0 330 33.08 10917.98 11979.00 9.7 5.3

Paychex PAYX QQQQ Med. 38.00 31.05 26.60 51.30 Wide 4.1 Z 06-24-02 0 350 28.65 10026.38 10867.50 8.4 4.8

Google GOOG QQQQ High 780.00 630.84 468.00 1209.00 Wide 0.0 C 07-14-11 0 17 530.59 9019.99 10724.28 18.9 4.8

Autodesk ADSK QQQ Med. 39.00 40.54 27.30 52.70 Wide 0.0 C 11-18-08 0 250 19.43 4857.50 10135.00 108.7 4.5

Discover Financial DFS QQQ High 34.00 32.65 20.40 52.70 Narrow 1.2 08-08-07 -200 300 21.39 6416.67 9795.00 52.7 4.4

Strayer Education STRA QQQQ High 130.00 88.29 78.00 201.50 Narrow 4.5 Z 10-19-11 0 110 88.72 9759.29 9711.90 -0.5 4.3

CME Group CME QQQQ High 364.00 284.66 218.40 564.20 Wide 3.1 X 01-13-12 0 30 235.13 7053.91 8539.80 21.1 3.8

Zimmer Holdings ZMH QQQ Med. 71.00 64.15 49.70 95.90 Wide 1.1 Z 11-17-10 0 125 50.34 6292.36 8018.75 27.4 3.6

International Speedway ISCA QQQ V.High 26.00 28.25 13.00 45.50 Wide 0.7 C 01-06-06 0 280 40.18 11251.49 7910.00 -29.7 3.5

National Oilwell Varco NOV QQQQ Med. 97.00 78.21 67.90 131.00 Wide 0.6 C 10-18-11 0 100 64.03 6402.94 7821.00 22.2 3.5

Oracle Corp ORCL QQQQ Med. 38.00 29.01 26.60 51.30 Wide 0.8 01-13-12 0 250 26.99 6747.25 7252.50 7.5 3.2

CarMax KMX QQQ High 33.00 32.78 19.80 51.20 Narrow 0.0 X 01-20-04 -150 200 14.71 2942.08 6556.00 122.8 2.9

Western Union WU QQQQQ Med. 29.00 17.65 20.30 39.20 Wide 2.3 10-02-06 0 365 17.74 6474.63 6442.25 -0.5 2.9Cloud Peak Energy CLD QQQQQ High 29.00 15.30 17.40 44.95 Narrow 0.0 03-15-11 0 400 19.97 7989.96 6120.00 -23.4 2.7

Magellan Midstream MMP QQ Low 68.00 71.49 54.40 85.00 Wide 4.6 X 04-28-08 0 75 35.83 2687.24 5361.75 99.5 2.4

Vulcan Materials VMC QQQQQ Med. 63.00 42.02 44.10 85.10 Wide 0.1 10-03-07 0 120 87.53 10503.68 5042.40 -52.0 2.2

Cisco Systems CSCO QQQQ Med. 26.00 19.96 18.20 35.10 Wide 1.6 X 01-21-11 0 250 20.84 5209.98 4990.00 -4.2 2.2

Microsoft MSFT QQQQ Med. 35.00 31.10 24.50 47.25 Wide 2.6 Z 08-22-05 0 150 26.30 3945.63 4665.00 18.2 2.1

Enterprise Products EPD QQQ Med. 55.00 50.24 38.50 74.25 Narrow 4.9 X 05-29-07 0 75 23.26 1744.64 3768.00 116.0 1.7

International Game Tech IGT QQQ High 19.00 16.40 11.40 29.45 Narrow 1.5 X 06-27-05 0 200 28.35 5669.00 3280.00 -42.1 1.5

Cemex CX QQQQ V.High 11.00 7.25 5.50 19.30 Narrow 0.0 12-11-06 +17 443 23.48 10402.92 3211.75 -69.1 1.4

Hare Portfolio

Cash Holdings 1691.27 0.8

Hare Portfolio Total 2.4 224795.00

Invest in the Hare ApproachThe Hassle-Free Way.Did you know that Morningstar Investment Services now offers a customizableportfolio patterned after StockInvestor s Hare portfolio? To learn more,call 1-866-765-0663.**

Goal of the Hare

The Hare Portfolio has two goals: to outperform the S&P 500 Index, and to generatepositive returns regardless of the broad market environment. Companies in thisportfolio tend to either be small or fast-growing, or have a high risk/return proposi-tion. We aim for all companies here to have an economic moat, preferably wide.C

C

Legend:

Shares added

Shares sold

New holding

UR Under Review

NR Not Rated

Footnotes:

Morningstar ratings and fundamentalsas of 04-09-12. Portfolio inceptiondate: 06-18-01. *March 7 to April 9.

Morningstar Investment Services,Inc. is a registered investmentadvisor and wholly owned subsidiaryof Morningstar, Inc.

Cost basis includes commissions. Returns since inception are

annualized and include dividends. Master limited partnership units

have different tax characteristicsthan common stocks and may not besuitable for tax-deferred accountssuch as IRAs. Please consult your taxadvisor before buying.

**

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Portfolio Roundup

Hare Performance Breakdown

150

120

90

60

30

0

-30

Cumulative Total Return Comparison (%)

pHare Portfolio pS&P 500 Index

From inception on June 18, 2001, through April 9,2012,

the Hare has produced a total return of 105.3%

compared to 40.3% for the S&P 500 Index and 40.5%

for the average large-cap growth mutual fund. Total

returns include dividends for both the Hare and the

benchmarks. During the last 12 months, the Hare has

outperformed just 22.1% of large-cap growth funds

but is still beating 98.3% of them since inception.

A couple of stocks in the Hare had a relatively tough

time since last issue, namely StrayerSTRA (off 8.5%)and Cloud PeakCLD (off 9.1%), the same stocks

that were drags on performance in February. On the

other hand, IGTIGT, International SpeedwayISCA,

and AutodeskADSK all appreciated more than 10%.

There were a number of fair value estimate changes.

On one hand, we trimmed OracleORCL by $3.

We also published a new $54 fair value estimate for

Energy Transfer EquityETE, down $4 from before

we put the stock under review. On the other hand, we

added $36 to the GoogleGOOG fair value estimate,and also added $4 to DiscoverDFS.

I made three trades in the Hare since last issue, all on

April 3. I trimmed Discover (200 shares at $33.37)

and CarMaxKMX (150 shares at $34.70) to make the

position sizes more accurately reflect the remaining

opportunity in these names. I then purchased a new

position, buying 220 shares of Express ScriptsESRX

at $56.90. Read further into this issue for much more

on Express Scripts.

Following all of these changes, the estimated intrinsic

value of the Hare is now up to $279,959, a signifi-

cant 3.6% jump from last issue. The net fair value

estimate increases as well as the trades were both

responsible for the increase in overall estimated

value. The Hare now trades at a 19.7% discount to

this estimated fair value, slightly better than the

18.4% discount seen last issue, thanks largely to

the fair value estimate increases that were of greater

magnitude than the market price increases. The

dollar-weighted average star rating is now 3.73, upslightly from 3.70 last issue.

by Paul Larson

Contact Paul Larson at [email protected]. Paul Larson personally ownsshares of the following Hare stocks:ADSK, CLD, CME, CMP, CSCO, CX, DFS, EBAY, EPD, ESRX, ETE, GOOG, IGT,ISCA, JOE, KMX, MA, MMP, MSFT, NOV, ORCL, PAYX, STRA, VMC, WU, ZMH.

Paul has increased his position in the stock in the past month.

