10 High-Conviction Buys From Our Ultimate Stock-Pickers

By Greggory Warren, CFA | Senior Stock Analyst

When we relaunched Ultimate Stock-Pickers nearly three years ago our aim was to come up with investment ideas that not only reflected the most recent activity of top investors we admire but that would be timely enough for investors to get 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 nearly all of our Ultimate Stock-Pickers having reported their fourth-quarter holdings, and equity markets rebounding nicely off their third-quarter lows, 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 5.4% of its stock portfolio invested in  3M Company (MMM) at the end of December 2011 compared to 2.1% in  Monsanto , have a higher degree of conviction in 3M than they do in Monsanto. That said, position size can sometimes be influenced by how much a portfolio manager wants to commit to a particular sector (especially when there are only a few truly investable ideas in that 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  American Express (AXP), which, while accounting for just 10.8% of the insurer's portfolio, represented 13.0% of American Express' outstanding shares.

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, relative to the impact the transaction has on the overall portfolio. We believe that new-money purchases can provide us with the most insight into what our Ultimate Stock-Pickers might think are the most attractive buying opportunities, as managers typically only put money to work in new names when their purchase decision carries a very high degree of conviction. Much 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 name that is new to the portfolio.

When looking at all of these different stock purchases, though, it pays to remember that these buy decisions were made during a prior period. This means the prices our top managers paid for these securities are 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. With the markets up close to 9% since the beginning of the year, and nearly 20% higher than they were at the end of the third quarter of 2011, it's likely that our managers were able to purchase securities at better prices than investors can realize today.

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

  Star Rating Moat Size Current Price (USD) Price/Fair Value Fair Value Uncertainty Market Cap ($mil) # Funds Buying Gilead (GILD) 4 Narrow 45.26 0.79 Medium $34,360 2 GlaxoSmthKlne (GSK) 3 Wide 44.63 0.91 Medium $112,548 2 Rsrch in Mtn (RIMM) 3 None 14.72 1.05 High $7,617 2 Citigroup (C) 4 Narrow 32.35 0.62 Very High $93,541 2 Devon Energy (DVN) 4 Narrow 75.19 0.72 High $30,410 1 Illinois Tool (ITW) 3 Narrow 55.92 1.02 High $26,851 1 Chrls Schwb (SCHW) 5 Narrow 13.52 0.59 High $17,573 1 Jhnsn & Jhnsn (JNJ) 4 Wide 64.46 0.84 Low $176,756 1 Tiffany 2 Narrow 64.68 1.16 Medium $8,237 1 Danaher (DHR) 3 Narrow 53.32 0.95 High $36,487 1

Stock Price and Morningstar Rating data as of 02-24-12. 

Looking at the buying activity of our top managers during the fourth quarter, it was probably one of the least active periods for stock buying that we've seen in quite some time. The list of top 10 high-conviction purchases highlights this fact, as the top stocks purchased during the period only had two managers buying shares, compared to prior periods when there were usually four of five managers buying a security that would ultimately make its way to the top of the list. We believe that this had a lot to do with the impact that the third-quarter downturn had on the actions of our managers, many of which were in cash preservation mode, anticipating a spate of outflows in response to the markets. And they were right to be concerned, as investors pulled more than $45 billion out of actively managed U.S. stock funds during the fourth quarter (and in the process made 2011 the second-worst year for actively managed U.S. stock fund flows since Morningstar first started tracking flow data more than a decade ago). It also explains the heightened level of selling activity we saw in the back half of last year.

It was against this backdrop that both Parnassus Equity Income (PRBLX) and Hartford Capital Appreciation (ITHAX) were picking up shares of  Gilead Sciences (GILD). At Hartford, the managers made a new-money purchase of Gilead during the fourth quarter, picking up nearly 4 million shares of the biotechnology firm. Meanwhile, the managers at Parnassus more than doubled their existing stake in the biotechnology firm, increasing their holdings to more than 4 million shares. Parnassus also made a significant new-money purchase in  Charles Schwab (SCHW), picking up more than 10 million shares of the brokerage, banking, and asset-management firm. Another manager that was making multiple high-conviction purchases during the period was the Hamblin Watsa Investment Council at  Fairfax Financial Holdings (FRFHF), which made meaningful additions to its stakes in both  Johnson & Johnson (JNJ) and  Research in Motion (RIMM). And Fairfax was not alone in adding to its position in Research in Motion, as the managers at Yacktman (YACKX) increased their holdings in the Canadian maker of the Blackberry phone by more than 60% during the most recent period.

The managers at RS Capital Appreciation also stepped up during the fourth quarter, picking up shares of both  Danaher (DHR) and  Tiffany during the period. With regard to their purchase of Danaher, the managers were adding to a position they had established during the third quarter, more than doubling the fund's holding in the diversified manufacturer. The managers also made a new-money purchase in Tiffany, which has been in and out of the portfolio on several occasions during the last 13 years. Believing that Tiffany is a "branded products company disguised as a retailer," the managers took full advantage of price weakness in the shares during the back half of 2011 to initiate yet another new position in the firm.

