Our Ultimate Stock-Pickers' Top 10 Buys and Sells

By Brett Horn | Associate Director, Equity and Credit Analysis

For most of 2011, our Ultimate Stock-Pickers were investing in a market that was headed downward, with managers in the mutual fund industry facing the prospect of a significant uptick in investor outflows from actively managed U.S. stock funds. When evaluating the activity of our top managers, we remain aware of the impact that these considerations can have on their holdings, purchases, and sales, as investor outflows will sometimes distort manager activity and limit the usefulness of the data, especially in periods like we saw during the back half of last year. While the U.S. equity markets rebounded nicely during the fourth quarter, with the S&P 500 Index up more than 11% on a price appreciation basis, investors threw in the towel on actively managed U.S. stock funds, pulling out almost as much from these funds during the period as they did during the third quarter of last year (when $49 billion flowed out of actively managed U.S. stock funds). As such, 2011 went down as the second-worst year for actively managed domestic stock fund flows since Morningstar first started tracking mutual fund flow data more than a decade ago, with investors pulling $100.9 billion out of the category (compared with $118.6 billion in outflows during the fourth quarter of 2008).

What is truly noteworthy, though, is the fact that investors pulled more money out of actively managed U.S. stock funds during the last two quarters of 2011 than they did during the back half of 2008 (even though the U.S. equity markets were down less than 5% in the second half of 2011 compared with a nearly 29% decline in the markets during the final two quarters of 2008). This also continues the trend we've seen over the last five calendar years of outflows from actively managed U.S. Stock funds in the final two quarters of each year outpacing those seen during the first half of the same year (regardless of market performance). It was against this background that our top managers were making their portfolio decisions during the fourth quarter of last year (and early part of the first quarter of 2012), with much of the data indicative of managers that continue to be engaged in good old-fashioned stock picking.

Our first hint of this type of activity is the fact that no one sector dominated our Ultimate Stock-Pickers' top buys and sells during the period, suggesting that our top managers were focused on finding undervalued stocks across the investing universe, as opposed to concentrating solely on a few beaten-down sectors or making moves to position their portfolios defensively or offensively. The second move that convinced us that most of our top managers were sticking to their knitting was the fact that eight of the top 10 purchases made during the fourth quarter had one or more manager actually putting money to work in new names. As you may recall, we believe that managers make new-money purchases only when they have a high degree of conviction in the stock that they are buying. That's not to say, though, that managers do not make high-conviction additions to their existing holdings; it's just that we believe it is far easier for them to put money to work in holdings that they are already comfortable with than it is for them to make a bet on a brand-new name.

We should note, however, that the fourth quarter was probably one of the least active periods for stock buying that we've seen in quite some time, which isn't too surprising given that many of our top managers were actually building up cash stakes in their portfolios (no doubt in anticipation of an uptick in investor redemptions in response to the third-quarter downturn). This likely means our Ultimate Stock-Pickers raised the bar somewhat when they put money to work during the fourth quarter, especially if the purchase was of a brand new name. With regard to the selling activity during the quarter, only four of the top 10 sales made during the period involved one or more managers completely eliminating their stake in a company. This suggests to us that our managers were mainly trimming back positions as opposed to making wholesale moves out of names, and it is possible that the threat of investor outflows had a greater impact on this side of the equation.

Ultimate Stock-Pickers' Top Holdings

  Star Rating Fair Value Uncertainty Moat Size Current Price (USD) Price/Fair Value # of Funds Holding Microsoft (MSFT) 3 Medium Wide 32.08 0.92 16 J&J (JNJ) 4 Low Wide 64.77 0.84 11 Wells Fargo (WFC) 4 Medium Narrow 31.28 0.76 12 Prctr & Gmbl (PG) 4 Low Wide 66.67 0.93 12 Wal-Mart (WMT) 3 Low Wide 59.01 0.97 13 Exxon Mobil (XOM) 4 Low Wide 86.33 0.87 7 Coca-Cola (KO) 3 Low Wide 69.18 1.00 8 PepsiCo (PEP) 4 Low Wide 62.52 0.87 9 Brkshr Hthwy (BRK.B) 4 Medium Wide 78.29 0.88 8 Cisco Sys (CSCO) 4 Medium Wide 19.76 0.76 12

Data as of 03/02/12. Fund ownership data as of funds' most recent filings.

