Our Ultimate Stock-Pickers' Top 10 High-Conviction Purchases
Several funds see value in communication services and technology.
Several funds see value in communication services and technology.
For roughly the past 10 years, 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 value. 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 good ideas each quarter that will be of interest to investors. With 24 of our Ultimate Stock-Pickers having reported their holdings for the fourth quarter of 2021, we now have a good sense of the stocks that piqued their interest during the period.
Recall that when we look at our Ultimate Stock-Pickers' buying activity, we concentrate 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 portfolio's size. 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' decisions 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 a multitude of factors, including our valuation estimates along with our moat, stewardship, and uncertainty ratings.
Despite earlier headwinds created by COVID-19, people and the markets slowly resumed prepandemic activities due to the largely successful vaccine rollout in the United States. The overall market recovery from mid-2020 led to many countries benefiting from supply chain bottlenecks easing, consumer spending bouncing back, and government action mitigating the economic impact. While the U.S. Federal Reserve has maintained the federal-funds rate to 0.00%-0.25%, we expect the Federal Reserve to implement a series of rate hikes to combat the rising inflation rates. The U.S. government needs to maintain economic growth, sustain vaccine rollout, observe new COVID-19 variants, and balance rising rates as inflation is at its highest rate in four decades. Regarding COVID-19, the U.S. government has taken many drastic measures since then to cushion the blow on the economy, including stimulus programs for consumers, unemployment benefits, easing pressures on debt markets, and establishing the PPP facility to help small businesses. With a democrat in the Oval Office, we could expect these measures to continue as the U.S. economy readies itself for a comeback. Similar programs have been implemented across Europe and Asia as countries seek to boost their economies. With anticipated rate hikes to fight inflation and continued vaccine rollout, our Ultimate Stock-Pickers have managed to find value in individual stocks during a period of volatility and uncertainty. These stocks are in a wide range of sectors such as technology, communication services, real estate, and healthcare.
In the top 10 high-conviction purchases list, the buying activity heavily leaned toward technology but also included real estate and healthcare. Most companies in the high-conviction purchases list received a narrow economic moat rating from Morningstar analysts, keeping in line with trends we have witnessed over the past several years. The three names we find most interesting on the high-conviction purchases and new-money lists are narrow-moat rated Fiserv (FISV), narrow-moat rated Becton, Dickson & Co. (BDX), and narrow-moat rated Activision Blizzard (ATVI). According to our Morningstar analysts, all three companies are trading at a discount to their fair value estimates.
There was a moderate amount of crossover between our two top 10 lists this period, with six names appearing on both lists. This quarter, many stocks received two high-conviction purchases from our Ultimate Stock-Pickers. These names include Mastercard (MA), Apple (AAPL), and Abbvie (ABBV). Mastercard particularly stands out as it was listed on both lists and was at the top of new-money purchases with three funds buying. All these companies have economic moats according to Morningstar research, which indicates that money managers place an emphasis toward blue-chip stocks such as these in a period of uncertainty.
Narrow-moat Fiserv particularly stood out for us as it attracted three high-conviction purchases, the highest out of all listed companies, to round off the fourth quarter of 2021. Fiserv currently trades at $94, a discount to Morningstar analyst Brett Horn’s fair value estimate of $121.
Fiserv is a leading provider of core processing and complementary services, such as electronic funds transfer, payment processing, and loan processing, for U.S. banks and credit unions, primarily focused on small and midsize banks. After merging with First Data in 2019, Fiserv now provides payment processing services for merchants and has 10% of its revenue generated internationally. First Data should boost overall long-term growth and help Fiserv adjust to a changing industry with initiatives like Clover, a small-business solution similar to Square’s offerings.
According to Horn, the acquiring business is significantly more macro-sensitive than Fiserv’s legacy operations. But payment volume has steadily improved and returned to year-over-year growth. Unless the pandemic takes a sharp negative turn, the long-term secular tailwind appears to be reasserting itself, and the worst seems to be past the industry.
According to Morningstar analysis, in the longer term, we expect the payments side to be the strongest engine of growth for Fiserv and expect First Data to maintain the momentum it had built before the merger. We expect more modest growth for the bank technology side of the business, given Fiserv’s strong market position and the mature nature of the banking industry. Horn emphasizes that the net effect will be a revenue compound annual growth rate of 7% over the next five years and operating margins that improve significantly over time—increasing from 9% in 2020 to 28% by 2025. The increase is due to depressed margins in 2020, the result of the sizable synergies from the First Data merger and a falloff in amortization expense over time. Excluding those factors, we don’t expect much underlying margin improvement, as we believe the reinvestment needs of the business will offset its inherent scalability for the foreseeable future.
Horn’s narrow moat rating for Fiserv reflects the company’s expansion efforts and sticky customer relationships. Fiserv’s core processing systems make up about 20% of revenue. Core processing is the nuts-and-bolts system that banks need to maintain their deposit and loan accounts and to post daily transactions. Given the integral nature of core processing to their operations, banks very rarely switch systems. Customers typically sign multi-year contracts, and customer retention approaches 99% annually. Fiserv’s leading market share also provides an edge in this scalable business.
