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Market Update

7 Stocks Top Managers Have Been Buying

Susan Dziubinski

During the past two weeks, volatility has crashed what had been a pretty placid stock market party. The rout was so pronounced that the media began reporting on the ups and downs of stocks. And that dire-sounding terminology we hadn't seen in the financial press in awhile--doom and gloom, market swoon, volatility plagues the market--resurfaced.

But market volatility isn't necessarily a "plague," as some would suggest. Of course, stock market uncertainty can be unsettling, but it can also be a stock-picker's friend, bringing down the prices of great companies.

Given the market's recent gyrations, it's a good time to see what some of our favorite managers have been buying. Today, we're checking up on a trio of Medalist managers who invest in large companies, sharing their new purchases from the fourth quarter. These might be new ideas to research further, or to simply put on a watchlist. If these stocks aren't in your buying range today, they may be tomorrow.

Bill Nygren and Kevin Grant, comanagers of Gold-rated Oakmark (OAKMX), look for companies that boast solid balance sheets and are led by smart capital allocators, and whose shares are trading at a deep discount to the pair’s estimate of private-market value. The duo took new positions in American Airlines (AAL), CVS Health (CVS), and Priceline Group (PCLN) in the fourth quarter.

In their latest commentary, Nygren and Grant admit that they haven't been fans of airlines in the past: The majors lacked pricing power and had poor corporate cultures. Recently, though, they think the industry has "become more mature and disciplined."

"American Airlines CEO Doug Parker sees substantial opportunity to grow value as the company completes the US Airways merger integration," they note. "He is improving the company's culture and restoring credibility with employees. Parker believes that American Airlines has around $5 billion of pretax earnings power, which is up 50% from our 2017 estimate, and he has bought back 37% of the company's shares since the merger closed. With the stock selling for a single-digit multiple of normal earnings power, we believe American Airlines is an attractive investment."

American is trading in 3-star range as of this writing, suggesting that shares are fairly valued according to Morningstar's metrics. In his latest report, senior equity analyst Chris Higgins notes that 2018 will be a key test for American specifically and the industry in general, because for the first time in a long while, a network carrier (in this case,  United Continental (UAL)) plans to increase capacity. Higgins points out that American continues to lead the industry in unit revenue growth and expects to expand capacity by 3% this year.

"American Airlines management is betting that a newer fleet, a more aggressive balance sheet, and ongoing cabin segmentation will position the company for competitive success against its network peers and enable it to compete more effectively with ultralow-cost carriers," says Higgins. "While we believe things have changed in the airline industry and American is better positioned, capacity growth still matters, and holding the line on pricing will be a challenge."

Nygren and Grant also scooped up CVS during 2017's fourth quarter.

"CVS is well positioned in a U.S. healthcare system that rewards scale, as the company owns the nation's largest pharmacy benefit manager, the largest retail pharmacy and the largest retail clinic," they say. "Both the PBM and retail pharmacy segments are as concentrated as they have ever been, and we believe these lines of business protect existing players and pose serious challenges for new entrants." 

Moreover, the pending acquisition of Aetna would only add to the company's "broad suite of assets through which to address sector-wide trends."

They think the market is underestimating the company's competitive advantages across multiple end markets. Morningstar senior equity analyst Vishnu Lekraj agrees. Morningstar assigns CVS a wide economic moat and a stable moat trend; shares currently trade in 4-star range, suggesting that they're undervalued.

"We believe CVS is a premier healthcare services player that possesses a wide economic moat," says Lekraj in his latest company report. "The firm's substantial claim volume gives it the opportunity to take advantage of two key industry drivers: supplier pricing leverage and centralized cost scale."

But what to make of the  Amazon.com (AMZN) - Berkshire Hathaway (BRK.A) (BRK.B) JPMorgan Chase (JPM) entry into the field?

"While there could be some potential given the capital and clout of the three partners, we believe certain investors are underappreciating the moaty nature of the healthcare supply chain and the formidable competitive advantages that have insulated its major players," says Lekraj. "All potential new competitors would face significant headwinds trying to break into any vertical along the chain because the dynamics of the healthcare market are very difficult to navigate." (Lekraj has more about the impact of the new partnership on healthcare.)

Lastly, Nygren and Grant checked into Priceline in the fourth quarter. They like the online travel giant's extremely high returns on capital, strong margin profile, and superior growth outlook.

