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Our Ultimate Stock-Pickers' Top 10 Buys and Sells

The decline in the equity markets created plenty of buying opportunities in the most recent period, but some of our managers seem to have jumped into energy stocks sooner than they should have.

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By Greggory Warren, CFA | Senior Stock Analyst

Equity markets can be fickle things at times. After running up more than 12% during the first quarter of 2012, the U.S. markets (as exemplified by the S&P 500 TR Index) declined 3% during the second quarter, but only by virtue of a strong rally in the final weeks of June. Concerns about everything from the future of the eurozone to slowing growth in developing markets like China and Brazil, as well as a stalled economic recovery in the U.S., weighed heavily on the minds of investors, who (according to our research) continue to prefer fixed income over actively managed equities. Looking at the stock sectors that got hit the hardest in the second quarter, financial services and technology were both down 8% on a total return basis, energy declined 6%, basic materials and industrials fell 4%, and stocks from the consumer cyclical sector dropped 3%. The decline in the U.S. markets during the second quarter did, however, make stocks look a bit cheaper than they did at the end of the first quarter, with the market-cap weighted price/fair value estimate for Morningstar's stock coverage universe standing at 83% at the end of June (and dipping even lower during the month of May), compared with 92% at the end of March.

It was against this background that our top managers were making their buy and sell decisions during the second quarter (and early part of the third quarter) of 2012. Unlike previous periods, where the buying activity among our Ultimate Stock-Pickers was relatively limited, with our managers sticking with names already in their portfolios when putting capital to work, we saw a marked increase in purchases during the second quarter, with plenty of new-money buys among the top 10 purchases made by our top managers during the period. As you may recall, we believe that new-money purchases provide us with the most insight into what our top managers think are the most attractive buying opportunities, as portfolio managers tend to only put money to work in new names when their purchase decision carries a very high degree of conviction. This is based on the belief that it is far easier for investment managers to put money to work in holdings that they are already comfortable with than it is for them to make a bet on a name that would represent a new addition to the portfolio.

Not surprisingly, all of the buying during the second quarter was centered in the weakest sectors, with stocks from the financial services, technology, and energy sectors heavily represented on our list of top 10 purchases. With regard to the selling activity during the quarter, four of the top 10 sales that were initiated during the period involved stocks from the consumer defensive sector, which was up 2% on a total return basis from the end of March until the end of June. It is also noteworthy that eight of the top 10 sales during the second quarter involved at least one of our top managers completely eliminating their stake in a firm. The buying and selling activity that took place during the most recent period also had an impact on the top 10 holdings of our top managers, with  United Parcel Service (UPS) and  3M (MMM) falling off the bottom of the list due to a couple of outright sales, with  Oracle (ORCL) rising up the ranks as a result of increased buying activity from five of our top managers, and  Coca-Cola (KO) moving up by virtue of the other names being displaced.

Our Top Managers Remain Overweight in Financial Services

From a sector allocation perspective, the portfolios of our Ultimate Stock-Pickers remain more heavily weighted toward financial services stocks, which accounted for 17% of their aggregated holdings at the end of the second quarter, compared with 13% for the market overall. That is, however, down from the year-ago period, when financial services accounted for more than 20% of the holdings of our top managers (and 14% of the S&P 500 TR Index). Our Ultimate Stock-Pickers also lightened their exposure to consumer defensive stocks, which accounted for 14% of their holdings at the end of the second quarter of 2012 (versus 12% for the benchmark), a big step down from the 19% they had invested in the sector in the year-ago period. While a fair amount of this was the result of managers trimming back positions over the last four quarters, it was moves made by  Berkshire Hathaway (BRK.A)/(BRK.B) to raise cash for the investment portfolios that are being run by Warren Buffett's two new lieutenants--Todd Combs and Ted Weschler--that contributed heavily to the changes, with the insurer selling off significant chunks of  Kraft Foods (KFT) and  Procter & Gamble (PG) during the last year.

