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Market Update

3 Stocks Top Managers Have Been Buying

Managers from BBH, Dodge & Cox, and Oakmark picked up a grocer, healthcare companies, and--somewhat surprisingly--Netflix last quarter.

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Stocks extended their winning streak in the third quarter: The S&P 500 rose 4.5% for the period and was up 14% for the year. And they continued their ascent in October. By most metrics--including Morningstar's own --stocks entered the fourth quarter fairly valued, if not overvalued. 

Finding opportunity in an overvalued market can be a tall order. Yet three of our favorite Medalist managers did just that during the third quarter. Here's what they bought.

Managers Tim Hartch and Michael Keller of Silver-rated BBH Core Select (BBTRX) maintain a concentrated portfolio of profitable cash generators boasting strong balance sheets. They generally only buy stocks trading 25% or more below their estimated intrinsic value. The duo initiated a position in Kroger (KR) in August, and snapped up more shares in September.

"The company has a long-tenured senior management team that has successfully navigated multiple periods of change," note Hartch and Keller in their latest commentary. Kroger, which is the largest traditional grocer in the United States by revenue, has consistently gained market share in recent years. Hartch and Keller expect the company to effectively leverage its size and scale to maintain a leadership position in the changing retail landscape.

"In our view, the company stands out among peers given i) its demonstrated ability to consolidate a still-fragmented food retailing market, ii) its forward-thinking approach to using technology to improve the shopping experience and store operations, iii) its pioneering use of sophisticated data analytics, and iv) its expansive private label program, which drives margin benefits and provides value to consumers. These key competitive advantages and Kroger's ability to invest behind them have been critical in the recent period of food cost deflation, which has put enormous pressure on smaller, sub-scale players, many of whom have been forced out of the business."

Morningstar analyst John Brick agrees. Kroger maintains a number-one or -two position in most major and minor markets, which gives it a cost advantage, he says. And Kroger's strong data analytics allow it to effectively align its merchandise and promotions with customer preferences.

"We believe the combination of its cost edge and intangible assets positions it well to compete with other mass merchants, as well as alternative outlets including e-commerce and hard discounters such as Aldi and Lidl," says Brick in his latest research report. Morningstar assigns Kroger a narrow economic moat, based on its cost advantages and intangible assets. As of this writing, the stock is trading in 4-star range, suggesting that shares are undervalued relative to our fair value estimate.

The investment committee at Gold-rated Dodge & Cox Stock (DODGX) uses bottom-up, fundamental research to find undervalued companies with strong management, competitive advantages, and solid growth potential--often taking advantage of bad news to pick up fundamentally sound businesses. During the third quarter, the team found some attractive opportunities in healthcare--among them, Gilead Sciences (GILD), known for its HIV and HCV franchises.

"While Gilead is facing patent expirations for some of its blockbuster drugs, we believe the company will return to growth and the current valuation is overly pessimistic," explained management in its latest commentary.

Morningstar assigns Gilead a wide economic moat rating.

"We think patent protection on newer HIV regimens and Gilead's continued dominance in the hepatitis C market will be enough to ensure strong returns for the next couple of decades," notes sector strategist Karen Andersen in her latest report. The company's profit margins on its HIV and HCV portfolios are stellar, she adds. "But Gilead needs HCV market stabilization, strong continued innovation in HIV, solid pipeline data, and smart future acquisitions to return to growth."

Shares of Gilead currently trade in 3-star range, suggesting they're fairly valued by Morningstar's metrics today.

Bill Nygren, manager of the Gold-rated Oakmark (OAKMX), is a value investor who favors smart capital allocators running financially healthy companies with growth potential--and he'll only buy if valuations appear attractive in absolute terms. So how did Netflix (NFLX) end up in the portfolio in the third quarter?

Nygren explains in his latest commentary:

"Last quarter, when our analyst began his presentation recommending Netflix, selling at more than 100 times estimated 2017 earnings, I was more skeptical than usual. His opening comment was that Netflix charges about $10 per month while HBO Now, Spotify and Sirius XM each charge about $15. 'All the company would have to do is raise prices 50% and the P/E ratio would fall to the low teens,' he argued. Anecdotally, those who subscribe to several of these services tend to value their Netflix subscription much higher despite its lower cost. Quantitatively, revenue-per-hour-watched suggests Netflix is about half the cost (subscription fees plus ad revenue) of other forms of video. Netflix probably could raise its price to at least $15 without losing many of its subscribers. For those reasons, Netflix is now in the Oakmark portfolio."

Morningstar analyst Neil Macker agrees that Netflix is the premier streaming video on demand provider, and expects the firm to use its Big Data to stay on top. Morningstar assigns Netflix a narrow economic moat, thanks to its massive subscriber base domestically, its expansion internationally, and the data that comes with both.

In October (after Nygren's commentary was published), Netflix announced price increases, lifting the monthly price of the 2-stream HD and 4-stream 4K subscriptions to $10.99 (up from $9.99) and $13.99 (up from $11.99) respectively.

"Given the firm's continued cash burn and need to invest further in content, the price increase was not surprising but the timing was, given that this is the third hike in the last three years," notes Macker. "We believe that many subscribers will continue to pay, but churn will spike and the price increase will make competing services look more attractive to potential subscribers."

The stock is significantly overvalued by Morningstar's metrics today, trading in 1-star range.

Susan Dziubinski does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.