Ultimate Stock-Pickers: Top 10 Buys and Sells
Top managers continue to find new opportunities, while taking full advantage of a rising stock market to book some gains.
By Greggory Warren, CFA | Senior Stock Analyst
The rally in U.S. equity markets over the last five-plus years has led to a trebling of the S&P 500 Index--from a low of 676.53 on March 9, 2009, to a near record high of 2067.56 on Nov. 28, 2014--and has seen the market advance with relatively few corrections (of more than 5%), the last one taking place during the back half of 2012. Although the markets went a little haywire near the end of September (and start of October), they never quite made it into correction territory, and quickly recovered any of the ground that was lost and pushed on to new highs. While this has benefited the portfolios of most investors, it has limited the options for our Ultimate Stock-Pickers, many of whom continue to struggle to find ways to put new money to work.
As we noted in our last article, the buying and selling activity that we've seen from our top managers during the last five calendar quarters is the lowest we've seen from them since we relaunched the Ultimate Stock-Pickers concept in early 2009. The trend of fewer and fewer meaningful purchases started midway through 2013, with the top managers' buying activity since then being much more notable for its breadth than for its level of conviction. With many of our Ultimate Stock-Pickers taking advantage of the run-up in the markets to trim or exit positions that have (in their minds) become fully valued, some have chosen to funnel the proceeds of these sales back into names already in their portfolios, especially where there is a perceived relative discount to the market. For others, especially those not constrained by investment mandates requiring them to be fully invested at all times, it has meant building up cash balances to the point where they are more than double the average cash balance currently held by U.S. stock funds.
These activities have skewed some of the results we see from our top managers each period, with a larger-than-average number of new money purchases and outright sales occasionally appearing in our quarterly lists of top 10 buys and sells, as was again the case during the most recent period. That said, we still saw a fair number of high-conviction purchases during the third quarter (and the early part of the fourth quarter), with most of this buying activity focused on companies with wide economic moats, as many of our managers continue to seek out higher quality businesses trading at relative discounts to their fair value estimates. While the sheer number of purchases has dwindled as the market has moved higher, we are still seeing some overlapping trades among our top managers. Common sales activity continues to be a bit harder to find, as most of our top managers are trimming or selling outright positions that they think have become overvalued, with the ultimate "sell" prices likely varying from manager to manager given their different methodologies.
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 47.81 1.04 394,586 16 WellsFargo WFC 3 Medium Narrow 54.48 1.09 283,663 15 Google GOOG 3 High Wide 541.83 0.99 368,552 14 AIG AIG 3 High None 54.8 0.91 76,982 6 P&G PG 3 Low Wide 90.43 0.96 248,614 11 BerkHath BRK.B 3 Medium Wide 148.69 0.95 348,412 8 Oracle ORCL 3 Medium Wide 42.41 1.01 190,355 10 BankAmer BAC 3 High Narrow 17.04 0.95 178,467 7 Pepsi PEP 2 Low Wide 100.1 1.11 150,941 9 Cmcst CMCSA 2 Medium Wide 57.04 1.27 148,498 10
Data as of 11/28/14. Fund ownership data as of funds' most recent filings.
As in past periods, the aggregate holdings of our Ultimate Stock-Pickers in Energy, Utilities, Communication Services, and Real Estate remain underweight relative to the weightings of these sectors in the S&P 500 Index. Our top managers continuing to hold overweight positions in the Financial Services, Consumer Defensive, Health Care, and Basic Materials sectors (with positions in Technology, Industrials, and Consumer Cyclical stocks within 50 basis points of the index). That said, we note that Technology-related stocks--like wide-moat rated IBM (IBM), eBay (EBAY), Oracle (ORCL), Accenture (ACN), and Alibaba (BABA)--garnered the most buying interest from our top managers during the period. Several of these names showed up on out lists of top 10 high-conviction purchases and top 10 new-money buys in our last article, so we were not surprised to see them making the final list of top 10 purchases during the period.
