Ultimate Stock-Pickers: Top 10 Buys and Sells
While our top managers were once again net sellers during the period, they still made some bullish consumer cyclical bets.
Our primary focus with the Ultimate Stock-Pickers concept for the past nine years has been to uncover investment ideas that our equity analysts and top investment managers find attractive and reveal these names in a timely enough manner for investors to gain some value from it.
As part of this process, we scour the quarterly and monthly holdings of 26 different investment managers--22 of which manage mutual funds covered by Morningstar's fund research group and four of which manage the investment portfolios of large insurance companies--as they become available, attempting to identify trends and outliers among their holdings as well as any meaningful purchases and sales that took place during the period.
In our last article, we walked through some of the buying activity of our Ultimate Stock-Pickers during the first quarter and beginning part of the second quarter of this year. This was an early read on the purchases--focusing in on high-conviction purchases and new-money buys--being made during that period, based on the holdings of around 95% of our top managers. Our Ultimate Stock-Pickers were once again net sellers during the period (albeit at a declining pace), as they were during the immediate preceding periods in 2016. Overall activity levels, moreover, declined back to the levels seen for the first three quarters of 2016 after increasing during the fourth quarter of 2016.
With all of our top managers having reported their holdings, we have a more complete picture of what they were up to during the first full period following the post-election rally last period. The continued net conviction selling of our top managers during the period and the tone of their quarterly commentaries demonstrates continued caution within the current environment. In spite of this, buying activity was slightly greater than in the first three quarters of 2016. As such, we believe our Ultimate Stock-Pickers still found some specific names that piqued their buying interest, even as they took advantage of continuing market gains to trim other positions.
The conviction buying during the latest period was once again focused on high-quality names with defensible economic moats—exemplified by a high number of wide- and narrow-moat companies on our list of top 10 (and top 25) high-conviction purchases for the first quarter. As for the selling activity, some of it appeared to be focused on the trimming of larger holdings to manage position size or to simply pare back stakes that closely approached our top managers’ own internal estimates of fair value. Other positions—specifically, UPS (UPS) and Qualcomm (QCOM)—were trimmed by some of our top managers due to diminished confidence in their respective future prospects. CSX (CSX) was the most widely sold security during the period. It was sold by five of the six managers that held it coming into the first quarter, with two of our Ultimate Stock-Pickers selling the position outright and another selling it with conviction.
Wide-moat rated Alphabet (GOOG) /(GOOGL), Wells Fargo (WFC), Oracle (ORCL), Berkshire Hathaway (BRK.A) /(BRK.B), Johnson & Johnson (JNJ), and Pepsi (PEP), were other names that remained top holdings even after some selling during the quarter, with many of the managers that were selling already having some of the largest exposures to each stock. We should also note that an overwhelming majority of the names on the list of top 10 stock sales are currently trading at or above our fair value estimates, indicating that we do not see significant mispricing opportunities for most of them. The only exception was wide-moat rated Wells Fargo. The stock currently trades at a 21% discount to our analyst’s fair value estimate.
The most notable conviction sales to us during the period were CSX and Progressive (PGR). CSX has risen over 50% year to date—an astounding rate—on market expectations related to the CEO appointment of noted railroad consolidator Hunter Harrison. The stock currently trades slightly above our analyst’s fair value estimate as the market seems to have baked in expectations related to Harrison’s position at the helm. In a similar fashion, since the start of the first quarter until the date of this publication, Progressive’s stock has runup over 20% and currently trades at a 31% premium to our analyst’s fair value estimate. As such, it is no surprise to us that from a valuation perspective some of our top managers would want to cash in their chips and take some of their winnings off the table.
Ultimate Stock-Pickers' Top 10 Stock Holdings (by Investment Conviction)
- source: Morningstar Analysts
Even with this activity, our top managers remained underweight in communication services, energy, healthcare, and utilities relative to the weightings in the S&P 500 as of the end of April 2017. Our Ultimate Stock-Pickers also continued to hold significantly overweight positions in the financial services, industrials, and technology sectors (with their exposure to basic materials, consumer cyclical, consumer defensive, and real estate being less than 100 basis points from the benchmark index). Compared with last period, our managers saw their aggregate holdings shift more into consumer defensive and technology and shift out of energy names.
