Ultimate Stock-Pickers: Top 10 High-Conviction and New-Money Purchases
Our early read on the buying and selling activity of our top managers uncovered a few ideas worth considering.
By Joshua Aguilar | Associate Equity Analyst
For the past nine years, our primary goal with the Ultimate Stock-Pickers concept has been to uncover investment ideas that not only reflect the most recent transactions of our grouping of top investment managers, but are also timely enough for investors to get some value from them. In cross-checking the most current valuation work and opinions of Morningstar's own cadre of stock analysts against the actions (or inactions) of some of the best equity managers in the business, we hope to uncover a few good ideas each quarter that investors can dig a bit deeper into to see if they warrant an investment.
With over 95% of our Ultimate Stock-Pickers having reported their holdings for the first quarter of 2017, we have a good sense of what stocks piqued their interest during the period. While the story of 2016’s fourth quarter was the post-market rally related to the expected business-friendly reforms of newly elected President Trump, the story of the first quarter revolved around concerns of a fractured government unable to execute on an ambitious agenda. President Trump and the Republican-controlled Congress were unable to push through the American Health Care Act of 2017 (AHCA) and successfully deliver on their promise to “repeal and replace” Obamacare. Some observers are concerned that this could have a potential spillover effect to other parts of the president’s agency, specifically tax reform. Our initial thoughts on the actions of our top managers is that their actions, or lack thereof, mirror the reaction of the general market. Some top managers have specifically expressed concern over the fractured status in Washington. One fund manager specifically mentioned that his fund’s initial enthusiasm for a particular position was tempered by the seemingly anti-trade posture of the nascent Trump administration.
As a result, the overall activity level for our top managers noticeably dropped during the period. Our top managers remained net sellers, as was the case in the previous four quarters of last year, and the overall level of both buying and selling activity also dropped during the period relative to last period. In fact, overall activity levels for our top managers reached their lowest level for the past five consecutive quarters. In addition, the number of top managers that made new-money purchases decreased slightly during the period. As was the case during the fourth quarter, many of the positions that were initiated during the first quarter of this year were relatively small, with one notable exception coming from the insurance firm, Alleghany (Y), which we discuss below.
Recall that when we look at the buying activity of our Ultimate Stock-Pickers, we focus on high-conviction purchases and new-money buys. We think of high-conviction purchases as instances where managers have made meaningful additions to their portfolios, as defined by the size of the purchase in relation to the size of the portfolio. We define a new-money buy strictly as an instance where a manager purchases a stock that did not exist in the portfolio in the prior period. New-money buys may be done either with or without conviction, depending on the size of the purchase, and a conviction buy can be a new-money purchase if the holding is new to the portfolio.
We also recognize that the decision to purchase any of the securities we are highlighting in this article could have been made as early as the start of January, with the prices paid by our managers being much different from today's trading levels. Therefore, we believe it is always important for investors to assess for themselves the current attractiveness of any security mentioned here.
Looking more closely at the top 10 high-conviction purchases during the first quarter of 2017, the buying activity was more diversified relative to last quarter, but still slightly concentrated in the Technology sector. Notably, three wide-moat, cloud-based giants stood out in our list of top 10 high-conviction purchases, including Amazon (AMZN), Microsoft (MSFT), and Oracle (ORCL). A couple of Healthcare names also stood out, including previously profiled, wide-moat rated Gilead Sciences (GILD) and narrow-moat rated Abbott Laboratories (ABT). Perhaps most notable in our list of top 10 high-conviction purchases was the astounding nine funds buying into communication services name, Comcast (CMCSA). That said, caution may be in order as the stock has risen just over 12.5% since the start of the year and is trading at a 18% premium to our analyst’s fair value estimate. The rest of the purchases were made in the Basic Materials, Consumer Cyclical, Energy, and Financial Services sectors. As was the case during prior periods, most of the high-conviction buying activity was focused on high-quality names with defendable economic moats, exemplified by the greater number of wide- and narrow-moat names in our list of top 10 high-conviction purchases (as well as among the top 25 high-conviction purchases).
