The Top 10 Holdings of Our Ultimate Stock-Pickers' Index
Large-cap growth and large-cap value strategies maintain gains above index, market is undervalued.
Fund investors would like to see their actively managed funds beat the market every year, but they've been left wanting for well over a decade. The lack of consistent outperformance on the part of large-cap active managers (the main contributors to the Ultimate Stock-Pickers concept) has been well documented by the S&P Indices Versus Active Funds (SPIVA) U.S. Scorecard. For the 10-year period ending in June 2018, the index group noted that a striking 89.15% of large-cap managers have lagged their respective benchmarks. This year, only 28.6% of large-cap core managers have outperformed their index. Other investment styles fared better, as 58.0% of large-cap value managers and 63.7% of large-cap growth managers outperformed their respective benchmarks.
The last two years have seen some active managers fare better than past years. In 2017 and 2018, over half of both large-cap growth and large-cap value funds have outperformed their benchmarks. Between the growth and value strategies, growth has fared the best during this period. Morningstar's own indexes bear out this same pattern, as our large-cap core index (7.8% return) lagged our large-cap value index (8.6%), and both fared much worse than the large-cap growth index (27.4%). These returns reflect the time horizon SPIVA used (June 30, 2017 to June 30, 2018) and reveal that large-cap growth was the area with the most momentum. It should be noted that the market has been markedly different since the end of June with the current sell-off, and therefore these patterns may already have changed.
The fund managers represented in our Ultimate Stock-Pickers concept have had their own issues with relative long-term performance. Only seven of our 22 top funds were beating the S&P 500 on a 10-year total return basis as of Dec. 12. That said, our Ultimate Stock-Pickers may be doing better more recently, as eight of our 22 fund managers are beating the S&P year over year from 2017, and the index as a whole is beating the S&P 500. The Morgan Stanley Inst Growth (MSEGX) fund and the T. Rowe Price Blue Chip Growth Fund (TRBCX) were doing the best relative to the S&P 500 on a 10-year basis, and the Oakmark Equity And Income Fund (OAKBX) as well as the FPA Crescent Fund (FPACX) were doing the worst relative to the S&P 500 on a 10-year basis.
As a reminder, the Ultimate Stock-Pickers concept was devised as a stock-picking screen, not as a guide for finding fund managers to add to an investment portfolio. Our primary goal has been to identify a sufficiently broad collection of stock-pickers who have shown an ability to beat the markets over multiple periods (with an emphasis on longer-term periods). We then cross-reference these managers' top holdings, purchases, and sales against the recommendations of our own stock analysts on a regular basis, allowing us to uncover securities that investors might want to investigate further. There will always be limitations to our process, as we try to focus on managers that our fund analysts cover and on companies that our stock analysts cover, which reduces the universe of potential ideas that we can ultimately address in any given period. This is also the main reason why we focus so much attention on large-cap fund managers, as they tend to be covered more broadly on the fund side of our operations and their stock holdings overlap more heavily with our active stock coverage. That said, by limiting themselves to the largest and most widely followed companies, our top managers may miss out on some smaller ideas that have the potential to generate greater outperformance in the long run.
The overall market has taken some wild swings in 2018. After shooting as much as 11% above our analysts' aggregate fair value estimates during January, stocks became more reasonably valued in March, April, and May. The heat of summer brought back hot stock valuations, and our analysts saw that the overall market valuation was slightly above the fair value ratio once again. Since October, the overall market has declined back below our aggregate fair value estimate. Morningstar now sees the overall market as undervalued with the median stock trading at an 8% discount below our fair value estimate.
Taking a look at the cyclically adjusted price/earnings, or CAPE, ratio, which divides the current market price by the average of 10 years of earnings (adjusted for inflation), it currently stands at around 28.78, below where it was for our last article (32.8). This is high compared with the historical mean of 16.59 and median of 15.68, with Shiller relying on market data from both estimated (1881-1956) and actual (1957 onward) earnings reports from companies represented in the S&P 500 Index. Despite the recent market declines, we still have a relatively high ratio. We remain below only the dot-com bubble, where the ratio achieved a value of 44.19. Today's CAPE levels are just below what the ratio was before Black Tuesday but well above the period before the Great Financial Crisis. The CAPE ratio is generally used to assess potential returns from equities over longer time frames, with higher-than-average CAPE values implying lower-than-average long-term annual returns going forward, which is what we're gleaning from the current ratio. While not intended to be an indicator of impending market crashes, it has provided warning signs for investors in the past.
Performance of Morningstar Ultimate Stock-Pickers TR Index Relative to S&P 500 TR Index (as of 11/30/18)
- source: Morningstar Analysts
Aside from tracking the holdings, purchases, and sales as well as the ongoing investment performance of our Ultimate Stock-Pickers, we also follow the makeup and results of the Morningstar Ultimate Stock-Pickers TR Index. For those who may not recall, the Ultimate Stock-Pickers index was set up to track the highest-conviction holdings of 26 different managers, a list that includes our 22 top fund managers as well as the investment managers of four insurance companies— Berkshire Hathaway (BRK.A)/(BRK.B) Markel (MKL), Alleghany (Y), and Fairfax Financial (FRFHF). It is constructed by taking all the stock holdings of our Ultimate Stock-Pickers that are not only covered by Morningstar stock analysts but have either a low or medium uncertainty rating and ranking them by their Morningstar Conviction Score. The Morningstar Conviction Score is made up of three factors: 1) the overall conviction (number and weighting of holdings), 2) the relative current optimism (holdings being purchased), and 3) the relative current pessimism (holdings being sold).