Paul has reduced his position in the stock in the past month.

2012 Morningstar, Inc. All rights reserved. Any opinions, recommendations,or information contained herein: (i) is for educational purposes only; (ii) is notguaranteed to be accurate, complete, or timely; (iii) has not been tailored to suitany particular persons portfolio or holdings; and (iv) should not be construed asinvestment advice of any kind. Neither Morningstar nor any of its agents shallhave 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. Beforemaking any investment, consult with your financial advisor. Morningstar employeesmay have holdings in the stocks recommended.

Total Return (%) Index Level This Month 12 Month Since Inception

Hare Portfolio 1.9% 2.1% 6.9%

S&P 500 Index 1382.2 3.5% 6.3% 3.2%

*

p51100

p2650

p1125

p010

Top Five Sectors (%)

a Technology 18.4

y Financial Srvcs 17.0

o Energy 13.4

r Basic Mtrls. 12.8

t Cons Cyclical 11.9

Style Breakdown (%)

Value Blend Grth

Lrg

Med

Sm

4 10 30

2 20 9

3 22 0

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

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8

Todays Best Ideas

Here is a new monthly feature in which Paul highlights some of the stocks fromthe Tortoise and Hare that look the absolute most attractive to him today.The companies are ranked here by their attractiveness. Data as of April 9, 2012.

Pauls Favorites for New Money

eWestern Union WU | QQQQQFair Value Est. Current Price The risks the company faces from technological disruption are over-

blown as the technical hurdles to connect one countrys telecom

and payment infrastructure to another countrys are immense. Plus,

Western Union is in a very good position to utilize whatever

the next payment standard is. Meanwhile the stock trades at just

9 times earnings and with a free cash flow yield near 10%.$29.00 $17.65

rSt. Joe JOE | QQQQFair Value Est. Current Price St. Joe moves down the list from the top spot after appreciating

since last month. Progress has been made developing the area

around the new Panama City airport and Port of St. Joe. Mean-

while, the stock continues to be priced at dirt-cheap levels. Theimplied valuation on the companys land is near a mere $2,500 per

acre, dramatically undervaluing the significant number of acres

around the airport and along the beach. Meanwhile, limiting the

downside, the company has just $54 million in debt balanced

against $186 million in cash and Treasuries.

$26.00 $17.33

tExelon EXC | QQQQFair Value Est. Current Price Owning the largest nuclear power plant fleet in the country, Exelon

is a low-cost generator of electricity. While exceptionally low

natural gas prices have been a headwind thus far, a major tailwind

is emerging in the form of tightened EPA emissions standards for

its competitors that stand to raise the price of electricity. While we

wait for this positive catalyst to unfold, we can collect a juicy

5.5% yield on the shares (adjusted for the Constellation merger).$54.00 $38.23

uVulcan Materials VMC | QQQQQFair Value Est. Current Price This firm has suffered through terrible cyclical headwinds during

the last four years, and those headwinds should become

tailwinds sooner than later. Home construction activity should

normalize to roughly match new household formation. Not

only will recovering volumes help revive revenue, but there is also

significant operating leverage built in as currently underutilized

assets become more efficiently used. The Martin Marietta MLM

merger proposal looks inferior.

$63.00 $42.02

iEnergy Transfer Equity ETE | QQQQFair Value Est. Current Price We recently published a new $54 fair value estimate. ETE is like an

asset manager in that it can grow its earnings by increasing the

profits from its underlying businesses or by managing more assets.

Both are likely to occur. The merger with Southern Union is likely to

keep distribution growth from happening for a couple of quarters,

but the current yield of 6.1% is relatively rich.$54.00 $40.05

oExpress Scripts ESRX | QQQQFair Value Est. Current Price The newest addition to the Wide-Moat Watchlist is also now in the

Hare portfolio. The merger with Medco created a wide-moat firm.

Meanwhile, the company trades at just 13 times forward consensus

EPS estimates despite having the secular tailwinds of an aging

population (more overall prescription drug use), more generic drugs

available, and societys need to lower overall health-care spending.$73.00 $56.32

pCompass Minerals CMP | QQQQFair Value Est. Current Price An exceptionally warm winter has opened up an opportunity to

buy one of the relatively few wide-moat firms with a positive

moat trend. While near-term results from its highway salt business

should be very weak, the long-term competitive advantages are

only growing stronger as the company increases capacity and

reduces unit costs at its two flagship facilitiesGoderich and

Great Salt Lake. See Page 22 for more.$93.00 $70.65

aCME Group CME | QQQQFair Value Current Price The company has a wide moat thanks to the network effect, which

is one of the most potent sources of competitive advantage.

Reflecting the moat, this company is exceptionally profitable, as

operating margins routinely top 80% and aftertax margins

approach 40%. We can buy the shares at just 14 times 2012

estimated earnings. Meanwhile, CME just bumped its dividend

(new yield: 3.1%) and initiated a special annual dividend ($3 per

share for this year).

$364.00 $284.66

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Stew. GradeMorningstar Stewardship Grade CNew Addition aTortoise Holding bPotential Tortoise Holding cHare Holding dPotential Hare Holding

Company Name Star Rating

FairValue-Uncert.

Fair-Value

CurrentPrice

Consider-Buying

MoatTrend

Stew.Grade

Yield(%) P/E

Port-fol io Comments*

3M MMM QQQQ Low 100.00 86.33 80.00 k X 2.7 14.5 a

Abbott Laboratories ABT QQQQ Low 70.00 60.97 56.00 k C 3.4 20.2 a

Adobe Systems ADBE QQQ Med. 33.00 33.22 23.10 l C 0.0 21.2 d

Advisory Board ABCO Q Med. 58.00 86.82 40.60 k C 0.0 66.7 d

Allergan AGN QQQ Med. 92.00 ] 93.94 64.40 l 0.2 31.3 d

AllianceBernstein AB QQQ High 15.00 14.74 9.00 l V 3.3 d

Altria MO QQ Med. 24.00 31.16 16.80 k C 5.3 19.0 d

Amazon.com AMZN QQQ High 225.00 191.87 135.00 k X 0.0 d

Ambev ABV QQQ High 36.00 40.83 21.60 k 3.8 28.4 b

American Express AXP QQQ High 54.00 57.16 32.40k

X 1.4 14.0 a

Amgen AMGN QQQ Med. 68.00 67.02 47.60 l V 2.2 16.6 d

Anheuser-Busch InBev BUD QQQ High 70.00 70.67 42.00 l 1.9 23.7 b

Applied Materials AMAT QQQQQ Med. 19.00 11.86 13.30 k C 3.0 10.2 d

AstraZeneca AZN QQQQ Med. 53.00 44.05 37.10 l C 8.9 6.0 d

Autodesk ADSK QQQ Med. 39.00 40.54 27.30 k C 0.0 33.2 c

Automatic Data Prcssng ADP QQQ Med. 57.00 54.57 39.90 k X 2.9 20.2 a

Bank of New York Mellon BK QQQQ High 35.00 23.34 21.00 k C 2.2 11.5 b

Berkshire Hathaway BRK.A QQQQ Med. 150000 ] 119700 105000 k 0.0 19.3 b

Berkshire Hathaway BRK.B QQQQ Med. 100.00 ] 79.76 70.00 k 0.0 18.3 a

Biogen BIIB QQ Med. 107.00 126.61 74.90 k C 0.0 25.1 d

BlackRock BLK QQQ Med. 216.00 202.74 151.20 j C 3.0 16.4 d

Innovation basis of moat. Two thirds of sales outside U.S.

CEO Buckley stepping down, replaced by Inge Thulin.

