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Investing Specialists

10 Ultimate Stock-Picker High-Conviction Buys

An early read of their purchases shows that our top managers were building up stakes in more defensive names during the third quarter.

By Greggory Warren, CFA | Senior Stock Analyst

As many of you may recall, the members of The Morningstar Ultimate Stock-Pickers Team regularly scour through the holdings, purchases, and sales of more than 25 different investment managers, each with a track record of beating the market over extended periods of time, in order to surface stocks that may have caught the attention of these top managers. Given the breadth of our own equity research, we feel that we are in a fairly unique position to cross-check the activity of these Ultimate Stock-Pickers against the valuation work and opinions of Morningstar's own cadre of stock analysts, with the end goal being to uncover investment ideas that investors might find useful.

With more than 20 of our top managers having already reported their stock holdings for the most recent period, we're beginning to get a good feel for where our Ultimate Stock Pickers were putting money to work during the third quarter and early part of the fourth quarter. With the markets in turmoil during much of this period, some of the trading activity was reminiscent of the fourth quarter of 2008 and first quarter of 2009, when many managers were selling more stable names--like International Business Machines (IBM), Wells Fargo (WFC), and Abbott Laboratories (ABT)--to help meet redemption requests. After seeing more than $25 billion flow into U.S. stock funds (and $15 billion flow into international stock funds) during the first quarter, investors reversed course during the second quarter, pulling money out of equities at an accelerating rate. This trend continued into the third quarter, with investors pulling out close to $45 billion from U.S. stock funds (and more than $3 billion from international stock funds).

After trailing off a little in September, outflows from U.S. stock funds picked up dramatically again in October, matching the levels that were seen during the height of the debate over the U.S. debt ceiling, and the subsequent lowering of our government's AAA credit rating by S&P, during July and August. It was against this backdrop that our Ultimate Stock-Pickers were reviewing their portfolios and making purchases or sales that they felt would prepare them for the next stage in the markets. Much as we saw in the second quarter, our top managers continue to have a reserved attitude about the global markets and the U.S. economy. While there are glimmers of improvement out there, it looks like top-down events--like the back-and-forth in Europe over the future of not only Greece and Italy but also the European Union itself, the ongoing debate about federal spending here in the U.S., and the moribund state of the U.S. employment and housing markets--will continue to trump company fundamentals. All of this creates even more volatility in the markets, which explains why most of our managers closed out the most recent period with marginally higher levels of cash on hand, in the event that redemptions continue at an elevated pace in the near term.

Our Top Managers Still Putting Money to Work
While the selling activity has spiked over the last couple of quarters, there has also been a fair amount of buying activity, as some of our managers saw the third quarter as an opportunity to either shore up positions in existing holding or build stakes in new names. As you may recall, when we look at the purchases made by our Ultimate Stock-Pickers in any given period, we tend to focus more heavily on high-conviction purchases, which we define as instances where managers make meaningful additions to their existing holdings, or where they make significant new-money purchases in names that were not in their portfolios at the end of the previous periods. We believe that managers send signals about the level of conviction they have in a stock holding by how much of their portfolio (on a percentage basis) they're willing to commit to a name at any given point in time. For example, we can probably safely assume that the managers at the Yacktman (YACKX) fund, which had 12.6% of their stock portfolio invested in PepsiCo (PEP) at the end of the third quarter, compared with 1.2% in  Colgate-Palmolive (CL), have a higher degree of conviction in PepsiCo than they do in Colgate.

That said, position size can sometimes be a reflection of a sector bet more than anything else, especially when there are only a few truly investable ideas in a sector. It can also be indicative of a situation where a manager has built up a large stake in a company that has now become difficult to unwind. For instance, Bruce Berkowitz continues holds a very large position in American International Group (AIG) though his Fairholme (FAIRX) fund, which he would find difficult to either increase or decrease in size given that he is already the second-largest shareholder in AIG (behind the U.S. government). A quick look at Berkowitz's third-quarter holdings also shows that he has not only run through the large cash cushion he has traditionally maintained for his fund, but also is holding a portfolio chock full of financial services stocks that could prove difficult to unwind if he needed to raise additional cash in a hurry--not the best position to be in when the markets are as volatile as they have been this year.