The overall makeup of the top 10 stock holdings by investment conviction did not change at all. In fact, the only change related to the order of appearance on the list, with wide-moat rated Wells Fargo and narrow-moat rated Apple (AAPL) moving further up. Apple moved further up because it was number two on our list of high-conviction purchases, second only to Comcast (CMCSA) which saw a disproportionate number of funds buying into the name. As we have chronicled in recent issues, the name was heavily added by Berkshire Hathaway during the first quarter. Wells Fargo and Oracle merely swapped positions, although both stocks were widely sold during the period.
Taking a closer look at the aggregate high-conviction buying during the most recent period, only three of the 10 names that showed up on our list were also represented on our list of top 10 high-conviction purchases in our last article. For those who may not recall, when we look at the buying activity of our Ultimate Stock-Pickers we tend to focus on high-conviction purchases and new-money buys. We think of high-conviction purchases as instances where managers make meaningful additions to their existing holdings, or where they make significant new-money purchases, with a focus on the impact that these transactions have on their overall portfolio.
Ultimate Stock-Pickers' Top 10 Stock Purchases (by Investment Conviction)
- source: Morningstar Analysts
Our list of top 10 conviction stock purchases was far more concentrated this time in consumer cyclical stocks than the diversified list of stocks last time we looked at our Ultimate Stock-Pickers’ top 10 buys and sells. From the standpoint of the number of top managers buying into a name, Comcast was the period’s most notable high-conviction purchase. The name topped the list after 13 of our Ultimate-Stock Pickers bought the stock during the period. From a valuation perspective, wide-moat rated Gilead Sciences (GILD) and McKesson (MCK) continue to be the most undervalued names on our list of top 10 conviction buys. Aside from McKesson and Gilead Sciences, which were extensively profiled in our most recent issue, narrow-moat rated TJX Companies (TJX) and Citigroup (C) are the most undervalued names on the list. Examining closely our top 10 conviction holdings, Wells Fargo is by far and away the most undervalued name on our list.
Wells currently trades at a 21% discount to our fair value estimate. Recent Form 4 filings made with the Securities & Exchange Commission (SEC) reveal that CEO Tim Sloan and Chairman Stephen Sanger bought shares in the company at a price of $51.65 per share, both directly and through various investment vehicles. The wide-moat rated bank was the subject of the first question at the Berkshire Hathaway Annual Shareholder Meeting this year. The Ultimate Stock-Picker firm is the bank’s largest shareholder. Berkshire pared down its stake in Wells in mid-April. The conglomerate’s motivation for doing so, however, was not due to any souring in its assessment of the bank’s future prospects but because of Federal Reserve regulations that would have required Berkshire to become a bank holding company. This was not a step Buffett wanted to undertake. Buffett attributed his prior relative silence on the name due to this regulatory oversight limiting Berkshire to passive investor status. Addressing concerns about its holding, the recent fraudulent accounts scandal, and Berkshire’s own parallels to Wells Fargo’s decentralized business model, Buffett had this to say:
You're going to have incentive systems at almost any business. There's nothing wrong with incentive systems, but you've got to be very careful what you incentivize, and you can't incentivize bad behavior. And if so, you better have a system for recognizing it. Clearly, at Wells Fargo, there was an incentive system built around the idea of cross-selling and the number of services per customer, and the company at every quarterly investor presentation highlighted how many services per customer. So, it was the focus of the organization, a major focus, and undoubtedly people got paid, and graded, then promoted based on that number—at least partly based on that number. Well, it turned out that, that was incentivizing the wrong kind of behavior. We've made similar mistakes. I mean, any company is going to some mistakes in designing a system, but it's a mistake, and you're going to find out about it at some point…the main problem was they didn't act when they learned about it. It's bad enough having a bad system, but they didn't act.
Morningstar analyst Jim Sinegal, however, believes that Wells Fargo has already recognized its past issues and has begun to rectify its incentive system with an emphasis on customer service. He believes that this could be a positive development for the bank, as team members will move away from previously unproductive activities that both harmed reputation and never added to performance to activities that build value for the firm. Sinegal points to several metrics to prove that the bank is already showing some signs of stabilization. He notes that total branch interactions were down only 4% from March of last year and that account closures actually declined from the year-ago period.
