Four Buy Ideas from One of Our Ultimate Stock-Pickers

By Vishnu Lekraj | Stock Analyst

Could you beat the market if you were able to invest in only 40% of its equity assets? It would be like playing the college football National Champion Florida Gators with only 40% of the required players on the field. This may seem like a huge handicap, but impressively, fund manager Nick Kaiser has done precisely this, and not with just one portfolio but two separate funds. Kaiser has managed both the  Amana Trust Growth (AMAGX) and the  Amana Trust Income (AMANX) funds to impressive returns, beating the S&P 500 Index (SPX) handily over the past 10 years. The truly unique feature about the Amana funds, however, is that they are tailored to Muslims and, as such, have to adhere to strict Islamic laws.

This means that neither fund can hold the stock of any firm that generates more than 5% of its revenue from alcohol, tobacco, pork processing, gambling, or the borrowing or lending money. At first glance, it might seem like a nearly impossible task to manage a portfolio (let alone two) with such extremely tight restrictions, but we believe that these restrictions have actually been more of a blessing than a curse in that they have forced Kaiser and his team to be much more disciplined about stock selection as they work to keep their portfolios in line with their investment philosophy. This is borne out by the fact that the funds have relatively low turnover, which is not only a byproduct of Amana's commitment to a more disciplined research process but an adherence to its no-gambling mandate, which limits the amount of short-term buying and selling that can be done by the fund managers.

Because of restrictions on firms that engage in either borrowing or lending, not only are the stocks of many financial firms off-limits as well (a big plus during last year's market meltdown), but so are companies with debt/market cap ratios in excess of 33%. In all, we think that restrictions like these have not limited the managers at Amana, but have actually created more conviction and conservatism for the aggregate holdings of the two funds. Given the superior performance of both funds, even with the restrictive nature of each of their investment mandates (religious and otherwise), we were curious to see what stocks were actually held in these two portfolios and whether or not there was any overlap between the funds (which could be a sign of higher conviction behind either a single security or a sector of the market).

Considering the Common Convictions
Aside from the religious restrictions, the Amana family of funds is separated by two distinct investment policies. The Amana Growth Fund invests in stocks with good earnings growth and low P/Es relative to their industries, while the Amana Trust Income Fund picks stocks that pay a dividend and are attractively priced. Even though both funds have separate investment policies, the religious restrictions create a scenario where a few common identifiable industries are held by both portfolios. Taken in aggregate, the holdings of the two funds are concentrated in five identifiable Morningstar stock sectors--health care (19%), hardware and software (19%), industrial materials (17%), consumer goods (12%), and telecommunications (9%)--accounting for three quarters of their total stock holdings at the end of the second quarter.

Within health care, the largest concentration is in drug manufacturers, which accounted for 12% of the combined portfolios. Hardware and software is actually two separate Morningstar sectors, with the funds having 13% of their combined portfolios in hardware--split pretty evenly between computer hardware and semiconductors--with software composed entirely of application software firms. At 17% of aggregate holdings, industrial materials includes a wide array of industry groups, with metals and mining (5%) and industrial products (4%) being the two largest. Consumer goods is made up primarily of processed and packaged goods (5%), which is another way to say food and beverage firms, and household and personal products. In the telecommunications sector, the two funds are heavily concentrated in communication services, made up primarily of telephone service providers.

Screening the Holdings for Buy Ideas
Cognizant of the sector concentration within the aggregate holdings of the two funds, we went looking for stocks held in both portfolios that have great earnings growth, pay a dividend, offer great value, and have been long-term outperformers. These characteristics are similar to what we at Morningstar believe make great businesses, and such stocks usually carry either a wide or narrow economic moat. Cross-referencing the common stock holdings of the two funds at the end of June, we uncovered the following 15 holdings that were held by both of the funds:

15 Common Holdings of AMAGX and AMANX
	Star Rating	Fair Value Uncertainty	Moat Rating	Current Price ($)	Price/ Fair Value	Morningstar Sector
Eli Lilly & Company (LLY)		Medium	Wide	32.87	0.61	Health Care
Novartis AG (NVS)		Low	Wide	45.16	0.62	Health Care
Johnson & Johnson (JNJ)		Low	Wide	60.32	0.75	Health Care
Wyeth		Medium	Wide	46.98	0.80	Health Care
Rio Tinto PLC		Medium	Narrow	162.83	0.61	Indl Mtls
Regal-Beloit Corporation (RBC)	N/A	N/A	N/A	46.56	N/A	Indl Mtls
Intel Corporation (INTC)		Medium	Wide	19.05	083	Hardware
Taiwan Semi Manufacturing (TSM)		High	Narrow	10.95	1.10	Hardware
PepsiCo, Inc. (PEP)		Low	Wide	56.49	0.83	Cons Goods
Genuine Parts Company (GPC)		Low	Narrow	37.45	1.17	Cons Svcs
EnCana Corporation (ECA)		Very High	Narrow	52.51	0.81	Energy
BP PLC (BP)		Medium	Narrow	50.68	0.87	Energy
United Parcel Service (UPS)		Medium	Wide	54.12	0.77	Business Svcs
Canadian Pacific Railway (CP)		Medium	Narrow	48.04	1.60	Business Svcs
McGraw-Hill Companies (MHP)		High	Wide	29.00	0.88	Media
Data as of 08-13-09.

