Our Ultimate Stock-Pickers Top 10 New-Money Purchases
New-money purchases in technology and consumer goods, and Berkshire finds value in the financial sector.
For the past nine years, our primary goal with the Ultimate Stock-Pickers concept has been to uncover investment ideas that reflect the most recent transactions of our grouping of top investment managers in a timely enough manner 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 of some of the best equity managers in the business, we hope to uncover a few good ideas each quarter that investors can dig into a bit deeper to see if they warrant an investment. With 25 out of our 26 Ultimate Stock-Pickers having reported their holdings for the third quarter of 2018, we now have a good sense of what stocks piqued their interest during the period.
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 when 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 recognize that our Ultimate Stock-Pickers' decision to purchase shares of any of the securities highlighted in this article could have been made as early as the start of July, so the prices paid by our managers could be substantially 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 based on myriad factors, including our valuation estimates and our moat, stewardship, and uncertainty ratings.
After the recent volatility shocks, some of the bearish quarterly commentary written near the S&P 500's all-time high may seem predictive. That said, we recognize that several commentators have been bearish on the market for quite some time, and we note that despite the recent market downturn, the total return of the S&P 500 continues to be over 200% since the pre-crisis all-time high. One commentary on the dangers of market overconfidence that we found worth reading is from FMI Large Cap's (FMIHX) annual report:
“The bull market stretched into uncharted territory in the third calendar quarter, reaching its longest duration and one of its strongest up-cycle performances on record. Investors continued to focus on the good news—the U.S. economy, Wall Street’s version of earnings and rising stock prices…while ignoring danger signals—overconfidence (as reflected in valuations), rising rates and inflation, unbridled debt accumulation, a burgeoning trade war and perhaps some signs of fatigue in the economy. Faith in index funds and exchange-traded funds (ETFs) continued unabated, despite the ‘crowded trade’ nature of many of these products. High confidence in technology shares harkens back to the 1990s, with exceptionally optimistic valuations for both established and startup companies. Private equity transactions, in all but a small minority of cases, are taking place at record-high valuations and debt leverage. So-called ‘covenant-lite’ conditions have returned to the high yield arena. Across the board there appears to be little regard for safety and downside protection.”
Looking more closely at the top 10 high-conviction purchases during the third quarter of 2018, the buying activity continued to be diversified from a sector perspective, with most bets seeming to be name specific rather than broad industry bets. The only sector that received more than two high-conviction purchases was financial services, which had three high-conviction purchases. The new-money purchases list is somewhat more concentrated in the technology and consumer cyclical sectors, as each received three purchases.
As was the case during prior periods, most of the high-conviction buying was focused on high-quality names with defendable economic moats. Morningstar's analysts have concluded that seven out of the 10 companies that received the most high-conviction purchases have either a wide or a narrow economic moat. The two names we find most interesting on the high-conviction purchases list are wide-moat rated Allergan (AGN) and narrow-moat rated Broadcom (AVGO).
- source: Morningstar Analysts
There was a moderate amount of crossover between our two top-10 lists this period, with four names on both lists. This quarter, only two stocks received at least two new-money purchases from our Ultimate Stock-Pickers: both FPA Crescent Fund (FPACX) and Markel Corp (MKL) purchased no-moat rated Mohawk Industries Inc (MHK), and two growth investors, Morgan Stanley Inst Growth (MSEGX) and T. Rowe Price Blue Chip Growth Fund (TRBCX), purchased narrow-moat rated IAC/InterActiveCorp (IAC). We were interested that Morgan Stanley Inst Growth also made a new-money purchase into Netflix Inc (NFLX), given that our research indicates that the stock is substantially overvalued.
No Ultimate Stock-Pickers discussion on recent purchases would be complete without looking at what Berkshire Hathaway (BRK.A)/(BRK.B) has been up to, and this quarter it seems that the insurance company saw value in the financial sector. Berkshire's largest conviction purchase was narrow-moat Bank of America Corporation (BAC), which now accounts for 11.7% of the portfolio. The insurance company made conviction purchases into wide-moat US Bancorp (USB) (now 3% of Berkshire's portfolio), narrow-moat Goldman Sachs (GS) (1.9% of the portfolio) and made new-money conviction purchases into wide-moat Oracle (ORCL), narrow-moat JPMorgan Chase (JPM), and the Travelers (TRV), and no-moat PNC Financial Services Group (PNC) (each of which represent less than 2% of the portfolio).
