Top Picks From Four of Our Best-Performing Managers

By Jim Ryan | Senior Stock Analyst

With the second quarter of 2010 behind us, we thought it would be interesting to take a deeper look at the most recent holdings, purchases and sales of the Ultimate Stock-Pickers that have managed to outperform the market year-to-date, as well as over the course of the last year. We believe that the actions of these managers, which have also handily beaten the S&P 500 Index (SPX) on an annualized basis over both the last five- and ten-year time periods, could provide investors with a much better sense of what is working best in today's equity markets.

After rallying more than 60% off the bottom that was reached in the early part of March 2009, the S&P 500 hit a rather large speed bump in the second quarter of this year. Despite evidence that the U.S. economy was on the mend, investors became concerned that a sustained recovery could take far longer to come to fruition. Some of this was due to a few trouble spots that continue to linger domestically, and part of it was due to the emergence of a major debt crisis in the Europe.

In an economy that is primarily driven by the consumer, domestic retail sales remain weak, employment growth has been tepid at best, and unemployment claims have stayed at elevated levels. And while there are pockets of recovery in the U.S. housing market, it could still take years before it stabilizes. Meanwhile, the emergence of sovereign debt crises in Greece, Spain and Portugal, had left investors wondering if the turmoil in the European Union would derail the global economic recovery.

Total Return (%) Track Record for Best Performing Managers

Total Return data as of 06-30-10. Source: Morningstar.

After holding steady through April, the markets started to fall apart in May, closing out the second quarter down more than 11%. Against this backdrop, 14 of our 22 fund managers beat the market during the quarter. Of these fourteen, 10 managers have outperformed year-to-date. And of those ten, 8 of them-- Amana Trust Growth (AMAGX),  Fairholme (FAIRX),  FMI Large Cap (FMIHX),  FPA Crescent (FPACX),  Mutual Shares (TESIX),  Tweedy Browne Value (TWEBX),  Wintergreen , and  Yacktman (YACKX)--have outperformed (or in the case of FPA Crescent come close to outperforming) the market over the last year. As these eight managers have also beaten the market on an annualized basis over the last five- and ten-year time periods, we believe that we're more likely to find better performing stock ideas among their top holdings, purchases and sales.

Working with the Most Timely Information
As we've noted many times before, one of the biggest limitations of our methodology is that the data we rely on is not always as timely as we would like it to be, given that investment managers have 45 days from the end of each quarter (and in some cases even longer) to file their holdings with the SEC. While we alleviate some of this by tapping into our own database of fund holdings, which gets updated more frequently, there is always going to be some lag between the time at which a manager decides to buy or sell a security and when we actually find out about it, especially if we're relying solely on their 13-F filings with the SEC.

This has been a problem for us with one of our best performing managers, Bruce Berkowitz's Fairholme fund, which has tended to file around 60 days after the close of each quarter. Further complicating things is the fact that the fund has a November fiscal year-end, meaning that the data we procure for Fairholme is always going lag the data we collect for the majority of our top managers. For example, as second quarter data starts rolling in we're looking at June 30th holdings for the majority of our managers, while with Fairholme we'll be looking at the fund's positions as of May 31, 2010.

While it is true that we can get a glimpse at what the fund has been accumulating in the interim through 13-G filings with the SEC, the data from these filings are limited to stocks where Fairholme holds between 5% and 20% of the company and don't offer us any insight into how the rest of the holdings in the fund have been impacted. That said, we do know that Berkowitz has been bulking up on financial services stocks since his last 13-F filing, building up stakes in  American International Group (AIG),  Goldman Sachs (GS), and  MBIA (MBI).

With all of that in mind, of the eight top performing managers we highlighted above, we have updated holdings so far for four funds--Amana Trust Growth, FMI Large Cap, FPA Crescent, and Yacktman. Of these, FPA Crescent was the clear winner during the second quarter, posting a less than 6% loss versus a more than 11% decline for the S&P 500. While this helped lift the fund's year-to-date performance well above that of the other managers, one-year performance was stronger at FMI Large Cap and Yacktman. As we noted previously, all of these funds have beaten the S&P 500 on an annualized basis over both the last five- and ten-year time periods.

Two Top Picks from FPA Crescent
One of FPA Crescent's top ten holdings, and a long-standing favorite of the Morningstar health-care team, is  Covidien . During the second quarter, the manager increased its stake in this 5-star rated firm by more than 40%, with the stock making up close to 8% of the fund's equity portfolio at the end of the period. Covidien, the former health-care unit of  Tyco International , develops, manufactures, and distributes medical and imaging devices, pharmaceuticals, and other health-care products to medical professionals worldwide. After a few years of investing in research and development, bolstering its salesforce, and pruning its product lineup, Morningstar analyst Alex Morozov believes that Covidien has returned to prominence in the medical device arena. He thinks that Covidien's strategy of refocusing on product niches adds to the sustainable competitive advantages in its core business, and that over time will lead to margin expansion and earnings growth.

Another top holding at FPA Crescent is  AON Corporation (AON), a firm that is also in the midst of some strategic changes. While AON built its reputation in the insurance brokerage industry, the firm went through some difficult times during the early part of last decade, only beginning to turn the ship around over the last five years after management initiated a significant restructuring. Morningstar analyst Bill Bergman believes that the firm's recent announcement that it is buying human resources firm  Hewitt Associates  will allow AON to build on the foundation it has put in place over the last couple of years, expanding its business offerings with cross-selling opportunities. As with Covidien, FPA Crescent increased its holdings in AON by more than 40% during the second quarter, with the stock making up more than 7% of the fund's equity portfolio at the end of the period.