Out of the 15 stocks listed above, we cover 14--with Regal-Beloit (RBC) not currently covered by our analysts, despite our rather extensive coverage list of over 1,800 stocks here at Morningstar. Of the 14 we do cover, all of them have either a wide or narrow moat, meaning that our analysts believe they have durable competitive advantages that will allow them to generate above-average profitability over an extended period of time, which confirms our previous thoughts on the likely quality of these common holdings.

Four Names Worth Considering
As we believe firmly in buying only the best companies at the best prices, we've drilled down deeper to the four 5-star stocks on the list-- Eli Lilly (LLY),  Novartis (NVS),  Johnson & Johnson (JNJ), and  Rio Tinto --as we feel that they offer a tremendous amount of value right now given where the stocks are trading relative to our own fair value estimate. Of these four names, three are in the health-care sector, which is not too surprising given that the sector makes up one fifth of the combined portfolios of the two Amana funds. All of the health-care names also have wide moats and two out of the three have low uncertainty ratings, which is an indication that our analysts have a better feel for the future cash flow potential of these firms than they would for companies with higher uncertainty bands.

Given the track record of these two funds, the conviction that they have in these four names gives us a slightly higher degree of confidence in our own assessment, which is that these four stocks have and should continue to outperform the market and currently offer a great entry point for investors (regardless of their religious affiliation). For an idea of what our analysts are currently thinking about each of these stocks, consider the following comments we've collected:

 Eli Lilly & Company (LLY)
Our analyst Damien Conover believes Eli Lilly's innovative culture and strong financial commitment to developing the next generation of drugs has set it apart from its peers. While the next few years will likely still see strong demand for its current stable of drugs, Lilly faces one of the steepest patent cliffs in the pharmaceutical industry, with more than 40% of its current sales encountering generic competition between 2011 and 2013. Damien thinks Lilly's strong near-term earnings growth should increase its strategic options for dealing with the patent losses, and he cites acquisitions and the development of its internal pipeline as ways the firm can mitigate its patent losses over the next decade.

 Novartis AG (NVS)
Damien also likes Novartis, which he feels derives its strength from a diversified operating platform that includes branded pharmaceuticals, generics, vaccines, diagnostics, and consumer products. Although the majority of Novartis' competitors focus solely on the high-margin branded pharmaceutical segment, Novartis runs four complementary operations that reduce overall volatility and create cross-segment synergies. In an industry plagued by stagnant growth, Novartis emerges as a juggernaut with diversified operating platforms and an industry-leading number of new potential blockbuster drugs.

 Johnson & Johnson (JNJ)
Johnson & Johnson is another of Damien's favorite picks. The firm stands alone as a leader across the major health-care industries, controlling the top or number-two leadership spot in 70% of its products. Damien believes that the combination of a diverse revenue base, a robust research pipeline, and exceptional cash-flow generation form a wide economic moat for the company. Patent losses on antipsychotic Risperdal and neuroscience drug Topamax, as well as recent side-effect concerns with anemia drug Procrit, will weigh on near-term performance. However, he strongly believes the company's breadth can overcome these issues.

 Rio Tinto PLC 
The only other firm on our list, and the only non-health-care pick to make it past our screen, is Rio Tinto. One of our Australian analysts, Mark Taylor, covers the firm for Morningstar and views it as one of only a few top-tier global miners. Through selective acquisitions and grass-roots exploration, Rio Tinto has assembled a large portfolio of long-lived, low-cost assets that provide it with significant competitive advantages. Geographic and product diversification give the company relatively stable cash flows and lower operating risk than many of its mining peers. Overall, he feels that Rio Tinto's world-class asset base and capable management team make it one of the few miners that can earn more than its cost of capital through the commodity cycle.

Disclosure: Vishnu Lekraj does not own shares in any of the companies mentioned above.