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 22 out of our 26 Ultimate Stock-Pickers having reported their holdings for the fourth quarter of 2018, we now have a good sense of what stocks piqued their interest during the period. We should note that we will likely not be able to effectively gather data for one of our Ultimate Stock-Pickers, Boston Partners All Cap Value(BPAIX), this quarter due to a change in its reporting structure.
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 October, 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.
Many of the Ultimate Stock-Pickers have been trying to reconcile the fourth-quarter market downturn with encouraging macroeconomic and corporate earnings data. Though many warnings of market overconfidence in 2018 seemed foretelling, corporate earnings generally grew in line with analyst expectations. That said, the added market volatility may benefit many of the value-oriented Ultimate Stock-Pickers, as value strategies are considered to have somewhat less risk than the general market. FMI Large Cap(FMIHX), a value fund, alluded to this dynamic in its commentary on the fund's annual report.
The severe decline in the December quarter may have woken the complacent, reminding them that stocks go both ways…Additionally, while it might seem a bit unsporting, it is gratifying to see some of the rankly speculative stocks get crushed. Many of these high-wire acts were performing without a net, so to speak. In a rough market, burning cash and losing money are not comforting words to investors, many of whom are tasting fear for the first time. The muscle memory of a 10-year growth-driven bull market doesn’t change in one quarter, however, so we expect sharp growth stock rallies within the context of a return to normal in valuations. Our working thesis is that investors will capitalize the good growth companies at lower multiples and abandon the rickety companies, both of which should work in our favor.
Looking more closely at the top 10 high-conviction purchases during the fourth quarter of 2018, the buying activity seemed to be more sector-focused than the last quarter. Financial services and technology each contributed three names to the high-conviction purchases list. No other sector contributed more than one stock to the high-conviction list. The new-money purchases list is also more concentrated by sector than we have generally seen recently, as four of the top 10 stocks were from the industrials sector, and the technology sector also contributed three stocks to the top 10 list.
As is frequently the case, 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 on the high-conviction purchases list and eight out of the top 10 new-money purchases have either a wide or a narrow economic moat.
That said, Copart Inc(CPRT), was given a wide economic moat and StoneCo(STNE) was given a narrow economic moat by our quantitative analysts and is not covered by a Morningstar equity analyst. The names that we found most interesting on the high-conviction and new-money purchases lists are American International Group(AIG), wide-moat rated Microsoft(MSFT), and General Motors(GM). We also took note that some Ultimate Stock-Pickers made conviction purchases into wide-moat rated Automatic Data Processing(ADP), though our research indicates that the stock is substantially overvalued.
Top 10 High-Conviction Purchases by Our Ultimate Stock-Pickers
There was a moderate amount of crossover between our top-10 lists this period, with four names on both lists. This quarter, we were surprised to see much more convergence in the Stock-Pickers' high conviction and new-money purchases than we have previously seen. FPA Crescent(FPACX), Oakmark Equity And Income(OAKBX), and Diamond Hill Large Cap(DHLAX) all made conviction purchases into AIG this quarter.
Diamond Hill Large Cap Fund's management provided some color on the reasoning behind this move, stating, "We believe AIG now has one of the best management teams in the industry and is nearing an inflection point in its turnaround" in its quarterly commentary. This sentiment is largely in line with Morningstar analyst Brett Horn's thesis on the property, casualty, and life insurer.
Wide-moat rated Halliburton(HAL) was also popular with our Ultimate Stock-Pickers during the fourth quarter, as American Century Value(AVLIX), Dodge & Cox Stock(DODGX), and Oakmark Investor(OAKMX) all made conviction purchases into the second-largest oilfield services company. Six other stocks on the high-conviction list were purchased by more than one Ultimate Stock-Picker, and seven stocks on the new-money purchases list were bought by two Ultimate Stock-Pickers.