Our top managers' overall buying and selling activity during the most recent period also slightly affected the list of top 10 holdings of our Ultimate Stock-Pickers, with narrow-moat rated Bank of America (BAC) replacing wide-moat Johnson & Johnson (JNJ), and wide-moat Comcast (CMCSA)/(CMCSK) replacing narrow-moat rated Apple (AAPL). Both Johnson & Johnson and Apple made our list of top 10 sales during the period, while Comcast was a top 10 purchase. Although Bank of America saw a fair amount of buying activity, it was the continued improvement in the price of the stock (which rose more than 9% during the third quarter), as well as the sales of Johnson & Johnson and Apple, that helped lift the bank from its twelfth-place position at the end of the second quarter.
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 IBM IBM 4 Medium Wide 162.17 0.83 160,711 4 eBay EBAY 3 High Wide 54.88 0.87 68,568 5 Oracle ORCL 3 Medium Wide 42.41 1.01 190,355 5 Cmcst CMCSA 2 Medium Wide 57.04 1.27 148,498 2 Accenture CAN 3 Medium Wide 86.33 1.07 57,374 4 GoldSachs GS 3 High Narrow 188.41 1.13 82,013 3 Glencore GLEN 2 High None 5 1.46 62,894 2 Alibaba BABA 2 High Wide 111.64 1.24 274,965 3 Citizens Fin CFG - - - 24.63 - 13,662 2 WellsFargo WFC 3 Medium Narrow 54.48 1.09 283,663 4
Data as of 11/28/14. Fund ownership data as of funds' most recent filings.
As we noted, Technology-related stocks garnered the most buying interest from our top managers during the third quarter (and early part of the fourth quarter) of 2014. Of particular note was the fact that IBM, eBay, Oracle, and Accenture were each purchased by four or more of our top managers, with new money being put to work in each of the last three names. While IBM and eBay both battled for headline space during the back half of the year, IBM made most of its news near the end of October (where we have much less data about the purchase and sales of our top managers). It will be interesting to see what impact Big Blue's abandoning of its 2015 earnings guidance had on our Ultimate Stock-Pickers, six of which held the stock at the end of the period. Of note was the significant purchase of the stock by Prem Watsa and the managers at Fairfax Financial Holdings (FRFHF). The insurance company's stake in the name--at 13.8% of the firm's equity portfolio--exceeded the 12.4% position size that Warren Buffett has built up in IBM in Berkshire Hathaway's (BRK.A)/(BRK.B) stock portfolio.
As for eBay, the stock was the target of two new-money purchases (and four high-conviction purchases) during the period. While we did not see much commentary from the buyers of the stock, with one of the two new-money buyers of the name-- FMI Large Cap (FMIHX)--and all of the other high-conviction purchasers-- Dodge & Cox Stock (DODGX), ASTON/Montag & Caldwell Growth (MCGIX), and Vanguard PRIMECAP (VPMCX)--offering little to explain their transactions, we did get the following from Todd Ahlsten at Parnassus Core Equity (PRBLX) about his fund's new-money purchase of eBay during the third quarter:
We bought the stock in July after it dropped primarily due to investor concerns regarding sales growth at its core eBay.com business. Another overhang at the time was the unexpected departure of the head of PayPal, which is a valuable subsidiary of eBay. When we bought the stock, the risk-reward seemed favorable due to the company's sustainable competitive advantages, exposure to fast growing end markets and reasonable valuation.
This did little, though, to address the major event at eBay during the third quarter. As we noted in our last article, the stock ended up jumping in late September when eBay announced plans to make PayPal an independent company in the second half of 2015. Although eBay's management team historically has been reluctant to separate its Marketplaces operations from PayPal, Morningstar analyst R.J. Hottovy believes that it may now be appropriate to unwind the two businesses due to evolving commerce and payment environments and PayPal's decreasing dependence on Marketplaces (less than 30% of payment volume today and potentially less than 15% within three years). He expects the spin-off to make it easier for PayPal to extend its payments platform to other marketplaces, such as Amazon.com (AMZN) and Alibaba, and thereby boost its growth prospects.