Diversified firm with patent-protected drugs and a leading

diagnostics operation. Splitting into two.

Acrobat and Photoshop are industry standards.

HTML5 gradually displacing Flash.

Similar to Corp. Executive Board but focused on health-care

and education sectors. Sensitive to economic conditions.

Specialty pharmaceutical company that derives more than

one third of its revenue from Botox.

Top-tier asset manager. Conditions in capital markets can

both help and hurt results.

Focused on U.S. tobacco market. Marketing ban raises

barriers to entry. High taxes actually yield pricing power.

Head and shoulders above competition in online retailing.

Increasing competition with Apple and Google.

Dominates Brazil beer market; strong in other markets, soft

drinks. Currency volatility with Brazilian real has moderated.

Large payment network combined with lending operation.Loan losses have continued to fall.

Top-shelf biotech. Anemia drugs contending with

reimbursement pressures and biosimilars.

Controls 25% of global beer market. Cut overhead expenses

and marketing to help pay for merger.

Semiconductor equipment standard-bearer. Technological

lead and broad product portfolio. Very cyclical.

Number one in gastrointestinal (ulcer) drugs. Hefty late-stage

pipeline. Expanding biologic presence.

AutoCAD software is close to a standard and has very high

switching costs. Recovery in demand continues.

Payroll processing leader. Minimal client turnover. Low

interest rates hurt earnings, as does anemic labor market.Mammoth in asset custody and management. Benefits from

large scale. Featured this issue.

Buffett still going strong. Bought big stake in IBM. Started

buying back shares. Woodstock for Capitalists around corner.

B-share value is now worth 1/1500th of A-share. Investments

during crisis paid off handsomely. History could be repeating.

Multiple-sclerosis leader with two leading treatments,

Avonex and Rituxan. Tysabri has good efficacy and potential.

After several mergers, now the largest asset manager in the

world, with more than $3 trilli on under management.

Wide-Moat Watchlist More Wide-Moat Watchlist Information!If you wish to read more about any of the companies on the Wide-Moat Watchlist,please visit msi.morningstar.com. We have made available the analyst reportsfor each of the companies on the watchlist.

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10

*Fair value based on Morningstar analyst estimates. Data through April 9, 2012. URUnder Review ]Fair Value Increased [Fair Value Decreased jPositive kStable lNegative

Wide-Moat Watchlist (continued)

Company NameStarRating

Fair ValueUncert.

FairValue

CurrentPrice

ConsiderBuying

MoatTrend

Stew.Grade

Yield(%) P/E

Port-foli o Comments*

Boardwalk Pipeline Prtnrs BWP QQQQ Low 29.00 26.85 23.20 l C 7.9 24.6 d

Bristol-Myers Squibb BMY QQ Med. 30.00 33.04 21.00 l C 4.1 15.3 d

British Amer Tbco BTI QQ Med. 82.00 101.07 57.40 k X 5.5 20.4 d

Buckeye Partners LP BPL QQQQ Low 67.00 59.88 53.60 k X 6.9 50.0 d

Campbell Soup CPB QQQQ Low 36.00 33.24 28.80 k C 3.5 14.1 b

Capella Education CPLA UR High UR 34.68 UR k X 0.0 10.2 d

Caterpillar CAT QQQ High 111.00 103.57 66.60 l X 1.8 14.0 b

CH Robinson Worldwide CHRW QQQQ Med. 73.00 64.00 51.10 k X 2.1 24.4 d

Cisco Systems CSCO QQQQ Med. 26.00 19.96 18.20 l X 1.6 15.6 c

CME Group CME QQQQ High 364.00 284.66 218.40 k X 3.1 10.5 c

Coca-Cola KO QQ Low 69.00 72.87 55.20 k X 2.8 19.8 b

Colgate-Palmolive CL QQ Low 92.00 97.04 73.60 k X 2.6 19.6 b

Comcast CMCSA QQQ Med. 30.00 29.33 21.00 l C 2.2 19.6 d

Compass Minerals CMP QQQQ Med. 93.00 70.65 65.10 j 2.8 15.9 c

Corporate Executive Board EXBD QQQ Med. 38.00 40.39 26.60 l C 1.7 24.2 d

CoStar Group CSGP QQQ High 64.00 68.49 38.40 j X 0.0 d

Dassault Systemes DASTY QQ Med. 72.00 89.59 50.40 k C 0.7 30.0 d

Diageo DEO QQ Med. 79.00 96.27 55.30 k X 2.2 22.9 b

Dun & Bradstreet DNB QQQ Med. 85.00 81.55 59.50 k X 1.9 15.5 d

Eaton Vance EV QQQ High 28.00 27.45 16.80 k C 2.8 14.4 d

eBay EBAY QQQQ Med. 42.00 36.30 29.40 k Z 0.0 14.7 c

Eli Lilly LLY QQQ Med. 40.00 39.72 28.00 l C 4.9 10.2 d

Equifax EFX QQQ Med. 41.00 43.21 28.70 k C 1.7 23.1 d

Exelon EXC QQQQ Med. 54.00 38.23 37.80 l 4.0 10.2 a

Expeditors International EXPD QQQQ High 61.00 45.85 36.60 k Z 1.1 25.6 d

Natural gas pipeline company that is well-positioned for

growth. Large cost overruns on projects in recent years.

Major patent losses in 2011 offset by strong pipeline.

Focusing on core pharmaceutical business.

Cash-cow firm. Successfully taking cigarettes into emerging

markets. High taxes yield pricing power.

Pipelines tend to have moats because of their geographic

advantage. Bought general partner. Buying storage assets.

Strong brands and market share in excess of 70%. Very

defensive business. Volumes weak recently.

High amount of scrutiny around for-profit education lately.

We are highly likely to downgrade moat rating.

Sensitive to economic cycles, so results may be bumpy.

Company benefiting from commodity boom.

Leading truck brokerage with an interesting business model.

Benefits from network effect and scale advantages.

Still 800-pound gorilla of networking. Cash flow and hoard

provide buffer. Restructuring effort starting to bear fruit.

Largest futures exchange in the world benefits from network

effect. MF Global scandal has hit shares. Bought in Hare.

Extremely long-lived moat. Bought bottlers in North America

in an attempt to give flexibility with new products.

Has 44% worldwide market share in toothpaste. Large

overseas exposure. About 75% of sales outside U.S.

Unmatched ability to offer multiple services via one

connection. Bought NBC Universal from GE.

Low-cost producer of salt and sulfate of potash fertilizer.Weather is leading to near-term earnings weakness.

Collects and sells best-practices intelligence. Growth

stopped in recession, has now stabilized.

Controls info critical to commercial real estate industry.

Databases very costly for competitors to replicate.

French product-life management and design software firm,

focused on higher-end products. Significant switching costs.

Largest spirits producer in the world. Strong brands and

exclusive distribution that competitors cant match.

Database model characterized by high barriers to entry and

low incremental costs.

Money-management firm with below-average customer

turnover. Industry problems have stung less here.Classic network effect. PayPal going very strong, marketplace

growing again. GSI purchase working well thus far.

Leading maker of mental-health drugs. Steep patent losses in

coming years offset by decent pipeline.

Credit bureaus operate in an oligopoly. Like other database

firms, enjoys low costs and high barriers to entry.

Large fleet of nuclear plants gives cost advantage. Low nat.

gas prices sting. Constellation deal has been completed.

Freight consolidation business model benefits from network

effect, scale. Outstanding management.

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Fair ValueUncert.