The index itself is composed of three subportfolios—each one containing 20 securities—that are reconstituted quarterly on a staggered schedule. As such, one-third of the index is reset every month, with the 20 securities with the highest conviction scores making up each subportfolio when they are reconstituted. This means that the overall index can hold anywhere between 20 and 60 stocks at any given time (because some stocks may remain as the highest-conviction score holders in any given period, meaning there can be overlaps in the holdings, reducing the total number of different stocks held). In reality, the index is usually composed of 35 to 45 securities, holding 41 stocks in all at the end of November. These stocks should represent some of the best investment opportunities that have been identified by our Ultimate Stock-Pickers in any given period. It can also have more concentrated positions than one might find in a typical mutual fund, with the top 10 (25) holdings in the index accounting for 36.18% (68.1%) of the total investment portfolio at the end of last month. The size and concentration of the portfolio does change, though, as the index tries to tap into the movements and conviction levels of our top managers over time.
Top 10 Stock Holdings of the Morningstar Ultimate Stock-Pickers TR Index (as of 11/30/18)
- source: Morningstar Analysts
Looking at the top 10 stock holdings of the Morningstar Ultimate Stock-Pickers index at the end of November, there are several names trading at a material discount to our analysts' fair value estimates, such as narrow-moat rated CVS Health Corp (CVS) and Air Products & Chemicals Inc. (APD), and wide-moat rated Walt Disney Co. (DIS) and Philip Morris (PM). As is frequently the case, the top 10 holdings fit well within Morningstar's moat methodology, as all of the top 10 holdings have been given either a narrow or wide moat by Morningstar analysts.
The name that stuck out most to us was Walt Disney, which is trading at a 14% discount to Morningstar Analyst Neil Macker's fair value estimate of $130. Macker believes that Disney owns the most attractive combination of content creation and distribution among the major media companies, as its media networks segment and its collection of Disney-branded businesses have demonstrated strong pricing power in the past few years.
Macker sees Disney as two distinct yet complementary businesses: media networks, which include ESPN and ABC, and Disney-branded businesses, including parks, filmed entertainment, and consumer products.
In light of recent discussions and concerns about content distribution migrating to over-the-top or subscription video on demand channels, such as Netflix, from pay TV, Macker believes that the wide-moat firms with the best production studios, deep content libraries, and live programming rights will have the best chance to navigate these changes. Macker sees Disney as one of these wide-moat companies. Disney's media networks segment includes ESPN, the dominant player in U.S. sports entertainment. ESPN profits from the highest affiliate fees per subscriber of any cable channel and generates revenue from advertisers interested in reaching adult males ages 18-49, a key advertising demographic that watches less scripted television than other demographics. Macker recognizes that this dual income stream is a significant advantage not shared by the broadcast networks, which rely primarily on ad revenue. Disney also has the attractive Disney Channel, one of two dominant cable networks for children; and ABC, one of the four national broadcast networks. On the production side, Disney boasts four movie studios with tremendous records (Disney Animation, Pixar, Marvel, and Lucasfilm) along with multiple TV studios, including ABC Studios. Macker expects the unique content on ESPN and Disney Channel will provide the firm with a softer landing than its peers as viewing transfers to an over-the-top world over the next decade.
Disney's other components rely on the world-class Disney brand, sought after by children and trusted by parents. Over the past decade, Disney has demonstrated its ability to monetize its characters and franchises across multiple platforms--movies, home video, merchandising, theme parks, and even musicals. Macker expects continued expansion at Shanghai Disneyland and the opening of the Star Wars parks will allow sales growth through this venue. Macker thinks that the stable of animated franchises will continue to grow as more popular movies get released by the animated studio and Pixar, which has already generated hits such as Toy Story, Cars, and Frozen. Similar to the animated franchises, Disney arranged the Marvel universe to create a series of interconnected films and product tie-ins. To Macker, Disney's acquisition of Lucasfilm appears to be a positioning of the Star Wars franchise in the same manner. Disney's theme parks and resorts are almost impossible to replicate, especially considering the tie-ins with its other business lines.
Quarterly results are showing that this thesis is playing out. Disney outperformed Macker's expectations on both revenue and EBITDA. On the distribution side, revenue increased largely due to higher rates that were partially offset by a small decline in subscribership. Notably, the rate of subscriber loss has been shrinking for the past five quarters. Looking forward, the company is focused on its direct-to-consumer efforts as the firm enters an important transitional fiscal year. The new ESPN+ subscription service has reached over 1 million subscribers since its launch in April 2018, and Macker remains positive on the potential impact of the Disney+ service that is set to launch in late 2019.