Low-cost funding is perhaps the best source of a bank’s competitive advantage. In Wells’ case, its low cost of funds comes primarily from its deposit base. In the past, Warren Buffett has compared Wells Fargo with GEICO as the low-cost producer in each of their respective industries. He has also said that Wells’ low costs of funds insulates it from managerial missteps. Buffett believes that investors can’t remove Wells Fargo’s customer base from the equation when evaluating the bank. To Buffett, banks make money off their customers from having a large spread on assets and not making any big mistakes on the asset side of the balance sheet, as he believes Wells has successfully done historically.
Like Buffett, Sinegal believes that Wells has a vast and dense branch network, which allows the bank to maintain the top share in one third of its markets and an oligopolistic position as the second- or third-largest player in another one third of its markets. Furthermore, Sinegal points out that Wells has grown its deposit market share to 10% or more in 21 states. According to Sinegal, 20% of the bank’s tangible assets are funded by deposits bearing no interest expense. Sinegal adds that average deposit balances expanded 7% over the 12 months preceding April of this year and 1% in the first quarter. Sinegal believes, recent excesses excluded, that the bank’s historic focus on cross-selling supports it moat and enables it to build tight relationships with customers rather than engaging in one-off transactions. To Sinegal, not only does this produce sticky deposits, but it also results in more productive assets as evidenced in the bank’s financials. Sinegal points to revenue totaling 4.7% of average assets last year as proof, well ahead of most of the bank’s peers.
Narrow-moat rated Citigroup is another financial services name that caught our eye and appeared on our list of 10 conviction purchases. Vanguard PRIMECAP (VPMCX) initiated a new position in the stock, while both Vanguard PRIMECAP and Oakmark Equity & Income (OAKBX) also meaningfully added the name to each of their overall portfolios. Two other funds also added to their Citi positions during the period. Morningstar analyst Jim Sinegal also covers the name. While he likes shares in Wells more than in Citi (he assigns Wells both a more attractive certainty and moat rating as well as a lower price to fair value estimate), he still views shares of Citi as undervalued. The stock trades at a 13% discount to his fair value estimate. Sinegal further believes that the company’s recent progress is underappreciated. The company has historically teetered on the edge on more than one occasion. In the 1980s, the bank took massive losses on emerging market loans. Similar losses occurred to its loan portfolio due to heavy exposure to commercial real estate in the early ’90s and subprime-related securities last decade. Sinegal believes that the bank is finally on the road to rehabilitation. He specifically points to the bank’s efforts in raising capital, shedding assets, and bulking up its leadership team with experienced bankers. Sinegal also believes that management’s focus on buybacks over dividends will provide the firm with much-needed flexibility. In the first quarter, Citi’s management returned $2.2 billion to shareholders, equivalent to an annualized 5.4% of the company’s market capitalization on April 13 of this year.
In Sinegal’s view, Citi’s narrow moat stems from cost advantages in its core banking operations and from switching costs and intangible assets in investment banking. Of Citi’s approximately $900 billion in deposits, Sinegal estimates that about one fourth costs the bank nothing in interest expenses. He sees economies of scale as the key source of Citi’s cost advantage and believes that Citi’s truly global presence differentiates the bank from nearly all its peers. Given its diversified revenue exposure to Latin America and Asia, Sinegal believes that the bank is poised to ride the growth of these economies through the coming decade. Sinegal also believes that Citi should remain a bank of choice for global corporations, thanks to its ability to provide a variety of services across borders. He states that developing economies should offer an attractive combination of high margins and rapid credit over time in comparison to mature, Western economies and adds that the firm’s strong equity capital base should help it weather almost any storm. While the company generated an 8.5% return on tangible common equity (ROTCE) in its most recent quarterly results, Sinegal expects that Citi can improve ROTCE to 10% and greater by 2019, when excluding its deferred tax assets.
