By Greggory Warren, CFA | Senior Stock Analyst
The rally in U.S. markets over the past five-plus years has not only led to a more than 150% increase in the value of the S&P 500 TR Index (from the depths of its lows during the first week of March 2009). It also has left many of our Ultimate Stock-Pickers bereft of ideas about where to put new money to work. As we noted in our last article, the first quarter (and early second quarter) of 2014 was one of the weakest buying environments we have seen since we relaunched the Ultimate Stock-Pickers concept in April 2009. The trend toward fewer and fewer meaningful purchases by our top managers started midway through last year, with the buying activity we were seeing being much more notable for its breadth than for its level of conviction. With many of our managers taking advantage of the run-up in the markets to trim or exit positions that they think have become fully valued, some have opted to funnel the cash back into names that were already held in their portfolios (especially where there is a perceived relative discount to the market).
Even though the market as a whole looks modestly overvalued, with Morningstar's stock coverage universe trading at 1.03 times our analysts' estimates of fair value at the end of May, a case can still be made for stock market gains in the year ahead. Looking back over the past decade, we've seen our universe of covered stocks post further gains in two different years after the S&P 500 rose more than 25% in the preceding year. In 2010, the market increased another 15% after gaining more than 26% during 2009, with Morningstar's stock coverage universe peaking at about 1.10 times our analysts' fair value estimates during the year. While it could be argued that the 2010 gain was nothing more than the S&P 500 continuing its climb out of the depths of the 2008-09 bear market, we saw the same thing happen in 2004. Coming off of a nearly 29% gain in 2003, the market increased close to 11% that year, with Morningstar's stock coverage universe approaching 1.15 times our fair value estimates near the end of 2004. Based on these two examples, a 7%-12% gain in the value of the S&P 500 is not outside of the realm of possibilities, but with the market already up 5% year to date there seems to be less room for the market to run.
As we noted last time, our Ultimate Stock-Pickers continue to be conflicted about what comes next for this market, with fewer and fewer managers showing signs of bullishness. Many of our top managers believe that equity prices fully reflect what good news exists, with one of the more colorful commentaries on the state of the markets coming from Pat English, lead manager of FMI Large Cap (FMIHX), in his most recent quarterly letter:
"This bull market reminds us of the old movie, "Groundhog Day," with Bill Murray. Phil Connors (Murray) repeatedly wakes up to Sonny & Cher on the radio, and has to live the same day over and over no matter what he does. Similarly, this market seems to stay the same…expensive…despite a litany of less than appealing fundamentals: corporate revenue growth weakening, spotty job growth (actually falling when adjusted for the drop in average workweek hours), China slowing, emerging markets swooning, Syria and the Middle East aflame, Russia swiping Crimea and acting with hostility elsewhere, biotechnology stocks soaring on sketchy fundamentals, and classic signs of overexuberance (Whatsapp, Pandora, etc.). Of course, there are some positives, including improved bank lending and consumer sentiment, but so far precious little is being translated into sustainable economic growth. Valuations, as articulated ad nauseam in recent letters, remain extremely high from a historical perspective. Investor bullishness and the raft of low-quality IPOs are additional signs of speculative excess. Added to this is the continuing fiscal crisis, a toxic political environment, and a monetary policy that all but ignores the potential ramifications of conjuring up $4 trillion of high-powered money out of thin air.
Unlike "Groundhog Day," we can't stop the clock and make all the bad things turn out great. We own this set of shaky fundamentals, and we own them at high valuations. Most bull markets are impervious to fundamentals in the short run, but not over the long haul. The problem is that investors believe they can spot signs of trouble and "get out with their skin." Unfortunately, this rarely happens. Simply look at the aforementioned list of real and anecdotal signs that might typically be tipping points for a stock market. So far each one proved false but instead of Tweedy, Browne Value investors counting their lucky stars and derisking, they actually do the opposite, becoming more emboldened and aggressive. It's why when markets turn, they rarely decline to an average or median level, but more commonly overshoot on the downside. The euphoria turns to panic and as the disillusionment deepens, the once overvalued becomes cheap. It's also why most studies show that the average investor has achieved about a 3% return in the stock market while the S&P 500 has done close to 10%.