A Few Top Ideas from Yacktman
Consumer goods firms  PepsiCo (PEP) was the largest holding at Yacktman at the end of the second quarter, making up 10% of the equity holdings in the fund after the manager increased its stake in the beverage and snack foods giant by close to 25%. These additions by Yacktman seem almost prescient in light of the improvement seen in PepsiCo's North American operations during the second quarter. Morningstar analyst Phil Gorham points out that while this wide-moat company may have lost the battle for leadership in the cola industry to  Coca-Cola (KO) it continues to win the war in the broader snack and beverage market.

Yacktman more than confirmed his thesis, noting that "Frito Lay, the most valuable division of PepsiCo, is the dominant snack chip company in the world. This business has significantly higher market share than any of its competitors, and its dominant market share produces substantially higher margins than most other packaged food companies." Yacktman wasn't putting all of its eggs in one basket, though, as the fund was also buying additional shares in Coke during the quarter, making it the third largest stock holding at the end of the period. While Phil thinks Coke is a solid wide moat firm worth considering, he feels that the valuation on PepsiCo is a bit more compelling right now.

Health care continues to be a major focus for Yacktman, which increased the amount of its portfolio dedicated to the sector from 14% at the end of the second quarter of 2009 to nearly 20% at the end of the most recent period. The manager doubled its stake in  Johnson & Johnson (JNJ), making it the fourth largest holding in the portfolio, and increased is position in  Pfizer (PFE) by more than 40%, with these two stocks accounting for 12% of the fund's equity holdings at the end of the period. Morningstar analyst Damien Conover covers both of these wide-moat firms and considers both of them to be buyable at today's prices, although noting that there is a lesser degree of uncertainty surrounding Johnson & Johnson than there is for Pfizer.

Three Stocks from FMI Large Cap
Noting that "[v]olatility and worry [had] returned to the market in the second quarter," it was interesting to see where FMI Large Cap was putting its money to work. While the fund made meaningful additions to existing stakes in  Berkshire Hathaway (BRK.A) / (BRK.B),  Nestle (NSRGY), and  Wal-Mart (WMT), it was the additional purchases of  3M (MMM) and  Bank of New York Mellon (BK) that stood out to us. Increasing its holdings in 3M by nearly 20% during the quarter, the fund elevated the diversified manufacturer of industrial products to its second largest holding at the end of the period. Morningstar analyst Adam Fleck thinks the firm has performed admirably during the recession and that international opportunities will pave the way for continued success.

The managers at FMI Large Cap also increased their holdings in Bank of New York Mellon by nearly 20%, making it the fourth largest stock holding in the fund at the end of June. The company is the product of the 2007 merger between Bank of New York and Mellon Financial, which created one of the world's largest financial services companies. Through its custody operations, Bank of New York Mellon is a leader in providing back-office services to other financial firms, while the company's asset-management and private banking operations serve institutional and high-net-worth individuals globally. Although second quarter top-line growth disappointed Morningstar analyst Michael Kon, he still believes that the company is on track to meet his projections for the full year.

New to the fund in the second quarter was the agricultural/industrial material provider  Monsanto , in which FMI Large Cap established a 3% position in its stock portfolio. While still viewed as a wide moat firm by Morningstar analyst Elizabeth Collins, she notes that in a year when Roundup herbicide profits are disappearing and crop prices are relatively weak the launches of new corn and soybean technologies have been slower than expected. Elizabeth believes that Monsanto will eventually be successful but that most investors have probably adopted a "show me" approach following several periods of "over-promising and under-delivering" by management. She does note, however, that Monsanto is currently down more than 25% year-to-date, and at one point was down as much as 45%, helping to explain why managers like FMI Large Cap may have stepped up during the second quarter.

Parsing Amana's Diverse Portfolio
It's always been difficult to pick out a single stock for consideration in the Amana Trust Growth portfolio as the fund tends to follows a widely-disbursed approach with little concentration in any single stock or sector. That said, the managers at Amana were very active during the second quarter, making additions to a number of its existing positions, as well as several new money purchases. The only problem with this activity, though, was that most of these purchases involved stocks that Morningstar believes are fully-valued. For example, Amana's top three holdings,  Apple (AAPL),  Akamai Technologies (AKAM) and  Intuit (INTU) are all trading at a premium to our fair value estimates right now.

It is worth noting, though, that Amana did double down on  Stryker (SYK), one of the few holdings in the fund trading at a 5-Star price and a favorite of Morningstar health care analyst Julie Stralow. Amana also made a meaningful addition to  Qualcomm (QCOM) during the second quarter, much as the fund had done during the first quarter. Qualcomm is the innovator of code division multiple access technology, a key communications. Noting that the company faces a host of strong competitors in the wireless handset chip space (losing out when handset prices plummet), Morningstar analyst Brian Colello believes that Qualcomm will still be able to generate stellar profitability for the foreseeable future.

Top Picks from Four of Our Best Performing Managers

Stock Price and Morningstar Rating data as of 07-23-10

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