Top 10 New-Money Purchases by Our Ultimate Stock-Pickers
The conviction purchases into American International Group are quite in line with Morningstar's investment research. That said, we have covered Horn's thesis on no-moat rated AIG extensively in previous issues, so we direct potential investors to the December 2018 issue of Ultimate Stock-Pickers, “Large-cap growth and large-cap value strategies maintain gains above index; market is undervalued,” and to Horn's August 2018 Select piece, "Outlining AIG's Path to Mediocrity."
Turning to the technology sector, Alleghany's (Y) and Parnassus Core Equity Investor's (PRBLX) conviction purchases into Microsoft were quite in line with Morningstar's valuation. Parnassus justified its purchase into this blue-chip consumer and enterprise software producer by reasoning that, "Microsoft has unrivaled enterprise relationships and a comprehensive portfolio of offerings across information technology, from infrastructure to software. The enterprise transition to the cloud is still nascent and, as it matures, Microsoft should become even more engrained in the digitized economy."
Morningstar analyst Dan Romanoff is also bullish on the name due to its cloud leadership, stating that Azure is the centerpiece of the new Microsoft. Romanoff cites that Microsoft's Azure has several distinct advantages. In particular, Azure offers customers a painless way to experiment and move select workloads to the cloud. Romanoff thinks that continued adoption will not be difficult. Since existing customers will remain in the same Microsoft environment, applications and data are easily moved from on-premises to the cloud.
Another factor that Romanoff likes is that Azure is an effective launching point for secular trends in artificial intelligence, business intelligence, and the Internet of Things as the product continues to launch new services centered on these broad themes. Romanoff believes that Azure, Dynamics 365, and Office 365 are all scaling as they drive a secular shift to the cloud and should help drive operating margins up from 33% in fiscal 2019 to 41% in fiscal 2028.
Beyond Azure, Romanoff thinks that investors in Microsoft are also buying monopoly-like positions in cash cow businesses such as Office and OS. Romanoff believes that Microsoft Office, including both the cloud-based 365 version, which is available for a monthly subscription, and the perpetual license version, is protected by a wide moat driven by high switching costs and network effects. Evidence for wide moat can be seen by Microsoft's 88% market share in office suites, despite it charging at least $70 per year to use the product.
Given that similar products are available for free from Google(GOOGL) and in open source providers, Romanoff is impressed with Microsoft's pricing power. Romanoff cites that Office Suite's large installed base draws in software developers to create products specifically for Microsoft Office, which supports the product's network effect.
Romanoff sees Microsoft's wide-moat Windows business as another profitable venture that supports Microsoft's growth. To Romanoff, the Windows business benefits from high switching costs and a network effect. Windows accounts for approximately 18% of total revenue, is growing in the midsingle digits, and has an 83% global market share for PC operating systems. Apple has the next largest share at 13%. Although Romanoff believes that Windows has slowly been bleeding market share with the rise of Apple(AAPL) and the introduction of some alternative PC operating systems, he recognizes that Windows revenue has grown for three consecutive years.
Romanoff does not see a viable OS alternative for the mass market and thinks that PC users overwhelmingly do not contemplate their operating system. At the enterprise level, CIOs and IT managers require proven reliability, significant software support, and a product roadmap to ensure their investment in IT infrastructure will offer an appropriate return. Romanoff thinks that there is simply too much at stake in financial, operational, and informational terms to warrant companies switching to competing operating systems.
The second high-conviction purchase that piqued our attention was Diamond Hill Large Cap Fund's and Oakmark Fund's conviction purchase of General Motors. Diamond Hill's management provided this reasoning for the purchase: "Global automobile manufacturer General Motors Co. (GM) has a strong product mix and cash flow driven by its truck and SUV programs. As the mix of auto sales trends more toward crossovers, SUVs, and trucks, we believe GM is well positioned."
Morningstar analyst David Whiston agrees with this bullish sentiment. Whiston thinks that General Motors is starting to see the upside to high operating leverage, thanks to lower fleet sales and smarter manufacturing than in the past, including a reduction in its vehicle platforms. GM is already a leader in truck models, so the company's competitive lineup in all segments, which combined with a much smaller cost base, demonstrates to Whiston that General Motors is starting to realize the scale to match its size.