FairValue

CurrentPrice

ConsiderBuying

MoatTrend

Stew.Grade

Yield(%) P/E


Express Scripts ESRX QQQQ Med. 73.00 ] 56.32 51.10 k 0.0 22.3 c

ExxonMobil XOM QQQQ Low 91.00 83.88 72.80 l 2.2 10.0 a

Fastenal FAST Q Med. 34.00 51.58 23.80 k Z 1.3 42.6 d

Federated Investors FII QQ High 19.00 22.42 11.40 k C 4.3 15.5 d

Fiserv FISV QQQ Med. 69.00 68.77 48.30 k C 0.0 20.2 d

Forward Air FWRD QQ Med. 32.00 35.41 22.40 l 0.8 22.1 d

Franklin Resources BEN QQQQ Med. 145.00 124.81 101.50 k 0.9 14.5 d

General Dynamics GD QQQ Med. 75.00 70.82 52.50 k Z 2.9 10.2 a

General Electric GE QQQQ Med. 25.00 19.20 17.50 l X 3.5 15.6 b

GlaxoSmithKline GSK QQQ Med. 49.00 45.02 34.30 l X 5.9 13.8 b

Google GOOG QQQQ High 780.00 630.84 468.00 k C 0.0 21.2 c

Graco GGG QQ Med. 48.00 53.54 33.60 k X 1.7 23.1 d

Grupo Aero del Norte OMAB QQQ High 16.00 15.87 9.60 k V 3.3 18.6 d

Grupo Aero Pacifico PAC QQQ High 43.00 37.35 25.80k

C 1.8 17.6 d

Grupo Aero del Sureste ASR QQ High 62.00 71.97 37.20 l V 3.6 17.6 d

Grupo Televisa TV QQQQ Med. 26.00 20.99 18.20 k C 0.7 24.9 d

Harley-Davidson HOG QQ High 39.00 46.92 23.40 l X 1.3 20.1 b

Hershey Company HSY QQ Med. 48.00 59.81 33.60 l C 2.5 21.8 b

Home Depot HD QQQ Med. 49.00 50.58 34.30 k X 2.3 20.5 b

IBM IBM QQ Low 182.00 204.94 145.60 k X 1.5 15.7 d

Imperial Tobacco Group ITYBY QQ High 69.00 78.90 41.40 k X 5.4 14.1 d

Intel INTC QQQ Med. 26.00 27.76 18.20 k X 3.0 11.6 d

IntercontinentalExchange ICE QQQ High 145.00 135.84 87.00 k X 0.0 19.7 d

International Speedway ISCA QQQ V.High 26.00 28.25 13.00 k C 0.7 20.5 c

Intuit INTU QQ Med. 46.00 59.11 32.20 k X 1.0 26.7 d

New addition to the watchlist following merger with Medco.

Roughly 40% share. Bought in Hare. Highlighted this issue.

Largest, most efficient oil company. Recent rise in oil prices

and refining margins should lead to near-term profit spike.

Distributor focused on fasteners. Past Morningstar CEO of

the Year winner at helm. Great execution, but a pricey stock.

Major player in the money-management industry. Potential

reforms to money market funds a major uncertainty.

The largest bank-processing firm. Enjoys significant

customer-switching costs as evidenced by 99% renewal rate.

Has no rival with the same scale and service quality

because of its wide transport network.

Owns some of the best-established brand names in the

mutual fund industry.

Defense firm focused on cash generation. Allocates capital

with discipline. Federal budget constraints a headwind.

Leader in large number of industries. Firm survived capital

markets freeze and recession. Reducing GECS exposure.

Strong drug portfolio despite recent negative safety data on

Avandia. Well-positioned in vaccines.

Majority share of search, expanding into other areas. Bought

Motorola for its patents. Rivalry with Apple increasing.

Dominant in several niche markets, such as paint sprayers.

Benefits from efficient scale phenomenon.

Airport monopoly in central and northern Mexico.

Benefits from efficient scale.

Airport monopoly in west-central Mexico, includingGuadalajara. Yet another efficient-scale situation.

Third major owner of Mexican airport concessions.

Completed third terminal at Cancun airport.

Dominates Mexican broadcast media industry, especially

programming.

Among the strongest and most profitable brands.

Demographics represent significant headwind.

Largest candymaker in the U.S. with a 30% share.

Trust still controls in excess of 80% of voting power.

Maintained profitability in cyclical trough. Same-store sales

quite strong recently thanks to warm winter weather.

Bread and butter is servicing complicated IT infrastructure at

core of most firms. Berkshire Hathaway bought 5% stake.Fourth-largest tobacco firm in world. Cash cow.

Nearly 50% share in U.K. market.

Semiconductor behemoth. Scale advantages. Antitrust issues

have resurfaced overseas.

Electronic exchange focused on energy futures. Benefits from

network effect. Regulation change still a risk.

Strong ties to NASCAR sanctioning body and also benefits

from efficient scale. Casino opened in Kansas.

Dominates small-business accounting, tax-prep, and personal

finance software. Large switching costs.

C

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12




Fair ValueUncert.

FairValue

CurrentPrice

ConsiderBuying

MoatTrend

Stew.Grade

Yield(%) P/E


Intuitive Surgical ISRG Q Med. 343.00 539.07 240.10 j X 0.0 43.7 d

Jack Henry & Associates JKHY QQ Med. 30.00 ] 33.23 21.00 k 1.4 20.0 d

John Wiley & Sons JW.A QQQ Med. 46.00 46.86 32.20 l X 1.7 14.9 d

Johnson & Johnson JNJ QQQQ Low 77.00 64.92 61.60 k C 3.5 18.6 a

Kinder Morgan KMI QQQ Med. 38.00 39.38 26.60 k 3.2 57.8 b

Kinder Morgan EnergyPtnr KMP QQQ Med. 86.00 82.22 60.20 k 5.6 b

Kinder Morgan Management KMRQQQQ Med. 86.00 74.10 60.20 k 0.0 a

KLA-Tencor KLAC QQQ Med. 51.00 53.28 35.70 k C 2.6 12.0 d

Landstar System LSTR QQQ Med. 53.00 57.38 37.10 k 0.4 24.1 d

Legg Mason LM QQQ High 30.00 ] 26.27 18.00 l 1.2 18.2 d

Linear Technology LLTC QQQ Med. 36.00 32.05 25.20 k X 3.1 15.1 d

Lockheed Martin LMT QQ Med. 71.00 88.74 49.70 k 4.5 11.3 b

Lorillard LO QQQ High 120.00 136.40 72.00 k X 4.6 17.1 d

Lowes LOW QQQ Med. 34.00 31.09 23.80k

Z 1.8 21.7 a

Magellan Midstream MMP QQ Low 68.00 71.49 54.40 k X 4.6 19.5 c

Martin Marietta MLM QQQQ Med. 118.00 83.83 82.60 k 1.9 49.5 d

MasterCard MA QQQ High 394.00 439.29 236.40 l C 0.3 29.6 c

Maxim Integrated Products MXIMQQQ Med. 27.00 27.78 18.90 l X 3.2 17.4 d

McCormick MKC UR Low UR 53.87 UR k 2.3 20.7 b

McDonalds MCD QQQ Low 100.00 98.88 80.00 k 2.8 18.8 b

McGraw-Hill Companies MHP QQ High 40.00 48.69 24.00 l C 2.1 17.7 d

Medtronic MDT QQQQ Med. 46.00 37.75 32.20 k 2.6 12.1 b

Merck MRK QQQQ Med. 46.00 38.73 32.20 l C 4.3 19.2 b

Microsoft MSFT QQQQ Med. 35.00 31.10 24.50 l Z 2.6 11.3 c

Monsanto Company MON QQQ Med. 83.00 ] 76.59 58.10 k 1.6 21.7 d

Currently has monopoly position in robotic surgery. One of

the widest moats in all of health care, if not entire market.

