Our Ultimate Stock-Pickers' Top 10 High-Conviction and New-Money Purchases
Our managers continued to find names to put new money to work during the first quarter even as equity markets reached new highs.
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 equity analysts against the actions of some of the best equity portfolio 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 further action.
With all but one of Ultimate Stock-Pickers having reported their holdings for the first quarter of 2019, we now have a good sense of which stocks piqued their interest during the period. While the Morningstar coverage universe now trades at 100% of our aggregate fair value estimates, which suggests that the median stock under Morningstar's coverage is trading at its fair value, there were a lot more bargains to be found after the dramatic sell-off in the markets during the fourth quarter of 2018.
Astute readers of Ultimate Stock-Pickers content will recall that when we look at the buying activity of our Ultimate Stock-Pickers we tend to focus more heavily on high-conviction purchases and new-money buys. We think of high-conviction purchases as instances where one of our managers has made a meaningful addition to a stock that was already in their portfolio, with "meaningful" being defined by the size of the purchase relative to the size of the investment portfolio overall. We define a new-money buy strictly as an instance where a manager purchases a stock that did not exist in the portfolio at the start of the period. New-money buys may be done either with or without conviction, depending on the size of the purchase, while a conviction purchase does not necessarily need to be a new-money buy.
We also recognize the fact that the decision to purchase any of the securities that are highlighted in this article could have been made as early as the start of January of this year, with the prices that were paid by our top managers being dramatically different from today's levels. Consequently, we believe it is important for investors to assess for themselves the current attractiveness of any security that is mentioned, looking at a myriad of factors, including our valuation estimate, as well as our moat, stewardship, and uncertainty ratings.
Top 10 High-Conviction Purchases by Our Ultimate Stock-Pickers
- source: Morningstar Analysts
Looking more closely at the top 10 high-conviction purchases that were made during the first quarter of 2019, the buying activity was reasonably diversified. No sector contributed more than two names to the top 10 high-conviction purchases list. As is frequently the case, most of the high-conviction buying that took place during the quarter was focused on high-quality names with narrow or wide economic moats. And of the stocks we are highlighting, only Booking Holdings (BKNG), UnitedHealth Group (UNH), and FedEx (FDX) are trading meaningfully below our analysts' fair value estimates, while CME Group (CME) it trading at a hefty premium.
When we compared this past quarter's high-conviction purchases list with the prior quarter's high-conviction purchases list, there was no overlap, which was not surprising given the very different market environments that existed in the fourth quarter of 2018 and first quarter of 2019. That said, eight of the 10 stocks in our high-conviction purchase list were bought by at least two Ultimate Stock-Pickers during the March quarter, similar to what we saw during the December quarter. There was also a moderate amount of crossover between our two lists of top 10 high-conviction purchases and top 10 new-money buys this period, with seven names appearing on both lists. There were also four names that had at least two Ultimate Stock-Pickers initiate new-money purchases into them this quarter.
Digging Deeper Into the High-Conviction and New-Money Purchases
Wide-moat Berkshire Hathaway (BRK.B) tried to steal some of our thunder a few weeks ago when CEO Warren Buffett noted that one of his two lieutenants--Todd Combs or Ted Weschler--had made a new-money purchase of wide-moat rated Amazon.com (AMZN). Given that Buffett has lamented his decision not to invest in Amazon (or Jeff Bezos) in the past, though, it was surprising to not see him get more on board with the purchase, lifting Berkshire's stake above the $1 billion mark that most often reflects holdings that he is wholeheartedly behind. While the insurer did commit an estimated $800 million to the purchase of 483,300 shares of the Internet retailer, it ended up falling short of the threshold for the top 10 (and top 25) new-money purchases list(s) this time around, as it was not quite large enough of a position relative to the massive size of Berkshire's equity portfolio (worth $199 billion at the end of the March quarter).
Top 10 New-Money Purchases by Our Ultimate Stock-Pickers
- source: Morningstar Analysts
That said, our research does indicate that Amazon's shares are currently trading at a meaningful discount to their fair value estimate, which may justify further attention from long-term investors. Morningstar analyst R.J. Hottovy contends that even though Amazon's disruption of the retail industry is well documented, the company continues to find ways to evolve its business model. Hottovy thinks that the firm's combination of competitive pricing, unparalleled logistics capabilities and speed, and high-level customer service makes it an increasingly vital distribution channel for consumer brands. Hottovy believes Amazon has one of the wider economic moats in the consumer sector and is likely to reshape retail, digital media, enterprise software, and other categories for many years to come.
