Should You Sell These Five Ultimate Stock-Picker Stocks?

By Drew Woodbury | Stock Analyst

As you may recall from our last article, we firmly believe that portfolio managers send signals about how they feel about a particular stock by the amount of money they're willing to commit to it at any given time, which is why we focus on not only the holdings of our Ultimate Stock-Pickers, but on their purchases and sales as well. Generally, we assess the relative attractiveness of an individual security by how many funds are currently holding it, by the percentage that each stock makes up of each manager's portfolio, and by whether or not our Ultimate Stock-Pickers have been adding to or subtracting from their positions. However, we also like to look at new money purchases and outright sales, which we feel offer additional insight into the thinking of our top managers about their holdings.

Having focused primarily on stocks our Ultimate Stock-Pickers have been actively buying in most of our articles, we figured it was time for us to dedicate a piece to companies that our managers have been selling. We think this is appropriate, especially given that the markets, as represented by the S&P 500 Index (SPX), are up more than 60% since they bottomed out in early March of last year. When looking at the sales made by our Ultimate Stock-Pickers, we tend to pay particularly close attention to situations where a manager has sold a significant portion of a particular holding during a short time period--especially outright sales (where a manager has completely eliminated a stake in a security). We view cases like these as particularly important, as they signal that a manager has a high degree of conviction behind their decision to sell the stock, as opposed to sales where they are simply trimming a holding that has become fully valued, or exceeds their estimate of its value.

That said, analyzing stock sales must be done cautiously. Managers can choose to sell a stock for many different reasons that are not necessarily related to their opinion on the value of the firm. For example, during the financial crisis we saw a lot of fund managers selling stocks, and high quality stocks at that, in order to raise cash needed to meet investor redemptions. While this is much less likely to be a factor right now, as net outflows from U.S. stock funds declined from close to $100 billion in 2008 to around $25 billion last year, investors should always be cautious when looking at sales by portfolio managers.

Of the 26 top managers on our Investment Manager Roster,  Hartford Capital Appreciation (ITHAX) had the most outright sales, eliminating stakes in 20 different companies concentrated in the following sectors: Consumer Goods, Energy, Financial Services, and Industrial Materials. That said, the fund also made 19 new money purchases (15 of which were meaningful) in companies from the Consumer Goods, Consumer Services, Financial Services, Health Care, and Industrial Materials sectors. This leads us to believe that the managers were not only making subtle sector allocation adjustments but were deliberately swapping into stocks in sectors they wanted to stay exposed to, but with securities they believed would outperform the holdings they were replacing.

Ultimate Stock-Pickers' Five Highest Conviction Sales

Stock Price and Morningstar Rating data as of 03-26-10 unless otherwise noted.

Rather than focus solely on moves like those that were made by Hartford Capital Appreciation, we've decided to look at the five "highest conviction" sales made by our top managers during the most recent period. Diving into these five stocks, we noticed a number of possible themes emerging. First and foremost, we saw plenty of managers selling stocks that were in the process of being acquired by other firms. Burlington Northern was probably the best example of this, as two of the nine managers holding the stock coming into the fourth quarter of 2009 had eliminated their positions by the end of the year (with  Berkshire Hathaway (BRK.A) (BRK.B) closing its acquisition of the railroad in early February of this year).

Cadbury , which is in the process of being acquired by  Kraft Foods (KFT), is another example of this phenomenon. As you may recall,  Oak Value unloaded its stake in Cadbury even as the managers of the fund believed Kraft's offer was a discount to the candy company's intrinsic value. Sometimes the value you can realize today is far better than the value you can realize longer term (especially if you have someplace more lucrative to stash that cash). The same logic probably held for  Canon (CAJ) which, while not being acquired by anyone, had nearly doubled in value from the lows of early March of last year.

Do Energy Sales Signify a Souring on the Sector?
A second theme involved two stocks on our list:  PetroBras (PBR) and  Devon Energy (DVN), both of which were being sold with conviction by at least three of our managers. While looking at these sales in isolation, one might come to the conclusion that some of our managers have taken a bearish view towards energy stocks. After all, both PetroBras and Devon Energy were meaningful reductions for  Alleghany , which also made outright sales of  EOG Resources (EOG) and  XTO Energy  during the period.  Meanwhile, Harbor Capital Appreciation was not only making an outright sale of its stake in PetroBras but also eliminated holdings in  Halliburton (HAL) and OAO Gazprom .