Bank processing firm similar to Fiserv, but focused on smaller

banks. Enjoys exceptionally high customer switching costs.

Publisher enjoys high returns on capital. Science and

technical franchises especially lucrative.

Diversified health-care giant. Reform legislation mild net

positive. Recalls hurt results. Exiting stent business.

Structured as regular corporation. Owns general partner of

KMP. Announced blockbuster merger with El Paso.

Large master limited partnership focused on energy transport

and storage. KMI purchase should lead to many dropdowns.

Different share class of KMP without MLP tax complexity.

Pays in shares instead of cash. Long-time holding in Tortoise.

Still dominates certain niches of highly cyclical

semiconductor supply industry.

Logistics firm very similar to C.H. Robinson, benefiting from

network effect.

Now among the largest asset managers on the planet. Still

smarting from damage done during financial crisis.

Among semiconductor companies, lower-risk. Has a

concentrated amount of industrys design talent.

Defense market now highly consolidated. Sole provider of

many key defense items, particularly in aerospace.

Dominates menthol tobacco category. FDA scrutinized

menthol products, but we think outright ban is unlikely.

Same-store sales bounced thanks to warm weather. Overallhousing market is showing signs of life.

Pipelines and energy-storage assets. Annuitylike with

inflation hedge. Great business, but units are not cheap.

High transport costs gives geographic advantage. Volumes

off significantly, pricing holding up. Bid for Vulcan.

Benefits from cash-to-plastic shift. Federal Reserve diluted

Dodd-Frank debit card rules. Positive operating leverage.

Leading analog chipmaker with concentration of industrys

engineering talent.

More than 2 times larger than its next competitor in spices

and seasonings. Very stable business, but not exactly cheap.

Brand and scale make Golden Arches unique. Same-store

sales holding up very well in anemic economy.Splitting publishing and S&P ratings businesses. Dodd-Frank

implementation a wild card. Few friends in D.C. today.

Largest medical equipment maker with wide product portfolio

and technological lead. Featured this issue.

Patents on pharmaceutical products basis for moat. Bought

Schering-Plough in bid to gain scale, diversity.

Windows is flat, but Office still selling well and growing.

Raised cash for unknown reason. Bought Skype.

Large technological lead in seeds. Roundup facing pricing

pressure from generics. Antitrust issues surfacing.

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Fair ValueUncert.

FairValue

CurrentPrice

ConsiderBuying

MoatTrend

Stew.Grade

Yield(%) P/E


Moodys MCO QQ High 35.00 41.60 21.00 l C 1.5 16.7 b

MSCI MSCI QQQ Med. 41.00 36.76 28.70 k C 0.0 26.0 d

National Oilwell Varco NOV QQQQ Med. 97.00 78.21 67.90 k C 0.6 16.6 c

Nike NKE QQQ Med. 100.00 ] 110.69 70.00 k 1.3 23.0 d

Northern Trust NTRS QQQQ High 58.00 46.22 34.80 k X 2.6 18.7 b

Novartis NVS QQQQ Low 69.00 54.72 55.20 k X 4.5 14.5 a

Novo Nordisk NVO QQ Med. 120.00 145.00 84.00 k X 1.3 29.0 d

ONEOK Partners OKS QQ Med. 46.00 54.06 32.20 k C 4.5 16.1 d

Oracle ORCL QQQQ Med. 38.00 [ 29.01 26.60 k 0.8 15.3 c

Paychex PAYX QQQQ Med. 38.00 31.05 26.60 k Z 4.1 20.7 c

PepsiCo PEP QQQQ Low 72.00 65.35 57.60 k Z 3.2 16.2 a

Pfizer PFE QQQQ Med. 27.00 22.05 18.90 l C 4.0 19.9 a

Philip Morris PM UR Med. UR 88.37 UR k 3.5 18.2 d

Potash Corp of Saskatchew POT QQQQ High 56.00 44.10 33.60k

1.3 12.6 d

Procter & Gamble PG QQQQ Low 72.00 66.81 57.60 k X 3.1 19.6 a

Qualcomm QCOM QQQ Med. 62.00 66.50 43.40 l Z 1.5 24.0 d

Ritchie Bros. Auctioneers RBA QQQ Med. 24.00 [ 22.33 16.80 j X 2.0 31.1 d

Roche Holding RHHBY QQQQ Med. 52.00 42.99 36.40 k C 0.0 16.2 b

SABMiller SBMRY QQ Med. 33.00 40.29 23.10 k C 1.0 24.0 b

Sanofi-Aventis SNY QQQQ Med. 46.00 37.02 32.20 k 4.7 13.2 b

Schlumberger SLB QQQQ Med. 94.00 67.59 65.80 k X 1.6 19.3 d

SEI Investments SEIC QQQ Med. 19.00 20.25 13.30 l C 1.5 18.2 d

Spectra Energy SE QQQ Low 32.00 31.17 25.60 k X 3.6 17.6 b

Spectra Energy Partners SEP QQQ Low 31.00 31.34 24.80 k V 6.1 19.2 b

St. Joe JOE QQQQ High 26.00 17.33 15.60 k 0.0 NA c

Pressured by mortgage and structured-finance mess. Could

be disrupted by implementation of Dodd-Frank legislation.

Owns numerous equity indexes, some of which are industry

standards. Licenses provide high-margin earnings stream.

A 2011 addition to watchlist after we upgraded moat rating.

Dominant share in drilling rig equipment. Bought in Hare.

Strong brands and global scale translate to high returns on

capital. Margins are a current concern.

Relatively conservative company. Focused on large

institutions and the wealthy.

Unique in that patented pharmaceutical business married to

large generics business. Swiss currency playing havoc.

Leader in diabetes treatments. Rivals also attracted to

growing diabetes market.

Like most pipeline firms, has very long advantage duration

and is relatively low-risk. Low nat. gas prices do not hurt.

Maintains enviable position in the database market. Sun

Micro integration proceeding.

Focused on small businesses. High customer switching costs.

HR services still growing faster than core payroll business.

Dominant salty-snacks company. Boasts 16 brands with more

than $1 billion in sales. Bought some of its bottlers.

Lipitor patent has expired, but firm should still earn more

than $2 per share in 2012. Stock is no longer a table-pounder.

Tobacco industry enjoys huge barriers to entry, and high

taxes actually lead to pricing power.

Largest fertilizer producer in world and part of cartel. Cashbid by BHP Billiton killed by Canadian regulators.

Has 24 brands that generate more than $1 billion in sales

annually. Reached new deal to sell Pringles.

Intellectual property powerhouse in wireless industry.

Patents provide very high-margin revenue stream.

Industrial equipment auctioneer based in Canada benefits

from network effect. We recently lowered our fair value est.

Largest biotech company in the world, with relatively large

number of biologics.

Has 15% of worldwide beer market. Near monopoly in

certain countries. Joint venture in N. America doing well.

Wide lineup of branded drugs and vaccines. Recently closed

on purchase of Genzyme.We recently upgraded moat rating. Intellectual property lead

in specialized oil services.

Strong technology platform to offer investment-processing

services. Very high switching costs.

Owns giant midstream natural gas business, as well as

general partner of Spectra Energy Partners.

Majority owned by Spectra Energy. Structured as MLP. Has

less attractive stock valuation than peers at moment.

Huge amounts of undeveloped land in Florida. Development

around new airport and seaport has started.