Key top-line metrics, such as active users (with a 12% compound annual growth rate over the past five years), total physical and digital units sold (23% CAGR), and third-party units sold (30% CAGR) continue to outpace global e-commerce trends, which suggests that Amazon is gaining market share. Hottovy has also been impressed by Amazon's margin expansion story in spite of large investments in new fulfillment infrastructure/capacity, content deals, AmazonFresh, hardware (such as the Echo/Alexa-enabled products), new delivery technologies, and physical store expansion. He believes that there is both a defensive and an offensive reasoning behind Amazon's recent move to update its Prime offering from a two-day free shipping program to one day.
From the defensive side of things, Hottovy believes the move will help fend off competitors like Walmart (WMT), Target (TGT), and Best Buy (BBY), which have steadily narrowed the delivery speed gap with Amazon over the past 12-18 months. Offensively, Hottovy expects the expansion to one-day delivery capabilities, which will necessitate $800 million of incremental investment in the second quarter (and additional investments as the year progresses), will create new third-party seller monetization opportunities and unlock new subscription service offerings. While he recognizes that some capital decisions haven't always yielded strong returns, Hottovy expects Amazon will be able to sustain 9%-10% operating margins by 2023, all while continuing to grow the company's top line.
Looking more closely at the three names that piqued our interest this quarter—Booking Holdings, UnitedHealth Group, and FedEx--due primarily to the fact that they continue to trade at meaningful discounts to our analysts' fair value estimates, we saw three of our Ultimate Stock-Pickers-- Diamond Hill Large Cap (DHLAX), Oakmark Equity and Income (OAKBX), and AMG Yacktman (YACKX)—making higher-conviction new-money purchases of narrow-moat Booking Holdings during the period. While these three managers empirically agreed that the stock was undervalued during the first quarter, only the Oakmark Equity and Income provided commentary on why it chose to initiate a position in the name:
“Booking Holdings (formerly known as Priceline) is a pioneer and global leader in the online travel industry. We believe that Booking's strong brands, significant investment expenditures, and scale advantages have given it a formidable network effect. Add to that the company's geographic exposures, revenue mix, and superior online traffic conversion, and it is clear that Booking has one of the best operating models in the industry. Yet share prices fell after the company issued weaker-than-expected quarterly guidance due to rising macroeconomic pressures in Europe and the company's increased investment expenditures. Unlike investors focusing on the very short term, we believe Booking's investment spending will enable the company to exceed average market growth rates for the long term. Factoring in the company's net cash and investments, Booking's stock trades at a discount to the market's P/E ratio, despite the company's superior growth outlook, above-average margin profile, and high returns on incremental capital. Therefore, we find Booking stock an attractive investment opportunity.”
Morningstar analyst Dan Wasiolek has a favorable view of the company's shares at current prices, as well, with the stock currently trading at a nearly 20% discount to his $2,200 per share fair value estimate. Wasiolek expects Booking Holdings' global online travel agency leadership position to expand over the next decade due to its superior position in China, its continued leadership in Europe, and its expanding presence in vacation rentals, restaurant bookings, and attractions. He believes that Booking has built a leading network of hotel properties and other services, which drives an increasing user base and a powerful network effect. Wasiolek points to Booking's size to explain why the company was able to generate a network effect.
For travelers, Booking.com was intriguing because it offered agency bookings, which allowed them to pay after a hotel visit versus having to pay upfront with merchant bookings. This helped drive increased customer traffic, which in turn drove hotel inventory to the website. Wasiolek thinks this created a positive virtuous cycle at a time when no other competitor had begun to build scale in Europe—customers and hoteliers joined, which drove further hotel inventory and customer traffic. He notes that Booking monetized the network by taking a commission on each reservation made through its platform.
Wasiolek anticipates that Booking's size and market position will sustain its network effect. Booking and Expedia (EXPE) each control over 30% of the online travel agency booking market, with the rest of the market being highly fragmented. At this point, Wasiolek believes it would be extremely expensive for any smaller new entrants to gain customer traffic or supplier scale. Any new entrant would need substantial human capital to build relationships with hotels and gather crucial hotel information and photos from those hotel properties. This entrant would also need to spend heavily on advertising to attract customers to the website, and any customers they did get would require IT, data center, and 24/7 customer support services to retain.
Recent evidence suggests that despite a tough macro environment in Europe, Booking's network effect is still intact. Wasiolek estimates that the firm is taking a consistent proportion of each reservation, which indicates to him that Booking has maintained its strong competitive position. Further, the company noted recently that the traffic it generates directly is outpacing traffic from paid sources, a sign in Wasiolek's view that Booking's network is resonating well with travelers.