Another manager doing double-duty with the high conviction purchases during the period was FMI Large Cap, which made meaningful new money purchases in  Illinois Tool Works (ITW) and added to their existing stake in  GlaxoSmithKline (GSK). The managers at FMI Large Cap were joined in their purchase of GlaxoSmithKline by their counterparts at Columbia Dividend Income (LBSAX), which had the following to say about their new-money purchase of the name:

"During the fourth quarter, we initiated a position in GlaxoSmithKline, one of the world's leading research-based pharmaceutical and health-care companies with major research centers in the United Kingdom, United States, Belgium, and China. GlaxoSmithKline has strong franchises in the areas of anti-infectives, respiratory, gastrointestinal/metabolic, and vaccines. It also has a consumer health-care portfolio comprised of over-the-counter medicines, oral-care products, and nutritional health-care drinks. The company generates above-average free cash flow from operations, and its late-stage pipeline of new drugs appears to be improving. They also have a relatively robust revenue and earnings profile with less patent expiration risk as compared to some of its peers."

 Citigroup (C) was another stock that was bought by more than one of our Ultimate Stock-Pickers, as both FPA Crescent (FPACX) and Mutual Shares (TESIX) made new-money purchases in the bank during the most recent period. Meanwhile,  Devon Energy (DVN) was purchased with conviction by  Alleghany , which was surprisingly a big net seller of energy stocks during the fourth quarter. The insurer's largest holding at the end of the third quarter of 2011 was  ExxonMobil (XOM), with Alleghany holding more than 8 million shares its stock portfolio (accounting for more than 40% of its equity holdings). During the fourth quarter, the insurer sold off 5 million shares (which still left ExxonMobil as its single largest stock holdings, at more than 30% of its equity holdings) in order to raise cash, in our view, for its $3.4 billion purchase of Transatlantic Holdings , a top 10 global property and casualty reinsurer that the company planned to merge into its own operations.

Top 10 New-Money Purchases by Our Ultimate Stock-Pickers

  Star Rating Moat Size Current Price (USD) Price/Fair Value Fair Value Uncertainty Market Cap ($mil) # Funds Buying Cisco (CSCO) 4 Wide 20.14 0.77 Medium $107,990 2 NetApp (NTAP) 3 Narrow 43.08 0.94 Medium $15,377 2 Citigroup (C) 4 Narrow 32.35 0.62 Very High $93,541 2 Illinois Tool (ITW) 3 Narrow 55.92 1.02 High $26,851 1 Chrls Schwb (SCHW) 5 Narrow 13.52 0.59 High $17,573 1 Tiffany 2 Narrow 64.68 1.16 Medium $8,237 1 General Elctrc (GE) 4 Wide 19.24 0.77 Medium $202,387 1 Motorola Sltns (MSI) 3 Narrow 49.43 0.99 Low $15,686 1 Unilever 3 Narrow 33.59 0.96 Medium $99,764 1 Varian Med 3 Narrow 66.56 0.96 Medium $7,585 1

Stock Price and Morningstar Rating data as of 02-24-12.

With four of the 10 top new-money purchases during the fourth quarter already making our list of top 10 high-conviction purchases, we'll focus on the other names that popped up on the list.  Cisco Systems (CSCO) is a name that has been getting a lot of attention from our top managers, who first started throwing money at it in earnest during the fourth quarter of 2010. Of our 26 Ultimate Stock-Pickers, 12 of them held Cisco at the end of the fourth quarter of 2011, with Aston/Montag & Caldwell Growth (MCGIX) and Hartford Capital Appreciation joining those ranks by virtue of their new-money purchases in the name. Of his purchase of Cisco during the quarter, Ronald Canakaris at Aston/Montag & Caldwell Growth noted:

"Networking firm Cisco has become more streamlined and focused, with its restructuring program expected to generate approximately $1 billion in annual cost savings. We think strong free cash-flow and ample cash on its balance sheet can lead to higher dividends and increased share repurchases. The company is ideally positioned to benefit from continued growth in IP data traffic fueled by mobile, video, and cloud technology."

Canakaris also threw new money at  General Electric (GE) and  Unilever during the period, noting that he "viewed diversified industrial manufacturer and service company General Electric as attractively valued given its nearly 4% dividend yield and leverage to late-cycle industries," and that solid organic growth (especially in emerging markets) and a focus on improving operating margins could help Unilever generate consistent double-digit earnings growth in the long run.

Meanwhile,  NetApp (NTAP), one of the fastest-growing companies in networked storage, was picked up by two of our managers during the quarter, with both Dodge & Cox Stock (DODGX) and Hartford Capital Appreciation putting new money to work in the firm. As for the other purchases that made the list,  Motorola Solutions (MSI) and  Varian Medical Systems , the former was picked up by Parnassus Equity Income during the quarter, while the latter was purchased by Jensen Quality Growth (JENSX). Of its purchase of Varian, the managers at Jensen noted that:

"Varian is a medical equipment company focused primarily on x-ray technology applications. Products include radiation therapy devices, x-ray tubes, and digital image detectors. Varian maintains a dominant global market share and large installed base of radiation therapy equipment. Switching costs are high due to the steep learning curve and need for robust service infrastructure. Varian has a diverse geographic revenue mix and a tiered product offering based on price/performance that allows it to enter into some emerging markets at a lower price point. To fund this new position, the Jensen Investment Committee trimmed positions from the Fund's existing Healthcare holdings."

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Disclosure: Greggory Warren holds positions in none of the securities mentioned above. It should be noted, however, 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.