Seven High-Conviction Stocks from the Ultimate Stock-Pickers

By Todd Young | Senior Stock Analyst

With the growing popularity and lower costs associated with index investing, we often wonder why individual investors would pay higher fees for some actively managed mutual funds that, in our view, do nothing more than track the index they are benchmarked against. When a manager holds more than 200 stocks in a fund, we believe it becomes increasingly more difficult for that manager to really know and understand each holding. Such broad indexing has not been the case for our Ultimate Stock-Pickers, many of whom tend to be far more concentrated than the average mutual fund.

As you may recall, when we assess the top purchases and sales of the managers included in our Investment Manager Roster, we look at how many of them hold a particular security and whether or not they've been adding to or subtracting from their positions. We also look at the percentage each security makes up of their equity portfolios to determine the level of conviction a manager might have in a particular name by the amount of capital they have committed to it. Given the slightly more concentrated portfolios run by many of our top managers, we thought it would be useful to sift through some of the higher-conviction holdings maintained by of our current list of Ultimate Stock-Pickers.

Searching for High-Conviction Holdings
The average number of holdings for each of our 26 investment managers is 60, which we feel is a reasonable number of names to follow, especially as many of these portfolios are managed by more than one person. Only two managers hold more than 100 stocks, while 15 of them have 50 or fewer holdings. If every holding was equally weighted, an equity portfolio with 60 holdings means that each stock makes up 1.67% of the total portfolio. With many of our managers building up concentrated positions in some of their highest-conviction holdings, individual positions actually run the gamut from less than a tenth of a percentage point to a high of 37% for  Fairfax Financial's (FFH) holding in  Odyssey Re  (which is a bit misleading because Odyssey is a subsidiary of the Canadian property and casualty insurer). Furthermore, there are only 10 positions in any of the 26 funds that are above 10% of the fund's net asset value.

Drawing an arbitrary line in the sand, we decided to look only at holdings that made up 3% or more of any single portfolio, which we believe is an indication of a relatively high level of conviction as it is well above the 1.67% average position size for a portfolio with 60 holdings. Sifting through the roughly 1,500 holdings of our top managers, we found 260 securities that made up more than 3% of a portfolio's holdings, with many names appearing more than once. The list includes not only the top 10 holdings of our Ultimate Stock-Pickers, which are fairly well-known to most investors, but a slew of other names that many investors may never have heard of before.

Looking Beyond the Obvious Names
Believing it sometimes pays to look where others are not looking, we've decided to bypass many of the more well-known names--like  Berkshire Hathaway (BRK.A) (BRK.B),  Coca-Cola (KO),  Pfizer (PFE), and  Microsoft (MSFT)--on this list in favor of some of the lesser known companies we feel are held with a higher degree of conviction by some of our top managers. Focusing on firms that are highly regarded by our analysts, and for the most part trading at or near Morningstar's Consider Buying price, we came up with the following securities that we feel are worth investigating further:

Seven High-Conviction Ultimate Stock-Pickers' Stocks
	Star Rating	Fair Value Uncertainty	Moat Rating	Current Price ($)	Price/ Fair Value	No. of Fund Owners
Automatic Data Processing (ADP)		Medium	Wide	35.35	0.69	7
Medtronic, Inc. (MDT)		Low	Wide	34.71	0.72	8
Apollo Group, Inc.		Medium	Wide	69.60	0.70	1
Monsanto Company		Medium	Wide	73.20	0.55	4
Equifax, Inc. (EFX)		Medium	Wide	26.41	0.73	1
Waste Management, Inc.		Medium	Narrow	28.03	0.85	3
Accenture, Ltd. (ACN)		Medium	Narrow	33.74	0.91	5
Stock price data and Morningstar ratings as of 07-01-09.

 Automatic Data Processing (ADP)
ADP is held by seven funds and represents more than 3% of the portfolios at the  Jensen Fund (JENSX) and  Chase Growth (CHASX). Our analyst Vishnu Lekraj, believes ADP's wide economic moat is built on the high customer switching costs and business-model scalability inherent in its operations. The firm provides services that satisfy companies' human resources needs, such as payroll processing. Vishnu believes the nature of these services provides ADP with a higher level of stickiness in its customer base, most of whom would find it extremely difficult to revamp such a critical aspect of their operations. ADP augments this stickiness with long-term contracts that average 10 years, with prices increasing typically on an annual basis.

