Our Ultimate Stock-Pickers’ Top 10 Buys and Sells
Managers continue to buy wide-moat stocks.
For the past decade, our primary goal with Ultimate Stock-Pickers 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 investment managers: 22 managers oversee mutual funds covered by Morningstar’s manager research group and four Stock-Pickers run the investment portfolios of large insurance companies. As holdings data becomes 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 our early read on our Ultimate Stock-Pickers' purchasing activity during the fourth quarter of 2019. The piece itself was an early read on individual purchases--focused on high-conviction and new-money buys--that were made during the period, based on the holdings of almost all our top managers. As all our Ultimate Stock-Pickers have reported their holdings for the period, we think that it is appropriate to now examine our managers' high-conviction purchases and sales in aggregate. As stock prices have changed since our Ultimate Stock-Pickers chose to purchase or sell the holding, we urge investors to analyze securities at current valuation levels before making any investment decisions and provide our fair value estimates, moat ratings, stewardship ratings, and uncertainty ratings to help investors along the way.
We were not surprised to see a continuation of a long-standing trend of net selling by our Ultimate Stock-Pickers. We think that this trend may be due the shift toward passive products. Despite the net selling, our Ultimate Stock-Pickers still made several high-conviction purchases as well as sales.
Our Ultimate Stock-Pickers continued their long-standing trend of buying, selling, and holding high-quality companies that Morningstar believes have developed sustainable competitive advantages. Morningstar's analysis shows that all the top 10 high-conviction holdings have either a narrow or wide economic moat and that eight of the top 10 conviction holdings have a wide economic moat. Additionally, nine of the 10 companies composing the top 10 high-conviction purchases and high-conviction sales lists have been granted either a narrow or wide economic moat by Morningstar analysts.
From a sector allocation perspective, our Ultimate Stock-Pickers are taking about as active of a stance as they were last quarter. The Ultimate Stock-Pickers remain meaningfully underweight in the real estate, utilities, energy, and communication services sectors. The favorable shift toward the consumer sector has continued, with our managers overtaking the S&P 500 in this arena. The Ultimate Stock-Pickers remain meaningfully overweight in the industrials, financial services, consumer cyclical, consumer defensive, and basic materials sectors, and are now slightly underweight in the technology sector.
As many of the Ultimate Stock-Pickers are long-term investors, we were not surprised to see that the composition of our top 10 conviction stock holdings was largely the same as the prior quarter, with the only change being the replacement of MasterCard MA with UnitedHealth Group UNH. We noticed that the relative ordering of the top 10 stock holdings changed somewhat, with Bank of America and Johnson & Johnson moving up the list, while Comcast CMCSA, Berkshire Hathaway BRK.B, and JPMorgan Chase JPM moved down the list. Our Ultimate Stock-Pickers continue to hold companies from the financial services sector with conviction, contributing four stocks to our list. We think that most of the top 10 conviction holdings list is undervalued, with a few notable exceptions. Our research indicates that wide-moat rated JPMorgan Chase and wide-moat Johnson & Johnson JNJ are fairly valued, while narrow-moat Apple AAPL is overvalued. As Wells Fargo WFC has maintained its position on the top 10 conviction holdings list for quite some time, we believe it is worthwhile to discuss the company's performance and take a closer look at Morningstar analyst Eric Compton's outlook on the bank.
As stated, one company on the top 10 stock holding list that is within our coverage universe is wide-moat Wells Fargo, currently held by 12 funds. One of the biggest financial services firms in the United States, the bank is finally starting to pull itself out of years of scandal. This medium uncertainly stock currently trades at about a 25% discount to Morningstar analyst Eric Compton's fair value estimate of $56.
Compton argues that Wells Fargo has built sustainable economic advantages as a result of cost advantages and customer switching costs. Wells Fargo is not only one of the largest U.S.-based banks by assets, it also leads in market share and operations in key competitive areas. The bank has the largest retail branch network in the U.S, making it one of the top deposit gatherers nationwide. In addition, the bank maintains top-level share in debit cards, middle-market commercial banking services, and asset and wealth management operations. Moreover, Wells Fargo faces the lowest surcharge for being a global systemically important bank among the big four.