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14



Fair ValueUncert.

FairValue

CurrentPrice

ConsiderBuying

MoatTrend

Stew.Grade

Yield(%) P/E



St Jude Medical STJ QQQQ Med. 49.00 38.91 34.30 k 2.4 15.4 d

Starbucks SBUX QQ Med. 48.00 57.42 33.60 l 1.2 34.5 b

State Street STT QQQ High 50.00 43.82 30.00 k C 2.2 11.6 d

Stericycle SRCL QQ Med. 77.00 84.77 53.90 j X 0.0 31.5 d

Stryker SYK QQQQ Med. 63.00 54.15 44.10 k X 1.6 15.7 d

Sysco SYY QQQQ Med. 36.00 29.11 25.20 k X 3.7 14.9 a

T. Rowe Price TROW QQQ Med. 61.00 63.61 42.70 k X 2.1 21.8 d

Time Warner Cable TWC QQ Med. 70.00 79.93 49.00 l C 2.8 16.1 b

Total System Services TSS QQ Med. 19.00 22.54 13.30 l C 1.8 19.6 d

United Parcel Service UPS QQQ High 80.00 79.19 48.00 j X 2.9 20.6 b

United Technologies UTX QQQQ Med. 100.00 80.23 70.00 k Z 2.4 14.6 b

Verisk Analytics VRSK Q Med. 32.00 46.83 22.40 k C 0.0 28.7 d

Visa V QQQ High 105.00 119.50 63.00 l 0.7 31.5 d

Vulcan Materials VMC QQQQQ Med. 63.00 42.02 44.10 k 0.1 c

Wal-Mart Stores WMT QQQ Low 61.00 60.13 48.80 l X 2.6 13.2 a

Walt Disney DIS QQQ Med. 45.00 42.11 31.50 l X 1.4 15.9 b

Waters WAT QQQ Med. 96.00 90.08 67.20 k Z 0.0 19.2 d

Weight Watchers Intl WTW QQQ High 77.00 74.48 46.20 k C 0.9 18.1 d

Western Union WU QQQQQ Med. 29.00 17.65 20.30 k 2.3 9.6 c

Zimmer Holdings ZMH QQQ Med. 71.00 64.15 49.70 k Z 1.1 15.9 c

Part of implantable cardioverter defibrilator oligopoloy.

No longer just a fast-follower.

Brand creates large barrier to success for competitors.

Diversification of distribution channels working thus far.

Enviable position in custody and asset management. Balance

sheet was problem during credit crisis.

Medical waste is a noncyclical business, and Stericycle has a

dominant share. Mark Miller won CEO of Year for 2009.

Orthopedic devices benefit from demographic trends.

Government crackdown on industry relatively benign.

Wide-moat distributors are rare, but this one dominates

thanks to its scale. Food inflation a headwind to profitability.

Asset manager with excellent fund lineup and ethical

reputation.

Communications capabilities competitors cant match.

Spin-off from Time Warner complete.

Handles applications, billing, collections, and customer

service for credit card issuers.

Scale and network density give cost advantage. Strong

balance sheet. Expanding network in Europe by buying TNT.

Diversified company operating efficiently in several industrial

markets. Service contracts quite lucrative.

Became publicly traded in late 2009. Collects data essential

to insurance industry operations.

Enjoys advantages from network effect and scale. Federal

Reserve diluted Dodd-Frank debit card rules.

Volumes down by roughly half from peak. We recommendstanding pat on MLM bid for now.

Retailing goliath enjoys cost advantages. Anticyclical: Did

relatively well during recession, lagging during recovery.

Owns theme parks, movie studios, and TV properties. Very

strong brands, extensive media library.

Large share in analytical instruments important in drug

discovery, research, and manufacturing.

Highly recognizable and respected brand. Insurance

reimbursement could ignite growth.

Strong brand and large network of more than 400,000 agents.

Average transaction size now flat, volumes still growing.

Leading provider of orthopedic devices. Cyclical and

demographic trends on firms side.

WatchlistRecommendationsThese are all the Wide-Moat Watch-list firms trading below their ConsiderBuying price as well as those tradingabove their Consider Selling price.

Applied Materials AMAT

Vulcan Materials VMC

Western Union WU

Advisory Board ABCO

Fastenal FAST

Intuitive Surgical ISRG

Verisk Analytics VRSK

Stocks to Consider Buying Stocks to Consider Selling

7/29/2019 Moats April 2012

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Wide-MoatStatistics

Wide-Moat Firms With the Highest Yield (%)

AstraZeneca AZN 8.9

Boardwalk Pipeline Partners BWP 7.9

Buckeye Partners BPL 6.9

Spectra Energy Partners SEP 6.1

GlaxoSmithKline GSK 5.9

Kinder Morgan Energy Partners KMP 5.6

British American Tobacco BTI 5.5

Imperial Tobacco Group ITYBY 5.4

Altria MO 5.3

Eli Lily LLY 4.9

Wide-Moat Firms With the Lowest Forward P/E Ratios

Western Union WU 9.1

Sanofi SNY 9.1

Caterpillar CAT 9.1

General Dynamics GD 9.1

Bank of New York Mellon BK 9.2

Pfizer PFE 9.4

ExxonMobil XOM 9.4

Novartis NVS 9.7

State Street STT 9.7

Cisco Systems CSCO 10.0

Wide-Moat Firms Trading at Best Price/Fair Value Estimate Ratios

Western Union WU 0.61

Applied Materials AMAT 0.62

St. Joe JOE 0.67

Bank of New York Mellon BK 0.67

Vulcan Materials VMC 0.67

Exelon EXC 0.71

Martin Marietta Materials MLM 0.71

Schlumberger SLB 0.72

Expeditors International of Washington EXPD 0.75

Median Price/Fair Value Estimates

Coverage Universe 0.95

By Moat Rating

Wide 0.99

Narrow 0.94

None 0.95

By Fair Value Uncertainty

Low 0.99

Medium 0.98

High 0.92

Data as of April 9, 2012

Performance: Morningstar StockInvestor Portfolios vs. S&P 500

Period Tortoise (%) Hare (%) Tortoise & Hare Combined (%) S&P 500 (%)

2001* 9.1 0.7 4.9 -4.8

2002 -1.6 -23.9 -12.3 -22.1

2003 26.2 26.3 26.2 28.7

2004 13.1 26.9 18.8 10.9

2005 8.0 3.2 5.8 4.9

2006 13.7 22.0 17.3 15.8

2007 1.6 5.2 3.3 5.5

2008 -22.2 -32.4 -26.8 -37.0

2009 19.4 45.6 30.5 26.5

2010 9.7 14.3 11.9 15.1

2011 7.3 1.4 4.5 2.1

Trailing 12 Months 5.9 3.9 4.9 6.3

Since Inception Cumulative 119.5 105.3 112.4 40.3

Since Inception Annualized 7.6 6.9 7.3 3.2

Data as of April 9, 2012. Returns include interest and dividends. *Since Inception June 18, 2001. Time-weighted, assuming equal investments at inception.**Morningstar Investment Services, Inc. is a registered investment advisor and wholly-owned subsidiary of Morningstar, Inc.

Invest Like the Tortoise

and Hare

Morningstar Investment

Services** offers customizable

separate account stock portfo-

lios patterned after these popular

StockInvestorstrategies.

Call 1-866-765-0663 to learn more, or

e-mail [email protected]

7/29/2019 Moats April 2012

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16

Merck recently has become one of the more attractive

opportunities in health care.