The second stock that piqued our interest this time around was wide-moat UnitedHealth Group, which saw a high-conviction purchase from Jensen Quality Growth (JENSX) and a conviction new-money purchase from the managers at Markel (MKL). Morningstar analyst Jake Strole believes that adverse headlines created by the public debate around the various "Medicare for All" proposals put forth by some of the Democratic presidential candidates have brought this blue-chip healthcare stock's valuation to a level that is out of line with the company's fundamentals. Strole estimates that there is a relatively low likelihood of widespread industry disruption from these ongoing debates and that the opportunity for private insurers to continue to be part of the solution suggests to him that UnitedHealth is more likely than not to continue earning excess returns well into the future.
The company itself is a combination of the largest private health insurer, a leading ambulatory care and health analytics franchise, and the soon-to-be second-largest pharmacy benefit manager by volume in the United States. While UnitedHealth primarily generates revenue from insurance premiums, it also has a growing health services segment. Strole's current fair value estimate of $300 per share, which is equivalent to around 20 times his 2019 earnings estimate, largely assumes the firm will continue expanding its medical insurance enrollment 2.5% annually the next five years, which should lead to mid-single-digit premium growth, and that the company's health service segment will grow at a low-double-digit clip.
He views UnitedHealth as being well positioned in the healthcare sector broadly, as well as relative to its peers in the managed-care industry, due to its massive scale and the synergies available to its health services segment. Strole thinks this gives the firm sustainable cost advantages and a network effect that should allow UnitedHealth to generate excess returns for an extended period of time.
Strole believes UnitedHealth's unmatched scale and scope supports his cost advantage argument. He thinks the firm's massive insured population (approximately 14% of the total U.S. insured population) allows for greater centralized fixed-cost leverage. In his view, the combination of UnitedHealth's insurance operations with one of the largest pharmacy benefit managers and outpatient service providers in the country has created opportunities for sizable cost benefits because it allows the firm to target a lower margin on its insurance book to secure strong enrollment while making up for lost profitability through cross-selling newly insured groups on its pharmacy benefit program.
He also asserts that UnitedHealth's larger membership base allows for greater negotiating leverage, leading to lower medical costs per member and the opportunity to lower premiums or improve its benefits offering to secure enrollment growth. UnitedHealth's lowest-among-peers per-member rate of medical claims paid suggests to Strole that its membership base has already given it sizable leverage over the healthcare providers with which it contracts. He also believes that synergies with its health services segment, Optum, contribute to the firm's overall cost advantage.
As for the company's network effect, Strole believes that a plan network like UnitedHealth's becomes more valuable to patients, payers, and providers with increased enrollment. For patients, Strole argues that as a plan's negotiating leverage expands, either premiums become relatively more affordable or the plan invests in a broader swath of benefits for its members. For payers, expanding enrollment allows for greater per-member profitability and a more attractive offering, either through better pricing or a more enticing benefits package. And for providers, participating in an expanding plan network provides access to greater patient volume, a key component of profitability in a business with high fixed costs over the short run. Altogether, Strole believes that these three dynamics create barriers to entry for would-be competitors, as putting together an attractively priced provider network in a new geography is prohibitively difficult without the membership pool and vice versa.
The third and final stock that caught our attention this quarter was narrow-moat rated FedEx. Two of our Ultimate Stock-Pickers-- Dodge & Cox Stock (DODGX) and Columbia Dividend Income (LBSAX)--made additional high-conviction purchases of the logistics firm during the period, but neither offered up explanations for the uptick in ownership. Morningstar analyst Keith Schoonmaker currently has a $202 per share fair value estimate on the name, leaving it firmly in "consider buy" territory based on the margin of safety required by his medium uncertainty rating. Schoonmaker believes FedEx has built an international shipping network that would be difficult and costly to duplicate due to stiff barriers to entry and awards the company a narrow moat rating based on cost advantage, efficient scale, and network effect moat sources.
He views FedEx's domestic parcel shipping business favorably, believing that the company reaps the rewards of rational pricing provided by an oligopoly with wide-moat rated United Parcel Service. Schoonmaker thinks that any new entrant would need to commit extensive resources to capture critical volume from the entrenched players, considering the prohibitively high cost of replicating their networks of planes, trucks, sorting sites, rights to fly, and skilled employees. He highlights DHL's decade-long attempt during the 2000s to enter the domestic U.S. parcel delivery market to demonstrate the steep barriers that exist. Even after massive investment, DHL lost nearly $1 billion on its U.S. operations in 2007, and the company finally quit the market in 2009 after it determined the incumbent duopoly was too powerful to challenge without extended losses. While Schoonmaker notes that there are some potential headwinds coming from shippers performing their own fulfillment, he expects the ongoing secular growth of e-commerce to provide a long runway for continued U.S. ground growth for FedEx.
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Disclosure: As of the publication of this article, Burkett Huey has ownership interests in Berkshire Hathaway and Amazon.com. 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: AMZN. Find out about Morningstar’s editorial policies.