Another name that appeared on our list of top 10 conviction purchases for the first time in recent issues is narrow-moat rated TJX Companies. The company is the well-known proprietor of many off-price retailer names, including T.J. Maxx, Marshalls, and HomeGoods, among others. The stock currently trades at a 13% discount to our analyst’s fair value estimate. FMI Large Cap (FMIHX) initiated a new position in the stock, while both FMI Large Cap and Montag & Caldwell Growth (MCGIX) made meaningful additions in the name to each of their respective portfolios. Ronald Canakaris and Andrew Jung, the managers at Montag & Caldwell Growth, commented on the name in their most recent quarterly commentary:
We added to TJX Companies after the company reported better-than-expected fourth-quarter results, driven by good traffic at every division, and the company continues to enjoy good same-store sales comparisons amid a difficult retail environment. Inventories are in good shape, and margins have been better than expected.
Morningstar analyst Bridget Weishaar echoes some of the thoughts expressed by the managers at Montag & Caldwell Growth. In a recent note, Weishaar stated that in spite of retail environment headwinds, TJX’s performance continues to top that of department stores. Weishaar points to superior same-store sales comparison figures relative to competitors and believes that the company appears to be continuing to maintain or gain market share. She believes that this reaffirms her narrow-moat rating. Like Canakaris and Jung, Weishaar also highlights other first-quarter financial metrics to support her view of TJX’s intact competitive advantages, including an increase in merchandise margin and a 7% decline in inventory on a per-store, constant currency basis. She continues to believe that the company will increase revenue at about a 7% compound annual growth rate over her 5-year explicit forecast.
Weishaar thinks that top-line growth can be sustained through the benefit of scale inherent in access to over 18,000 vendors worldwide, the availability of highly automated distribution centers, and a proprietary inventory management system that allows for local customization of merchandise at more than 3,500 stores. She also thinks TJX will expand adjusted operating margins by approximately 30 basis points by the end of her explicit forecast. As such, Weishaar believes that TJX’s current valuation offers investors an attractive domestic and international growth story, strong free cash flow generation, and a proven record of success in both strong and weak economic environments through its branded stores. She also lauds TJX’s decision to further capitalize on growth opportunities in the home goods market through introduction of a new brand, HomeSense, and the rollout of HomeGoods at Marmaxx locations. She believes this specifically demonstrates management’s ability to quickly execute on high-return strategies. Aside from TJX’s experienced management team and inherent competitive advantages, Weishaar also touts the company’s compelling discounted offerings. As such, she sees low execution risk associated with the name.
Best Idea and wide-moat rated Disney (DIS) is a name we previously profiled. In contrast to the names mentioned above, Disney actually appeared on our list of top 10 conviction sales. However, we believe that Disney is one of the most undervalued names on our lists. Furthermore, only one Ultimate Stock-Picker sold the name with conviction—insurance firm Alleghany (Y)—and also sold the firm outright during the period. Of the eight firms that previously held the stock during the period, including Alleghany, only one other firm sold the name. Five held onto their positions unchanged, while one firm, Markel (MKL), made a slight addition to its position. The market soured on the name after the firm reported weaker-than-expected results from its ESPN division in its most recent quarter. The stock currently trades at a 20% discount to Morningstar analyst Neil Macker’s fair value estimate. Macker believes that while all media networks continue to suffer due to weaker-than-expected advertising revenue and subscriber losses, Disney’s parks and resorts business helps bolster the firm against these pressures. The segment is still expanding, with its Shanghai resort driving that growth. The Shanghai resort was expected to reach 10 million visitors by the week of May 10 of this year, ahead of management’s expectation that it would reach the milestone by its one-year anniversary in June. Also on a positive note, the company’s increase in expenses was lower than Macker had anticipated, despite an expected sizeable jump in ESPN’s broadcasting costs related to the National Basketball Association’s (NBA) rights.