Surprisingly enough, Berkshire's sale of more than three quarters of its stake in  Johnson & Johnson (JNJ) over the same time frame did not dull the enthusiasm among our top managers for the healthcare sector, which continues to account for 14% of their total holdings (compared with 11% for the broader market). Our Ultimate Stock-Pickers were also slightly overweight in consumer cyclical and industrials for the first time that we can remember, which may be a sign that some of them feel that we've bottomed out in some of the more economically sensitive industries. As far as the areas of the market where our top managers are underweight, technology continues to lead the pack, followed by utilities, energy, communication services, and real estate. Oddly enough, our Ultimate Stock-Pickers had started to pick up some traction in the technology sector, with both  Google (GOOG) and  Cisco Systems (CSCO) making the top 10 holdings at one time or another over the last two years. But with four of the 11 managers that held Cisco at the end of the first quarter of 2012 selling their positions outright during the most recent period, the networking giant doesn't even crack the top 25 holdings these days.

Energy has been a strange bedfellow for our Ultimate Stock-Pickers as well, with the actions of one manager in particular-- Alleghany (Y) --seeming to account for a lot of the buying and selling activity that we've seen in the sector over the last year or so. The insurer made a big splash in  Exxon Mobil (XOM) in 2010, building up a position that accounted for as much as 40% of its total stock portfolio at this time last year, using the proceeds from the sale of Burlington Northern Santa Fe to Berkshire Hathaway in February 2010 to fund the purchases. In just two quarters, though, Alleghany sold off almost its entire stake in Exxon Mobil, a big chunk of its stake in  ConocoPhillips (COP), and all of its holdings in  Devon Energy (DVN) to help fund the purchase of Transatlantic Holdings, a top global property and casualty reinsurer, which Alleghany expects to merge into its own operations. That said, the insurer turned right around and threw enough money at  Hess (HES),  Occidental Petroleum (OXY), and  Apache (APA) this year to make all three of these energy companies top five holdings in its stock portfolio at the end of the second quarter.

Ultimate Stock-Pickers' Top 10 Stock Holdings (by Investment Conviction)

 

  Star Rating Fair Value Uncertainty Moat Size Current Price (USD) Price/Fair Value Market Cap (mil) # of Funds Holding Mcrsft (MSFT) 4 Medium Wide 30.82 0.88 $262,637 16 J&J (JNJ) 4 Low Wide 67.43 0.88 $186,516 13 Wlls Frg (WFC) 4 Medium Narrow 34.03 0.81 $180,602 12 Google (GOOG) 3 High Wide 685.09 0.88 $225,168 13 P&G (PG) 3 Low Wide 67.19 1.05 $185,917 11 Wal-Mart (WMT) 2 Low Wide 72.60 1.19 $246,835 13 Brk Hthw (BRK.B) 4 Medium Wide 84.34 0.84 $198,960 9 Pepsi (PEP) 3 Low Wide 72.43 1.01 $113,111 10 Oracle (ORCL) 4 Medium Wide 31.65 0.83 $156,901 10 Coca-Cola (KO) 3 Low Wide 37.40 1.01 $169,551 7

Data as of 08/31/12. Fund ownership data as of funds' most recent filings.

Much as we saw during the first quarter, a couple of names were supplanted on the list of top 10 conviction holdings of our Ultimate Stock-Pickers, with UPS and 3M, both relatively new additions to the top 10 holdings, falling off in favor of Coca-Cola and Oracle. While it does not surprise us to see more economically sensitive industrials names like UPS and 3M falling off, nor Coke moving up the list, given the movement in the markets during the second quarter, we were kind of surprised by the shift toward Oracle, which was aided by a new-money purchase by  FPA Crescent (FPACX) and a meaningful addition by  Aston/Montag & Caldwell Growth (MCGIX)--with the latter firm being one of the four managers that eliminated Cisco from their portfolios during the period. That said, both UPS and 3M are still held by nine of our top managers, and remain in the top 15 holdings of our Ultimate Stock-Pickers overall, putting them well within striking distance should the markets look more favorably on industrials in the future.