Hottovy has left his wide moat rating on the firm unchanged, noting that each of the two entities possesses a strong enough stand-alone "network effect" advantage to warrant a wide economic moat (the inference is that PayPal will have a wide-moat rating once it is spun off from eBay). While he previously had been concerned that a split could disrupt the combined network effect of the two businesses, he now believes that shared services agreements should help to preserve data-sharing and customer acquisition synergies, while also allowing the leadership of each unit to pursue new relationships that would further enhance their respective networks. Hottovy's current fair value estimate of $63 per share for eBay is comprised of stand-alone valuations of $32 per share for PayPal, $27 per share for Marketplaces/eBay Enterprise, and almost $4 per share in net cash. At current trading levels, the stock does appear to be reasonably priced (trading at 87% of Morningstar's fair value estimate), but also requires a slightly wider margin of safety given the high uncertainty rating applied to the valuation.
With regard to Oracle, we had one of our Ultimate Stock-Pickers-- BBH Core Select (BBTEX)--making a new-money purchase in the name, with four other managers-- Oakmark (OAKMX), FPA Crescent (FPACX), AMG Yacktman (YACKX), and Alleghany (Y)--making meaningful additions to their existing holdings during the most recent period. Timothy Hartch and Michael Keller, the managers of BBH Core Select, who made three separate purchases of the stock during the third quarter (bringing their total position size to around 2.5% by the end of September), noted the following about their new-money buy of Oracle in their quarterly letter to shareholders:
During September we purchased a new position in Oracle Corp., which has been on our investment “wish list” for several years. Oracle is the world’s largest enterprise software company, holding the leading market share position in databases and enjoying strong competitive positions in middleware, application software, cloud-based software, specialized IT hardware, and services. We have long been attracted to Oracle’s business model based on several enduring and powerful attributes, including (1) the foundational nature of its infrastructure software, which engenders high switching and search costs for substitutes, (2) the loyalty of its customer base (retention rates well above 90%) which drives significant amounts of recurring maintenance and subscription revenue (approximately 58% of total sales), and (3) the high degree of operational maturity and scale we see in its direct sales force and productive Research and Development (R&D) organization.
We believe that enterprise software is an attractive category in the global technology sector, benefiting from favorable secular growth trends such as the growing prominence of specialized software for mission-critical infrastructure and applications, exponential data growth and global enterprises’ desire to harness the power of all forms of data to gain their own competitive advantages. Despite current concerns regarding slower license revenue growth, the long-term prospects remain attractive in our view given the strong tailwind of data and user growth as well as Oracle’s strong commitment to developing faster and more scalable technologies to take advantage of these market dynamics.
Through organic and inorganic means, the company has been broadening its business mix across vertical and departmental software categories, thus widening the channels through which larger quantities of infrastructure software can be sold in the future. With its capable and experienced management team, we believe Oracle exhibits a long-term oriented approach that can sustain and grow revenue, earnings, and free cash flow per share over time.
This echoes the thinking of Morningstar analyst Rick Summer, who notes that Oracle doesn't have to be the first innovator to maintain its dominance in enterprise software. While there have been many critics of Oracle's long-date acquisition strategy, Summers believes that the company has shored up its defenses, successfully anticipating the threat of cloud computing and providing its customers with a path for technology and service upgrades. That said, Summers also thinks that the current stock price already reflects much of this optimism, with Oracle closing out November slightly above his $42 per share fair value estimate. While he does note that the stock got a bit more attractive in late September/early October, when the shares dipped down into the mid-to-upper $30s, they quickly rebounded.