Ultimate Stock-Pickers' Top 10 Stock Sales (by Investment Conviction)
- source: Morningstar Analysts
While affiliate fee growth at media networks remains strong in Macker’s view at 4% year over year, the company experienced slowing growth in pay television subscribers. Macker acknowledges this is worrisome, but he believes that the inclusion of Disney channels in every standalone Internet media pay service that has launched demonstrates the strength of the firm’s overall channel package. Furthermore, while Macker acknowledges recent pressures to ESPN’s business model, he counters by stating that the channel did post some impressive viewing numbers with its highest calendar first-quarter ratings in five years. He also points out that while there is a lot of focus on the cost side of the business, the NBA contract is the last major increase on the content side for ESPN until fiscal year 2022. In spite of near-term headwinds, Macker believes that ESPN is the dominant player in U.S. sports entertainment. He adds that its position and brand strength still empower the network to charge the highest subscriber fees of any cable network, which in turn generate sustainable profits. He also believes that both its media networks segment and collection of Disney-branded businesses have demonstrated strong pricing power in the past few years.
Narrow-moat rated Qualcomm was another undervalued name appearing on our list of top 10 conviction sales and one we have previously profiled. The stock currently trades at a 14% discount to our analyst’s fair value estimate. Both Columbia Dividend Income (LBSAX) and Montag & Caldwell Growth made meaningful sales in the name and completely exited their respective positions during the period. The name has divided a number of Ultimate Stock-Pickers, with three funds selling, three funds buying, and two funds holding the name during the period. The net share change for our top managers, however, equaled sales of 1,857,869 shares of Qualcomm stock. Furthermore, none of the three top managers purchasing the name purchased with conviction, nor was the name widely purchased during the period. Investors can perhaps take solace in the fact that noted value investor and CEO of Baupost Group Seth Klarman recently initiated a position in the name. A recent 13F filing Baupost submitted to the SEC reveals the fund made its Qualcomm share purchases during the first quarter. The stock is also a Morningstar Best Idea.
The market had apparently been further spooked since Apple announced in late April that it would stop paying royalties owed for iPhones to supplier firm Qualcomm altogether. The fund managers at Montag & Caldwell Growth specifically detailed the reasons for the firm’s initial reduction and eventual outright sale of the name:
The position was initially reduced after the U.S. Federal Trade Commission filed a lawsuit against the company alleging unfair licensing practices. We believed this action could undermine the company's efforts to defend its intellectual property in foreign jurisdictions. We subsequently reduced further and ultimately exited the position after Apple filed a lawsuit accusing Qualcomm of monopolizing the market for chips for wireless devices and of withholding $1 billion in retaliation for cooperating with antitrust authorities in South Korea. We expected the legal overhang would continue to cloud any positive fundamental developments in the near to intermediate term.
When asked for justification as to why Apple stopped paying Qualcomm royalties, Apple CEO Tim Cook said the following in the company’s most recent earnings call:
You can’t pay something when there is a dispute about the amount.… They think we owe some amount, we think we owe a different amount, and there hasn’t been a meeting of the minds there. And at this point we need the courts to decide that unless over time we settle between us on some amount.… They do some really great work around standard essential patents, but it’s one small part of what the iPhone is. We don’t think that’s right, and so, we are taking a principled stand on it, and we strongly believe that we are in the right. And I’m sure they believe that they are, so that’s what courts are for.
As a result of Apple’s announcement, the company reduced its guidance for its fiscal third-quarter to exclude royalty revenue from Apple’s contract manufacturers. Morningstar analyst Abhinav Davuluri covers the name and points out that management had discussed this possibility during its most recent earnings call in mid-April. The recent news has prompted Davuluri to completely extract Apple-related royalty revenue from the next six quarters to his Qualcomm valuation. However, Davuluri is maintaining his fair value estimate as he reasons Qualcomm’s long-standing agreements with Apple’s contract manufacturers remain valid and enforceable. He further foresees catch-up royalty payments occurring following the resolution of the disagreement. Davuluri concedes that at this point, the legal battle between the two giants will be protracted for the foreseeable future. While he acknowledges that the firm will continue to face adversity, Davuluri reiterates his view that long-term investors should find current prices in Qualcomm shares compelling given future tailwinds associated with the pending acquisition of Dutch semiconductor firm, NXP (NXPI).
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Disclosure: Joshua Aguilar has an ownership interest in both Berkshire Hathaway (BRK.B) and Disney (DIS), 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 has a position in the following securities mentioned above: DIS. Find out about Morningstar’s editorial policies.