Ten High-Conviction Buys from Our Ultimate Stock-Pickers

Brett Horn | Associate Director of Equity Research

Over the years, we've learned that successful investing requires that investors have their own point of view, which often means acting against the crowd. That said, completely ignoring the opinion of others is myopic, and often leads to disaster. While we at Morningstar benefit from the work of a large staff of stock analysts who evaluate companies under a consistent framework and methodology, we're not averse to learning from the insights of some of the best portfolio managers in the business. Through our Ultimate Stock-Pickers concept, we sift through the holdings, purchases, and sales of these top managers, hoping to not only uncover new investment ideas, but to gain further conviction in the recommendations of our own analysts through the real-world actions of some of the top minds in the industry.

With more than 80% of our top managers having reported their stock holdings for the most recent period, it is a good time to look at where they've been putting money to work by looking at both high-conviction purchases, and new-money buys. As you may recall, 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 probably safely assume that the managers at the  Yacktman (YACKX) fund, which had 12.7% of its stock portfolio invested in  News Corporation  at the end of the first quarter, compared to 1.3% in  Colgate-Palmolive (CL), have a higher degree of conviction in News Corp than they do in Colgate. 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 positions that might be difficult to unwind. For instance, Bruce Berkowitz holds a very large position in  St. Joe (JOE) though his  Fairholme (FAIRX) fund, which he might find difficult to either increase or decrease in size given that his fund holds about one quarter of all shares outstanding, and has effectively taken over leadership of the firm by capturing a majority of the company's board seats.

When looking at the stock purchases made by our top managers, it also pays to remember that the decision to buy these different securities was made during a prior period. As much as we'd like to be looking over their shoulders while our Ultimate Stock-Pickers hit the "buy" button, we doubt that they would be pleased with that arrangement, leaving us to be content with waiting for their quarterly holdings disclosures (which are generally filed within 60 days from the end of each fiscal quarter). This only increases the likelihood that the prices our top managers paid for these securities are much different than where they are today. Throw in a little volatility, such as we saw in the first quarter with the S&P 500 starting out the period at 1,257, rising as high as 1,343 in late February before retreating to 1,257 in mid-March, and finishing up the quarter at 1,326, and it becomes all that much harder to find the same bargains our top managers may have been seeing. That said, there were plenty of stocks that did not participate in what ended up being an upward movement in the markets during the first quarter, so we expect to find some ideas that continue to represent buying opportunities today.

Looking at the buying activity of the managers that have reported their holdings so far, we think that it is also important to note that inflows into U.S. stock funds exceeded $25 billion during the first quarter, which was their highest level since the first quarter of 2006 (and the first positive quarterly flows since the first quarter of last year). International stock funds also witnessed a decent level of inflows, with close to $15 billion flowing into them despite the turmoil in the Middle East, and the natural disasters in Japan, Australia, and New Zealand. With most of our top managers seeing money flow into their funds during the quarter, there was plenty of buying activity (about the highest we've seen across the group since we relaunched Ultimate Stock-Pickers two years ago). That said, much of the buying activity was focused on additions to existing positions rather than new-money purchases. While there were plenty of purchases made with a high degree of conviction behind them, the fact that there were few new-money buys (much as we've seen over the last year or so) tells us that the more than two-year rally in the markets has made it increasingly harder for our managers to move out of their comfort zones.

Top 10 High-Conviction Purchases by Our Ultimate Stock-Pickers

Stock Price and Morningstar Rating data as of 05-13-11 unless otherwise noted.

Looking over the top 10 high-conviction purchases that were made by our Ultimate Stock-Pickers during the most recent period, a few things stand out. First and foremost, we don't see a lot of 5-star names on the list. To us, this is not terribly surprising. At Morningstar, we believe that the market in the aggregate is marginally overvalued, and don't see too many deep-value opportunities following the strong rally in the markets over the last two years. The scarcity of 5-star names should, therefore, be seen as a dearth of truly attractive buying opportunities in our coverage universe, rather than a reflection of some sort of fundamental difference between our analysts and our top managers regarding the value of these firms. We also take comfort in the fact that we don't see our Ultimate Stock-Pickers throwing a lot of money at names that our analysts feel are materially overvalued (which would garner either a 2- or 1-star rating). It should also be noted that all of the top 10 purchases were firms with either wide or narrow economic moat ratings, with the preponderance of them having wide economic moats around their businesses. This tells us that our top managers continue to be focused on firms that have some sort of long-term competitive advantages, as opposed to chasing the "smaller, more-cyclical, and lesser quality issues" that have seen the largest increase in value since the market rebounded in March 2009.

