Ultimate Stock-Pickers' Top Stock Picks Outperforming the Market

By Greggory Warren, CFA | Senior Stock Analyst

As we've mentioned in past articles, 2011 continues to look an awful lot like 2010. After the markets rose more than 5% during the first quarter of both years, concerns over sovereign debt in the Southern countries of the European Union sparked a rather marked decline in the equity markets in the second (and third) quarters of 2010 and 2011. Throw in a manufactured debt-ceiling crisis here in the United States this year, which only added to the concerns that investors already had about the moribund pace of the economic recovery (as it became apparent that Washington was far more concerned with playing politics than getting anything done to improve the economy), and domestic stock markets returned to levels of volatility not seen since May of last year (with daily trading activity looking more and more like it did during the darkest days of the financial crisis).

With the S&P 500 Index down slightly more than 5% from the start of 2011 through the end of last week, the markets are about where they were this time last year. While it would be nice to see the S&P 500 recover from here, much like it did during the final four months of 2010, we're not holding out for a 20%-plus return through the end of 2011 (which is what it took to generate a double-digit gain in the benchmark index last year). With the economy not getting much better (and yet at the same time not getting much worse), and equity markets continuing to be volatile (turning as rapidly on good news as they have on bad), we could just as easily close out the year in positive territory as we could end it with the markets losing more ground. Add to that the fact that the next two months represent the most difficult period historically for the markets--with September typically being the worst month for market returns and October recording five of the 10 largest daily percentage declines over the past century--and the odds continue to favor more downside than upside in the near term.

Against this backdrop, it is interesting to note that more than a handful of our top managers were beating the market this year through the end of last week. Of the nine fund managers outperforming so far in 2011, only one of them--Yacktman (YACKX)--had a positive return. We highlighted the success that the father and son team of Donald and Stephen Yacktman has had historically in an article earlier this year, noting that their fund has produced returns over the last three-, five-, and 10-year time frames that have not only surpassed the S&P 500 Index by a wide margin, but also have beaten every one of the 22 mutual fund managers on our Investment Manager Roster.

Over the last year, Yacktman was also one of only two fund managers--the other being  Aston/Montag & Caldwell Growth (MCGIX)--to beat the market. Both managers were overweight in more traditional defensive sectors over the last 12 months, with more than 25% of their portfolios in consumer defensive stocks and another 15%-plus in health-care names. While not even close to generating the level of outperformance produced by the energy sector (which was up more than 25% year over year), both sectors were up at least 15% (compared to a 10% total return for the market overall). Yacktman and Aston/Montag & Caldwell Growth also had less than 10% of their total stock holdings invested in financial services--the worst performing sector in the market over the last year (as well as year to date)--which was far less than the 22% in aggregate that our Ultimate Stock-Pickers had invested in financials over the last year.

With just two of our top fund managers beating the market over the last year, we were curious to see how the top holdings, purchases, and sales of all of our Ultimate Stock-Pickers from the year-ago period fared over the last 12 months, in order to see if their collective stock picking was able to outperform the markets, as well as their own individual funds. As you may recall, we determine the level of conviction that our managers collectively have in a particular stock holding by not only noting how many funds hold the name, and whether or not they've been adding to (or subtracting from) their positions, but also by looking at the percentage that each security makes up of the portfolios being run by each of our top managers.

Performance of Ultimate Stock-Pickers' Top Holdings Year Over Year   Current Price (USD) Year-Ago Price (USD) Year-Ago Star Rating Price Return Dividend Yield Total Return Brksh Hthwy (BRK.B) 69.37 81.19 3 -14.6% - -14.6% Jhnsn & Jhnsn (JNJ) 64.07 58.61 5 9.3% 3.7% 13.1% Coca-Cola (KO) 69.74 57.38 3 21.5% 3.2% 24.7% Exxon Mobil (XOM) 72.14 61.06 5 18.1% 3.0% 21.1% Wells Fargo (WFC) 24.20 25.10 5 -3.6% 1.6% -2.0% Microsoft (MSFT) 25.80 23.94 4 7.8% 2.7% 10.4% Prctr & Gmbl (PG) 62.55 60.07 5 4.1% 3.4% 7.5% Wal-Mart (WMT) 52.03 51.76 4 0.5% 2.7% 3.2% Amrcn Exprss (AXP) 48.51 40.88 3 18.7% 1.8% 20.4% CncPhllps (COP) 66.44 54.43 3 22.1% 4.6% 26.7% S&P 500 Index       7.7%   9.9%

Current and Year-Ago Stock Price and Morningstar Rating data as of 09-02-11 and 09-02-10, respectively.