Although all of these names are trading around or below Morningstar's fair value estimates, Morningstar's analysis shows that Goldman Sachs is the only firm that is meaningfully undervalued. For more details on Berkshire's investment portfolio, please see Morningstar analyst Greggory Warren's recent note: "Berkshire Hathaway Increases Bet on Banks and Other Financial Services Firms in 3Q."
- source: Morningstar Analysts
One high-conviction purchase that is quite in line with our investment research is Sound Shore Fund's (SSHFX) new-money purchase into wide-moat Allergan PLC, a specialty pharmaceutical manufacturer that produces medicines such as Botox and Restasis. This medium uncertainly stock currently trades at about a 36% discount to Morningstar analyst Michael Waterhouse's $245 fair value estimate.
Waterhouse argues that Allergan has built sustainable economic advantages as a result of its scale in the niche markets of ophthalmology and aesthetics and a sufficient pipeline. These aesthetic market, in particular, enjoy much higher barriers to entry and lower risk of generic competition than most pharmaceutical products.
The company also has a significant presence in the primary care markets of women’s health, gastrointestinal, urology, and central nervous system therapeutics Waterhouse expects that Allergan’s historical product innovation should help keep pricing and market share healthy and predicts that Allergan will maintain its historical successes in fending off most generic threats through patent litigation and new product launches, including products like ubrogepant and atogepant, oral CGRPs for migraine, and rapastinel, a drug for acute depression.
Waterhouse thinks that the market has negatively overreacted to the expectation that two of Allergan's major products, Restasis and Botox, will face competition. Though Waterhouse recognizes that generic competition will be a near-term negative for Restasis, the generic launch continues to be delayed, which allows Allergan to continue extracting economic profit on the product for the moment. Another fear that the market appears to be pricing in is competing product pressure on Botox, though Waterhouse anticipates that the Botox franchise will remain a core growth driver for Allergan over the long term.
On the cosmetic side, the likely approval of competing toxins from Evolus in 2019 and Revance's RT002 in in 2020, are only a modest concern to Waterhouse due to the limited differentiation of these products. On the therapeutic side where Botox continues to essentially enjoy a monopoly, the recent launch of CGRPs for migraine should represent a manageable headwind thanks to growth in Botox’s other therapeutic indications, such as urinary incontinence.
One of the most interesting technology companies on our high-conviction purchases list is narrow-moat Broadcom, Inc. FPA Crescent Fund made a conviction purchase to its Broadcom position this quarter. This medium uncertainty stock currently trades at a 21% discount to Morningstar analyst Abhinav Davuluri's $300 fair value estimate.
Davuluri argues that Broadcom is part of the heavyweight class of chip leaders and boasts intangible assets around the designs of products that go into a multitude of end markets. The company produces a wide variety of inputs for consumer and industrial technology, including radio frequency filters and amplifiers used in high-end smartphones, such as the Apple iPhone and Samsung Galaxy devices as well as connectivity chips that handle standards such as Wi-Fi and Bluetooth. Although smartphone component players are normally not moatworthy, as large customers like Apple (AAPL) and Samsung (SSNLF) may exert pricing pressure or require material volume discounts while threatening to move to a competitor’s offering for the next iteration of a flagship device, Davuluri does not expect Broadcom to be displaced overnight in any premium devices.
This is because single filters typically cost less than $0.50, which Davuluri reasons is cheap enough to make it less likely that Apple and its competitors will prioritize cost over performance when selecting filters. Broadcom is reasonably exposed to the smartphone space, as 30% of Broadcom's sales come from high-end smartphones. Broadcom also produces an assortment of solutions for wired infrastructure, enterprise storage, and industrial end markets.
One major tenet behind Davuluri's bullish thesis on Broadcom is that the market became overly bearish on the firm in the wake of the company's announcement that it would acquire CA, a leading vendor of IT management software and solutions for mainframe infrastructure and enterprises. Though the deal represented a 27% premium to Morningstar's fair value estimate for CA at the time of the deal's announcement, Davuluri thinks the premium paid by Broadcom was reasonable. Davuluri expects that the potential for cost-cutting and the stable performance of CA's mainframe business should allow for solid non-GAAP EPS accretion for Broadcom.