As for Accenture, one of our Ultimate Stock-Pickers--Oakmark--made a new-money purchase in the name, and three other managers--ASTON/Montag & Caldwell Growth, FMI Large Cap, and Markel (MKL)--made meaningful additions to their existing holdings during the most recent period. Bill Nygren and Kevin Grant, the managers of the Oakmark fund, noted the following about their new-money purchase of the name in their quarterly letter to shareholders:
Accenture PLC (ACN - $80) -- Accenture is one of the largest consulting and outsourcing companies in the world with over $30 billion of net revenues. Accenture is one of very few companies that can serve customers in both capacities globally, with scale, and across most industry verticals. As a result, roughly 60% of revenue is from projects where Accenture is the sole service provider from conception through completion, and more than 90 of Accenture's top 100 customers have been clients for more than 10 years. Management has a long track record of disciplined capital allocation, having reduced the share count by nearly one-third over the past decade, and it recently initiated a fairly generous dividend. Accenture sells for less than 15x EPS, net of more than $7 per share of cash on the balance sheet. We believe this is an attractive price for such a high-quality and well-managed franchise.
Morningstar analyst Andrew Lange expects Accenture to outperform the broader IT services industry over the long run, despite a highly competitive and fragmented market, due to the advantages provided by the meaningful switching costs and intangible assets embedded in its business. He further notes that Accenture works with the largest and most progressive multinational corporations in the world, providing it with early insight into the biggest challenges facing businesses and keeping it in a market-leading position when it comes to solutions. Lange expects developments in mobile, social, cloud, and analytics to be important growth drivers for the IT services industry, with Accenture playing an important role in transitioning corporations from legacy platforms to new delivery models given its services expertise. As for valuation, the stock was trading closer to $76 per share (or about 94% of our fair value estimate) back in mid-October, having traded off in the week following Accenture's annual analyst day meeting, but has since rebounded to a slightly overvalued position. For long-term investors, Lange notes that the company produces a substantial amount of free cash flow, and expects healthy shareholder distributions from the firm for the foreseeable future.
Very little was said by the three managers-- Morgan Stanley Institutional Growth (MSEGX), Oppenheimer Global (OPPAX), and Vanguard PRIMECAP--that were buying Alibaba during the period, but we assume that the purchases were tied more directly to the initial public offering of the Chinese company's shares on the U.S. market in mid-September. All three of them are well-known large-cap growth fund managers, with enough assets under management to get their funds an initial allocation. Although none of these managers offered much insight into the decision to purchase the shares, our local Chinese analyst, Yue Yao in Shenzhen, made a compelling case for the firm in June, noting that Alibaba had a wide economic moat around its operations, driven largely by a strong network effect (among the rarest, and most powerful, of the five sources that Morningstar uses to assess a company's economic moat). Yao's work served as the foundation for much of the information that U.S.-based analyst R.J. Hottovy relayed to investors ahead of the IPO. Both Yao and Hottovy think that Alibaba's network effect is unusual, having been established in an industry (China e-commerce) that is at a relatively early stage in its life cycle. They also noted that many of the other companies to which Morningstar has assigned network-effect moat sources participate in more mature industries. While the original fair value estimate of $90 per share that Morningstar ascribed to Alibaba represented a meaningful opportunity in relation to the offering price of $68 per share, the stock has since risen to $112 per share (we note that Alibaba actually closed at $94 per share on the first day of trading). With the stock trading at around 125% of our fair value estimate, it is difficult to get too excited about the name, but both Yao and Hottovy think that the firm has plenty of long-term potential.