With most disconnects between economic fundamentals and equity prices tending to rectify over the long run, the biggest unanswered question for investors is whether the economy improves to support current stock valuations or stock valuations adjust to reflect the current state of the economy. This could explain why we continue to see a greater focus on the part of our Ultimate Stock-Pickers on companies with economic moats--particularly those with wide economic moats--in their buying activity. Also of note is the fact that four of the top 10 purchases this period-- Procter & Gamble (PG), Unilever (UN)/(UL), Diageo (DEO), and Colgate-Palmolive (CL)--were directed at Consumer Defensive names, with two other high-conviction purchases-- Zoetis (ZTS) and Sanofi (SNY)--focused on Health Care stocks (which have traditionally been viewed as more defensive than stocks from other sectors). Meanwhile, the trend of selling activity outstripping buying activity seen over the past few quarters continued during the most recent period, with many managers taking advantage of the ongoing market rally to book gains--a point that was expounded on by the managers of Tweedy, Browne Value (TWEBX) in their most recent quarterly commentary to the fund's shareholders:
As we have said before in some of our more recent updates, we are now five-plus years into a strong recovery in equity prices, which in our opinion has outstripped the underlying economic recovery. It should come as no surprise that most securities are, in our view, fairly and, in some instances, overpriced. While we are seeing some new idea flow in lesser developed economies, it is not enough to offset the pruning we have been doing in our Fund portfolios and, as a result, we hold more cash reserves than we would like. Many so called “new technology and media” companies today trade at what we feel are nosebleed valuations, and as we write we are seeing a bit of a correction in those shares. Should that activity, or any of the macro fires that are burning around the world, begin to affect the broader market, we may very well get an opportunity to put some of the Funds’ cash reserves to work. In the interim, we will remain patient.
As in past periods, the aggregate holdings of our Ultimate Stock-Pickers in Utilities, Energy, Communication Services, and Real Estate remain underweight relative to the weightings of these sectors in the S&P 500 TR Index, with our top managers continuing to hold overweight positions in the Financial Services, Consumer Defensive, Basic Materials, and Health Care sectors; (while positions in Technology, Industrials, and Consumer Cyclical stocks remain within 100 basis points of the index). Also of note is the fact that five of the top 10 purchases during the period involved new money being put to work by at least one of our Ultimate Stock-Pickers, while six of the top 10 sales saw one or more manager completely eliminating the name from their portfolios. That said, the overall buying and selling activity of our top managers during the most recent period did have a slight impact on the list of top 10 holdings of our Ultimate Stock-Pickers, with Johnson & Johnson (JNJ) replacing United Parcel Service (UPS), which was sold outright by one of our top managers during the fourth quarter.
Ultimate Stock-Pickers' Top 10 Stock Holdings (by Investment Conviction) Company Name Star Rating Fair Value Uncertainty Moat Rating Current Price (USD) Price/ Fair Value Market Cap (USD mil) # of Funds Holding Microsoft MSFT 3 Medium Wide 40.94 0.97 343,211 16 Wells Fargo WFC 3 Medium Narrow 50.78 1.04 270,257 15 Google GOOGL 3 High Wide 571.65 1.1 386,311 15 AIG AIG 3 Medium None 54.07 1.04 78,062 7 P&G PG 4 Low Wide 80.79 0.91 219,675 11 BerkHath BRK.B 4 Medium Wide 128.35 0.86 300,594 8 Pepsi PEP 3 Low Wide 88.33 0.99 134,829 11 Wal-Mart WMT 3 Low Wide 76.77 0.96 250,481 12 J&J JNJ 3 Low Wide 101.5 1.03 289,146 12 Oracle ORCL 3 Medium Wide 42.02 1.02 186,563 9
Data as of 05/30/14. Fund ownership data as of funds' most recent filings.
As we noted above, all of the buying and selling that we saw during the most recent period had very little impact on the list of top 10 holdings of our Ultimate Stock-Pickers. That said, the list has seen a few meaningful changes since we relaunched the concept five years ago. For starters, wide-moat rated Microsoft (MSFT) and Google (GOOG) have become two of the most widely held stocks of our top managers, with 15 or more of our 26 Ultimate Stock-Pickers holding stakes in the names. While a fair amount of this ownership comes from the growth-oriented managers on our Investment Manager Roster, we've seen more than a handful of our large-cap blend and value managers stepping up and investing in the two technology names. Although Microsoft is not new to the list, being held by 13 of our 26 Ultimate Stock-Pickers at the end of the first quarter of 2009, Google didn't really hit the radar until the latter half of 2011 and didn't make the list of top 10 holdings until the first quarter of 2012. We also note that Google remains the top conviction holding of our Ultimate Stock-Pickers even after six of our managers trimmed their stakes in the name during the most recent period.
