Conflicting Moves Among the Ultimate Stock-Pickers

By Drew Woodbury | Associate Stock Analyst

As we noted in one of our articles last week, the fourth quarter of 2008 and the first couple of months of this year posed a significant challenge to most investors--including the top managers we monitor at Ultimate Stock-Pickers. Many were actively buying and selling securities, either adding to (or subtracting from) existing positions or taking advantage of the market weakness to build positions in new names. One of the stranger dynamics of the period, though, was that some managers were actually buying securities that others were actively selling.

Within our roster of 25 top managers are what we consider to be some of the smartest and savviest investors out there. Despite having many things in common--like a strong track record of performance, a dedication to fundamental research, and a commitment to their investment strategies, not all of these managers think alike. One of the interesting things about markets is that conflicting opinions and perspectives rise to the surface every day. For two parties to consummate a stock transaction there must be two conflicting points of view: one that generates a buy decision and one that leads an investor to sell. The buyer thinks the price is going to go up, while the seller believes the price is going to decline. While this statement is perhaps a bit too simple--with factors like portfolio considerations, risk management, and/or liquidity needs offering up alternate reasons for stock transactions--it is more often than not the simplest reason.

Screening for Stocks Both Bought and Sold
Sifting through the holdings and transactions of the managers on our Investment Manager Roster, we went looking for instances where four or more of them were buying a particular security at the same time that three or more were selling. In this case, unlike what we've done with our lists of top purchases and top sales, we're not focused on transactions done with conviction, just the absolute number of managers that were both buying and selling the same security. The result of the screen was the following four securities:  3M (MMM),  Johnson & Johnson (JNJ),  Procter & Gamble (PG), and  Pfizer (PFE).

So, why would four or more managers buy these four stocks, while three or more different managers were in the process of selling them? Although the answers to this question are probably varied and, in reality, difficult to decipher for certain, we can examine some of the possibilities that might have led to these transactions and come to conclusions about what the trades mean.

Market Conditions May Have Influenced Trades
The first, and probably most important, thing to remember is the time period that we are examining. The fourth quarter of 2008 was one of the worst quarters in the history of the U.S. stock market, as the S&P 500 Index (SPX) declined 22% in the last three months of the year. And, unfortunately, things did not really improve much during the first few months of 2009, with the market declining another 20% in value. This unique and dramatic market decline surprised many people, and led many investors to rush for the exits. According to Morningstar FundFlow data, nearly $180 billion was withdrawn from mutual funds in the fourth quarter alone. The pace of redemptions had an impact on investment managers' decisions and only compounded the large portfolio losses being caused by the market decline. As investors withdrew from mutual funds, many funds were forced to sell securities in order to raise cash to meet the redemption requests. Forced selling only magnified the stock market downturn, and on and on the cycle continued.

With that in mind, it would be easy to assume that the short-term liquidity needs created by the increase in redemptions caused some managers to sell the stocks we highlighted above, even as other managers found them trading at compelling enough valuations to purchase. The selling managers may have found that these four stocks were the best ones to unload, given that they had fallen in value much less than the market overall, rather than selling some of their losers, which they might have felt would eventually bounce back. It is also just as likely that some managers were selling these names in order to raise capital to put to work in downtrodden securities at the height of the market collapse. We thought as much when we recently looked at Berkshire Hathaway's (BRK.A) (BRK.B) sale of half its stake in Johnson & Johnson and 10% of its position in Procter & Gamble.

Looking at the Potential Difference of Opinion on 3M
Whatever the reason for the sales, there was still a difference of opinion that led four or more managers to buy the same four securities--3M, Johnson & Johnson, Procter & Gamble, and Pfizer--that three or more of their peers were selling. The simplest explanation could be that the buyers of these companies believed them to be good investments, with the prices of the stocks likely to go up, while the sellers were of the opposite belief. The managers could have had different fundamental opinions about the companies, given the shift in the markets and the prospect for a global economic slowdown, or they could have simply had much different time horizons for their investments.

To put color on some of the factors that could have led to fundamental differences of opinion on one of these securities, we've taken a deeper look at the bull and bear cases for 3M, hoping to glean more insight into what drove managers to either buy or sell the stock.

Bears Say: 3M, like many U.S. companies, has faced some significant economic headwinds, especially in the fourth quarter of last year. As 3M derives nearly two thirds of its revenues from overseas, its results were also hit by a slowing global economy, as well as the appreciation of the U.S. dollar against many other major currencies. With a sharp drop-off in year-over-year volumes coupled with unfavorable foreign-currency translation, the firm's sales and profitability have declined dramatically.

Bulls Say: While it is true that 3M faces near-term headwinds, the firm's innovative culture, defensible patents, and low-cost manufacturing have carved a wide moat around its business that should enable the company to reap outsize rewards over the long run. Given the dramatic drop in the stock market generally, the negative news during the last half of 2008 (which is likely to continue through 2009) is likely incorporated in the stock price already.

Focused on the Long-Term
At Morningstar, we believe in evaluating a company from a long-term perspective rather than concerning ourselves with short-term fluctuations in earnings or the stock price. Fund managers, however, can be bound by a set of requirements and mandates that force them to adopt a more short-term perspective. Mutual funds operate on a 12-month schedule and must report their holdings and performance results on a quarterly basis. If a manager is invested in a company that faces difficult headwinds over the next year or so (as is the case for 3M), but has long-term potential nonetheless, the manager may actually feel compelled to focus on the short-term decision to sell (or not purchase) the security, given that his or her performance may be judged on a similar short-term time frame. Individual investors, by contrast, do not generally have to worry about such constraints and can take advantage of this kind of behavior, which at times can drive stocks to attractive valuation levels, to invest in quality companies for the long-term.

Stocks Bought and Sold
	Star Rating	Fair Value Uncertainty	Economic Moat	Current Price ($)	Price/ Fair Value	No. of Fund Owners
Johnson & Johnson (JNJ)		Low	Wide	52.59	0.66	15
Procter & Gamble (PG)		Low	Wide	49.50	0.64	12
3M (MMM)		Low	Wide	57.88	0.68	10
Pfizer (PFE)		Medium	Wide	13.58	0.52	9
* as of 05-01-09. Fund ownership data as of the funds' most recent filings.

Even with the difference of opinion among our top managers, our analysts at Morningstar continue to believe that each of the four companies uncovered by our screen have a wide economic moat around their businesses. Each one is also rated 5-stars, the highest rating we assign stocks, as we believe they are not only trading at a considerable discount to their intrinsic value but at levels where we would recommend investors consider purchasing shares. For more information about our opinion on these four stocks, as well as the 2,000 other companies we cover, please see our full list of Stock Analyst Reports on Morningstar.com.

Disclosure: Drew Woodbury doesn't own shares in any of the companies mentioned above.