Two of our money managers made high-conviction new-money purchases of Becton, Dickson, a wide-moat medical technology company, currently trading at a discount to Morningstar analyst Alex Morozov's fair value estimate of $306.
In Morozov’s view, BD is the world's largest manufacturer and distributor of medical-surgical products, such as needles, syringes, and sharps-disposal units. The company also manufactures diagnostic instruments and reagents, flow cytometry, and cell imaging systems. Morozov notes the pandemic has made it difficult for the company due to the volatile COVID-19-induced hospital admissions. The slowdown in admissions hit the firm's surgery and vascular business particularly hard. According to Morningstar analysis, the peripheral artery disease business as a very attractive opportunity for BD. Further, as hospital admissions recover, we should see a material bounce in the rest of the business lines that sagged during the pandemic. Assuming, of course, we don't see another massive infection wave.
Morozov shares that some uncertainty resides in BD’s pump infusion system (Alaris). The FDA recalled Alaris in 2020, creating a blemish on the company’s previously clean execution track record. However, BD has benefited from the pandemic-driven demand. The company stands to benefit modestly from testing as well as vaccine-related syringe demand.
According to his analysis, Morozov highlights the significant investment into R&D in BD’s medical device business. Morozov notes the firm's pipeline is the strongest it's been in a long time. The firm is also expanding its presence in informatics, which historically hasn't been its core focus. Device interconnectivity is an important pillar of BD's new strategy, in which it aims to control a larger portion of the care continuum. Disease management, particularly in areas like diabetes where BD has always been strong, is an attractive opportunity, both in the developed world and in emerging markets.
Morozov believes that BD possesses a narrow economic moat stemming from switching costs. The foundation of BD's moat is its manufacturing scale in the basic surgical products segment, which accounts for more than half of its business. The company is the largest manufacturer of needles/syringes; competition can't match BD's scale, making competing on price very difficult. That said, the company is not entirely a price-setter, as the business is very commodity-like, so the pricing increases are primarily achieved through product mix (decreases on mature lines offset by higher pricing on new product introductions). BD's diagnostic business is squarely in the narrow-moat bucket—its robust installed base, responsible for steady recurring revenue, provides a switching cost defense against new entrants.
Our Ultimate Stock-Pickers also made two high-conviction purchases in narrow-moat Activision Blizzard, one of the world's largest video game publishers. Activision Blizzard currently trades at a discount to Morningstar analyst Neil Macker’s fair value estimate of $92.
According to Macker, Activision Blizzard is one of the world's largest third-party video game publishers and owns some of the largest and most well-known video game franchises. Activision's impressive franchise portfolio includes World of Warcraft, which boasts more than $8 billion of lifetime sales, and Call of Duty, which has sold over 175 million copies across 14 titles over 12 years.
Activision’s strategy focuses on engaging users beyond the initial game sale via extending the monetization window by expanding the use of multiplayer options and releasing downloadable content. Both methods encourage gamers to hold on to the original game longer than previous generations and provide an income stream from consumers who purchase the game secondhand. Activision has used DLC and multiplayer to extend the life of multi-billion-dollar franchises such as Call of Duty, and we believe franchises like Hearthstone and Overwatch can also sustain long-term success.
In January of this year, Microsoft (MSFT) announced that it plans to acquire Activision Blizzard for $68.7 billion or $95 per share in cash. Macker mentions that we expect regulators will heavily scrutinize the deal, given the recent anti-Big Tech fervor on both sides of the aisle in Washington. Microsoft expects the acquisition won’t close until fiscal 2023 (ending June), implying that it agrees with our view on the level of regulatory oversight. From a larger video game industry perspective, the deal signals that Microsoft increasingly believes that Game Pass and its cloud streaming add-on will be the path forward as it competes against Sony and Nintendo on the console side and Steam and Epic in the PC market. The addition of Call of Duty to Game Pass will make the service a must-have for any Xbox console owner and could help turn the tide against PlayStation in many non-U.S. markets where the previous generations of Xbox consoles have struggled to gain a foothold. Game Pass already has over 25 million subscribers, and the addition of the Activision Blizzard catalog should supercharge subscriber growth.
On the competitive advantage front, Macker assigns Activision a narrow economic moat rating, thanks to its lucrative gaming portfolio and its ability to adapt to numerous changes in the video game industry. Its portfolio of widely successful franchises allows the firm to monetize its intellectual property year after year by delivering content via sequels, expansion packs, downloadable content, and toys, exemplified by the decade-old World of Warcraft franchise and the annual versions of Call of Duty. These franchises can also spawn games that move the company into new areas such as F2P (Hearthstone from WoW) and mobile (Call of Duty Mobile). The company's franchises have a dedicated user base, providing Activision with the leverage to push more of its games via direct digital channels, thus bypassing retailers, generating higher gross margins, and improving returns on invested capital.
Disclosure: Eden Alemayehu, Justin Pan, and Eric Compton have 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.
Eden Alemayehu does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.