Morningstars Take

Facing increased competition, patent losses, and a

pipeline of late-stage drugs with poor chances of

approval, Merck greatly improved its long-term outlook

by acquiring Schering-Plough. Without Schering,

Mercks prospects were muddled, despite its recent

success launching several new blockbusters. Now,

with the addition of Schering, we believe Merck is

favorably positioned for long-term growth. Mercks

new products during the last few years have helped

offset recent patent losses. Januvia for diabetes,Isentress for HIV, and the Gardasil vaccine against

human papillomavirus represent new blockbusters.

All the drugs enjoyed monopoly positions at the time

of launch. However, current and expected competition

from other big drug firms likely will create a drag

on these drugs growth during the next few years.

Still reeling from the patent loss on hypertension drugs

Cozaar/Hyzaar in early 2010, Merck faces the loss

of its next top drug in terms of revenue generation:

Singulair for respiratory ailments in 2012. Singulairrepresents more than 10% of the combined sales of

Merck and Schering. While losses in international

markets should not fade as fast as in U.S. markets,

the patent expirations create major roadblocks to

Mercks growth.

Mercks efforts to develop a reliable late-stage pipe-

line have yielded questionable results. The Food

and Drug Administration denied Merck approval for

cholesterol drug Tredaptive (formerly Cordaptive)

in early 2008. Subsequently, Merck reported poor clin-ical data on late-stage drugs Rolofylline for heart

disease and Telcagepant for migraines. Fur ther, key

late-stage drug anacetrapib for atherosclerosis is

chemically extremely similar to a drug (torcetrapib)

that failed to receive FDA approval, raising the risk

that anacetrapib might meet the same end. Deciding

not to wait for new internal pipeline drugs, Merck

significantly strengthened its operations by acquiring

Schering-Plough for about $40 billion. Schering brings

in a very strong pipeline of late-stage drugs with

Pauls PositionMerck MRKStock Focus | Damien Conover, CFA

80

60

40

20

0

-20

-40

Total Return

p

Merck (%)p

S&P 500 Index(%)

Fundamental Table

Fiscal Year Ended Dec-09 Dec-10 Dec-11 *Dec-12 *Dec-13 *Dec-14 *Dec-15

Sales ($ mil) 27,428 45,987 48,047 47,160 45,481 46,273 47,577

Operating Income ($ mil) 15,392 2,957 8,280 12,416 10,868 11,761 12,620

Net Income ($ mil) 12,899 861 6,272 8,978 7,788 8,466 9,116

Free Cash Flow ($ mil) 1,931 9,144 10,660 12,812 10,395 9,536 10,326

EPS $3.26 $3.42 $3.76 $3.76 $3.50 $3.59 $3.70

ROIC (with goodwill) 33.6% 5.7% 9.2% 15.1% 13.6% 14.1% 14.7%

*Morningstar Estimates, Base Scenario

Profile Management & Stewardship

Merck makes pharmaceutical products to treat

conditions in a number of therapeutic areas,

including cardiovascular disease, asthma, infec-tions, and osteoporosis. The company also has

a substantial vaccine business, with treatments

to prevent hepatitis B and pediatric diseases as

well as HPV and shingles. Following the Schering

acquisition, about 45% of the companys sales

are generated in the United States.

At the beginning of 2011, Ken Frazier took over

as CEO, replacing Dick Clark. With Clark nearing

the age of retirement, we view the new leader-ship as a continuation of Mercks past strategy

and not a red flag causing concern. Regarding

the new CEO, Fraziers almost two decades of

experience at Merck across most major divisions

should position him well to lead the company.

Also, Frazier deserves much of the credit for the

successful handling of the Vioxx litigation as

he held Mercks general counsel position during

the majority of the litigation. Mercks board is

packed with current and retired CEOs, which can

lead to quid pro quo compensation packages

for top executives, but lends valuable strategic-

planning experience.

Rating Fair Value Current Price Price/Fair Value Consider Buy Consider Sell

QQQQ $46.00 $38.73 0.84 $32.20 $62.10

Econ. Moat Moat Trend Uncertainty Credit Rating Stewardship Stock Style

Wide Negative Med. AA C 4

Market Cap PE Proj. Yield P/B P/S P/CF

$117.9 bil 19.2 4.3% 2.2 2.5 9.7

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

7/29/2019 Moats April 2012

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blockbuster potential and faces only limited patent

losses during the next few years. Combining the

two entities should also yield more than $3 billion in

annual cost savings. While Merck historically has

chosen to grow through internal development, we

believe the Schering acquisition places Merck in

a stronger strategic position.

Mercks Economic Moat and Trend

While Mercks competitive advantage has been

eroding during the last several years, the company still

supports a wide economic moat. Patents, economies of

scale, and a powerful intellectual base buoy Mercks

business and keep it well shielded from the competi-

tion. As the bedrock of Mercks wide moat, patentprotection should continue to keep competitors at bay

while Merck strives to introduce the next generation

of drugs. Further, the companys enormous cash flows

support a powerful salesforce that not only sells

currently marketed drugs, but also serves as a deter-

rent for developing drug companies seeking to launch

competing products. As a result, Merck offers

a powerful partnership opportunity for externally

developed drugs. The cash flows also put the

company in the rare position of supporting the approx-

imately $800 million in research and developmentneeded on average to bring each new drug to the

market. Lastly, while not as powerful as in the 1990s,

Mercks research laboratories still hold a vast data-

base of knowledge that should help the company

maintain its leadership positions in drug discovery

and development.

Merck faces a deteriorating moat trend. While patent

protection still shields the majority of Mercks drugs

from competition, the company is not developing

enough new drugs to offset eventual patent losses. Inthe post-Vioxx era, the FDA has grown increasingly

risk-sensitive, tending to approve only very safe drugs

or drugs in highly needed areas such as cancer.

While diverse, Mercks pipeline still has sizable expo-

sure to primary-care indications, which carry high

hurdle rates required for approval. Exacerbating the

issue, insurance companies are steadily reducing

coverage for follow-on drugs, forcing drug firms to

push for true innovation and reducing the power

of their distribution networks. The U.S. government

also is evaluating comparative effectiveness programs

and more aggressive price negotiations, potentially

raising the bar for future innovation. Partially offset-

ting these issues, international markets remain

a bright spot for the company, and Merck is forging

ahead with more innovative development with a

particular focus on biologics. The acquisition of

Schering-Plough brings in a stable consumer health-

care business and a host of biologic drugs with

much stronger barriers to entry.

Valuation

Our fair value estimate is $46 per share. We believe

Mercks acquisition of Schering-Plough will yield

enough earnings growth to offset the steep purchaseprice. In particular, we expect several billion dollars

in annual cost savings. Scherings strong late-stage

pipeline should boost Mercks long-term growth rate.

On the patent side, Merck will face major generic

competition to its blockbuster drug Singulair in 2012.

Therefore, we anticipate a high degree of volatility

in sales growth as the patent expires. However,

we expect sales of marketed products and products

still under development eventually to offset sales

lost to the Singulair patent expiration, and the addi-

tion of Scherings pipeline further remedies Merckspatent cliff.

One of the key uncertainties facing Merck is the

success of its recently launched drugs. Given the low

trajectories of recently launched drugs, we have

projected relatively conservative estimates for several

new products including Saphris, Dulera, and Bridion.

However, under a more bullish scenario, we could see

our estimates double. In this bullish case, our fair

value estimate would increase to $50. Conversely,

side effects or payor pushback could cause all ofthese drugs to fail. Under this bearish scenario, our

fair value estimate would fall to $40.