The Disney-branded businesses side also had a strong showing. The studio segment outperformed again as the firm continues to benefit from a strong 2018 slate including Incredibles 2, the highest grossing Pixar film ever. Parks and resorts also remain an area of growth, though the growth is somewhat inflated because 2017 was negatively impacted by Hurricane Irma. That said, per capita spending and domestic attendance increased at healthy rates, and the segment is poised for operating margin expansion.
Top 10 Contributors to Morningstar Ultimate Stock-Pickers TR Index Performance (12/1/17-11/30/18)
- source: Morningstar Analysts
Looking at the year-over-year performance of the Morningstar Ultimate Stock-Pickers index from Dec. 1, 2017, to Nov. 30, 2018, the standouts from the top 10 contributors included wide-moat Starbucks (SBUX) and wide-moat Merck & Co (MRK). Based on an attribution analysis of the index (relative to the S&P 500) over the trailing 12 months, wide-moat Intuit (INTU) and Starbucks generated the most active return for the Ultimate Stock-Pickers over the period. There are not many names that are trading at a material discount to their fair value estimate, as only narrow-moat Sabre Corp (SABR) is trading at 4-stars relative to Morningstar senior analyst Dan Wasiolek's fair value estimate. This is sensible since the highest-performing names of last year have already been run-up by investors.
Sabre Corp's core business is its global distribution system, which allows travel agents (both traditional and online) as well as travel management companies to source content and book travel for clients. All airlines supply content to global distribution systems and then pay the distribution system a negotiated booking fee for transactions completed on the platform. The business model is driven by transaction volume and not pricing. In addition to the distribution segments, Sabre also has a growing IT solution division that integrates technology between suppliers and travel agents with the global distribution system platform.
Wasiolek thinks that the company holds a network advantage, as its global distribution system hosts content from all global airlines—that pay Sabre a booking fee—and that this scale of content attracts use by both traditional and online travel agents, as well as travel management companies that receive incentive fees from Sabre to book on its global distribution system and in turn encourages airlines to provide more inventory to the platform. Wasiolek also believes the core distribution business holds an efficient scale advantage. Sabre, Amadeus (AMADY), and Travelport (TVPT) combined control nearly 100% of the GDS market, which signals to Wasiolek that an efficient scale barrier exists. The main risk to Sabre and the industry is that technological advances will allow travel booking directly through supplier websites or through direct connections between suppliers and online travel agents, which would bypass Sabre. While this would be disastrous for companies like Sabre, Wasiolek thinks that the mixed success the airline industry has had in bypassing or replicating a GDS supports the efficient scale and network advantage in Sabre's distribution business.
Wasiolek believes that this narrow-moat name still has room to run, based on a forecast of travel network and airline hospitality revenue growth that is partially offset by travel network and airline hospitality cost of revenue. Wasiolek is forecasting above-industry revenue growth for Sabre because he thinks that Sabre will release technology products that lead to increased integration with its global distribution system platform and that Sabre will grow its products within underrepresented international regions.
Top 10 Detractors From the Morningstar Ultimate Stock-Pickers TR Index Performance (12/1/17-11/30/18)
- source: Morningstar Analysts
While lists of top-performing stocks would expectedly be largely composed of stocks that have run up, our top detractors list can sometimes be a good area to look for contrarian opportunities. We thought that one of the most compelling stories to make the list is no-moat rated American International Group (AIG), which is trading at a substantial discount to Morningstar senior analyst Brett Horn's fair value estimate. Horn recognizes AIG's poor historical performance, which he attributes to previous management's focus on growth and a lack of discipline. That said, Horn now thinks that the company has set a course in the opposite direction.
Horn's bullish thesis on AIG rests on a mean-reversion story that focuses on AIG's historically weak commercial property and casualty underwriting. Horn thinks that it is reasonable to believe that AIG will be able to turn around this historically problematic business line because the relatively new CEO, Brian Duperreault, has been successful in building commercial property and casualty insurance franchises in the past. Horn notes Duperreault built ACE Limited (now Chubb (CB)) essentially from scratch into a large, best-of-breed commercial insurer focused on the same business lines and customer base as AIG. To Horn, Duperreault's underwriting experience contrasts with previous management, as the previous CEO, Peter Hancock, lacked experience on the underwriting side. Duperreault's experience gives Horn confidence that AIG's underwriting problems are not insurmountable for an effective and focused manager.
Horn is not especially concerned about AIG's other businesses because they have generally positively offset the commercial property and casualty weakness. The company's life insurance operations are performing quite well, generating a double-digit adjusted ROE every quarter since the second quarter of 2016.
While AIG has not shown a lot of tangible progress in improving underwriting results so far, Horn appreciates that it will take some time to solve its issues, given the company's size, the magnitude of its issues, and the inherent delay between implementing better underwriting practices and their appearance in reported results. Horn's fair value estimate of $76 per share equates to a price/book multiple of 1.1 times, which largely reflects a belief that the company is changing from an anomaly of poor performance in the insurance world to simply being a mediocre insurer.
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Disclosure: Burkett Huey has no ownership interests in any of the securities mentioned. Eric Compton has no ownership interests in any of the securities mentioned. 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.