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 Pepsi PEP 2 Low Wide 100.1 1.11 150,941 4 Microsoft MSFT 3 Medium Wide 47.81 1.04 394,586 6 AIG AIG 3 High None 54.8 0.91 76,982 1 TimeWrnr TWX 3 Medium Wide 85.12 1.09 72,505 3 Schlmbrgr SLB 5 Medium Wide 85.95 0.59 102,425 3 CHRobsn CHRW 2 Medium Wide 73.74 1.12 10,837 3 J&J JNJ 2 Low Wide 108.25 1.09 305,943 5 Apple AAPL 2 High Narrow 118.93 1.19 697,095 3 GlaxoSmthKln GSK 3 Medium Wide 46.45 0.97 111,405 3 McDonald's MCD 3 Medium Wide 96.81 1.02 94,794 3
Data as of 11/28/14. 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 to be discerned by the sectors represented, as two stocks each were sold from the Technology, Health Care, and Consumer Cyclical sectors, with the remaining sales representing a scattering of different sectors. The selling managers also provided very little commentary about these particular transactions. Both BBH Core Select and Diamond Hill Large Cap (DHLAX) appear to have sold off their stakes in PepsiCo (PEP) during October, with the shares continuing to rise steadily since the middle of that month. We also saw Jensen Quality Growth (JENSX) and AMG Yacktman, where PepsiCo was the top holding in each fund at the end of September, pare back their stakes slightly during the third quarter. If the outright sales of the stock by Both BBH Core Select and Diamond Hill Large Cap hold up when the funds report their actual fourth-quarter holdings, it will be interesting to see what commentary gets attached to the sales, given that the shares continue to be held by nine of our Ultimate Stock-Pickers.
Of the six other stocks where we saw outright sales-- Time Warner (TWX), Schlumberger (SLB), CH Robinson Worldwide (CHRW), Johnson & Johnson (JNJ), GlaxoSmithKline (GSK), and McDonald's (MCD)--the rationale offered by the managers making these trades was few and far between. That said, the managers at FMI Large Cap did note that the bid by Twenty-First Century Fox (FOXA)/(FOX) for Time Warner in mid-July did give the fund an opportunity to exit the stock. This turned out to be a prescient move, as Fox withdrew its bid less than three weeks later (after Time Warner rebuffed the takeover bid), with the stock dropping back down to $72 per share (from a high of $87 per share in response to Rupert Murdoch's initial $85 per share bid for the firm). FMI Large Cap also eliminated its stake in GlaxoSmithKline during the third quarter, noting that it has been "a disappointing investment," and that the fund's "thesis that both the industry and the company had changed proved not to be the case." In this particular case, the losses taken on the stock were likely offset by the gains that FMI Large Cap booked on its sale of Time Warner earlier in the period.
As for some of the other outright sales, Todd Ahlsten at Parnassus Core Equity noted the following about his fund's sale of CH Robinson Worldwide in his quarterly letter to shareholders:
We exited one holding during the quarter: C.H. Robinson, a logistics provider focused primarily on the North American trucking industry. This stock made a modest gain for the Fund in the two years that we owned it. We exited the position in September, due to concerns related to the long-term direction of the company’s competitive advantages. As a broker operating between shippers and freight carriers, Robinson has benefited for many years from its large network in North America and a superior technology platform. Our fear is that over time the company’s technology edge may erode, as other competitors invest heavily into their own capabilities. Of course, it’s possible that Robinson will maintain its dominance in the truck brokerage industry, but our conviction in this outcome is not high enough to justify owning the company’s shares.
The managers of BBH Core Select noted the following about their elimination of Johnson & Johnson from their portfolio during the third quarter:
We trimmed and then ultimately sold our remaining position in Johnson & Johnson during the third quarter. We had been progressively reducing this position in 2014 as the shares traded closer to our intrinsic value estimate. Johnson & Johnson was a meaningful contributor to the Core Select’s performance on a total return basis over the five years we owned our position. J&J proved to be a good representation of an ideal application of our Core Select process – we first underwrote the company’s degree of fit with our criteria and assessed its business prospects and risks. When investor sentiment toward J&J turned negative due to some temporary challenges, we made our initial purchase at a 25% discount to our estimate of J&J’s intrinsic value per share. Our intrinsic value estimate grew over time, but the stock ultimately compounded at a higher rate, thus narrowing the valuation discount until it was eventually eliminated. Throughout this time period, we always felt that the capital we had invested in J&J was well protected. Not all of our investments will play out exactly this way, but this is the model for which our investment team always aims.
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Disclosure: Greggory Warren owns shares in the following securities mentioned above: 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.