Ultimate Stock-Pickers' Top 10 Stock Purchases (by Investment Conviction) Company Name Star Rating Fair Value Uncertainty Moat Rating Current Price (USD) Price/ Fair Value Market Cap (USD mil) # of Funds Buying P&G PG 4 Low Wide 80.79 0.91 219,675 7 Chevron CVX 4 Low Narrow 122.79 0.93 234,647 2 Unilever UN 3 Medium Wide 43.41 0.99 131,159 6 Citigrp C 3 High Narrow 47.56 0.99 145,385 5 CSX CSX 3 Medium Wide 29.4 0.95 29,408 2 Diageo DEO 3 Medium Wide 128.79 1.01 81,495 3 Zoetis ZTS 2 Medium Wide 30.7 1.28 15,371 2 Clgte-Palm CL 2 Low Wide 68.41 1.14 64,007 2 Sanofi SNY 4 Medium Wide 53.3 0.83 141,226 3 NatOilVrco NOV 3 Medium Wide 81.65 1.02 34,946 3
Data as of 05/30/14. Fund ownership data as of funds' most recent filings.
As we noted above, Consumer Defensive stocks garnered the most buying interest from our top managers during the first quarter (and early part of the second quarter) of 2014. In our last article we talked more extensively about Unilever and Diageo, both of which were new money purchases picked up with a fair amount of conviction by the managers that were buying during the period. In the case of Unilever, this also marked the second consecutive quarter that our Ultimate Stock-Pickers put a meaningful amount of capital in the name. Coming into 2014, we saw both Pat English at FMI Large Cap and Tom Gayner at Markel (MKL) putting new money to work in the name, with Steve Romick at FPA Crescent (FPACX) also meaningfully adding to his fund's stake in Unilever. This was followed by six managers buying shares during the first quarter of 2014, with Timothy Hartch and Michael Keller at BBH Core Select (BBTEX) making a high-conviction new-money purchase; the managers at FMI Large Cap and Markel making meaningful additions to their relatively newer sakes; and the managers at FPA Crescent, Oakmark (OAKMX), and Oppenheimer Global (OPPAX) all making additional purchases of smaller amounts of the company's common stock.
While the managers at BBH Select Core also put a little bit of money to work in Diageo during the period, it was nowhere near the level of conviction that we saw from both Oakmark and Oakmark Equity & Income (OAKBX) during the first quarter. Bill Nygren at Oakmark was also one of the driving forces behind the high-conviction purchases of Citigroup (C) during the most recent period, making a meaningful new-money purchase in the name. We also saw Rajeev Bhaman at Oppenheimer Global substantially increase his fund's stake in the bank, while the managers at Diamond Hill Large Cap (DHLAX), FPA Crescent, and Sound Shore Investor (SSHFX) all increased their holdings in Citigroup. As for Colgate-Palmolive, the stock was a meaningful new-money purchase for Weston Hicks and the insurance portfolio managers at Alleghany (Y), which as we noted last time around were the driving force behind the high-conviction purchases of both Chevron (CVX) and CSX (CSX), having made new-money purchases in both names during the first quarter.
While Procter & Gamble may not have attracted new-money attention during the period, we did see seven of the 11 Ultimate Stock-Pickers that hold the name adding to their stakes during the period, with the managers at Diamond Hill Large Cap, Jensen Quality Growth (JENSX), and Sound Shore Investor all making substantial additions to their existing holdings. The two Health Care names on the list--Zoetis and Sanofi--were both new-money purchases for at least two of our top managers during the most recent period. As we noted during our last article, the managers at BBH Core Select made a high-conviction new-money purchase of Zoetis, which develops, produces, and delivers animal health medicines and vaccines for both livestock and companion animals. Their interest in the animal health firm was seconded by Robert Goldfarb and David Poppe at Sequoia (SEQUX), as their fund established a small stake in Zoetis during the same period.
As for Sanofi, it was the recipient of new-money interest from both Oakmark and Sound Shore Investor. In his quarterly letter to shareholders, Bill Nygren at Oakmark noted that the fund had added four companies--Citigroup, Diageo, General Mills (GIS), and Sanofi--to the portfolio during the first quarter that he and the other managers of the fund felt were high-quality and attractively priced. Of Sanofi in particular, Nygren noted the following about his purchase of the stock:
Sanofi is a pharmaceutical company with a good mix of durable businesses with strong growth characteristics. The company has a strong franchise in diabetes treatments, maintaining dominant market share in this rapidly growing category. Sanofi is a leading player in emerging markets, where sales growth rates are twice that of the overall pharmaceutical market. Sanofi is also a leader in vaccines, and they have a strong footprint in over-the-counter products. We think that margins and profitability should improve as the company leverages fixed R&D spending and enforces good cost controls. The company’s balance sheet has more cash than debt, and the shares sell at a substantial discount to our estimate of intrinsic value. Moreover, Sanofi has a dividend yield of 3.7%.
National Oilwell Varco (NOV), the final name on our list of top 10 purchases, was also a new-money purchase, picked up with a fair amount of conviction by the managers of Dodge & Cox Stock (DODGX), making it the seventh manager to build up a stake in the energy firm during the past couple of years.