These same managers, though, were also buying energy stocks during the period. While Alleghany was putting money to work in  Hess (HES),  ExxonMobil (XOM),  Occidental Petroleum (OXY), and  Plains Exploration & Production , Harbor Capital Appreciation made a new money purchase in  Massey Energy . Its also interesting to note that when looking at our 26 top managers in aggregate, the energy sector still accounts for 8% of holdings versus 9% at the end of the third quarter of 2009 and 10% in the year ago period. With the Energy sector not up as strongly as some other sectors of the market last year, and our managers buying almost as much as they were selling during the most recent period, its hard to come to the conclusion that there was a souring on energy stocks by our top managers. If anything, these sales look like nothing more than moves by our managers to rotate holdings in their portfolios rather than signaling a change in their outlook for the sector.

Trying to Understand Berkowitz's Sale of Pfizer
Perhaps the highest profile example of this type of move was Bruce Berkowitz's sale of  Pfizer (PFE) from his  Fairholme (FAIRX) fund. As you may recall from one of our past articles, Berkowitz had built up a significant stake in the pharmaceutical firm, amassing more than 76 million shares of Pfizer's common stock from the second quarter (ended May) of 2008 to the third quarter (ended August) of last year. Before selling off more than 59 million shares of the stock (or 77% of his stake in the company), Pfizer had accounted for more than 17% of Fairholme's stock portfolio. When discussing his sale of Pfizer with one of our fund analysts, Berkowitz recently noted that his fund's initial move into Pfizer 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. Although not pointing directly at Pfizer, he also noted 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 at the end of the most recent period. Trying to make more sense of Berkowitz's sale of Pfizer, we recently sat down with Morningstar analyst Damien Conover to get his take on the firm, as well as Berkowitz's rationale for selling, and also wanted to get his take on the impact that the new health care reform legislation might have on the pharmaceutical industry.

Damien, thanks for your time. As you know, Bruce Berkowitz made a well-publicized sale of Pfizer in his Fairholme fund during the fourth quarter (ended November) of last year. What do you think could have motivated him to sell?

Not much has changed with Pfizer over the last few quarters besides the finalizing of the Wyeth purchase. Further, the announcement of the Wyeth transaction occurred several months before Bruce Berkowitz made the decision to sell. Therefore, I feel he was motivated by other investments that could have offered better upside than Pfizer.

In hisconversation with one of our fund analysts, Berkowitz mentioned the recurrence of non-recurring items and the need to repatriate earnings in pharmaceutical companies as some of his reasons for selling. Could you explain what he meant?

As with every major acquisition Pfizer has made in the past, the Wyeth acquisition will likely cause many non-recurring charges on the income statement, which makes the company's true earnings power more difficult to analyze. These charges typically include write downs to amortization and restructuring charges. In regards to repatriating earnings, Pfizer needed to bring cash back to the U.S. that was generated overseas to help finance the Wyeth acquisition. Unfortunately for Pfizer, the repatriation triggers a much higher tax rate for the company, which will hurt earnings for several years.

In light of all this noise, how do we view Pfizer's long-term competitive position?

Over the long term, we believe Pfizer has very strong competitive advantages. We believe patent protection on branded drugs and an entrenched sales distribution network creates a wide economic moat for the firm. The patents provide strong pricing power for Pfizer, which enables the firm to generate higher returns on invested capital than its weighted average cost of capital. Further, the company can augment its internal research and development efforts by leaning on its entrenched sales distribution channel, which makes the company a prime partner for a smaller drug company that lacks the resources to market a new drug. The company faces several significant patent losses over the next few years that will weigh on its growth potential. However, the company's competitive position remains strong.

Now that it has been passed, what is the impact of the health care reform bill on Pfizer?

We feel that the reform bill will be a net neutral for the pharmaceutical industry and Pfizer. We feel the bill's mandate for people to obtain insurance will create enough volume to largely offset the bill's cost to the industry of approximately $85 billion over the next decade.

What do we think of the company's valuation? Do you think that the company's fundamentals support Berkowitz's decision to sell?

We disagree with Berkowitz's decision to sell, as we feel Pfizer currently carries a very attractive valuation. While we are not expecting much growth for Pfizer over the next few years, we believe the company will be positioned for moderate growth following the 2012 U.S. patent loss on Lipitor. Further, we believe the company's strong cash flow generation will likely result in an increase to the company's dividend, which already yields an attractive rate of close to 4%.

Given Damien's take on Pfizer, and the fact that we could find no compelling reasons (other than valuation, in Canon's case, and stock rotation within a sector, as was the case with the energy names) to sell the other four stocks on our list of high conviction sales, it's difficult to say that we would go along with these moves by our top managers. As we've always said, it is far easier to buy into the purchase activity of most managers, since at the most basic level these investors are putting money to work in stocks that they believe will appreciate over time. Discerning the rationale behind a sales (absent an explicit statement from the manager doing the selling) is always going to be an arduous task, and in some cases the opinions of our top managers will run contrary to not only our analysts but other managers on our list of Ultimate Stock-Pickers.

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Disclosure: Drew Woodbury does not own shares in any of the securities mentioned above.