Looking at the top 10 holdings of our Ultimate Stock-Pickers at the end of the year-ago period, the list was weighted more toward sectors that actually outperformed over the last year--such as energy (up 28%), consumer defensive (up 16%), health care (up 15%), and technology (up 11%)--as opposed to those that underperformed--like financial services (down 10%). This left our managers with six top holdings that outperformed the market (on a total return basis). That said, the outperformance wasn't necessarily a direct result of sector allocation, as two of the three consumer defensive names on the list-- Procter & Gamble (PG) and Wal-Mart (WMT)--actually underperformed the market during the last year. And while the energy, health care, and technology names all lived up to the outperformance generated by their sectors,  American Express (AXP) actually bucked the trend of underperforming financials, generating a 20% total return year over year. It is also interesting to note that on an equal-weighted basis, these 10 stocks beat the market over the last 12 months.

Only time will tell if a majority of the top holdings of our Ultimate Stock-Pickers during the most recent period will also outperform the market. While eight of the top 10 holdings from the year-ago period are still on the list this year, American Express and  ConocoPhillips (COP) were replaced in the interim with  PepsiCo (PEP) and Cisco Systems (CSCO) (which are currently cheaper on a price-to-fair-value basis than the two companies that they replaced). Looking at the top 10 holdings of our Ultimate Stock-Pickers at the end of the most recent period, there is the potential for a 20%-plus return if all of the stocks on the list reach our analysts' current fair value estimates over the course of the next year.

Performance of Ultimate Stock-Pickers' Top Purchases Year Over Year   Current Price (USD) Year-Ago Price (USD) Year-Ago Star Rating Price Return Dividend Yield Total Return Occdntl Ptrlm (OXY) 83.41 77.84 3 7.2% 2.2% 9.3% Exxon Mobil (XOM) 72.14 61.06 5 18.1% 3.0% 21.1% Microsoft (MSFT) 25.80 23.94 4 7.8% 2.7% 10.4% Amrcn Intl Grp (AIG) 23.66 30.09 3 -21.4% - -21.4% Goldman Sachs (GS) 107.06 139.78 3 -23.4% 1.0% -22.4% Brksh Hthwy (BRK.B) 69.37 81.19 3 -14.6% - -14.6% Coca-Cola (KO) 69.74 57.38 3 21.5% 3.2% 24.7% MasterCard A (MA) 320.68 204.73 3 56.6% 0.3% 56.9% Jhnsn & Jhnsn (JNJ) 64.07 58.61 5 9.3% 3.7% 13.1% Pfizer (PFE) 18.46 16.40 5 12.6% 4.8% 17.3% S&P 500 Index       7.7%   9.9%

Current and Year-Ago Stock Price and Morningstar Rating data as of 09-02-11 and 09-02-10, respectively.

With our top managers sticking more with names they were comfortable with in the year-ago period rather than venturing off into too many new names, it didn't surprise us much to see five of the top purchases made during the second quarter of 2010 coming from the list of top 10 holdings during the period. Besides having four of the better performing top 10 holdings-- ExxonMobil (XOM),  Microsoft (MSFT), Coca-Cola (KO), and  Johnson & Johnson (JNJ)--on their list of top 10 purchases last year, our Ultimate Stock-Pickers also saw fairly strong performance from  Pfizer (PFE) and  MasterCard  (MA), the latter of which bucked the trend of underperformance by the financial services sector over the last 12 months.

Looking at the financial services firms on the list that traded more in line with the rest of the sector,  American International Group (AIG) and  Goldman Sachs (GS) were both high-conviction, new-money purchases for Bruce Berkowitz's  Fairholme (FAIRX) fund in the first half of 2010. As we've noted previously, Berkowitz started making a big bet on financials around two years ago, with the sector accounting for more than three quarters of Fairholme's stock holdings over much of the last year. As such, it does not surprise us to see Berkowitz's fund down around 13% over the last 12 months (and down more than 26% since the start of the year). With investor redemptions and increased purchases of financial services stocks eating away at the cash cushion Fairholme has traditionally maintained (which actually declined from 25% of the total portfolio earlier this year to less than 5% at the end of the most recent period), Berkowitz has lost one of the counterbalances he's had for the more concentrated stock positions he holds in his fund.

