Our Ultimate Stock-Pickers' Top 10 Buys and Sells
Technology names dominated our list of top-10 purchases, with Microsoft not only being a top-10 holding for our managers, but one of the highest-conviction purchases during the most recent period.
By Brett Horn | Associate Director
Despite steady gains in the U.S. equity markets last year, with the S&P 500 Index increasing 16% on a total return basis, things were a bit more tepid during the fourth quarter. The index actually lost a little ground as the markets dealt with the uncertainties of both the presidential election and the pending fiscal cliff. With close to USD 15 billion flowing out of actively managed U.S. stock funds during December 2012, last year's fourth quarter (with USD 44 billion in net redemptions) went down as the third worst quarter for outflows for the category since the middle of 2008 (with the fourth quarter of 2008 and fourth quarter of 2011 seeing outflows of USD 48 billion and USD 45 billion, respectively). Investors were actively selling off positions during the quarter, influenced by a desire to lock in capital gains before tax rates potentially increased at the end of the year. While some of this money made its way back into the category this year, with January 2013 recording the first positive flows for actively managed U.S. stock funds since February 2011, total inflows for the month were only USD 5 billion. While this type of investor behavior has created obstacles for our Ultimate Stock Pickers in the past, we did see a fair amount of buying and selling activity by our top managers during the most recent period, with those releasing monthly data reporting somewhat higher levels of trading activity on either side of the new year.
Much of the buying activity during the fourth quarter and early part of 2013 was centered on the energy and technology sectors, even though our managers' positions in these sectors, in aggregate, remain below their weights in the S&P 500. We also saw our Ultimate Stock Pickers lightening up on their exposure to consumer cyclical and financial services names, as the financial crisis and recession recede into the background and valuations for stocks with cyclical risk have become less attractive. Despite the trimming of some financial services names, our top managers remain the most overweight in this sector, while at the same time being the most underweight in Technology, with the increasing allure of relatively mature "old tech" names yet to overcome their historical aversion to this fast-changing sector of the market. It is also noteworthy that four of the top 10 purchases during the period involved new money being put to work by at least one of our top managers, while eight of the top 10 sales saw one or more managers completely eliminating the name for their portfolios. The buying and selling activity that took place during the most recent period also had an impact on the list of top 10 holdings of our top managers, with Oracle (ORCL) falling off the list (despite some additional buying activity by our top managers), and United Parcel Service (UPS) moving up the ranks to become a fairly meaningful holding for our managers overall.
Changes to the Investment Manager Roster
One of our goals with the Ultimate Stock-Pickers concept has been to be more proactive with the Investment Manager Roster, believing that this type of flexibility will allow us to maintain a list of top investment managers that can consistently generate high-conviction buy and sell ideas for investors. That said, we make changes to the Investment Manager Roster only once a year, gathering up data points and other information as we go through each calendar year that help us make more informed decisions. As a general rule, we will only remove a manager from the Investment Manager Roster if: (a) there is a meaningful change of managers for a fund (and we have little confidence that the succeeding management team will be able to replicate the level of performance historically generated by the fund); (b) a fund closes or merges with another fund, and the fund no longer follows the same investment processes, or is no longer run by the same management team; (c) the fund is no longer covered by Morningstar's mutual fund analysts; and, (c) the long-term performance of a fund has fallen meaningfully below benchmark returns.
Unlike last year, when we made two changes--replacing Matrix Advisors Value (MAVFX) and Columbia Value & Restructuring (EVRAX) with Sequoia (SEQUX) and Diamond Hill Large Cap (DHLAX) --we have only one change to announce this year: the removal of RS Capital Appreciation (RCAPX), which has been replaced with T. Rowe Price New America Growth (PRWAX). Much like last year, the driving force for removing RS Capital Appreciation was the fact that Morningstar's mutual fund analyst team stopped covering it. Add to that the fact that early this year, the folks at RS Investment Management dropped the key fund managers--David Carr, Larry Coats, and Christy Phillips--who were all responsible for its historical performance track record (and its predecessor, the Oak Value Fund), expecting to merge the assets into RS Growth (RSGRX), and the decision to drop the fund was that much easier.