Ultimate Stock-Pickers' Top 10 Stock Purchases (by Investment Conviction)

 

  Star Rating Fair Value Uncertainty Moat Size Current Price (USD) Price/Fair Value Market Cap (mil) # of Funds Buying Apache (APA) 5 Medium Narrow 85.75 0.61 $33,807 4 Occ Ptrlm (OXY) 4 Medium Narrow 85.01 0.79 $69,450 5 Google (GOOG) 3 High Wide 685.09 0.88 $225,168 6 Dvn Enrgy (DVN) 5 High Narrow 57.83 0.53 $23,469 5 Bnk NY Mlln (BK) 4 High Wide 22.54 0.64 $26,913 5 Thermo (TMO) 4 Medium Narrow 57.35 0.82 $21,101 3 Oracle (ORCL) 4 Medium Wide 31.65 0.83 $156,901 5 Visa (V) 3 High Wide 128.25 1.10 $105,305 2 Juniper (JNPR) 4 Medium Narrow 17.44 0.73 $9,023 4 J.P. Mrgn (JPM) 4 High Narrow 37.14 0.73 $142,003 5

Data as of 08/31/12. Fund ownership data as of funds' most recent filings.

As we noted above, the conviction buying that took place during the second quarter was centered in the weakest sectors of the market, with stocks from the financial services, technology, and energy sectors heavily represented on our list of top 10 purchases. It is also interesting to note that eight of the top 10 purchases during the second quarter involved at least one of our top managers making a new-money purchase in the name that was bought. And while Devon Energy,  Thermo Fischer Scientific (TMO), Oracle, and Google all made our preliminary list of top 10 high-conviction buys, which focuses more heavily on names where we're seeing high-conviction buys (as well as new-money purchases) on a manager by manager basis, as opposed to looking at the conviction purchases of all of our managers in aggregate, we spent much of our last article talking about Devon Energy, which benefitted from five high-conviction purchases, three of which were new-money buys on the part of our top managers. With all of the data in, we now see that Google saw just as strong of a display of conviction as Devon Energy did, with five managers--FPA Crescent, Aston/Montag & Caldwell Growth,  Oakmark (OAKMX),  Sound Shore (SSHFX) , and  Tweedy Browne Value (TWEBX) --also making high-conviction purchases, with both Sound Shore and Tweedy Browne making new-money purchases in the name.

Also of note was the fact that Thermo Fischer Scientific,  Juniper Networks (JNPR),  J.P. Morgan Chase (JPM), and Occidental Petroleum all saw meaningful purchases from at least three of our top managers, with the first three stocks each seeing new-money buys by at least two of the managers that were purchasing the stock during the period. Looking more closely at the individual securities, Apache was purchased by all four of the managers that held the stock at the end of the first quarter, with the managers at  Diamond Hill Large Cap (DHLAX) making a significant addition to their stake, using the proceeds from the sale of  Anadarko Petroleum (APC) to fund the purchase of Apache, as well as Devon Energy and Occidental Petroleum. This mimicked some of the movement by Alleghany, which we noted above had thrown enough money at Hess, Occidental Petroleum, and Apache this year to make all three of these energy firms top five holdings in its stock portfolio at the end of the second quarter.

Much like they did with Apache, five of the six managers that held Occidental Petroleum at the end of the first quarter bought more shares, with the purchases made by Alleghany, Diamond Hill Large Cap, and Aston/Montag & Caldwell Growth being the most meaningful. Continuing with the Energy theme, we saw three of our top managers-- Oakmark (OAKMX),  Oakmark Equity & Income (OAKBX), and  RS Capital Appreciation (RCAPX)--start up new stakes in Devon Energy, with two of the four managers that held the stock coming into the second quarter making significant additions to their holdings. As we noted in our last article, the managers buying the stock felt that there was a big disconnect between the market's impression of Devon Energy and the reality of the firm's operations, with all of them (and our own analyst, Mark Hanson) noting that the firm's management has demonstrated good financial stewardship over the years, with a focus on maximizing per-share reserves, production, and cash flows--all while maintaining a strong balance sheet.