Much as we noted with our Ultimate Stock-Pickers most recent top 10 holdings, only time will tell if their top purchases during the second quarter (and first part of the third quarter) of this year will outperform over the next 12 months. That said, the list of top 10 purchases this time around was dominated by technology and financial services stocks, which, while significantly cheaper on a price-to-fair-value basis than most other sectors, have been far less in favor with investors. In particular, several of our top managers may now wish they had walked away from  Hewlett-Packard (HPQ) during the second quarter rather than throwing additional money at the name, as the shares have declined more than 30% since the end of June after the company not only lowered its full-year guidance for the third quarter in a row, but also announced it was exploring strategic alternatives for its PC division, admitted that its table and phone strategies have been a failure, and announced a $10 billion software acquisition.

Performance of Ultimate Stock-Pickers' Top Sales Year Over Year   Current Price (USD) Year-Ago Price (USD) Year-Ago Star Rating Price Return Dividend Yield Total Return Gnrl Elctrc (GE) 15.76 15.15 5 4.0% 3.6% 7.7% BP Plc ADR (BP) 36.53 36.57 3 -0.1% 3.4% 3.3% Comcast 20.80 16.97 4 22.6% 2.4% 25.0% Avon 21.48 29.92 4 -28.2% 3.0% -25.2% Plains E&P 28.31 24.64 3 14.9% - 14.9% Diageo (DEO) 80.54 67.68 3 19.0% 3.7% 22.7% Wal-Mart (WMT) 52.03 51.76 4 0.5% 2.7% 3.2% UnitedHealth (UNH) 45.73 32.86 5 39.2% 2.1% 41.3% Assurant (AIZ) 33.37 37.62 3 -11.3% 1.8% -9.5% Nwmnt Mining (NEM) 64.47 61.53 3 4.8% 1.1% 5.8% S&P 500 Index       7.7%   9.9%

Current and Year-Ago Stock Price and Morningstar Rating data as of 09-02-11 and 09-02-10, respectively.

Looking at the list of top 10 sales that were made during the second quarter of 2010, only one of the names--Wal-Mart--was a top holding for our managers. The sale also appears to have been fairly prescient, as the stock returned less than 4% (on a total return basis) over the last year. It is also interesting to note that just four of the top sales from the year-ago period outperformed the market during the last 12 months, with none of those sales looking to be the result of "forced selling" (which we define as sales made by fund managers in order to meet investor redemptions during periods of market volatility). We would also note that the sale of  BP PLC (BP), which was dumped by three-- Amana Trust Growth (AMAGX),  Amana Trust Income (AMANX), and  FMI Large Cap (FMIHX)--of the four managers that held it coming into the second quarter of 2010, was directly tied to the Gulf of Mexico oil spill.

Much as we noted with our Ultimate Stock-Pickers most recent top 10 purchases and holdings, only time will tell if their top sales during the second quarter (and first part of the third quarter) were prudent moves or not. The one discernible trend in the most recent period was to sell down energy names--like  Total SA (TOT), Schlumberger (SLB),  Baker Hughes , and  Devon Energy (DVN)--which makes a lot of sense to us, given that the sector was up so strongly over the last year. As for the rest of the names on the list, these sales seemed to be driven more by the need to cover investor redemptions than anything else. We continue to believe that this trend extended well into the third quarter, given the dramatic downturn in the markets that started at the end of July. As such, we're likely to see even more quality names working their way up on to the list of top sales during the third quarter, much as we did last year (and during the fourth quarter of 2008 and first quarter of 2009).

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Disclosure: Greggory Warren owns shares in the following securities mentioned above: Amana Trust Growth, Amana Trust Income, and Procter & Gamble. It should also be noted that Morningstar's Institutional Equity Research Service offers research and analyst access to institutional asset managers. Through this service, Morningstar may have a business relationship with fund companies discussed in this report. Our business relationships in no way influence the funds or stocks discussed here.