When looking at the stock purchase made by our Ultimate Stock-Pickers, it also pays to remember that these buy decisions were actually made during a prior period. This means that the prices our top managers paid for these securities are likely to differ from where the stocks are trading today. As such, the security that had our managers excited during the third quarter might be not so exciting now, either due to a change in the company's position or movement in the share price. With the S&P 500 Index SPX up more than 10% from its mid-August lows (and approximately 15% from the start of October), it is more likely than not the case that many of their conviction purchases are trading at much higher prices than they were when our managers bought them. That said, many of them are still trading within reach of our own analysts' consider buy prices, making them worth monitoring, as the ongoing volatility in the global equity markets is likely to provide more buying opportunities for investors in the near term.

10 High-Conviction Purchases by Our Ultimate Stock-Pickers 

  Star Rating Moat Size Current Price (USD) Price/Fair Value Fair Value Uncertainty # Funds Buying Microsoft (MSFT) 4 Wide 26.91 0.84 Medium 5 Omnicom (OMC) 4 Narrow 44.35 0.89 Medium 3 Anhser-Bsch (BUD) 3 Wide 59.29 0.96 High 3 CVS (CVS) 3 Narrow 39.24 1.06 Medium 3 Google (GOOG) 4 Wide 608.35 0.82 High 3 PepsiCo (PEP) 4 Wide 63.28 0.83 Low 2 Abbott (ABT) 5 Wide 54.53 0.8 Low 2 Sysco (SYY) 4 Wide 27.75 0.77 Medium 2 Corning (GLW) 4 Narrow 15.19 0.8 High 2 Stryker (SYK) 4 Wide 49.48 0.79 Medium 2 Stock Price and Morningstar Rating data as of 11-11-11.

Looking over the 10 high-conviction buys of our Ultimate Stock-Pickers, it was interesting to see technology names like Microsoft (MSFT) and Google (GOOG) continuing to garner attention from our top managers, much as they did during the first and second quarters. In the most recent period, five of our Ultimate Stock-Pickers were making meaningful purchases of Microsoft, with Dodge & Cox Stock (DODGX) and FMI Large Cap (FMIHX) adding to stakes that were started earlier this year, and Hartford Capital Appreciation (ITHAX) establishing a new stake in the software giant. We also saw Columbia Dividend Income (LBSAX) and Oakmark (OAKMX) adding to what were long-standing Microsoft positions in their portfolios during the third quarter. With Google, both Amana Trust Growth (AMAGX) and Hartford Capital Appreciation made meaningful additions to their holdings in the firm, while the managers at Mutual Shares (TESIX) established a brand-new stake in the name.

And while the purchase wasn't picked up initially by The Ultimate Stock-Pickers Team, given that Berkshire Hathaway (BRK.A)/(BRK.B) had yet to file its 13-F with the SEC when we first put together the data for this article, it was interesting to see Warren Buffett announce this week that he had finally taken the plunge into the technology sector, picking up shares of IBM through the first, second, third, and fourth quarters of 2011 (even as some of our other top managers were selling the stock in the most recent period). Buying up 64 million shares of the technology giant, at a cost of more than $10 billion, Berkshire is now one of the largest shareholders in IBM (holding more than 5% of the company's total shares outstanding), which, given Buffett's long-standing aversion to technology stocks (mainly because he felt that it was too difficult to predict which technology firms would actually prosper in the long run), is a surprising turn of events. While some have argued that Buffett was paying a premium for IBM, our own calculations show him to be up at least 10% on his purchases (based on the cost basis figure that he revealed for his stake in the technology giant). This wouldn't be the first time that Buffett has shown a willingness to change course in order to put money to work, with the 2009 purchase of Burlington Northern Santa Fe being the best example.

Defensive Names Garnered More Attention in the Third Quarter
What was not surprising during the most recent period, though, was the number of defensive names that our top managers picked up in response to the volatility in the markets. From consumer defensive names like Anheuser-Busch InBev (BUD) and PepsiCo to health-care names like Abbott Laboratories and Stryker (SYK), our Ultimate Stock-Pickers were taking advantage of the decline in the markets to pick up these names at prices that either matched or surpassed our own analysts' consider buy prices. Anheuser-Busch is now held by five of our managers, with three of them--Alleghany , FPA Crescent (FPACX), and RS Capital Appreciation --each investing as much as 4% of their equity portfolios in the name. Meanwhile, PepsiCo continues to be held by nine of our top managers, with two of them--Yacktman and Oakmark Equity & Income--making meaningful additions to their holdings in the snack-food giant. Of note, though, is the fact that Columbia Dividend Income actually eliminated what had been a long-standing position in PepsiCo during the third quarter.

