Ultimate Stock-Pickers: Top 10 Buys and Sells
Activity levels have picked up amidst rising valuations and interest rates in the new year.
For the past nine years, Ultimate Stock-Pickers’ primary goal has been to uncover investment ideas our equity analysts and top investment managers find attractive, in a manner timely enough for investors to gain some value. As part of this process, we scour the quarterly (in some cases, the monthly) holdings of 26 different investment managers, 22 of which manage mutual funds that Morningstar's manager research group covers, and four of which manage the investment portfolios of large insurance companies. As they become available, we attempt to identify trends and outliers among their holdings as well as any meaningful purchases and sales that took place during the period under examination.
In our last article, we walked through some of the buying activity we were seeing from our Ultimate Stock-Pickers during the fourth quarter of 2017 (and the beginning part of the first quarter) of this year. The piece itself was an early read on the purchases—focused on high-conviction and new-money buys—that were made during the period, based on the holdings of nearly 90% of our top managers. With all our top managers having reported their holdings for fourth-quarter 2017, and with some reporting first-quarter 2018 results, we now have a much more complete picture of what they were up to during the period. Following what had been a recurring trend over the previous seven quarterly periods, our Ultimate Stock-Pickers were once again net sellers during the most recent period, reaching their highest levels during this time frame. Interestingly, and reversing a trend during this same eight-period length of time, overall activity levels are now at their highest levels.
We're not surprised by this rise in activity level as the fourth quarter and beginning portions of the first quarter have historically seen greater activity levels relative to other periods. The most recent quarterly commentaries we've surveyed also remained largely cautious, still expressing concern over rising valuations and interest rates. In terms of valuations, our own evaluation of our aggregate coverage universe seems to run contrary with this assessment. Currently, our market fair value estimate stands at 0.99, suggesting stocks are within the realm of reasonableness.
The trend of more and more capital flowing into passive products has, however, likely make the stock-picking environment more difficult as it results in all equities appreciating, regardless of the valuation of individual constituents. That said, our Ultimate Stock-Pickers still found some names that piqued their interest, and we believe these are worth highlighting from a valuation perspective.
The conviction buying that took place during the fourth quarter of 2017 (and the beginning part of the first quarter of 2018) 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. As for the selling activity during the period, most of it seemed to revolve around paring stakes that closely approached our top managers' own internal estimates of fair value, as was the case for positions in wide-moat Microsoft (MSFT), Wells Fargo (WFC), Walmart (WMT), narrow-moat Bank of America (BAC), JPMorgan (JPM), Nutrien (NT), Qualcomm (QCOM), and PayPal (PYPL). Some positions, like narrow-moat IBM (IBM), were either materially or outright sold by some of our top managers because of diminished confidence in its future prospects. Recall that last year, Warren Buffett specifically mentioned the effects of competition as underpinning his Berkshire Hathaway's (BRK.A)/(BRK.B) sales of IBM's shares. He has continued to aggressively sell off shares in the name. Recently, Buffett spoke to CNBC and had this to say about the name:
“Well I was wrong on—at least I felt I was wrong on IBM. Now, I may have been wrong when I sold it, too. But I certainly was wrong when I bought it. [While IBM recently showed an increase in revenue for the first time in 27 quarters] it was—the foreign exchange went with them, and it was the introduction of a new piece of hardware. I mean, it actually—they weren't up except for those two factors. But the cloud came along. And one of the most extraordinary things I've ever seen in business is when an unrelated type company—a retailer, you can call Amazon of that type, goes into another big industry and sees the future in it, gets into it, and then they gave—and Jeff Bezos would say this, he said it on the Charlie Rose show, some time ago—he got this amazing runway. I mean, the other players—here are all these 200 IQ people, you know, in that business, and they gave him year, after year, after year. It wasn't a secret of what he was doing. And he was, in an important way, revolutionizing the industry, and the other people sat on their hands, basically.”