 Medtronic (MDT)
Medtronic is owned by eight funds and accounts for more than 3% of the portfolios at the Jensen Fund,  Oak Value , and  Vanguard PRIMECAP (VPMCX). According to our analyst Debbie Wang, Medtronic enjoys one of the widest moats in the medical device arena and remains one of the largest pure-play device companies, with product lines to treat everything from cardiac arrhythmias and diabetes to Parkinson's and spinal fractures. Medtronic has proved to be a consistent innovator, which is the key to preserving pricing power in this industry. The firm has also cultivated close working relationships with physicians through its pharmaceutical sales reps, who often attend surgeries to provide their expertise and advice on whatever device is being implanted.

 Apollo Group 
While Apollo is held by only one of our managers, Chase Growth, it represents nearly 5% of that fund's holdings. Apollo is the largest for-profit education company in the U.S. with nearly 400,000 students. Our analyst believes that the firm's low cost structure and government-aided pricing power are the building blocks of Apollo's wide moat. Education stocks tend to be defensive in nature, as more people return to school during hard economic times in order to improve their skill sets and marketability. As the stock market has picked up this year, many investors have rotated out of defensive sectors into more cyclical names, which we believe has depressed the company's share price. Because Apollo is usually more acyclical than countercyclical, growing in both good and bad economic times, we think that at the right price it is worth a look.

 Monsanto 
Held by three funds, with  Aston/Montag & Coldwell Growth (MCGIX) holding a greater than 3% position, Monsanto is another wide-moat firm worth considering. The world's largest producer of agricultural seeds and a major producer of herbicides, Monsanto has come under pressure, according to our analyst Ben Johnson, as crop prices have come off of their midsummer-2008 highs and the near-term outlook for the firm's Roundup herbicide business has deteriorated in the face of weak demand and intense competition from generics. While lower crop prices will no doubt impact how much farmers can spend in the near term, Ben believes the effects on Monsanto's performance will be negligible. Because the company's products are never priced to reflect either the peaks or troughs in crop prices, he doesn't believe Monsanto's pricing power is likely to suffer to the extent that the market seems to be anticipating.

 Equifax (EFX)
While Equifax is held by only one of our top managers, the Jensen Fund, it represents nearly 4% of that fund's holdings. Our analyst Drew Woodbury likes Equifax's business model and the fact that it operates in an oligopolistic industry with only two other competitors--TransUnion and Experian. With each firm having little reason to compete on price, as lenders use information from all three credit bureaus concurrently, and the barriers to entry for the industry are nearly insurmountable (as potential entrants would have to replicate existing credit databases, like Equifax's credit information that dates back to 1899), the firm has a fairly wide moat around its business. While demand for the products and services provided by the credit bureaus did drop dramatically near the end of last year, Drew doesn't expect it to decline much further this year, allowing Equifax to start what he expects will be a gradual path to recovery.

 Waste Management 
Held in three portfolios, and making up more than 6% of  Parnassus Equity Income's (PRBLX) holdings during the most recent period, Waste Management is one of Morningstar analyst Bradley Meeks' favorite names in the waste management industry. While not a 5-star stock at today's prices, he feels it is definitely worth looking at should it reach our Consider Buying price. The company is the largest waste hauler in North America, with over 200 landfills and the ability to raise prices in order to offset lower waste volumes in this tough economic climate. Over the last five years, the company's disciplined pricing initiatives have helped expand operating margins from 13% to 17%. The company has also culled unprofitable waste contracts, helping to increase margins and steadily increase returns on invested capital.

 Accenture (ACN)
Accenture, which is owned by five managers (with Parnassus Equity Income holding close to a 4% position), is another name that although not trading near our Consider Buying price remains a favorite of our analyst Swami Shanmugasundaram. He likes the company's deep-rooted client relationships and the depth and breadth of its service offerings, which he feels are two essential traits necessary to grow and compete successfully in the highly fragmented IT services industry. Accenture's client list includes 96 of the Fortune Global 100 and more than three quarters of the Fortune Global 500. The company's portfolio of services spans the entire gamut of IT services  and it is far ahead of its competition in the scale and scope of its offerings.

While not all of these names are currently trading at or below our Consider Buying prices, they represent some of the highest-conviction holdings of our top managers and are favorites of our stock analysts here at Morningstar. We feel that they are definitely worth further investigation and we would encourage you to take a much deeper look at each of them to see if they might warrant inclusion on your own watch list or in your investment portfolio.

Disclosure: Todd Young doesn't own shares in any of the companies mentioned above.