As for the replacement fund, we've made every effort to replace the outgoing managers with managers who have similar investment characteristics, allowing us to maintain an appropriate level of diversity among the mutual funds in our list of top managers. The decision to pick T. Rowe Price New America Growth was made more difficult by the fact that we had a number of good candidates to pick from this time around. Our fund analysts pointed to the long-term track record that manager Joe Milano has posted, even though his fund trailed the S&P 500 Index last year. They also note that his approach favors bottom-up stock-picking, with the fund gravitating toward certain sectors where Milano thinks companies have a better chance of doing well in a slow-growth environment, including technology, health care, and industrials, while staying somewhat lighter in consumer defensive and consumer cyclical names. This makes it a good fit for our Investment Manager Roster, with our managers in aggregate tending to be lighter in energy, technology and utilities, and heavier in consumer defensive, financial services, health care, and industrials.
Having had interest in the past about which other managers came close to making the list, but were ultimately not selected as a replacement manager this time around, we would note that the following managers remain in our bullpen for Large Cap Growth managers: Morgan Stanley Focus Growth (AMOAX), MFS Global Equity (MWEBX), Harbor Capital Appreciation (HACAX) , and Fidelity Growth Company (FDGRX). As you may recall, we like to maintain a list of potential replacements for each of the three large-cap mutual fund categories--large-cap value, large-cap blend, and large-cap growth--that are represented on the Investment Manager Roster, so that we can readily swap out an outgoing manager with the best possible replacement, with many of the hard decisions that go into making the call about which manager comes on (or which goes off) the list already determined in advance.
Ultimate Stock-Pickers' Top 10 Stock Holdings (by Investment Conviction)Star Rating Fair Value Uncertainty Moat Size Current Price (USD) Price/Fair Value # of Funds Holding Microsoft (MSFT) 4 Medium Wide 27.95 0.80 17 Google (GOOG) 3 High Wide 806.19 1.09 15 J&J (JNJ) 4 Low Wide 76.70 0.95 12 Procter & Gamble (PG) 2 Low Wide 76.49 1.16 12 Wells Fargo (WFC) 4 Medium Narrow 35.39 0.84 11 AIG (AIG) 4 High None 37.85 0.81 7 Wal-Mart (WMT) 3 Low Wide 71.74 1.00 13 Brk.Hathaway (BRK.B) 4 Medium Wide 102.05 0.87 8 United Parcel (UPS) 3 Medium Wide 82.87 1.04 12 PepsiCo (PEP) 3 Low Wide 75.93 1.01 9
Data as of 03/01/13. Fund ownership data as of funds' most recent filings.
The buying and selling activity that took place during the most recent period also had an impact on the list of top-10 holdings of our top managers, with Oracle falling off the list (despite some additional buying activity by our top managers), and UPS moving up the ranks to become a fairly meaningful holding for our managers overall. That said, both Oracle and UPS (as well as Coca-Cola (KO)) have tended to be in the top 15 holdings of our top managers, making their movements on and off the list less dramatic than what we saw with American International Group (AIG) last year. As we noted last time around, we've been amazed by AIG's rapid rise up the ranks of the holdings of our top managers, given that up until last year, only Bruce Berkowitz at Fairholme (FAIRX), Saul Pannell at Hartford Capital Appreciation (ITHAX), and the managers at Mutual Shares (TESIX) were willing to commit capital to the firm, which has been mired in controversy ever since the U.S. government had to bail it out at the height of the financial crisis. Since the start of 2012, four more of our top managers--Diamond Hill Large Cap, FPA Crescent (FPACX), Oakmark (OAKMX), and Sound Shore (SSHFX)--have established stakes in the name, with the company making a number of moves over the last few years to shore up and simplify its operations, and trading at a market value low enough below its book value to draw much wider interest from our Ultimate Stock Pickers.