PepsiCo Leads Consumer Staples Purchases
While there were more managers buying both  Microsoft (MSFT) and  Cisco (CSCO) during the period than were buying shares of  PepsiCo (PEP), the snack food giant was being bought with more conviction by the four managers--Yacktman,  Oakmark Equity & Income (OAKBX),  Jensen (JENSX), and  Amana Trust Growth (AMAGX)--that purchased shares in the firm, elevating it to the top of the list. For Yacktman, PepsiCo is clearly a high-conviction idea, with the managers increasing their stake in the firm by close to 70% during the period, making the stock its second largest holding (at 12.0% of its total equity holdings) at the end of the first quarter. Interestingly enough, Yacktman also had a 5.4% stake in PepsiCo's main rival,  Coca-Cola (KO), at the end of the period. While we can assume that the managers believed that PepsiCo's valuation was far more attractive than Coke's, given its increased commitment to the name, Yacktman's quarterly commentary offered a little more color on what has become its biggest commitment on a sector basis:

"In the last two years as the overall market recovered, many consumer staples stocks have significantly underperformed the shares of more cyclical or commodity-oriented businesses. Current valuations for the consumer staple positions we hold are extremely attractive, especially given the low level of business risk we believe these franchises have."

Having received a relatively large amount of investor inflows during the quarter, and with the level of volatility seen in the markets during the period, the managers may have felt the need to put the money to work in more defensive names like PepsiCo, which represented a flight to safety in the midst of a buoyant market. The same could also be said for Oakmark, which made a meaningful new-money purchase in PepsiCo during the quarter, as well as Jensen and Amana Trust Growth, both of which increased their stakes in the snack food giant.

Microsoft is Old Tech Selling at Fire Sale Prices
Of the five managers that made high conviction purchases in Microsoft during the most recent period, two of them-- FMI Large Cap (FMIHX) and  Dodge & Cox Stock (DODGX)--made new-money purchases in the software giant. In its quarterly commentary FMI Large Cap called the firm a "high-quality cash machine," and that "[e]ven if Microsoft were to achieve little or no profit growth in the future (a highly unlikely scenario), the company is likely to deliver solid returns to investors through repurchases and growing dividends." Perhaps this is what continues to draw  FPA Crescent (FPACX), Jensen, and Yacktman to the stock, with each of these managers making meaningful additions to their existing holdings in Microsoft during the period. Yacktman, in particular, increased its stake in the software giant by more than 50%, with Microsoft being its fourth largest stock holding at the end of the first quarter (accounting for 5.6% of the portfolio). In their quarterly commentary, the managers at Yacktman highlighted its holdings in Microsoft, Hewlett Packard, and Cisco, classifying the group as "old tech" names and noting that "we think we are getting good businesses at fire sale prices" as this group is trading at half the multiple of the S&P 500 despite exhibiting "business characteristics that we believe are superior to the average company in the S&P 500."

Speaking with our analyst who covers the firm, Sunit Gogia, we learned that this longstanding goliath of the tech industry is operating under somewhat of a "cloud" these days. While not completely sanguine about the effects of cloud computing on Microsoft's competitive position, noting that "cloud-based services sever the historical ties between applications and operating systems and lower the barriers for switching among computing platforms," Gogia sees the risk as being somewhat balanced with the opportunities (as cloud-based software services will generate additional revenues for the firm). The managers at FMI Large Cap seem to agree that there are potential positives for Microsoft in this changing environment, noting that

"Microsoft's forward-thinking R&D efforts have made it the world's premier cloud computing company. Almost silently, the Windows-loaded notebook PC has become the lowest cost and best-performing Internet-connected device available. The targeted strategies of Apple and Google present specific risks, but we are being paid to take this risk at just 10 times free cash flow."