As we noted above, Google (like Devon Energy) stood out  from the rest of the pack because it is rare to see five of our Ultimate Stock-Pickers making high-conviction purchases in the same stock during any single period, and the fact that two of the managers that were buying shares were actually building new positions in the name demonstrates an even higher degree of conviction in the name, in our view. While none of these managers commented directly about their purchase of Google, Ronald Canakaris at Aston/Montag & Caldwell Growth did talk about his new-money purchase of Juniper Networks, as well as his outright sale of Cisco Systems, during the quarter. With regard to Juniper, Canakaris noted that he bought shares of the networking company because he expects it to deliver strong secular revenue and earnings growth as a result of continued rapid data traffic growth, market share gains in routers, and a dramatic expansion of the company's addressable market with the introduction of a broader portfolio of enterprise-class solutions. He noted that he sold Cisco after the networking company lowered its guidance for its fiscal fourth quarter. Canakaris also added to his stake in Oracle, which along with a significant new-money purchase by the managers at FPA Crescent helped to move the stock up into the top 10 holdings of our Ultimate Stock-Pickers.

Looking more closely at the conviction purchases of financial services stocks during the quarter, it is interesting to note that  American International Group (AIG), which had made our list of top 10 high-conviction buys, did not make the cut once all of the data was in and aggregated. What did stand out, though, were the meaningful purchases of  Bank of New York Mellon (BK), J.P. Morgan Chase, and  Visa (V). In the case of Bank of New York, four of the seven managers that held the stock at the end of the first quarter were buying during the most recent period, with Berkshire Hathaway and Tweedy Browne both making significant additions to their holdings, and the managers at FPA Crescent making a meaningful new-money purchase in the name. The buying of J.P. Morgan Chase was nearly as strong, with three of the five managers that held the stock coming into the second quarter buying more shares, and two other managers actually stepping up and putting new money to work in the name during the period. It should be noted, though, that one of our top managers--  Hartford Capital Appreciation (ITHAX)--made a meaningful reduction of its stake in this Big 4 bank.

With regard to Visa, we saw one significant purchaser of the stock in Alleghany, which when added to additions made by  Vanguard PRIMECAP (VPMCX), more than offset the selling that was taking place at Berkshire Hathaway and Aston/Montag & Caldwell Growth during the period. As for the other stock that made our list of top 10 purchases, Thermo Fischer Scientific saw the managers at FPA Crescent increase their stake in the firm by 40%, such that it accounted for 3% of its long stock positions at the end of the most recent period, while both RS Capital Appreciation and Sound Shore made new-money purchases in the name. The managers at RS Capital Appreciation--David Carr, Larry Coats, and Christy Phillips--noted that they were attracted by the company's global reach, wide product portfolio, and what they see as a value-creative growth strategy at the firm when they bought the shares.

Ultimate Stock-Pickers' Top 10 Stock Sales (by Investment Conviction)

 

  Star Rating Fair Value Uncertainty Moat Size Current Price (USD) Price/Fair Value Market Cap (mil) # of Funds Selling Wal-Mart (WMT) 2 Low Wide 72.60 1.19 $246,835 5 UnitedHlth (UNH) 4 Medium Narrow 54.30 0.84 $55,676 5 Abbott (ABT) 4 Low Wide 65.54 0.94 $103,074 3 UPS (UPS) 3 Medium Wide 73.81 0.92 $70,733 3 Pepsi (PEP) 3 Low Wide 72.43 1.01 $113,111 5 MasterCard (MA) 3 High Wide 422.90 1.07 $53,022 3 Chspk (CHK) 4 High Narrow 19.35 0.72 $13,085 2 Kraft (KFT) 3 Medium Narrow 41.51 0.94 $73,951 4 AnhsrBsch (BUD) 2 Medium Wide 84.18 1.20 $136,539 2 Csco Sys (CSCO) 4 Medium Wide 19.08 0.80 $103,183 4

Data as of 08/31/12. Fund ownership data as of funds' most recent filings.

As can be expected given the market activity (and all of the buying that was going on) during the quarter, the selling activity involved a lot of situations where managers were unloading stocks in order to put money to work elsewhere. And stocks from the consumer defensive sector seemed to get more attention than most, with our top managers making meaningful sales of  Wal-Mart (WMT),  PepsiCo (PEP), Kraft Foods, and  Anheuser-Busch Inbev SA (BUD). In the case of Wal-Mart, the retail giant was sold by five of the 14 managers that held it at the start of the second quarter, with  Dodge & Cox Stock (DODGX), FPA Crescent, and Tweedy Browne all making significant reductions in their stakes, and the managers at Sound Shore completely eliminating Wal-Mart from their portfolio. The selling of PepsiCo was nearly as deep, with five of the 11 managers holding it at the end of the first quarter selling shares. The most meaningful reductions were at  Yacktman (YACKX), where PepsiCo remains the fund's second-largest holding,  Mutual Shares (TESIX), which reduced its holdings in the snack food giant by more than 90%, and Oakmark Equity & Income, which completely eliminated its stake.