Wells Fargo is able to enjoy cost advantages as a result of conservative underwriting practices and decent operating efficiency. During the 2008 crises, the bank was less exposed to the riskiest mortgage products and was much less reliant on trading and capital markets as a source of income. Even though it did acquire distressed Wachovia, it still outperformed its peers during that time. Compton argues that the bank's history of risk management and respectable underwriting practices (which it has maintained over time) have helped advantage the bank.
Wells Fargo also historically demonstrated operating efficiency that was in line if not better than its peers, in spite of certain segments weighing down the ratio. Although the bank has recently been hit by legal charges, and the expense base has become bloated, Compton highlights that the legal charges will eventually cease and Wells will eventually be able to more fully concentrate on improving its underlying operational efficiency. This will bring the Wells Fargo back to a normalized operating position. Furthermore, as technology becomes more and more integrated within the banking system, Wells Fargo's large tech budget will enable it to grow investment while maintaining efficiency. Compton also points to the bank's better mix of fee income, which protects it against interest rate cuts, especially when compared with smaller regional banks. Compton acknowledges that while Wells Fargo has attractive deposit market share, its historical deposit cost advantage has declined over time.
There are additional switching costs as the bank's scale in certain businesses, accompanied by its diverse product offerings, allow it to generate economies of scale and economies of scope as it integrates its product offerings and sells them across their client base. Wells Fargo is able to offer a wide range of capabilities, ranging from investing, banking, and advisory, all to the same clients. The bank's scale will also allow it to continue to invest more in technology and enable access to unique client data, augmenting long run competitive advantages.
Recently, Wells Fargo finally reached a settlement with the Securities and Exchange Commission (SEC) and the Department of Justice (DOJ), including $3 billion in payments. Compton sees this as good news, as the last major regulatory probes into the bank over its previous sales practices may finally be winding down. Of course, the asset cap still remains, but once the asset cap on Wells Fargo is also removed, Compton argues that the company can revert its focus back to improving its core underlying operations. Though there might still be some hurdles ahead, this settlement is an excellent step in the right direction for the bank.
Wide-moat rated Charles Schwab currently trades at around a 15% discount to Morningstar analyst Michael Wong's fair value estimate of $49. The company is part of an industry that has recently garnered much media attention, initially as a result of Schwab's decision to slash trading fee commissions (this move was then replicated by its peers) and now due to the massive consolidation taking place among firms.
Wong argues that Charles Schwab exhibits industry-leading cost efficiency as a result of its enormous scale, which enables the company to sustain itself in a highly competitive environment. This was demonstrated last year, as it managed to generate excess returns in spite of trading fees bottoming out at $0.
Charles Schwab is one of the largest U.S. companies that conducts business in securities trading and wealth management, demonstrated by its client asset base of over $3 trillion. The firm's expense base is less than 20 basis points of costs per dollar of client assets, demonstrating its cost advantage in comparison with peers. Moreover, the company's big client base and lower costs enable the development of superior products compared with its peers. Wong cites Schwab's exchange-traded product line as an example, which is now a part of the top 10 biggest exchange-traded fund firms. Even though Schwab was late to arrive on the scene, its rapid rise in this arena is demonstrative of its ability to scale and generate a cost advantage. Its new online advisory platform will also serve to benefit the company with its wide net of clients and relatively low costs paving the path toward higher profitability.
Schwab's enormous scale on the banking side is evident with its $200 billion of deposits. The firm enjoys lower operating costs as a result of synergies with the brokerage segment. Additionally, a large portion of the banking portfolio is in low-risk agency mortgage-backed securities, with lending activities mainly catering particularly to more well-off company clients. These play a role in lowering credit costs, as well.
