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10 High Conviction Buys from Our Ultimate Stock-Pickers

Berkowitz wasn't the only manager we saw actively trading in the fourth quarter.

By Jim Ryan| Senior Stock Analyst

With half of our Ultimate Stock-Pickers having reported their fourth-quarter holdings, we've been able to glean some of the higher conviction moves made by a fair number of our top managers during the most recent period. Based on this early read of their holdings, purchases and sales, we walked away with the impression that our Ultimate Stock-Pickers had shifted their focus somewhat during the fourth quarter after two quarters of stunning performance by the markets. After bottoming out in early March, the S&P 500 Index  posted 16% gains in both the second and third quarters of 2009, which in and of themselves would have been impressive annual returns for most fund managers.

With such a strong run-up in the markets in just six months' time, we were expecting to see some of our Ultimate Stock-Pickers moving to trim (or even eliminate) overweight positions, especially if they felt that the appreciation they had witnessed during the rally was unsustainable, while also putting new money to work in underappreciated stocks. Looking at the trading activity of the thirteen fund managers we've been able to sift through so far, we were not disappointed.

While the single largest move involved just one fund-- Fairholme --and one stock-- Pfizer --there were more than 200 net purchases (versus 150 net sales) during the quarter. Of the top 25 highest conviction purchases made by our Ultimate Stock-Pickers, there was a much larger concentration in Consumer Goods names--like  PepsiCo ,  Coca-Cola ,  Clorox  and  Procter & Gamble --than in any other sector. This was a signal to us that our top managers might be moving into less risky and more stable stocks following the run-up in the markets. That said, there were also conviction purchases made during the period in three money-center banks-- Citigroup ,  Bank of New York Mellon , and  Bank of America --which, while well past the calamities that had brought them to their knees in the autumn of 2008, are hardly what we would call risk averse.

Berkowitz Shakes Things Up at Fairholme

This conundrum was probably best exemplified by the one big trade we had mentioned, Bruce Berkowitz's sale of more than three-quarters of his stake in Pfizer (which had accounted for more than 17% of Fairholme's total stock portfolio at the end of August). As you may recall, just six months ago we were talking about how Berkowitz had built up a significant stake in the drug manufacturer over the preceding year, using sales of  Berkshire Hathaway   to help fund the purchases. While we may have questioned the level of conviction Berkowitz was placing on Pfizer, as well as his notion that the company was "somewhat misunderstood" by the market, we agreed with the general premise that the stock was undervalued at the time.

In selling Pfizer, Berkowitz recently noted that his fund's initial move into the stock had been more defensive in nature, with Fairholme making its largest purchases of the stock just months before the market collapsed in 2008. While moves into more defensive names like Pfizer served the fund well during the crisis (evidenced by Fairholme's 30% decline in 2008 relative to a 37% decline for the S&P 500), Berkowitz believes that we are now operating in a more normal environment (albeit one that will still have aftershocks connected to the collapse of the financial markets) requiring a bit more offense than defense.

While not pointing directly at Pfizer, he did note that he is bothered by the recurrence of nonrecurring expenses in the pharmaceutical industry, as well as the impact that lower tax rates in some of the industry's overseas operations can have on an individual firm's cash flows and taxation should those funds need to be repatriated. That said, Berkowitz has maintained a 4% position in Pfizer, and still had one quarter of his stock portfolio invested in health care, with two-thirds of that stake invested in managed care providers-- Humana ,  WellPoint  and WellCare Health Plans --at the end of the most recent period.

Berkowitz also noted that Fairholme has continued "to sell that which is cheap, to buy that which is cheaper." Looking at the fund's highest conviction sales--Pfizer,  Northrop Grumman , and  Boeing --relative to its conviction purchases-- Burlington Northern , Citigroup, and Berkshire Hathaway--it looks like that may have been the case. Fairholme's sale of Pfizer, for example, which is currently trading at 0.7 times Morningstar's fair value estimate for the firm, was offset by the fund's purchase of Citigroup, which is currently trading at 0.6 times.

That said, Berkowitz also seems to have made a significant move into Burlington Northern just as that company was being taken out by Berkshire Hathaway. We'd be curious to know if that position, which was new to the portfolio in the fund's fiscal fourth quarter (ended November), was established well enough in advance of Berkshire's offer for Fairholme to take part in the nearly 30% rise in the stock's price after the deal was announced. If there's one thing we've leaned about Berkowitz over the years, it's that his timing is on more than it's off, which is probably why he's been one of the best performing fund managers over the last decade.