"Priceline's strong brands, significant investment expenditure and scale advantages should further enhance the company's powerful network effect," they argue. "In addition, its geographic exposure, revenue mix and superior online traffic conversion make it one of the best operating models in the industry."

Morningstar assigns Priceline a narrow economic moat and a positive moat trend.

"We expect Priceline's global online travel agency leadership position to expand over the next decade, driven by a superior position in China, continued leadership in Europe, and an expanding presence in vacation rentals and restaurant bookings, all of which are backed by leading marketing and technology scale," writes Morningstar senior equity analyst Dan Wasiolek in his latest company report. The company's size and market position will sustain its network effect, he says.

As of this writing, shares are trading in 3-star range, suggesting that they're fairly valued.

Veteran manager Phil Davidson leads the team at Silver-rated American Century Equity Income (TWEIX), focusing on dividend-paying stocks with healthy balance sheets. During the fourth quarter, they picked up shares of Pfizer (PFE).

"We initiated a position in Pfizer this quarter due to its attractive valuation, diversified product portfolio, and continued execution on new product launches," wrote the team in its latest commentary. "Additionally, the company should benefit from new U.S. tax regulations."

The drugmaker earns a wide economic moat rating from Morningstar with a stable moat trend; shares are currently trading in 4-star range, suggesting they're undervalued.

"Pfizer's foundation remains solid, based on strong cash flows generated from a basket of diverse drugs," says sector director Damien Conover in his latest report. "The company's large size confers significant competitive advantages in developing new drugs. This unmatched heft, combined with a broad portfolio of patent-protected drugs, has helped Pfizer build a wide economic moat around its business."

Conover expects 2% annual sales growth over the next three years as new drugs offset generic competition and an annual 10% growth rate on the bottom line as cost-cutting plans and share buybacks are introduced.

The team steering the Gold-rated Diamond Hill Large Cap (DHLRX), led by veteran manager Chuck Bath, takes a classic value approach, buying companies when their market prices are lower than the team's estimates of their intrinsic business values. Bath and team picked up shares of Fastenal (FAST), United Continental, and Devon Energy (DVN) during the fourth quarter.

Fastenal is one of the largest industrial distributors in the United States.

"The company has a unique service-oriented culture and we believe it is poised to gain meaningful market share over the next five years via its onsite and industrial vending growth initiatives," says the team in its latest commentary.

Though fairly valued at this time according to Morningstar's metrics, Fastenal earns a wide economic moat rating and a stable moat trend, thanks to its superior scale and ability to monetize its large network of customers and suppliers.

"Fastenal's vending and on-site solutions have become the firm's primary growth drivers," writes Morningstar analyst Brian Bernard in his latest report, "and if Fastenal can maintain its growth momentum in these platforms and defend operating margins, we expect the firm will continue to generate double-digit sales and earnings growth over the next few years."

United attracted Bath and his team with its improving operating performance.

"We believe it is in a good position to improve margins over the next few years via revenue and cost initiatives," they note. "Free cash flow generation should increase as capital expenditures decline from current peak levels, and the company recently announced an incremental $3 billion share repurchase authorization."

Although United's shares are trading at a 20% discount to Morningstar's fair value estimate as of this writing, they're no screaming bargain, given the very high uncertainty on the stock, stemming from continuous pricing pressures and low switching costs, and the cyclical nature of the industry and its high fixed costs. Adjusting for that very high uncertainty, shares earn a 3-star rating as of this writing, suggesting they’re fairly valued. (See how Morningstar calculates its fair value estimates and uncertainty ratings.)

"While we like management's hub optimization strategy, we think United still has a long row to hoe to right its operations and these fixes will likely entail near-term pain in the form of rapid capacity growth, which we think will hit unit revenue growth," says Higgins in his latest report. "Over the longer term we do think that United's new management team under CEO Oscar Munoz will right the ship and that the consolidated airline industry will remain profitable over the full cycle."

Oil and gas exploration and production company Devon Energy rounded out Diamond Hill Large Cap's fourth-quarter purchases. The team likes the firm's capital investment strategy and its potential divestiture program, which would focus the business around its most appealing core assets.

"We believe Devon holds an attractive, scalable acreage position in both the Delaware Basin and the Anadarko Basin that should drive meaningful improvement in return on invested capital over time," say Bath and his colleagues.

Morningstar analysts don't actively cover Devon. Based on Morningstar's quantitative valuation algorithm, however, shares are trading in 3-star range and are fairly valued. Here's more about Morningstar's quantitative ratings for stocks.

Susan Dziubinski does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.