Microsoft traded in a range of about $25 to $28 during the first quarter, and currently trades at a little over $25, so investors purchasing shares today are likely to be buying at a price that is comparable to--or maybe even a little better than--the price our Ultimate Stock-Pickers realized during the first quarter.

Our Top Managers Continue to Accumulate Cisco
Much as they had in the previous period, our top managers continue to be net accumulators of shares of Cisco Systems, with two of the five managers buying the stock during the first quarter making new-money purchases in the name. In its quarterly commentary,  Tweedy Browne Value (TWEBX) noted the following about its new-money purchase:

"Cisco is financially strong and we think statistically cheap. It has a dominant market position and has been growing within a category that we believe still has a lot of room for future growth. Perceived competitive threats and concerns about possible slower rates of growth have put pressure on Cisco's stock price, which has allowed us an entry point in the stock that we believe is at roughly a one third discount from a conservative estimate of the company's intrinsic value."

A sentiment that was likely echoed by the managers at  Mutual Shares (TESIX), which also established a new position in the name, as well as by Yacktman, Amana Trust Growth, and  Parnassus Equity Income (PRBLX), which continue to add to their stakes. While market concerns over increased competition in the switches segment, slowing growth, and the potential for margin compression have put pressure on the stock, our analyst, Grady Burkett, remains bullish on Cisco. He believes that the business is still fundamentally attractive, and that the market is not appreciating Cisco's commitment to improving capital allocation and the company's management structure. This sounds a lot like the comments put forth by the managers at Parnassus, who noted in their most recent commentary that "Cisco remains well-positioned over the long term due to its large scale advantages, significant customer switching costs, new products, and reputation as the leading provider of enterprise networking solutions. At less than 11 times estimated 2011 earnings, and with over $25 billion of net cash on its balance sheet, Cisco looks undervalued." And this was even before the company reported its fiscal third-quarter earnings, which included a modest lowering of the firm's near-term guidance, which led to another drop in the price of Cisco's common stock.

Fortress Balance Sheets Attract Some Managers
While there are some that might balk at the idea of buying Cisco, it is not the only attractively priced stock on our list of top 10 high-conviction purchases by our Ultimate Stock-Pickers. Trading at 71% of our fair value estimate,  JP Morgan Chase (JPM) is the second-cheapest stock on the list. While there weren't many financial services executives that came out of the financial crisis with an improved reputation, JP Morgan's CEO, Jamie Dimon, may be the highest profile member of this rather exclusive club. Morningstar analyst Jaime Peters believes that the company's success is largely due to Dimon's "tight grip on the risks the company takes as a whole," and his insistence on having a "fortress balance sheet." This, in her view, allowed the bank to operate from a position of relative strength during the crisis. That said, Peters feels that Dimon now faces a whole new set of hurdles as JP Morgan attempts to navigate what has become a more challenging regulatory environment, especially the Basel III standards (set to start phasing in during January 2013), which will force banks to hold more capital and, ultimately, crimp profitability. The fact that JP Morgan's current market price equates to a price/book multiple of only 1.1 times suggests to us that the market believes the company will have difficulty achieving excess returns given these new requirements. In Peters' mind, that's selling Jamie Dimon a bit short, as she continues to believe that JP Morgan can achieve a 13% return on equity in the long run.

The managers at  ASTON/Montag & Caldwell Growth (MCGIX) like the stock as well. JP Morgan is the only financial stock they hold, and they seem to think this financial giant is poised to excel given improving market conditions. As they noted in their most recent commentary, "we increased the position as we believed that dividend payments were likely to be implemented by the end of the first quarter, which subsequently occurred. In addition, the stock was attractively valued on both current and normalized earnings, the yield curve is steeper, and the macro environment has improved�which helps both credit-quality and loan demand." JP Morgan traded in a range of about $44 to $48 during the first quarter, and currently trades at about $43, so investors buying today are likely to realize a better price than our Ultimate Stock-Pickers did during the first quarter.

If you're interested in receiving e-mail alerts about upcoming articles from The Ultimate Stock-Pickers Team, please sign up here.

Disclosure: Brett Horn owns shares in the following securities mentioned above: Cisco Systems.