10 Recent High Conviction Purchases by our Ultimate Stock-Pickers

 Star RatingFair Value UncertaintySize of MoatCurrent Price ($)Price/Fair ValuePepsiCo 4LowWide61.190.9Burlington Nthn 3MediumNarrow100.231Merck 4MediumWide36.880.8Coca-Cola 3LowWide54.220.99Brkshre Hthwy 3MediumWide76.690.87Google 3HighWide536.40.98Clorox 4LowNarrow60.120.88Apple 3MediumNarrow198.670.98Int'l Bus Machines 3LowWide123.731Citigroup 4Very HighNone3.210.58

Stock Price and Morningstar Rating data as of 2-11-2010

Looking at the top 10 high conviction purchases made by the thirteen fund managers we've been able to track so far, it looks like the Consumer Goods sector has garnered a bit more favor with these funds. This represents a shift from what had been a predominance of purchases of Health Care names over the previous two quarters. One health care name did, however, make the list, with  Merck  being purchased with conviction by  Aston/Montag & Caldwell Growth ,  Columbia Dividend Income  and  Harbor Large Cap Value . For both Aston/Montag & Caldwell and Harbor, the purchase of Merck was also a new money buy during the quarter.

Two other areas that seemed to dominate the purchases during the third quarter, Media and Software, also fell by the wayside.  Yacktman , which significantly reduced its exposure to the Consumer Goods sector and invested heavily in Media stocks during the fourth quarter of 2008, reversed course during the final quarter of last year. Having trimmed back on its stake in Media firms like  Viacom , Yacktman quenched its thirst by buying both PepsiCo and Coca-Cola, and cleaned up with Clorox as well. Hardware stocks also gained some traction with our managers, although some of that was likely driven by anticipation of heavy Christmas shopping for  Apple's  popular product lineup.

In terms of individual fund activity,  Chase Growth  and  Matrix Advisors Value  were the most active during the quarter, making numerous buys and sells in their respective portfolios. The managers at Chase made meaningful purchases in Hardware firms Apple and  IBM  while selling off stakes in Software companies  McAfee ,  Oracle ,  Adobe  and  Microsoft . The fund also unloaded a handful of Telecommunications firms-- Research in Motion ,  Corning ,  DirectTV Group , and  Vodafone --funneling the proceeds into  Google .

Running a more value-oriented fund, Matrix was busy adding Financials, such as Bank of New York Mellon, Bank of America,  J.P. Morgan Chase  and  American Express . And much like Yacktman, the fund managers at Matrix were picking up shares of Consumer Goods firms, like Coca-Cola, Procter & Gamble and  Johnson Controls , while also taking stakes in Consumer Services operators  Carnival  and  eBay . That said, Matrix also made meaningful new money purchases in four health care names-- Genzyme ,  Medtronic ,  Zimmer , and  St. Jude Medical .

10 5-Star Stocks from Recent Purchases of our Ultimate Stock-Pickers

 Star RatingFair Value UncertaintySize of MoatCurrent Price ($)Price/Fair ValueJohnson & Johnson 5LowWide62.910.79Western Union 5MediumWide16.160.58Bctn Dcknsn & Co. 5LowNarrow75.220.77Genzyme 5MediumWide55.270.67Abbott Labs 5LowWide53.540.79ExxonMobil (XOM)5LowWide65.240.75Lowe's (LOW)5MediumWide22.170.62Monsanto 5MediumWide75.760.62Stryker (SYK)5LowWide52.170.72Arthur J. Gallagher (AJG)5MediumNarrow22.940.66

Stock Price and Morningstar Rating data as of 2-11-2010

Not finding any 5-Star names among the top 10 conviction purchases made by our abbreviated list of Ultimate Stock-Pickers, we went though all of the 200-plus net purchases made by these thirteen managers, and narrowed the list down to high conviction purchases still trading at prices that our analysts consider buyable. While health care may not have been as dominant in the list we highlighted above, the sector dominated this list. Given that we are not sector-allocation oriented, being far more interested in finding the most undervalued stocks that we come across in the holdings of our top managers, we've collected commentary from our analysts reflecting their current thinking on these names.