As was the case last period and the period before that, wide-moat Microsoft continues to be the most widely sold security during the fourth quarter (and the beginning part of the first quarter of 2018). Shares of the technology firm were sold by 10 of the 18 managers that held it coming into the fourth quarter, with three of our Ultimate Stock-Pickers, BBH Core Select (BBTEX), Yacktman Service (YACKX), and Oakmark (OAKMX) selling with conviction, with Oakmark outright closing its position. That said, three of our top managers did add shares of Microsoft to each of their respective portfolios during the period, including our latest addition to our Ultimate-Stock Picker roster, T. Rowe Price Blue Chip Growth (TRBCX), albeit in small quantities. Even so, Microsoft, along with wide-moat rated Alphabet (GOOG)/(GOOGL), Wells Fargo, Oracle (ORCL), Berkshire Hathaway, Comcast (CMCSA), and Johnson & Johnson (JNJ) as well as narrow-moat rated Bank of America, Apple (AAPL), and JPMorgan remained top holdings despite seeing a fair amount of selling during the period, with many of our top managers who were selling already having large exposures to each stock. We should also note that a majority of the names on our list of top 10 stock sales this period are currently trading nearly at or above our fair value estimates. The only exceptions, at over a 10% discount, were wide-moat rated Microsoft and narrow-moat rated Qualcomm and Nutrien.
The most notable conviction sales to us during the period were narrow-moat rated PayPal and JPMorgan Chase—with Paypal rising 84% in one year. Both stocks are currently trading well above our analysts' fair value estimates, with PayPal trading at a 39% premium, and JPMorgan trading at a 30% premium to analyst Jim Sinegal's estimates. With these two stocks continuing to trade at a premium, it was no surprise to us to see some of our top managers taking some money off the table in each name.
Ultimate Stock-Pickers' Top 10 Stock Holdings (by Investment Conviction)
- source: Morningstar Analysts
As for sector allocation, our top managers remained meaningfully underweight in energy, financial services, industrials, real estate, technology, and utilities relative to the weightings of the S&P 500 Index at the end of January. Our Ultimate Stock-Pickers also continue to hold meaningfully overweight positions in the basic materials, consumer cyclical, consumer defensive, and healthcare sectors (with their exposure to communication services being less than 100 basis points off the benchmark index). Compared with last period, our top managers saw their aggregate holdings shift significantly more into basic materials, consumer cyclical, and healthcare names.
The overall makeup of the top 10 stock holdings by investment conviction did not change compared with last period—only their order changed. Wide-moat rated Wells Fargo moved up in order of appearance on the list relative to Oracle, mostly due to Ultimate Stock-Picker Dodge & Cox Stock (DODGX) adding to its position during the period. That said, both stocks were sold with conviction and widely sold during the period in aggregate. Narrow-moat rated Apple also moved up the list, mostly due to Berkshire Hathaway adding shares to its position with conviction.
Taking a closer look at the high-conviction buying that we uncovered during the most recent period, no names that showed up on our list of top 10 high-conviction purchases last period showed up on our list this period. As an aside, it should be noted that we are looking at all transactions in aggregate here, whereas in the previous article we were focused on individual instances of high-conviction and new-money purchases.
Ultimate Stock-Pickers' Top 10 Stock Purchases (by Investment Conviction)
- source: Morningstar Analysts
As for where our top managers were focusing their attention, the list of top 10 conviction stock purchases this time around was appreciably more diversified than the last time we looked at our Ultimate Stock-Pickers' top 10 buys and sells, with two each of the top 10 conviction purchases coming from the consumer cyclical, energy, and healthcare sectors. Both wide-moat rated Medtronic (MDT) and no-moat rated Delta Air Lines (DAL) (the latter of which we extensively profiled in our most recent issue), were the period's most notable high-conviction purchases, with five of our Ultimate-Stock Pickers buying shares in each name during the period. Boston Partners All Cap Value (BPAIX) meaningfully added to its Medtronic position in the name during the quarter, while Boston Partners All-Cap Value and Alleghany (Y) both initiated a new position and purchased with conviction shares in Delta Air Lines. From a valuation perspective, wide-moat Medtronic was the most attractive name on our list. Also of interest to us was no-moat rated Baker Hughes (BHGE) as well as no-moat rated MetLife (MET).