Top 10 High-Conviction Purchases made by Our Ultimate Stock-Pickers
Unlike last quarter, there was very little crossover between our two top 10 lists this quarter. Only wide-moat rated Amazon, as well as Antero Resources (AR) and S&P Global (SPGI) showed up on both lists. No two funds coincided in a high-conviction, new money purchase. Notably, however, Alleghany did make Amazon a high-conviction, new-money purchase at over 5% to its overall portfolio, and the company was also held by four more of our Ultimate Stock-Pickers. In fact, Morgan Stanley Inst Growth (MSEGX) holds the name at nearly 10% of its overall equity holdings.
Top 10 New-Money Purchases made by Our Ultimate Stock-Pickers
Unlike last quarter, which saw a large number of stocks on the list as being fairly valued, a number of firms that were either on our top 10 high-conviction list or top 10 new-money purchase list are trading at discounts to our analysts’ fair value estimates. As such, there are still a few names on either of these two lists that might warrant a place on an investor’s watch list.
As we noted above, wide-moat, cloud-based players received slightly more attention during the first quarter relative to other industries. Wide-moat rated Amazon currently trades at a 9% discount to our analyst’s fair value estimate. Amazon has been the undisputed leader in the race to the cloud. The company’s Amazon Web Services, or AWS, has held onto around a 40% market share in both Infrastructure as a Service (IaaS) and Platform as a Service (PaaS) offerings for quite some time. For reference, the three next largest competitors, which include Microsoft, Google (GOOG) /(GOOGL), and IBM (IBM), in aggregate, account for nearly 25% of the total public IaaS and PaaS market. Amazon Web Services CEO Andy Jassy recently said the following during an interview at the University of Washington:
There’s so many things in our business that have been surprises to us. Probably the biggest of which is that it just took so long for the other large technology companies to offer something in this [cloud] space, but I don’t think in our wildest dreams we ever thought we’d have a six- to seven-year head start, especially because we’re across the lake from another big technology company in that space, and we all know so many people at each other’s companies.
Famed investor and Ultimate Stock-Picker Warren Buffett commented on how Berkshire Hathaway (BRK.A) /(BRK.B) missed out on Amazon in a recent CNBC interview. Buffett revealed that he recently pared down Berkshire’s IBM stake by approximately 30%, and that he’s revalued the shares downward, specifically on the heels of increased competition from the likes of Amazon. Buffett recently called Jeff Bezos the most remarkable business person of our age, and had this to say specifically about the competitive dynamics of Amazon’s business and the company’s exemplary stewardship:
I was impressed with Jeff early. I never thought he could pull off what he did on the scale that has happened. It’s changed your behavior. And the remarkable thing about Jeff…he’s done it in two industries almost simultaneously that really don’t have that much connection. I’ve never seen any person develop two really important industries at the same time and really be the operational guy in both. Take cloud services…he thought he would have two years of runway. He got seven years. You do not want to give Jeff Bezos a seven-year head start. He’s shaking up the whole retail world, and he’s also shaking up the IT world simultaneously. I take my hat off to him…And if you can find businesses that don’t require capital and they earn a lot of money, that’s how you can become rich very easily, very early…You can get the capitalized value of something. Jeff Bezos has talked about that in Amazon. He said, with Amazon, we needed the Internet. Somebody else spent billions of dollars developing it. But it wouldn’t have worked without the Internet. We needed transportation. Somebody else had already built the railroad and UPS. We needed payment systems. That would take billions of dollars to build. But that had already been done by Visa. So, he took three huge requirements where the other guys had spent the money, and then he combined them in a way that he didn’t have to spend the money…And it’s brilliant, I give him credit for it.
While Sequoia (SEQUX) has yet to report on their holdings for the quarter, the fund did comment and echoed many of Buffett’s thoughts on the name in its most recent annual report, and had this to say:
We exited our small position in Wal-Mart and replaced it with a similarly small position in Amazon. The company’s e-commerce operation (Amazon.com) and its cloud computing platform (Amazon Web Services) are two of the most advantaged businesses we’ve analyzed in quite some time. Both are growing fast and have miles of runway ahead of them. And they are run by arguably the most talented, customer-focused and long term-oriented businessman of his generation. At a consolidated level, Amazon produces very little in the way of reported profits. Amazon Web Services, whose financials are disclosed separately, earns very rich margins, but the larger e-commerce business reports scant earnings. Our research indicates that the company’s e-commerce business has substantial earnings power that is being masked by a variety of ambitious growth investments. The Fund purchased shares at what we believe to be a reasonable multiple of underlying earnings power excluding those investments. Estimating the long-term potential of Amazon’s many investments is an inherently imprecise exercise, which is why the investment thus far has been a small one.
