10 High-Conviction Buys from Our Ultimate Stock-Pickers
Recent buying activity offers insight into the thinking of our top managers.
By Brett Horn | Associate Director of Equity Research
When we relaunched Ultimate Stock-Pickers, our aim was to come up with investment ideas that not only reflected the most recent activity of top investors we admire, but which we believed could be timely enough for investors to extract some value from them. By cross-checking the most current valuation work and opinions of Morningstar's cadre of stock analysts against the actions of some of the top equity managers in the industry, we hoped to uncover ideas that investors would find useful. With more than half of our Ultimate Stock-Pickers having already reported their fourth-quarter holdings, and most equity markets up more than 60% off their bear market lows--with the S&P 500 Index (SPX) posting double-digit returns in each of the last two years--we thought it would be interesting to see where our top managers have been putting money to work lately.
Looking at the purchases our Ultimate Stock-Pickers make in any given period, we tend to hone in on both high-conviction purchases, and new money buys. We believe that managers send signals about the level of conviction they have in a position by how much of their portfolio (on a percentage basis) they're willing to commit to a given name at any point in time. For example, we can generally assume that the managers at FMI Large Cap (FMIHX), which had 5.5% of its stock portfolio invested in 3M Company (MMM) at the end of January 2011 compared to 2.8% in Schlumberger (SLB), have a higher degree of conviction in 3M than they do in Schlumberger. That said, position size can sometimes be influenced by the amount of the portfolio a manager wants committed to a particular sector (especially when there are only a few truly investable ideas in the sector). It can also be influenced by large legacy positions that have become difficult to unwind, which seems to be the case with some of Berkshire Hathaway's (BRK.A) (BRK.B) top holdings, like Coca-Cola (KO) and Wells Fargo (WFC), which made up 25.0% and 20.2%, respectively, of the insurer's total stock holdings at the end of the fourth quarter of last year.
We define high-conviction purchases as instances where managers make meaningful additions to their existing holdings, or make significant new money purchases in names not in the portfolio at the end of the previous quarter. We believe that new money purchases ultimately give us the most insight into what our Ultimate Stock-Pickers think might be the most attractive buying opportunities in the current period, as managers typically only put money to work in new names when their purchase decision carries a very high degree of conviction. As we've said in the past, we continue to believe that it is far easier for managers to put money to work in holdings they are already comfortable with than it is for them to make a bet on a new name.
When looking at all of these different stock purchases, it pays to remember that these buy decisions were made during a prior period. This means that the prices our top managers paid for these securities will likely to be different from where they are trading today. As such, the stock that had our managers excited in the fourth quarter might be not such a great buying opportunity now, either due to a change in the company's position,or movement in the share price. With the market up more than 5% since the beginning of the year, and more than 15% since the end of the third quarter of 2010, it's likely that our managers were able to purchase securities at better prices than investors can realize today. That said, not all stocks have rallied (or, in some cases, sustained their rallies) over the last few months, such that ideas our managers acted on in the fourth quarter could actually present an even better buying opportunity today.
Top 10 High Conviction Purchases by Our Ultimate Stock-PickersStar RatingSize of MoatCurrent Price ($)Price/Fair ValueFair Value Uncertainty# Funds HoldingCisco Systems (CSCO)5Wide18.700.62Medium8Procter & Gamble (PG)4Wide64.730.84Low123M (MMM)3Wide91.800.92Low7Paychex (PAYX)3Wide33.330.88Medium3Microsoft (MSFT)3Wide27.250.85Medium14Wells Fargo (WFC)3Narrow33.760.87Medium11Accenture (ACN)3Narrow52.400.95Medium6PepsiCo (PEP)4Wide63.870.87Low9Apollo Group (APOL)4Narrow42.990.74High3Sysco Corp (SYY)4Wide28.240.78Medium6
Stock Price and Morningstar Rating data as of 02-11-11
Cisco Systems (CSCO), for example, which was a high-conviction purchase for four of our top managers-- Parnassus Equity Income (PRBLX), Yacktman (YACKX), Matrix Advisors Value (MAVFX), and RS Capital Appreciation (RCAPX)--during the fourth quarter is currently trading below its average trading price in the low $20s during that three-month period. Of these four managers, Parnassus increased its holdings in Cisco by more than 150%, while Yacktman made a meaningful new money purchase in the name. With the stock hitting a rough patch in the current quarter (something we'll go into further details about later in the article), it will be interesting to see whether or not these same managers stepped up this month when the stock dropped down below $19 per share.