Merck remains in strong financial health, even

with the additional $8.5 billion in debt needed for the

Schering acquisition. We expect the combined

company will generate a free cash flow of approxi-

mately $12 billion in 2011. Mercks strong and

stable cash flows should whittle away the debt rela-

tively quickly.

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18

Here is another relatively attractive health-care firm.

When the Wide-Moat Focus index was reconstituted

a few weeks ago, Medtronic became a member.

Morningstars Take

With its diversified portfolio and strategy to develop

products for a wide range of chronic diseases,

Medtronic is well positioned to take advantage of

new trends in disease management.

This wide-moat companys vision is to establish a

significant presence in chronic diseases, in addition

to its historical stronghold in heart disease. Invest-

ments in neuromodulation, diabetes, and spinal prod-ucts from the middle to late 1990s have paid off

in spades, offering new revenue streams and taking

some pressure off heart products. Revenue from

those three product areas increased from 25% of total

sales in fiscal 2000 to 40% in fiscal 2011. Medtronics

diversified medical technology portfolio allows

it to better weather glitches in the development or

approval process for any particular new device.

While several of the firms key markets have experi-

enced slowing growth (including implantable cardio-verter defibrillators and spinal procedures), the firm

has focused on its fundamental strategy of innovation.

The firm is often first to market with new products.

For instance, Medtronics new Revo MRI-compatible

pacemaker received Food and Drug Administration

approval last spring and is the first such pacer in the

U.S. market. Because an estimated one third to one

half of pacemaker patients will eventually need an

MRI, Medtronics technology addresses a key limita-

tion of early generations of pacemakers. We expect

Medtronic will apply the same engineering knowl-edge to introduce MRI-compatible ICDs in the coming

years. Additionally, Medtronic enjoys a dominant

position in the emerging neuromodulation market.

While Medtronics electrical devices have been

primarily used for subsegments of incontinence and

chronic pain patients, the general therapeutic

approach is being applied to a number of additional

conditions including epilepsy, Parkinsons, treatment-

resistant depression, and essential tremor.

Pauls Position

Rating Fair Value Current Price Price/Fair Value Consider Buy Consider Sell

QQQQ $46.00 $37.75 0.82 $32.20 $62.10

Econ. Moat Moat Trend Uncertainty Credit Rating Stewardship Stock Style

Wide Stable Med. AA- 1

Market Cap PE Proj. Yield P/B P/S P/CF

$39.3 bil 12.1 2.6% 2.3 2.4 9.6

Medtronic MDTStock Focus | Debbie S. Wang

60

45

30

15

0

-15

-30

Total Return

p

Medtronic (%)p

S&P 500 Index(%)

Fundamental Table

Fiscal Year Ended Apr-09 Apr-10 Apr-11 *Apr-12 *Apr-13 *Apr-14 *Apr-15

Sales ($ mil) 14,599 15,817 15,933 16,201 16,345 17,210 18,199

Operating Income ($ mil) 2,801 4,215 4,001 4,213 4,111 4,376 4,473

Net Income ($ mil) 2,074 3,099 3,096 3,195 3,019 3,172 3,257

Free Cash Flow ($ mil) 3,380 3,558 3,240 4,102 3,448 3,361 3,387

EPS $3.13 $3.44 $3.61 $3.44 $3.56 $3.52 $3.60

ROIC (with goodwill) 18.9% 21.6% 20.2% 17.9% 16.0% 16.4% 16.4%

*Morningstar Estimates, Base Scenario

One of the largest medical device companies,

Medtronic develops and manufactures thera-

peutic medical devices for chronic diseases. Itsimplantable products include pacemakers,

defibrillators, heart valves, stents, insulin pumps,

and spinal fixation devices. The company

markets its products to health-care institutions

and physicians in the United States and

overseas. Foreign sales account for about 41%

of the companys total sales.

Medtronic gets good marks for its stewardship.

In 2011, Omar Ishrak left GE Healthcare to lead

Medtronic as CEO and chairman. While Ishrakhas had little direct experience with the cardiac

market or the device industry, he was consid-

ered a rising star at GE. We note Ishrak was the

pioneer behind GE Healthcares successful

entrance into the China markethe led efforts

to expand the product portfolio in order to

compete head-to-head with local imaging compa-

nies, which gave GE a substantial leg up in

the Chinese midmarkets. Considering Medtronic

has been making a number of investments

in China and has identified emerging markets as

a strategic source of growth, we think Ishrak

can bring valuable perspective.

Profile Management & Stewardship

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

7/29/2019 Moats April 2012

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Medtronic has pinned its hopes for growth on atrial

fibrillation, transcatheter heart valves, and drug-

resistant hypertension. The firm recently bulked up its

technology in these three areas with a series of

acquisitions. There is a growing body of clinical

evidence to support the efficacy of these therapeutic

approaches, especially for calcified aortic stenosis

and uncontrolled hypertension. We note that these

remain health conditions for which there are few

good treatment options. As favorable data comes out

of the clinical trials, Medtronic is appropriately armed

to expand these therapies into sizable new markets.

We expect to see Medtronic delve more deeply into

emerging markets, especially as new CEO OmarIshrak brings extensive experience with the Chinese

market. Medtronic was one of the earliest medical

device companies to establish a beachhead in China,

and that investment is beginning to pay off. Although

emerging markets continue to account for a small

portion of the firms current revenue base, we expect

that to expand steadily over the next 10 years. Impor-

tantly, the firm has concentrated on fundamental

building blocks that plant the seeds for a moat later

on. In China, for example, Medtronic has focused

on establishing itself as a resource for doctors, bothin terms of providing medical training on its products,

but also to help in creating a stream of patients.

Even the most innovative companies may stumble on

occasion, though. Medtronics late start in developing

a drug-coated stent has been a disappointment. The

firm received domestic regulatory approval for its own

stent in 2008, long after rivals Boston ScientificBSX

and Johnson & JohnsonJNJ established footprints

in that market. Further exacerbating the situation,

Medtronics first-generation stent technology wasntas impressive as that of rivals. There is the possibility

for a more favorable foray into this market with

Medtronics next-generation Resolute stent, especially

as J&J exits the market. But it is a market that is

not as moaty as some of the others that Medtronic

operates in.

Economic Moat and Trend

Medtronics wide moat is rooted in its dominant

presence in highly engineered medical devices to

treat chronic diseases, including those beyond its

historical stronghold in heart disease. Medtronics

moat is mainly related to several intangibles, including

intellectual property and carefully nurtured relation-

ships with physicians. Thanks to its persistent ability

to innovate, Medtronic is often first to market with

new products in various therapeutic areas. We expect

Medtronic to continue its record of innovation, based

on its extensive patent portfolio. According to inde-

pendent intellectual property evaluation publications

Device Linkand The Patent Board, Medtronic holds

the strongest intellectual property position based on

the number and technological strength of its patents.

Further, Medtronics diversified medical technologyportfolio allows it to better weather occasional

glitches in the development or approval process for

any particular new device. For example, even though

Medtronic trailed competitors by four years in

launching its drug-coated coronary stent, it hardly

skipped a beat as the cardiac rhythm management,

spinal, and neuromodulation businesses more than

compensated for its tardiness in stents. Another

element of Medtronics wide moat is its highly trained

salesforce and relationships with medical practitio-

ners. Doctors often rely on medical device sales repsfor their deep device knowledge as well as their

experience with device usage in a wide range of

patients. As a result, Medtronics reps play the role of

highly specialized experts who advise practitioners

on implantation, programming, and maintenance of

Medtronic devices and create sticky relationships

with medical practitioners.

Valuation

Our fair value estimate is

Documents

Moats April 2012