Morningstar analyst, and Consumer Cyclical team strategist, R.J. Hottovy sees Amazon as the most disruptive force to emerge in retail in several decades. He believes that Amazon’s operational efficiency, network effect, and laser focus on customer service provide the firm with sustainable competitive advantages that traditional retailers cannot match. He believes that this should yield additional market share gains in the years to come. He also believes that the firm’s growth potential is undeniable. Hottovy cites key top-line metrics, including a 15% five-year compound annual growth rate in active users, a 28% compound annual growth rate in total physical and digital units sold, and a 36% compound annual growth rate in third-party units sold. This growth outpaces global e-commerce trends and suggests to Hottovy that Amazon is gaining share while fortifying its network effect. Hottovy also believes that Amazon is gradually building an intriguing margin expansion story, including its 3.1% operating margins in 2016. Hottovy is optimistic that Amazon can near 7% operating margins by 2021 based on Prime memberships and fee increases, fulfillment center scale, third-party sales, and early signs of profitable international growth.
Turning to Amazon Web Services specifically, Hottovy believes that AWS has developed cost advantage, intangible assets, and network effect moat sources similar to those it has in its retail business. As alluded to in Amazon’s Andy Jassy’s University of Washington interview, Amazon’s public cloud computing offerings possess more than four times the capacity in use than the next 14 largest providers combined, according to Gartner statistics. Hottovy believes that this provides Amazon with scale advantages and often makes AWS the preferred name for corporations looking to reduce information technology expenditures. He forecasts average annual revenue growth for AWS of more than 30% over the next five years and believes that it can deliver 30%-plus margins over a longer horizon. Hottovy believes both are possible due to recent investments for additional capacity and other innovations as well as AWS’s highly scalable nature and other services outside of cloud storage, including a network of third-party software providers selling on AWS Marketplace.
Second in the cloud race is wide-moat rated Microsoft. The stock trades at an 12% discount to our analyst’s fair value estimate. Of our 26 Ultimate Stock-Pickers, 17 still held the name during the first quarter, with six increasing their respective positions. Two funds, Diamond Hill Large Cap (DHLAX) and Sound Shore (SSHFX), made the firm a high-conviction purchase. Ronald Canakaris and Andrew Jung of AMG Montag & Caldwell Growth (MCGIX) specifically commented on the position in their fund’s most recent quarterly commentary and had this to say about the name:
Microsoft was increased after the company reported solid fiscal second-quarter results, with both revenue and earnings beating consensus estimates. The upside was driven by better-than-expected growth in all three reported segments––cloud, servers and PCs––which sufficiently offset increased pressure from currency translations.
Although we have commented on wide-moat rated Microsoft in recent issues, Morningstar analyst Rodney Nelson recently attended the firm’s Build develop conference and financial analyst briefing which took place from May 10-12 of this year. Nelson reports that he came away with renewed confidence that Microsoft is paving a clear path to long-term success as a public cloud vendor. The company announced a number of forward-thinking services for its Azure platform, while also providing a financial road map for how the firm’s consolidated business will continue to evolve over the next several years.
Some examples of this increased functionality, according to Nelson, include its Intelligent Edge computing framework. This construct will allow for more effective, predictive, and real-time intelligent decision-making. Examples of this include predictive maintenance in the manufacturing sector by installing cloud-developed services to technology present in heavy duty machines. The company supports these efforts by collecting data from a vast array of sources. Services such as these, Nelson believes, will be vital for public vendors like Microsoft to attract and retain customers as well as drive heightened profit margins. Microsoft has also unveiled a number of tools to ease the data migration process required to move workloads to a cloud-based environment and has put in place a number of measures to assuage security concerns during such transitions. Nelson believes that services such as these will help ease the minds of enterprise customers concerned about moving and subsequently accessing data between on-premises and cloud-based infrastructures. Nelson also believes that Azure Stack will help unify any remaining on-premises infrastructure with public cloud assets by replicating Azure’s architecture within owned infrastructure.