Procter & Gamble (PG) was another name bought with conviction by four of our top managers-- Aston/Montag & Caldwell Growth (MCGIX), Parnassus, Yacktman, and Jensen (JENSX)--during the most recent period. Both Yacktman and Jensen increased their stake in the consumer products giant by around 30%, with Aston/Montag & Caldwell and Parnassus increasing their holdings by more than 50%. It's also interesting to note that Parnassus and Yacktman were big buyers of both Cisco and Procter & Gamble, which demonstrates these two managers search across a wide range of opportunities, from high tech to old school consumer products, in order to find holdings for their portfolios. The managers at Yacktman believe it is important to not only generate attractive, positive returns that outperform the benchmark over time, but protect investor capital from material, permanent losses. This generally has the fund picking up securities one at a time, emphasizing businesses that have strong market positions and relatively stable profit margins, generated by selling products or services that have fairly stable demand in both good times and bad.
Meanwhile, 3M drew additional interest from FMI Large Cap, which increased its stake in the industrial conglomerate by more than 40%. Jensen and RS Capital also made meaningful purchases in the name, with the managers at Jensen noting that, in the fourth quarter, they were actively trimming positions that had increased in value, deploying the profits into positions they felt were more attractive on a price-to-value basis. By the end of January 2011, Jensen had completely blew out Johnson & Johnson (JNJ) and made a meaningful reduction in its stake in Oracle (ORCL), while making a high-conviction new money purchase of Becton Dickinson (BDX), as well as meaningful additions to PepsiCo (PEP), Paychex (PAYX), United Technologies (UTX), Adobe Systems (ADBE), Equifax (EFX), Medtronic (MDT), Microsoft (MSFT), and Abbott Laboratories (ABT).
Jensen was not alone in its purchase of Pepsi and Paychex, as Yacktman made a meaningful addition to its stake in the snacks foods giant and Jensen significantly increased its stake in the payroll outsourcing firm. Jensen also had company in its purchase of Microsoft, with FPA Crescent (FPACX) increasing its stake in the software giant by close to 70%. The fund was not, however, a purchaser of Wells Fargo, which was a meaningful new money purchase at Parnassus, and a significant addition for Matrix Advisors Value. Accenture (ACN) was the recipient of two meaningful new money purchases during the quarter by Aston/Montag & Caldwell and Columbia Dividend Income (LBSAX). The managers at Aston/Montag & Caldwell initiated four new positions in their stock portfolio during the quarter--Accenture, Carnival (CCL), Apache (APA), and Halliburton (HAL). They noted that Accenture was experiencing an acceleration in the growth of bookings and revenue, and that the firm should benefit from a steady improvement in discretionary IT spending. The fund managers also believe that emerging market growth and a weak U.S. dollar could provide an incremental boost to earnings growth, as more than half of the company's revenue is derived outside of the United States.
We were not too surprised to see Apollo (APOL) show up on the list, as the for-profit education space has been embroiled in controversy for much of the last year, with respected investors on both sides of the trade voicing their opinions. The managers at RS Capital (the successor to Oak Value fund) had started building their stake in Apollo during the second quarter of 2009, increased their holdings in the first quarter of last year, and continued to pick up shares in the last two quarters of 2010. This marks the third time in the last five years that the managers have held a stake in this leader in the for-profit education industry. RS Capital was not alone in its purchase of Apollo, as Yacktman was also adding to its stake in the firm during the fourth quarter. Sysco (SYY), meanwhile, was a meaningful addition for both Yacktman and Parnassus, which increased their stakes in the food services distributor by 40% and 30%, respectively, during the most recent period. The company's fortunes remain closely tied to the improvement in the restaurant industry, which has been slow to recover in the aftermath of the collapse of the housing, credit and equity markets two and a half years ago. The company's focus expanding its distribution platform, improving its supply-chain efficiency, and increasing the productivity of its salesforce should drive growth longer term and prevent Sysco's competitive advantages from eroding over time.