Ultimate Stock-Pickers' Top 10 Stock Purchases (by Investment Conviction)Star Rating Fair Value Uncertainty Moat Size Current Price (USD) Price/Fair Value # of Funds Buying Apple (AAPL) 4 Medium Narrow 430.47 0.72 6 Cisco (CSCO) 4 Medium Wide 20.83 0.87 4 AIG (AIG) 4 High None 37.85 0.81 5 Devon Energy (DVN) 5 High Narrow 53.88 0.54 4 Oracle (ORCL) 4 Medium Wide 34.63 0.89 6 Abbott Labs (ABT) 3 Low Narrow 33.60 0.99 4 Expeditors (EXPD) 4 Medium Wide 38.82 0.76 4 Microsoft (MSFT) 4 Medium Wide 27.95 0.80 7 United Parcel (UPS) 3 Medium Wide 82.87 1.04 4 Wells Fargo (WFC) 4 Medium Narrow 35.39 0.84 4
Data as of 03/01/13. Fund ownership data as of funds' most recent filings.
As noted, the bulk of the conviction buying that took place during the most recent period was centered in the energy and technology sectors, with names from the technology sector having the bigger impact on our list of top 10 purchases. It should also be noted that four of the ten names on the list-- Apple (AAPL), Cisco Systems (CSCO), Expeditors International (EXPD), and UPS--saw new money being put to work by at least one of our top managers.
Microsoft (MSFT), already our managers' top holding on a conviction basis coming into the fourth quarter of last year, drew even more interest (with seven of our top managers adding to their stakes) as the stock declined about 10% during the period. The managers at Diamond Hill Large Cap had a meaningful position in the name coming into the quarter, and continued to see the cup as half full, boosting their stake by more than 10%, and noting in their quarterly letter:
Software provider Microsoft was a weak performer due to disappointing initial sales of mobile devices using its new Windows 8 operating system. However, Microsoft's business software sales continued to generate increasing levels of profit.
The managers at Dodge & Cox Stock (DODGX) also increased their stake in Microsoft by more than 10% during the quarter, noting that the position is part of a larger software play, and that the switching costs that form the basis of the company's moat is a key point of attraction:
Another theme within Tech for the Fund is an overweight position in Software. We find that enterprise software has high customer switching costs and high recurring revenue, which tend to mitigate risk over our three- to five-year investment horizon. The largest Fund holding in this area is Microsoft (a 2.6% position). The stock lagged in 2012, but we remain impressed with the durability of the company's Windows and Office suite of products as well as the growth coming from its Server and Tools division. Furthermore, Microsoft has a huge installed base of customers and launched an enhanced version of its Windows operating system last year.
Morningstar analyst Norman Young agrees that a wide economic moat still surrounds Microsoft's business. He notes that while conventional wisdom regards Microsoft as a technology giant in decline, there are glimmers of a more cohesive strategy through its updated Windows OS franchise. Young notes that Microsoft has been a step behind as competitors and new technologies have slowly eroded the moat around its Windows PC operating system. But he believes that the firm's new multiprong strategy to compete in the world of cloud computing and mobile devices should help rejuvenate its Windows OS and software franchises by creating a more cohesive user experience among multiple devices, which should strengthen the links among users, the OS, and the application software. While Young would like to see a slightly larger margin of safety, he sees the shares as undervalued from a long-term perspective. Microsoft traded in a range of about USD 26 to USD 30 during the fourth quarter, and currently trades in the middle of that range, so investors looking at the stock today are likely to realize prices comparable to what our managers were paying when they made their purchases.
Another familiar technology name that popped up on our list of top 10 purchases is Cisco, a stock that has maintained a fairly consistent presence on our top purchases lists over the last year or so. Cisco has been an integral part of the "old tech" theme we've seen play out among our managers, as low valuations on some of the stalwart names in the sector peaked their interest the last couple of years. In its quarterly letter to shareholders, Yacktman (YACKX) (which sat tight on its stake, representing 6% of portfolio, during the fourth quarter) noted that:
Cisco's shares performed satisfactorily in 2012. The shares continue to be inexpensive as investors generally are avoiding "old tech" shares, though not to the same extent as PC-related stocks. Our investments in technology companies are more a result of valuation than strong future growth prospects. As we often say, "It's almost all about the price."