Quantitatively, Nelson continues to see positive trends from both a top-line growth and gross margin expansion perspective as it relates to Microsoft’s commercial cloud. Nelson believes that the increasing adoption of premium services is helping to drive significant expansion in the firm’s Commercial Cloud profitability. Nelson also saw several encouraging examples of enterprise customers embracing multiple aspects of the modern Microsoft ecosystem, including products and services that each place greater computing demands on customers who adopt these solutions. Nelson believes that this trend will drive substantial incremental revenue growth for the Azure cloud. On the plus side, Microsoft CEO Satya Nadella echoed Nelson’s view that the public market is bigger than any of the firm’s prior addressable opportunities. Nelson believes the size of the public cloud opportunity will enable Microsoft to more than offset declines it faces in it legacy properties, particularly its Window business. Nelson believes that this flagship property migration has been and will continue to be a success, even in the face of intense competition from the likes of Amazon Web Services.
Wide-moat rated Oracle is another firm transitioning its service offering to the cloud. The company is the number-one solutions company and one of the largest software application providers in the world. However, the stock rallied about 16% during the first quarter and currently trades at about a 11% premium to our analyst’s fair value estimate. As of the close of the first quarter, 13 of our top managers still held the name, after one manager completely sold off the position. Trading activity was mixed, with three of our managers selling with conviction and two buying with conviction. AMG Montag & Caldwell Growth made the firm a high-conviction, new-money purchase. The managers at the fund has this to say about the name in their most recent quarterly commentary:
A new position was established in Oracle, a provider of application, platform, and infrastructure technology products and services. The company has rapidly pivoted from a purely on-premises database and enterprise application company to a cloud application and platform provider. The position was increased after the company reported better-than-expected fiscal-third-quarter results that showed that growth in cloud subscriptions is offsetting the license revenue declines.
An unusually high number of other manager commentaries also specifically profiled Oracle. Many of these commentaries also positively highlighted Oracle’s ability to transition to the cloud, as it appears to have successfully offset declines in on-premises license revenue. Some saw this previous trough during the shift from licenses to subscriptions as an opportunity to own what they believed was a high-quality business trading at a relatively attractive price.
Morningstar analyst Rodney Nelson also covers this name and believes that Oracle is at a crossroads. In contrast to many of the views expressed in manager commentaries, Nelson believes that the rise of cloud computing and open-source software over the past two decades have caught the software giant somewhat flat-footed. He thinks that the firm is in scramble mode as the company races its peers to the cloud. Specifically, Nelson believes that the once-fruitful economics of infrastructure software have been under siege by open-source alternatives. While Oracle’s database remains a behemoth, Nelson thinks that as workloads increasingly move to the cloud, enterprises are beginning to abandon the costly license and support model of the past and move to the more cost-effective and versatile subscription-based solutions of the future.
In support of recent changes the firm has made, Oracle co-founder, executive chairman, and chief technology officer Larry Ellison suggested that the firm’s IaaS solution will not only become a destination for applications built on Oracle databases but also for greenfield development projects. Greenfield development projects are those that are developed for a totally new environment, without concern toward integrating with legacy systems. Nelson openly questions this assertion by Ellison because of the competitive positioning of the “big three” players--Amazon, Microsoft, and Google. Specifically, Nelson believes that Amazon and Google have positioned themselves as fan favorites for emerging technology companies, while Amazon and Microsoft have been the preferred solutions for large enterprise customers. Even though Nelson acknowledges that Oracle’s recent results have been buoyed by across-the-board strength in the firm’s cloud business, he continues to have questions about the long-term addressable opportunity for the IaaS business in the face of more advanced offerings from the “big three.” While Ellison has pointed out that several large deals were imminent for Oracle’s IaaS offering, Nelson is not ready to bake in outsized expectations into his valuation of the firm. Nelson points out this offering constitutes only 2% of consolidated revenue and contributes gross margins in the 20s. He further encourages investors to be mindful of the price Oracle is paying for additional cloud revenue, both by way of acquisitions like NetSuite and through dramatic capital expenditure increases to fund its IaaS business.
Other names that made either one of our lists include two wide-moat rated names from the still beaten-down Healthcare sector--Best Idea McKesson (MCK) and previously profiled Gilead Sciences. Also worth mentioning are two no-moat rated names that are heavily reliant on commodity pricing-- USG (USG) and Best Idea Antero Resources. Given the greater leverage to more cyclical commodity prices, an increased margin of safety may be warranted. All four of these stocks trade at greater than 20% discounts to our analysts’ fair value estimates.