Two High Conviction Purchases Are Still Compelling
Looking deeper into the list, we see two stocks that we believe are worth delving deeper into, as these two names were not only the most widely bought by our managers during the most recent period but continue to trade at relatively attractive prices, based on our analysts' estimates of their fair value.
Cisco Systems (CSCO)
Our analysts covering the tech sector do not believe it is awash with companies with economic moats, as the fast pace of technological innovation makes sustainable competitive advantages hard to come by. But Morningstar analyst Joe Beaulieu believes that Cisco's dominance in data networking is clear. Its Ethernet switches, which move data along local computer networks, are ubiquitous in business information technology. Cisco's share of the switch market has hovered near 70% during each of the last five years, while Hewlett-Packard (HPQ), its closest competitor, languishes at around 10%. This dominance is unlikely to change in the foreseeable future, as enterprise IT managers are loath to switch vendors and risk network disruptions and corporate IT has practically standardized on Cisco equipment. While Joe does not contest the strength of Cisco's market position, he's not too enthralled with its unbridled pursuit of growth, which he feels could lead it to make ill-advised acquisitions, or enter less attractive businesses. Still, on balance, he thinks that the company can be successful long term.
Four of our top managers apparently believed the stock was trading at a reasonable enough valuation to warrant putting money to work in the name during the most recent period. In talking about its purchase of the technology firm, Yacktman noted that Cisco's shares have fallen more than 75% from their peak during the 2000 tech bubble, even though sales and earnings per share of the business have more than doubled. The managers noted that the company has a strong balance sheet, solid management, and that it was selling for around 12 times 2011 earnings during the fourth quarter after adjusting for net excess cash. That said, the stock was down almost 15% recently after the company reported fiscal second quarter earnings, as Cisco's gross margins came in below market expectations. Our analyst maintained his fair value estimate in the face of these weaker-than-expected results, noting that even if gross margins do not recover at all, it would only mean a slight haircut to his current valuation. As is often the case with value investors, it looks like our Ultimate Stock-Pickers might have been a tad early on this one, which means that investors are now looking at an even better bargain than most of our managers were seeing in the last three quarters of 2010.
Procter & Gamble (PG)
Our analyst, Lauren DeSanto, believes that Procter & Gamble's size confers tremendous benefits in terms of distribution, brand reach, and scale with suppliers, but that the goliath has been slow off the block in responding to the dramatic downturn in consumer spending. She notes that, over the past year, the firm has implemented plans to reinvigorate top-line and earnings growth, and remains confident in its strategies as the household product stalwart repositions itself for a more challenging economy. Lauren believes that at its core P&G possesses unprecedented skills in consumer understanding, marketing, and brand-building, and that these skills haven't wavered, despite the firm's slow reaction to the downturn. She also believes that the market is underestimating the company's strengths in light of its recent issues, and that the firm is now back on solid ground. P&G's aggressive plans to expand its brands into new categories and markets and to streamline its operations along the way, while not particularly new, have left its strategies and tactics far more integrated than they have been in some time.
While top-line growth will likely be constrained in the more mature markets where Procter and Gamble competes, the current market price, which equates to a 7% free cash flow yield (on fiscal 2010 results), does not give P&G credit for developing market opportunities, where Lauren expects it to leverage its brand portfolio and extensive distribution network to achieve its targeted 8% to 10% sales growth. Since the start of October 2010, the P&G has traded between $60 and $67 per share, with the stock currently trading a bit above the midpoint of that range. As such, it is likely that investors looking at the stock today would have an opportunity to purchase shares at a comparable price to that which our Ultimate Stock-Pickers realized during the fourth quarter of last year.
Disclosure: Brett Horn owns shares in the following securities mentioned above: Apollo Group.
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.