Turning to the most frequently addressed name in manager commentary that appears undervalued is Baker Hughes, which currently trades at a 14% discount to Morningstar analyst Preston Caldwell's fair value estimate. Ultimate Stock-Picker Dodge & Cox Stock owns the name and had this to say about it in the commentary of its 2017 annual report:
“In July 2017, GE Oil & Gas completed its acquisition of Baker Hughes, forming Baker Hughes GE (BHGE), now the second largest oilfield services company in the world after Schlumberger (also held in the Fund, 1.6% at year-end). By combining oilfield services (Baker Hughes) and oilfield equipment (GE Oil & Gas) businesses, BHGE is the only company that serves the upstream, midstream, and downstream segments of the Oil, Gas, and Consumable Fuels industry.
"Adjusting for the $17.50 per share cash dividend the Fund received in July, the stock was weak in 2017. While oil service activity levels have started to rebound in North America due to the resurgence of U.S. shale oil, hopes for an international recovery have been delayed. During the second half of 2017, we added to BHGE given its lower valuation, earnings growth potential, diversified business model, and financial strength. Management is targeting a $1.6 billion improvement in EBITDA, driven by 75% cost savings and 25% revenue synergies. BHGE has a long-term opportunity to increase its market share with its improved scale. BHGE’s leadership position in compressors and turbines generates long-term service contracts with attractive recurring revenue, which should reduce downside volatility. In addition, the company has a healthy balance sheet and recently announced a $3 billion share buyback. We believe BHGE provides attractive risk-reward diversification to the Fund’s Energy portfolio.”
While the run up in oil prices over the last six months has elevated share prices for integrated oilfield service companies in general, analyst Preston Caldwell sees Baker Hughes as the most attractively priced. He thinks the company's shares are being weighed down by negative sentiment regarding General Electric (GE), its parent company. This is in stark contrast to another integrated oilfield service company he also covers, Halliburton (HAL), which in his opinion looks downright expensive.
Caldwell believes that the rundown in Baker Hughes’s share price has more than erased the former expectations of substantial value-creation emanating from the merger of Baker Hughes and GE Oil & Gas (which closed in July 2017). Instead, he thinks that the market now seems to be pricing in overly negative developments for the combined company’s operations. While he recently made a downward adjustment to his fair value estimate for Baker, he believes his new view amply accounts for the difficulties the company will face in competing with Schlumberger (SLB) and Halliburton, as well as the headwinds its Turbomachinery segment will encounter in the key liquefied natural gas end-market. Furthermore, he adds that while the potential for a break-up of GE has rightly diminished investors' hopes that Baker Hughes will be transformed by the merger into an oilfield service company on par with Schlumberger or Halliburton, it nevertheless shouldn’t augur for a serious deterioration in the company’s existing competitive position.
Caldwell's current valuation is driven by his expectations for lower-than-average global oil and gas exploration and development expenditures. In general, he believes these expenditures will remain below the average levels of the previous cycle, which occurred from 2012 to 2014. He adds that the ascendance of low-cost U.S. shale oil and gas production has reduced the need to develop higher-cost sources of oil and gas production, thus leading to sustainably lower expenditures versus prior levels. As such, he expects the company’s revenue and profits to remain below levels achieved in 2012 to 2014.
In a recent note, Caldwell wrote that the fourth-quarter results for integrated oilfield service companies within his coverage fell in line with ongoing trends and unveiled few surprises to investors. Across the board, he observed that these companies experienced robust revenue growth in the high single digits. With one exception, he also saw continued strengthening in margins. From his vantage point, these results confirm his thesis that the strengthening financial results have remained largely due to the improvement in U.S. shale operations, where activity steadily increased throughout 2017. He thinks the impact on the bottom line has occurred primarily through the benefit of operating leverage as true pricing increases have generally been scarce in the industry. His views on the name echo many of the views from the fund managers at Dodge & Cox Stock.