The Healthcare sector as a whole has faced headwinds given political uncertainty surrounding the eventual passage of the AHCA. While Gilead Sciences was Parnassus Core Equity’s (PRBLX) worst performer, the firm revealed that it added to its position and made it a high-conviction purchase. In its most recent quarterly commentary, the fund’s managers stated that they did so because they believe the stock is a bargain at its current valuation. They believe that investors have become too pessimistic and are giving the company too little credit for its robust cash flows, its expanding HIV franchise, and its strong drug pipeline. Morningstar Healthcare strategist and analyst Karen Andersen recently maintained her $84 per share fair value estimate as recent first-quarter results were largely in line with her expectations for the firm. In fact, Andersen recently raised her estimates for the firm’s hepatitis C revenue for the year, as she believes the firm will hold on to a larger number of patients in Europe than she had previously anticipated. Further, her non-HCV expectations are higher than management guidance and consensus. She echoes Parnassus’s views given the firm’s dominance in HIV and HCV, and she notes its strong returns on invested capital over the next several years, even in her bear-case scenario.
Moving on to McKesson, in spite of near-term sector and company-specific headwinds, Morningstar analyst Vishnu Lekraj believes the firm will remain an essential link in the pharmaceutical supply chain. Specific headwinds the firm faces include the potential loss of its Rite Aid contract, slowing drug inflation, and increased competition for small/independent pharmacy market share. Lekraj believes that McKesson will be able to power through recent volatility as the firm is a critical partner to both its retail pharmacy clients and drug suppliers. Lekraj believes that the stock’s current price affords investors an opportunity to acquire shares in a wide-moat company at a material discount. The shares currently trade at a 23% discount his fair value estimate.
For the commodity-influenced players, Antero Resources Corp is a Best Idea, high-conviction and new-money purchase, and trades at a 23% discount to our analyst, Dave Meats’, fair value estimate. Antero Resources is the most active driller in the Appalachia region, and Meats views the name among the most attractively priced. Meats believes that Antero’s extensive firm transport and sales portfolio is enabling the firm to sell the majority of its production at premium, out-of-basin prices. This is the case in spite of weak natural gas prices in the Appalachia region. For comparative purposes, Antero’s realized third-quarter natural gas price was $0.05 above Henry Hub. Though natural gas still constitutes around 75% of the firm’s production, a substantial portion of its acreage is situated in areas with a fairly high liquids content. Meats believes this differentiates the company from its peers that are predominantly targeting dry gas and points out that the profitability of the company’s inventory continues to trend higher. Meats further adds that drilling and completion costs have steadily declined over the past two years in the Marcellus and Utica plays, and there is scope for further efficiency gains that could lower costs further. Lasts, Meats thinks that the productivity of Antero’s wells is likely to increase across the portfolio due to the widespread adoption of high-intensity completions.
USG was the subject of a question posed to Warren Buffett and Charlie Munger at the most recent Berkshire Hathaway Annual Shareholders Meeting. The firm has held the name for some time, and Buffett stated that USG had been disappointing due to the lagging gypsum business. He acknowledged that the name had not been a brilliant investment, but that if gypsum prices were at levels that they were in years past, it would have worked out a lot more in Berkshire’s favor. The firm’s shares currently trade at a 25% discount to our analyst, Brian Bernard’s, fair value estimate. Like Buffett, Bernard acknowledges that gypsum pricing has been a challenge, but he sees a bright future for USG. Bernard remains bullish on U.S. single family construction and repair and remodel activity, and he believes that the firm, which is the market leader in wallboard and the number-two player in ceilings, is well positioned to capitalize on growing demand for its products. He expects this demand to drive robust top-line growth and better profitability over the next few years, specifically on the heels of the firm’s advanced manufacturing initiative. At today’s current volumes, Bernard anticipates that savings from this initiative could result in operating margins in excess of 15%, about where the company’s profitability was during the 2005-06 peak. Given that the housing market has room to grow, Bernard sees further upside potential to margin improvement for the firm.
Disclosure: As of the publication of this article, Joshua Aguilar had a position in Berkshire Hathaway, while Eric Compton has no ownership interests in any of the securities mentioned above. 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.