Whiston thinks that General Motors has excellent earnings potential looking forward, as the company finally has a healthy North American unit and can focus its U.S. marketing efforts on just four brands instead of eight, as it did previously. Whiston thinks that GM's key holes in the U.S. product lineup (full-size sedans, full-size trucks, and SUVs) are now filled, and 2018 started the launch of new generations of the firm's most profitable vehicles. Whiston appreciates that GM now operates in a demand-pull model where it can produce only to meet demand and that the company is structured to do no worse than break even at the bottom of an economic cycle. The result is higher profits despite lower U.S. market share.
Quarterly results are supporting this thesis. Although 2018's fourth-quarter total company adjusted EBIT fell 8.3% year over year, GM North America's adjusted EBIT margin of 10.2% grew 20 basis points year over year. The new-generation light-duty full-size pickups and incentives as a percentage of average transaction price about flat with the fourth quarter of 2017 enabled GM to offset commodity and material cost increases.
Looking forward, Whiston expects that the first quarter of 2019 will be GM's weakest, but he remains optimistic on GMNA's prospects for 10% EBIT margin, given that there will be a full year of the new light-duty trucks and full production of the new-generation heavy-duty trucks in the second half of 2019.
Finally, we were interested to see that T. Rowe Price Blue Chip Fund (TRBCX) and American Funds American Mutual(AMRMX) made conviction buys into wide-moat rated Automatic Data Processing during the fourth quarter, given that Morningstar's research indicates that the shares are substantially overvalued. Morningstar analyst Colin Plunkett recognizes that Automatic Data Processing, the largest provider of payroll services in the U.S., will likely continue to benefit from the evolving and increasingly complex relationship between businesses and their employees but sees challenges in the medium term.
Plunkett thinks that ADP will need to increase its value proposition and introduce new offerings to maintain its high switching costs, though conceded in the short term, ADP is likely to benefit from increasing employment.
In recent years, a large tailwind for ADP and other payroll providers has been increased regulation varying across geographies, tax complexity, and the Affordable Care Act. The complexity of the ACA and its reporting requirements created additional revenue opportunities for payroll service providers. Additionally, the increased reporting complexity strengthens ADP’s grip on its customer base.
Given the daunting compliance and reporting requirements, human resources departments often do not risk substituting their payroll service provider out of fear it could result in errors that could lead to fines. This is particularly true for much of ADP’s customers, because they are small- and mid-size businesses that may not even have an HR department. More recently, ADP has been able to offset the absence of selling opportunities tied to new regulation through an expanding labor market.
ADP processes the payrolls of midsize businesses, and its sweet spot is somewhere between 25 and 100 employees. Although this has historically been an insulated space, Plunkett anticipates ADP's smaller business customers are seeing better value in do-it-yourself payroll solutions, while large enterprise customers have greater resources and bargaining power, resulting in lower switching costs and lower margins.
Over the medium term, Plunkett is concerned that ADP's clients will increasingly defect over issues related to its technology platform and customer service. ADP’s competitors have dedicated client service teams, which are their clients' go-to contact points for all service issues. In addition, ADP's competitors have stated that one of their biggest strengths is that client data is stored on one database using one system, which is quite different than ADP, which uses multiple systems that often use antiquated technology. While the company has been working to integrate these functions, Plunkett believes it will take time and investment to properly address.
Our analyst suspects that the expectations of ADP customers have changed. Customers no longer rely on a robust customer service offering, should issues arise. Increasingly, today’s customers demand a technology-enabled solution that allows customers to avoid calling customer service entirely. Previously, ADP's customer service was a great asset, but today it increasingly seems to us that this asset has an antiquated infrastructure that's costly to maintain and less agile. Plunkett suspects that this dynamic will moderate ADP's ability to cross-sell additional products or raise prices and forced the company to spend more on IT and customer service.
Disclosure: As of the publication of this article, Burkett Huey has ownership interests in Berkshire Hathaway and Microsoft. 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: MSFT. Find out about Morningstar’s