As for the cheapest name on our high-conviction purchase list, wide-moat rated Medtronic is a name we've highlighted in the past. The firm currently trades at a 19% discount to analyst Debbie Wang's fair value estimate. Following Medtronic’s strong fiscal third-quarter results, Wang's small adjustments were immaterial to her $97 fair value estimate. Medtronic's fiscal third quarter revealed comparable quarterly top-line growth of 7% in constant currency that was generally broad-based, thanks to adoption of new products in coronary and structural heart, advanced energy and stapling, and diabetes. Manufacturing costs were slightly lower than Wang's expectations, but these were offset by slightly higher selling and administrative expenses. Medtronic’s impressive execution and its ongoing effort to take advantage of new value-based opportunities underscores Wang's confidence in the firm’s wide economic moat.
From Wang's perspective, two aspects of the quarter were particularly noteworthy. First, management comments on its Guardian Connect continuous glucose monitor led her to believe Medtronic is ready to put some muscle behind marketing it as a stand-alone product. While it has been available on a stand-alone basis, Wang observed that most of Medtronic’s focus has historically been on insulin pumps. Medtronic’s Continuous Glucose Monitoring (CGM) offers individualized predictive alerts and taps into the big data analytics of IBM's Watson. As Wang has stated in the past similarly, though Medtronic's sensors have trailed those of Dexcom on accuracy, Medtronic has begun competing on other meaningful features and benefits. Wang sees this latest effort as another way Medtronic can leverage its major competitive advantage in diabetes—its data collection and analysis—which leads to better predictive algorithms.
Second, in Wang's view, Medtronic has pioneered ways to benefit from the shift to value-based reimbursement through risk-based contracting. For example, she points out that roughly 25% of U.S. Cardiac Rhythm Management (CRM) devices are under these types of contracts and have contributed to significant sales of the TYRX anti-infective envelope. While TYRX has not established separate reimbursement, Wang adds that hospitals are willing to pay extra for the envelope, with the knowledge that Medtronic will pay for the treatment of any patients that come down with device-related infections.
Wang thinks that this kind of risk-based contracting will gain momentum with hospitals seeking to reduce their financial risk associated with patient complications, and she believes Medtronic is well positioned to partner with customers in these types of situations. She adds that the firm has already begun to launch other types of risk-based programs, including for repeat target lesion procedures for patients who used Medtronic's drug-coated balloon, and rehospitalization of patients using Medtronic's cardiac resynchronization technology. She points out that Medtronic has been aggressively piloting this approach and then applying it to other technologies within its portfolio.
One final name that caught our eye is an insurance name. We think this name is more attractive on a relative basis given its 12% discount to analyst Brett Horn's $52 fair value estimate, or 1.1 times book value. Like other life insurers, MetLife is operationally leveraged to the capital markets. This has made for somewhat tough sledding in recent years, with the low interest rate environment presenting an ongoing headwind for the company. Even so, Horn believes this trend is set to reverse, and in the long run, he believes an eventual increase in rates should allow the company to generate better returns. Recently, 10-year U.S. treasury rates have been on the rise, almost hitting 3% in 2018 so far.
However, Horn thinks that MetLife is dealing with some regulatory issues, such as the fiduciary rule's effect on annuity sales as well as some recently self-reported issues relating to tracking certain payments, and as such some caution is warranted before entering the name. Going into more detail on the Department of Labor’s revised fiduciary rules, Horn believes these revised rules could hamper sales of variable annuities and retirement plan products for small businesses. More recently, MetLife announced that it would have to increase reserves by over $500 million. Horn thinks this relates to payments to missing or unresponsive annuity and pension recipients. The company also announced that the SEC has made an inquiry into the matter. To Horn, it is not yet clear whether there will be any material legal outcomes. Even so, he does think that the situation at least suggests that MetLife has been somewhat negligent in tracking down recipients, which does not reflect well on management, in his view. However, Horn commends management for being upfront that there were clear and ongoing internal mistakes made and for self-reporting the problem. He believes this could lead to a more favorable regulatory result. On the bright side, it appears the firm will not have to worry about being labeled a nonbank systemically important financial institution.