Davuluri thinks that this merger is a continuation of Broadcom CEO Hock Tan's generally strong serial acquisition strategy. The company has largely been successful in acquiring reasonably priced franchises that have strong profitability in mature markets. Broadcom then uses these acquired companies for solid cash flow generation with the potential for cost-cutting. This strategy has included mergers with or acquisitions of LSI, PLX Technology, Emulex, legacy Broadcom, and Brocade, each of which Davuluri thinks was strategically and financially sound. This acquisition with CA partially departs from this approach because the financial benefits of the deal will likely be quickly recognized, but the strategic benefits of the deal could take some time to be fully appreciated.
We were intrigued to see that Morgan Stanley Inst Growth Fund made a new-money purchase into Netflix Inc, the largest subscription video on demand provider, given that Morningstar analyst Neil Macker thinks that the stock's fair value estimate is materially lower than the current price.
Although Macker expects that Netflix deserves a narrow moat rating because its rapidly expanding user base creates a humongous data set that Netflix mines to better purchase and create content, Macker thinks that the market is excessively optimistic about the company's future subscriber growth and margin expansion. Macker's bearish thesis rests on a few key points, including that competition in the U.S. and internationally is increasing, and that competitors are planning on undercutting Netflix on pricing. Fundamentally, Macker envisages a world in which Netflix is one of the major OTT media channels, not the only one or part of a duopoly with Amazon (AMZN).
Macker anticipates that competition from other content providers will challenge the rate at which Netflix can acquire new subscribers. Disney (DIS) has launched subscription video on demand services, such as a sports-centered content service, ESPN+, and plans to launch Disney+, a direct competitor to Netflix, in late 2019. A smaller competitor, Hulu, has not grown at the same rapid pace as its larger and better-funded rivals, but the platform's subscriber growth has increased over the last couple of years.
Further, several niche subscription video on demand services have also been launched. Macker expects that it will be challenging for Netflix to meet the market's subscriber growth expectations given the increasing competition in the subscription video on demand market.
Macker also expects the subscription video on demand market to get more competitive on pricing. Generally, Macker thinks that subscribers have a higher sensitivity to price increases, which is demonstrated by the spike in subscriber churn during the summer of 2016 following two separate $1 price increases. Underlying this assumption is Macker's belief that the media coverage of the price increases reminds subscribers of the monthly auto-renewal and compels them to examine whether or not they are using the service. Disney's management has already declared that its new streaming service, Disney+, will launch at an aggressive price point relative to Netflix. Other, more niche subscription video on demand products generally price well under Netflix, as well.
While Macker does not believe that price will be the only factor in consumers’ subscription decision, we do believe a lower price for the new entrants could help overcome the library depth disadvantage versus Netflix that most platforms will face when launching. Further, other content firms, unlike Netflix, do not generate the majority of their revenue from subscribers so a producer like Disney would be able to undercut Netflix and remain below the streaming giant for an extended period.
Overall, Macker posits that Netflix will be one of many ways of consuming media, not one of a few. Macker points to long-term trends of continuous fragmentation within the content space and that older formats still attract viewers and can remain profitable, unlike other disrupted industries. For example, the attendance at movie theaters in the U.S. continues to fall from the peak in 2002, but the overall revenue has stayed relatively flat or grown over the last 15 years. The large content networks have dealt with the advent of cheap DVD players, home Internet, video on demand, streaming online video, and subscription video on demand. To Macker, the ability for multiple formats to remain relevant despite the emergence of new ones reflects another of our overarching themes about media.
Over the last century-plus, people in industrial and postindustrial economies have gained additional free time due to the advent of the five-day workweek along with other time-saving inventions. Macker thinks that what many humans do with that additional free time is to find another screen to place themselves in front of to devour more content and/or information. As a result, while the number of content-viewing options continues to increase, older platforms remain relevant and can still be profitable.
Disclosure: As of the publication of this article, Burkett Huey has no ownership interests in any of the securities mentioned above. 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.