 Johnson & Johnson 
At the top of the list is a 5-Star low uncertainty pick with the added attraction of a wide moat. Johnson & Johnson once again makes the grade, much as it did during the third quarter, with three of our Ultimate Stock-Pickers--Yacktman,  Davis NY Venture (NYVTX), and  Amana Trust Income (AMANX)--all added to their existing positions in the name during the fourth quarter. Morningstar analyst Damien Conover thinks the company's strong diversified operating lines coupled with a robust drug pipeline should help the firm generate steady long-term growth.

 Western Union 
While it was only purchased by one fund, Matrix Advisors Value, the fund made a meaningful new money purchase in Western Union. Our analyst Brett Horn notes that while the company spooked the market recently with weak 2010 guidance, the long-term drivers of the firm's money transfer business remains in place. He thinks that the current market valuation on the stock, which works out to about a 10% free cash flow yield, should reward shareholders in the long run.

 Becton, Dickinson and Company 
Like Johnson & Johnson, Becton Dickinson continues to be purchased by our top managers, with Amana Trust Income adding to an existing position and Davis NY Venture making a meaningful new money purchase of the name. Becton Dickinson has been a favorite of our analyst Alex Morozov for some time now. The company is the world's largest manufacturer and distributor of medical surgical products, such as needles, syringes, and sharps-disposal units. The firm also produces diagnostic instruments and reagents, as well as flow cytometry and cell imaging systems.

Genzyme was purchased with conviction by Matrix Advisors Value, which made a new money purchase in the name, while  Amana Trust Growth (AMAGX) was adding to an existing position. Our analyst Karen Andersen believes Genzyme's in-house innovation and smart acquisitions have enhanced its ability to succeed globally. Despite the impact that ongoing supply constraints of two of its leading rare disease therapies have had on results this year, Karen feels the firm's ongoing manufacturing and strategy improvements should set the stage for a recovery in 2010.

 Abbott Laboratories 
Five of the Ultimate Stock-Pickers we surveyed own Abbott, with three of them actually adding to their position during the most recent quarter, and Morningstar analyst Damien Conover can see why. He thinks that in contrast to its peer group, Abbott is well-positioned for growth as the company faces very few patent losses over the next five years. Further, he expects the firm to benefit from the strong growth that will come from its diverse operating lines and robust portfolio of currently marketed drugs.

 ExxonMobil (XOM)
The Energy sector makes a showing with ExxonMobil, which our analyst Allen Good feels has done an exceptional job of regularly achieving returns on invested capital that exceed those generated by its peers, mainly due to the global integration of its operations and delivery of mega-projects on time and under budget. The stock continues to trade at a significant discount to our fair value estimate, which may explain why Harbor Large Cap Value, Columbia Dividend Income and Amana Trust Income were all adding to their existing stakes.

 Lowe's Companies (LOW)
Amana Trust Growth was adding to wide-moat Consumer Services giant Lowe's during the quarter. Our analysts covering the industry believe that Lowe's has successfully taken on its much larger rival,  Home Depot (HD), via aggressive expansion into that retailer's markets over the past decade, competing on the basis of its superior operating model and customer service.

Harbor Large Cap Value added more Monsanto to an already sizable position during the fourth quarter. Our analysts view Monsanto as a firm with a dominant seed business with strong barriers to entry, excellent growth prospects, and high returns on capital. They believe Roundup's earnings will stabilize as the current glyphosate inventory glut is worked off. Meanwhile, the demand for yield-enhancing seeds will remain strong as farmers around the globe seek to produce more crops from a finite amount of land.

 Stryker (SYK)
Stryker has made our list in the past and it is a crowd favorite with four Ultimate Stock-Pickers holding large positions. Our analyst Julie Stralow likes the company and thinks that with its traditional orthopedic products chugging along well, it looks poised to gain some momentum during 2010, as it fleshes out its spine offerings and regains its footing in the MedSurg business with an improving economy and easy comparables.

 Arthur J. Gallagher (AJG)
A rare entry from the Financial Services space, insurance brokerage and risk consulting firm Gallagher rounds out the top ten. Columbia Dividend Income has been picking up the stock in bits and pieces and our analyst, Bill Bergman, can see why. Although a soft economy, weak insurance rates, regulatory uncertainty and near-zero interest rates have weighed on results of late, Bill thinks that the clouds are lifting in several areas. He also feels that a dividend yield near 6% on a company with Gallagher's growth prospects looks both attractive and defensible.

Disclosure: Jim Ryan does not own shares in any of the securities mentioned above.

The Morningstar Ultimate Stock-Pickers Team does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.