Ultimate Stock-Pickers' Top 10 Stock Sales (by Investment Conviction) Company Name Star Rating Fair Value Uncertainty Moat Rating Current Price (USD) Price/ Fair Value Market Cap (USD mil) # of Funds Selling Allergan AGN 3 Medium Wide 167.46 1.05 52,646 3 Google GOOGL 3 High Wide 571.65 1.1 386,311 6 BerkHath BRK.B 4 Medium Wide 128.35 0.86 300,594 5 UPS UPS 3 Medium Wide 103.88 1.11 94,927 3 Coke KO 4 Low Wide 40.91 0.93 180,912 2 BlckBry BBRY 3 Very High None 7.6 1.09 3,929 2 IL Tool Wks ITW 3 Medium Narrow 86.55 1.07 35,627 3 Merck MRK 3 Medium Wide 57.86 0.96 169,558 3 Nike NKE 2 Medium Wide 76.91 1.2 67,980 3 Quest Diag DGX 3 Medium Narrow 59.89 0.92 8,695 2
Data as of 05/30/14. Fund ownership data as of funds' most recent filings.
Looking at the list of top 10 sales during the most recent period, there was very little commentary from the selling managers about these particular transactions. In most cases (and where commentary exists), managers were selling because stock prices had exceeded their valuation, and, in some cases, to reduce their fund's exposure to emerging and developing markets and currency fluctuations. Google was interesting in that six different managers were selling the stock, three of them making meaningful reductions--FPA Crescent, ASTON/Montag & Caldwell Growth (MCGIX), and Vanguard PRIMECAP (VPMCX). That was offset slightly by purchases by Oakmark and Morgan Stanley Institutional Growth (MSEGX), the latter of which was meaningful in size. About the only name where we saw more than the standard rationale for an outright sale--"the stake was sold because the company's stock price reached our estimates of intrinsic value"--was with Oakmark Equity & Income's elimination of Quest Diagnostics (DGX). Clyde McGregor noted the following in his quarterly letter to shareholders:
The Fund eliminated six positions this quarter: three that worked out well (Cimarex Energy, Concho Resources and Crane) and three that didn’t (Encana, Hospira and Quest Diagnostics)… In the case of Encana and Quest Diagnostics, fundamental underperformance caused us to reexamine our investment cases. We have discussed Encana in previous letters, but a combination of significant management changes, pipeline politics and the exploding growth of North American shale gas production caused us to redeploy the money elsewhere. With Quest, its weakening market share and tougher industry conditions caused us to reduce our exposure to this industry.
We were also somewhat surprised to see Berkshire Hathaway (BRK.A)/(BRK.B) making the list of top 10 sales during the period, as we believe it is undervalued right now, trading at 86% of our fair value estimate. Of the five managers that were selling, the managers at Vanguard PRIMECAP made the biggest move, completely eliminating their stake in the firm. Bruce Berkowitz at Fairholme (FAIRX) also made a meaningful reduction in his Berkshire holdings, reducing his stake to less than 1% of his overall portfolio--which is now dominated by holdings in American International Group (AIG) and Bank of America (BAC). While the managers at FMI Large Cap were neither buying nor selling the stock during the period they did offer up a defense of their Berkshire holdings in their most recent quarterly letter, noting the following about their investment thesis on the firm:
Warren Buffett is now 83 years old. Many investors are worried about succession planning and are skeptical about the company's ability to grow book value at above market rates once Buffett steps down or dies. Buffett's passing will undoubtedly hurt the stock but we believe that it will be a short-term hit and it won't exactly come as a surprise. Further, investors are not giving the company credit for its increased earnings from non-insurance operations and are still valuing the enterprise like a financial institution. Given its fortress balance sheet and collection of above-average businesses, we estimate Berkshire's common stock is trading at a meaningful discount to its intrinsic value.
This echoes our own thinking on the stock, which notes both the positives and the negatives associated with the name longer term. We remain impressed with Berkshire Hathaway's long-standing ability to generate growth in book value per share in excess of its benchmark, believing it will take some time before the firm succumbs to the impediments created by the sheer size and scale of its operations, as well as the longevity of Warren Buffett and Charlie Munger. In our view, the company's shares continue to trade at a discount to our fair value estimate, providing investors with the potential for double-digit upside from today’s market prices. We would also note that Buffett has effectively created a floor under the company's stock price by announcing that he would be willing to buy back both Class A and Class B shares at prices up to 120% of reported book value (which stood at $138,426 per Class A share and $92 per class B share at the end of the first quarter of 2014), which implies downside protection for investors at prices 10%-15% below current trading levels.
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Disclosure: Greggory Warren owns shares in the following securities mentioned above: Citigroup, Colgate-Palmolive, General Mills, 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.