Alongside its cost advantages, we consider Charles Schwab's brand an intangible asset. We also believe the firm enjoys, at least to some extent, a network effect between its investment product manufacturers and sizable client base. Schwab's proprietary products and advice solutions maintain a decent proportion of client assets and are highly profitable, though they are not a material source of revenue compared to some other products the company offers. Moreover, the commission-free trading product platform adds value for both investment product manufacturers and clients, thus creating value for Schwab as well. The wealth management client base is also quite large, which enables Charles Schwab to provide additional benefits to affiliated companies. As a final note, Wong points out that even though its brand and network add value for Schwab, its scale-based cost advantage remains the company's greatest source of competitive advantage.
A key topic of interest remains Charles Schwab's impending merger with TD Ameritrade AMTD, which was first announced in November 2019 and is due to be completed in the latter portion of 2020. Wong estimates a 75% probability of the merger going through as any antitrust concerns in the online retail brokerage space can be mitigated by the inherently competitive nature of the industry. Even though the two firms' Registered Independent Advisor businesses will have a very large asset market share, the presence of a wide variety of wealth management firms combined with a much smaller portion of assets in the wealth management space will likely keep the two firms safe from antitrust issues.
While E-Trade ETFC was once a viable acquisition target for Charles Schwab in the event that the deal with TD Ameritrade falls through, Morgan Stanley's acquisition of the company has taken away this back-up plan for Schwab. Even so, further consolidation in the industry is beneficial for Charles Schwab, as it blurs business lines, indicates the competitiveness of the investment services industry, and paves the way for future opportunities.
The Top 10 Ultimate Stock-Pickers conviction sales list contains some new names in comparison to the previous quarter. Four of the conviction sales are also conviction holdings—wide-moat Microsoft MSFT, wide-moat Berkshire Hathaway, wide-moat Bank of America BAC, and wide-moat JPMorgan Chase & Co appear on both lists. Much of the selling activity came from the financial services sector, which contributed five names to the conviction sales list. Three of the 10 names on this list are overvalued according to Morningstar estimates, with only one of them being meaningfully overvalued. It is interesting to note the large number of undervalued names on this list, though that is not entirely surprising given the recent market sell-off stoked by fear of the economic impact of the coronavirus. One such name is no-moat rated BlackBerry BB, which trades at about a 30% discount to Morningstar analysts Mark Cash's fair value estimate of $7.60.
While BlackBerry was once known for its phones, the company is now in the business of selling applications of the Internet of Things. The Enterprise Mobility Suite, one of the company's core products, is a unified endpoint management solution that provides enterprises with the ability to view and control access to their network applications and devices using a simple interface. BlackBerry also provides embedded software such as QNX to power infotainment products and ADAS to assist drivers.
One key company focus is security, particularly providing end-to-end secured enterprise communication, which has been a key part of BlackBerry's business model for some time now. While the past few years have been difficult from a revenue perspective, the company expects 2020 to be its first full year of sustained growth in revenue. This will be in part due to a successful pivot toward the software model, which was driven by acquisitions over the last few years.
Even though Cash doesn’t see BlackBerry as moat-worthy, the recent acquisition of Cylance in 2018 will help the company increase product stickiness and thus improve the reach of the company's end-to-end capabilities. While BlackBerry will focus on growing organically in the short term, Cash posits that inorganic growth will continue to be one of the company's goals, particularly in the autonomous vehicles space.
The sell-off of undervalued stocks is not a surprise given the current economic and social climate. With coronavirus concerns growing as the virus spreads around the world, stock markets have been falling and have reached correction territory. Furthermore, software companies have faced supply chain disruptions as a result of the virus, with most of them producing goods in Asia. BlackBerry in particular has its own problems; the firm isn't as well established as giant industry players such as VMWare and Microsoft, making it a difficult environment from a competitive perspective. The company is also a high uncertainty name, and in today's climate, investors are more likely to lean toward safer stocks.
If you're interested in receiving email alerts about upcoming articles from The Ultimate Stock-Pickers Team, please sign up here.
Disclosure: Nupur Balain and Eric Compton have 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.
Eric Compton does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.