With the recent fall in its stock price, some of our top managers appear to believe that Apple has now joined the group of undervalued large cap technology firms. We saw four of our Ultimate Stock Pickers buying shares during the most recent period, with Diamond Hill Large Cap establishing a new position in the name, and the managers at Hartford Capital Appreciation, T. Rowe Price New America Growth, and Alleghany (Y) all making meaningful additions to their holdings in the firm. While his purchase of additional shares of Apple did not trip a signal for us during the period, Bill Nygren at Oakmark offered a somewhat measured take on the stock:
Our weighting in Apple is based on our assessment of its attractiveness, not its market cap. We believe Apple is priced very cheap relative to its current level of earnings. If we were confident that its current earnings were sustainable and that its management would distribute those earnings to shareholders via dividends or share repurchases, we would increase our weighting.
Morningstar analyst Brian Colello grants that Apple has faced many negative headlines in recent months, but still views the company as the world's premier smartphone maker. He continues to expect strong iPhone growth, thanks to robust smartphone adoption in both developed and emerging markets, and believes that iPad revenue will grow at an outstanding rate as consumers continue to adopt tablets over (or in addition to) PCs. He thinks that the adoption of these devices could even raise the switching costs associated with the iOS platform, which could potentially spur market share gains in other iOS products. Colello does note that pricing and gross margins for these devices may not hold up well in the long term, potentially stunting the firm's EPS growth, but believes that Apple should still generate tons of free cash flow in the years ahead. In his view, Apple must avoid missteps in its new product launches and fend off Samsung and low-end smartphone makers, but still expects it to be a leader in the smartphone pack, and believes the shares are attractively priced right now. Apple traded between USD 510 to USD 660 during the fourth quarter, and currently trades well below that range, so investors looking at the stock today are likely to realize prices much better than those which our managers paid.
While technology names dominated our list of top 10 purchases, we did see fairly widespread buying in the energy sector, even though Devon Energy (DVN) was the only stock to make our top 10 list. We've seen a lot of conviction buying in this name over the last year, with three of our top managers--Oakmark, Oakmark Equity & Income (OAKBX), and Tweedy Browne Value (TWEBX)--adding to already sizable stakes in the name. Tweedy Browne Value and Oakmark Equity & Income were the most notable buyers, increasing their stakes in Devon by 98% and 68%, respectively. Oakmark Equity & Income's commitment to the energy theme is especially remarkable given that of the five largest detractors to the fund's performance during the fourth quarter four of those stocks were energy names.
As for some of the other names on the list, we saw interest in Abbot Laboratories (ABT), with four of our top managers-- Jensen Quality Growth (JENSX), Columbia Dividend Income (LBSAX), Aston/Montag & Caldwell Growth (MCGIX), and Vanguard PRIMECAP (VPMCX)--adding to existing positions. In their quarterly commentary to shareholders, the managers at Columbia Dividend Income noted that they remain attracted to the company's growth prospects, even after the spin-off of AbbVie (ABBV):
Abbott Laboratories was scheduled to spin off its pharmaceutical business segment in January 2013 into a new company, AbbVie. The remaining segments of the business will remain a part of Abbott Laboratories. We are attracted to AbbVie's blood cancer drug in their pipeline and we also believe that the remaining segments of the company should have an above-average growth profile.
Expeditors International is a somewhat newer name for our list of top 10 purchases. The major buyer during the most recent period was Parnassus Equity Income (PRBLX), which made a meaningful new-money purchase in Expeditors, with the stock accounting for 2% of its portfolio at the end of December. The new position in Expeditors complemented a previously disclosed stake in C.H. Robinson (CHRW), with the managers at Parnassus noting the following about these firms:
We also own two businesses, C. H. Robinson and Expeditors International of Washington, which are leaders in logistics brokerage. These companies benefit from scale, since larger brokers have more extensive networks to match shippers and carriers. The other great thing about Robinson and Expeditors is that, unlike Sysco and UPS, they don't have to keep heavy equipment on their balance sheets. Less capital expenditure means more operating cash flow that can be distributed to shareholders. We've long admired these asset-light logistics companies, and were excited that their stocks dropped to levels in 2012, where we could buy them at value prices.