It should be said, given that there are rarely moats in insurance firms, in Horn's view, management's stewardship of the firm is an even more critical component of the analysis relative to non-insurance firms. Horn assigns a standard stewardship rating to the firm. While returns under current CEO Steve Kandarian have been less impressive than under his predecessor, Horn would attribute this primarily to a difficult industry environment as opposed to any major operational missteps. He does believe that the company's significant steps to lower its risk profile have negatively affected returns. Even so, he concludes this seems like a reasonable trade-off and is largely in favor of Kandarian's overarching strategy of MetLife moving toward more transparent operations and steadier cash flow generation. While MetLife's recent actions to sell off the retail advisor business and spin off parts of the company's retail operations seems to be in response to changing regulations, Horn gives Kandarian credit for crafting a reasonable plan to adjust to a changed situation and believes the resulting entity will be more attractive in the long run.
Finally, Horn also gives management points for an aggressive response to regulatory changes. Kandarian had been instrumental in steering the company away from retail banking. Two months into his CEO job, Horn also points out that Kandarian led the firm in selling its deposit banking business, which eventually allowed the firm to de-bank itself in 2013.
Ultimate Stock-Pickers' Top 10 Stock Sales (by Investment Conviction)
- source: Morningstar Analysts
Turning to our list of top 10 stock holdings by conviction, after the recent uplift in Comcast's shares with its announced bid for Sky (SKY), wide-moat Microsoft is the only name that seems attractive on our list. Even as it remains one of the most pared down names by conviction, with 10 funds selling it off based on valuation, the stock does trade at a slight 13% discount to analyst Rodney Nelson's fair value estimate. Ultimate Stock-Picker Jensen Quality Growth (JENSX) is also bullish on the name and had this to say about its stake:
“[Microsoft’s] growth continues to be driven by strong commercial cloud adoption including Office 365 and Azure, which combined grew 56% year over year and now has an annual revenue run rate of almost $19 billion. Commercial cloud is currently 15% of revenue. In our estimation, the cloud market is in its early stages, and we expect Microsoft to benefit greatly as a market leader. Overall, we are pleased with Microsoft’s performance and as such it continues to be a top holding in the Fund.”
Recently, the wide-moat firm reported second-quarter results that beat Nelson's above-consensus expectations across the board. Microsoft saw strong demand for each of its flagship cloud properties, including Azure, Office 365, Dynamics 365, and LinkedIn. The company also enjoyed a strong holiday period for its gaming unit. Finally, during reported second-quarter results, the tech firm's management also provided its initial update on the impact of U.S. tax reform, which was largely in line with the changes Nelson had already implemented in his model earlier in January. Nelson continues to be impressed by the durable, elevated growth rates the firm is seeing in its cloud properties, particularly as profitability continues to outstrip both management’s prior expectations and Nelson's own forecasts. As a result, Nelson recently lifted his fair value estimate last month to $106 per share from $100 per share.
In terms of recent positives, Microsoft’s conversion of existing customers into its cloud-based services is beginning to accelerate to the upside, and Nelson expects full-year sales growth to approach lower double-digit growth. Furthermore, Microsoft’s gross and operating margins have tracked well above management’s initial guidance for the year. Additionally, Nelson remains confident that Azure will assert itself as more of an equal peer to rival Amazon Web Services (AMZN) as opposed to a distant secondary player. Azure's revenue rose nearly 100% in the quarter, while Azure Premium Services extended its run of triple-digit growth to a 14th consecutive quarter. Since growth rates have substantially outstripped capital investment in this business, this has provided Commercial Cloud's gross margins a material boost. Nelson also believes that Azure Stake, the firm's hybrid cloud offering, could extend the competitive positioning of Azure and, as a result, insulate Microsoft’s wide economic moat. Other pleasant positives for Nelson include Microsoft's strong execution on its Office 365 migrations, its fold in of LinkedIn into its operating model, and its More Personal Computing segment results.
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Disclosure: Joshua Aguilar has an ownership interest in Berkshire Hathaway BRK.B, while Eric Compton has no ownership interests in any of the securities mentioned here. 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.