As we saw a few weeks ago, Berkshire Hathaway was a major seller of Kraft Foods, which Warren Buffett has looked to as a source of cash ever since the firm's purchase of Cadbury, a deal that the Oracle of Omaha had never truly warmed up to. Buffett was not alone in his selling, as the managers at Hartford Capital Appreciation made a significant reduction in their stake, while both FPA Crescent and Vanguard PRIMECAP completely eliminated their stake in the packaged foods giant. While the reasoning behind these sales is not readily apparent, it could be that these managers are not interested in the upcoming spin-off of Kraft's global snack business, to be named Mondelez (MDLZ), at the start of the fourth quarter. With regard to the other consumer defensive name on the list of top 10 sales, Anheuser-Busch Inbev was sold by two of the four managers holding the stock at the start of the second quarter, with Alleghany making the most meaningful reduction to its stake during the period.

Looking at the rest of the names on the list,  UnitedHealth Group (UNH),  Abbott Laboratories (ABT), and Cisco Systems stand out because each had two or more of our top managers completely eliminating their stakes in these names. In the case of Cisco, the selling by four of our 11 managers, all of which completely eliminated their stakes in the networking giant, was enough to drop the stock from a top 10 holding earlier this year to a position where it no longer makes the top 25 holdings of our Ultimate Stock-Pickers. As for the two healthcare names, Abbott was sold by three of the eight managers holding the shares at the end of the first quarter, with two managers-- Parnassus Equity Income (PRBLX) and Sound Shore--completely eliminating their stakes in the name. Meanwhile, UnitedHealth Group was sold by five of the six managers that held it coming into the second quarter, with three managers--Diamond Hill Large Cap, Hartford Capital Appreciation, and Mutual Shares--eliminating the health insurer from their portfolios (in some cases because the stock had reached their estimates of its intrinsic value).

With regard to the selling taking place with  MasterCard (MA), it is interesting to note that the main seller--Alleghany--was also putting a significant amount of capital to work in Visa during the second quarter. The managers at RS Capital Appreciation also significantly reduced their stake in MasterCard, but did not buy (nor do they own) shares of Visa during the most recent period. As for UPS, shares of the world's largest parcel delivery company were sold by three of the nine managers that held the stock at the end of the first quarter, with  FMI Large Cap (FMIHX) completely eliminating its stake in the firm. It should, however, be noted that one top manager-- Oppenheimer Global (OPPAX)--made a meaningful new-money purchase of shares of UPS during the second quarter. The final name on the list,  Chesapeake Energy (CHK), saw major sales from both Hartford Capital Appreciation and RS Capital Appreciation during the period. In the case of the former, the fund reduced its stake in the firm by more than 25% last month (after adding to it slightly during the second quarter on weakness).

The managers at RS Capital Appreciation, which completely eliminated the name from their portfolio, were a bit more brutal, noting that it had become "more evident that Chesapeake would continue to maintain a very aggressive capital spending plan in the face of rapidly declining underlying commodity prices for natural gas and oil," which had the effect of deteriorating their view of the risk profile of the company. They went on to note that "fund shareholders would have benefited had we sold the Chesapeake Energy position earlier and had we waited longer to initiate other energy positions," with the latter sentiment coming up more than a few times from mangers in the quarterly commentaries that we sifted through this time around.

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Disclosure: Greggory Warren owns shares in the following securities mentioned above: Kraft Foods and Procter & Gamble. It should also be noted that Morningstar's Institutional Equity Research Service offers research and analyst access to institutional asset managers. Through this service, Morningstar may have a business relationship with fund companies discussed in this report. Our business relationships in no way influence the funds or stocks discussed here.

The Morningstar Ultimate Stock-Pickers Team does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.