Morningstar analyst Matthew Young largely agrees with Parnassus' take. He believes Expeditors ranks as one of the highest-quality third-party logistics firms we cover, with a history of impressive execution and shareholder value creation. Moreover, he thinks that its large network of shippers and carriers bestows a robust value proposition and wide economic moat capable of defending long-run economic profits. Young further notes that since Expeditors doesn't own transportation equipment, it avoids capital intensity and employs minimal operating leverage, thereby reducing the full brunt of economic cyclicality. While he points out that persistently weak airfreight demand will continue to temper top-line growth and productivity in the short run, Young thinks that all of this negative sentiment has reduced Expeditors' equity valuation to fairly attractive levels. The stock traded in a range of about USD 34 and USD 40 during the fourth quarter of last year, and recently dropped back down into this range following somewhat disappointing fourth-quarter results, suggesting that investors can get in at a price comparable to that which Parnassus realized when it made its purchase.
Ultimate Stock-Pickers' Top 10 Stock Sales (by Investment Conviction)Star Rating Fair Value Uncertainty Moat Size Current Price (USD) Price/Fair Value # of Funds Selling eBay (EBAY) 3 Medium Wide 54.90 1.04 6 Amgen (AMGN) 3 Medium Wide 92.58 0.92 5 FedEx (FDX) 3 Medium Narrow 105.38 0.94 4 Lowe's (LOW) 3 Medium Wide 38.38 1.04 3 Amazon (AMZN) 3 High Wide 265.74 0.89 3 Gen'l Electric (GE) 3 Medium Wide 23.19 0.93 4 Visa (V) 2 High Wide 158.08 1.22 3 VeriSign (VRSN) 3 High Narrow 46.17 1.00 2 Stryker (SYK) 3 Medium Wide 64.90 1.03 2 Time Warner (TWX) 3 Medium Narrow 53.62 0.97 2
Data as of 03/01/13. Fund ownership data as of funds' most recent filings.
As we noted above, the bulk of the conviction selling that took place during the third quarter was centered in the consumer cyclical and consumer defensive sectors, with names from the consumer cyclical sector having the bigger impact on our list of top 10 sales. In addition, eight of the top 10 sales-- eBay (EBAY), Amgen (AMGN), Lowe's (LOW), Amazon.com (AMZN), General Electric (GE), VeriSign (VRSN), Stryker (SYK) , and Time Warner (TWX)--saw one or more of our top managers completely eliminating their stake in the name during the period. Looking at these sales overall, it seems like a reasonable guess that most of them were situations where our top managers were either raising capital for fourth-quarter redemptions, or recycling capital into more attractive names, as the list contains only one 4-star rated stock, compared to eight 4- or 5-star rated stocks on our list of top 10 purchases.
The most widely sold stocks were Amgen and eBay. Amgen appreciated over 30% during the course of 2012, so it’s likely that the managers that sold the name were satisfied with taking their gains and moving on to another opportunity. As for eBay, it was another great performer in 2012, with its shares up over 60% last year. The managers at Oakmark noted that they were happy to move on from eBay (as well as their stake in Time Warner) in their quarterly letter to shareholders:
We eliminated two holdings during the quarter, eBay and Time Warner. Both were very successful holdings for the Fund and were sold because their stock prices appreciated to levels that we believed were appropriate.
Hartford Capital Appreciation also completely eliminated its stake in eBay, while Dodge & Cox Stock, Aston/Montag & Caldwell Growth, Oppenheimer Global (OPPAX), and T. Rowe Price New America Growth all pared back their positions during the most recent period.
If you're interested in receiving e-mail alerts about upcoming articles from The Ultimate Stock-Pickers Team, please sign up here.
Disclosure: Brett Horn owns shares in the following securities mentioned above: Devon Energy. 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.