Looking more closely at CVS-Caremark (CVS), another consumer defensive name on the list, the stock continues to be held by eight of our top managers, three of which--FPA Crescent, Matrix Advisors Value (MAVFX), and Parnassus Equity Income (PRBLX)--were making significant additions to their holdings. In an odd twist, though, two of our Ultimate Stock-Pickers--Hartford Capital Appreciation and Oakmark Equity & Income--were actually selling the name with some conviction during the period, leading us to believe that our top managers were not in total agreement about the defensive nature of CVS in the current market environment. Either that, or the shares were a more attractive source of cash for them during the period, as both managers were fairly active buyers during the third quarter. As for the last consumer defensive name on the list, Sysco (SYY), the food distributor has been a favorite of our analysts for quite some time, and the shares continue to be held by five of our Ultimate Stock-Pickers, with two of them--Parnassus Equity Income and Yacktman--making meaningful additions to their positions during the quarter. But much like CVS, there are some that question the defensive nature of the name, with Jensen Quality Growth (JENSX) actually selling its entire stake in Sysco during the quarter, noting concerns "around end-market weakness and execution risk with business transformation initiatives" as reasons for moving out of the name.

It looks like a similar attitude took over our managers with regard to Abbott Laboratories, which continues to be held by eight of our managers, two of which-- Aston/Montag & Caldwell Growth (MCGIX) and Parnassus Equity Income--continue to add meaningfully to their stakes. But that still didn't stop two other managers--FPA Crescent and Jensen Quality Growth--from making significant reductions to their holdings (and in the case of FPA Crescent, completely eliminating Abbott from their portfolio). In fact, it looks like Jensen Quality Growth was making reductions in many of its health-care holdings, including Stryker and Medtronic (MDT), and using some of the capital to build up a brand-new stake in Laboratory Corporation of America (LH), with the fund's managers noting the following about their purchase:

"LabCorp exhibits the components we seek in a quality growth company. LabCorp is the number two North American clinical lab in terms of volume in an industry that is highly fragmented outside of the top two competitors. Its primary competitive advantage is scale. LabCorp is the industry’s cost leader due to operational advantages, including a centralized IT platform, and scale. It has benefited from a relatively stable end-market demand, strong market share position, and improving industry dynamics that have resulted from the consolidation of the laboratory testing business over the past decade. In line with our approach to adding businesses, not only is LabCorp a quality company, but we were able to purchase the stock at an attractive price."

While Jensen Quality Growth may have been selling off some of its stake in Stryker, the shares were being purchased in abundance by both Aston/Montag & Caldwell Growth and Yacktman, who were also adding meaningfully to their stake in Corning (GLW), much like the managers at Oakmark. As for the remaining name on the list, Omnicom Group (OMC), which is a powerhouse in advertising and marketing, we were a little surprised to see three of our managers--FMI Large Cap, Oakmark, and Aston/Montag & Caldwell Growth--making meaningful purchases in this more economically sensitive name. That said, the shares were bouncing off our consider buy price during much of August and September, making them far more attractive than they were earlier in the year. And with regards to its new-money purchase of the name, the managers at FMI Large Cap note that the business is "somewhat misunderstood by the investment community," with much of Wall Street being "overly focused on expensive, pure-play digital advertising stocks," while "undervaluing the broad-based, diversified advertising services companies like Omnicom." As many of our managers have amassed their long track records of beating the markets by going against the grain, we're not going to argue too much with this sort of reasoning.

With the remainder of our top managers set to release their holdings in the coming weeks, we should get a much better glimpse at the top purchases and sales during the most recent period. In the meantime, if you're interested in receiving e-mail alerts about any of the upcoming articles that will be published by The Ultimate Stock-Pickers Team, please sign up here, and we'll make sure to let you know once they've hit the site.

Disclosure: Greggory Warren owns shares in the following securities mentioned above: Amana Trust Growth, Colgate-Palmolive, and Medtronic. 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.

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.