Looking over our managers' top 10 conviction holdings at the end of the most recent period, little has changed over the last quarter (and over the last year, for that matter). The only name on the list of top 10 holdings this period that was not on the list after the third quarter closed out was  Cisco Systems (CSCO), which had actually popped up as a top conviction holding for our managers (for the first time) in the second quarter of 2011. We've noted on a number of occasions in past articles the growing interest that our managers have had in the technology bellwether. The stock has dramatically underperformed the market the last couple of years as worries about slowing growth, increasing competition, and poor capital allocation have served to drive the stock price down. Based on the comments made by our managers over the last year and a half, they seem to view Cisco as a high-quality franchise, and have exploited the opportunities the market has provided to buy the shares at attractive multiples. While the managers at the Yacktman (YACKX) fund may not have added to their position in Cisco during the most recent period (understandable given that the stock represented more than 5% of their stock portfolio at the end of the fourth quarter), Donald and Stephen Yacktman offered a solid summary of their stake (which they started to build in the fourth quarter of 2010) in their year-end shareholder update:

"During 2011 we substantially increased our position in Cisco Systems as the shares collapsed in the middle of the year. We think management has taken a realistic and prudent approach to handling the company's short‐term challenges, as did other investors, and the stock rebounded solidly at the end of the year. We think the shares continue to be attractive at current prices."

Twelve of our 26 Ultimate Stock-Pickers now hold the name, with two of them--ASTON/Montag & Caldwell Growth (MCGIX) and Hartford Capital Appreciation (ITHAX)--building new positions in Cisco during the most recent period. In his fourth-quarter commentary, Ronald Canakaris, the manager of ASTON/Montag & Caldwell Growth noted that he sees potential for better results in the future from the networking firm because:

"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."

Another thing of note is the fact that our list of top 10 conviction holdings continues to move closer and closer to the list of most widely held securities in our top managers' portfolios (a list that we maintain but do not publish). As you may recall, the Ultimate Stock-Pickers' concept looks to uncover the holdings, purchases, and sales with the highest level of conviction of our top managers, as opposed to ranking them by the number of managers that hold, purchase, or sell a particular security. We do this in a two-step process that first assesses the relative attractiveness of individual securities by noting how many funds actually hold it and whether or not they've been adding to (or subtracting from) their position, and then looks at the percentage each individual security makes up of the stock portfolios of the managers on our Investment Manager Roster, determining the level of conviction a manager has in a particular name by the amount they have committed to it.

When looking at all of the different purchases and sales that we have listed below, it should also be remembered that these buy and sell decisions were made during a prior period. This means that the prices our top managers faced when buying or selling these securities are likely different today than they were when they were being bought and sold. With the markets up more than 9% since the beginning of the year, and 20% higher than they were at the end of the third quarter of 2011, it's likely that our managers were seeing much lower prices when they initiated these transactions.

Ultimate Stock-Pickers' Top Purchases

  Star Rating Fair Value Uncertainty Moat Size Current Price (USD) Price/Fair Value # of Funds Buying Devon Energy (DVN) 4 High Narrow 73.00 0.70 3 Chrls Schwb (SCHW) 5 High Narrow 13.82 0.60 4 Prctr & Gmbl (PG) 4 Low Wide 66.67 0.93 4 Gilead (GILD) 4 Medium Narrow 46.99 0.82 3 Illinois Tool Wrks (ITW) 3 High Narrow 55.50 1.01 3 Sysco (SYY) 4 Medium Wide 29.35 0.82 4 J&J (JNJ) 4 Low Wide 64.77 0.84 4 Lowe's (LOW) 4 Medium Wide 28.13 0.83 4 Life Tech 3 High None 47.59 0.93 2 General Elctrc (GE) 4 Medium Wide 18.97 0.76 2

Data as of 03/02/12. Fund ownership data as of funds' most recent filings.

As we noted above, looking over our list of top purchases, no theme is immediately apparent, as purchases were fairly spread out across multiple sectors. This suggests that our managers were focused on simply buying high-quality companies at attractive prices.  Devon Energy (DVN) tops our list, with three managers buying, but none establishing a new position.  Alleghany was the biggest buyer, building on its already large position, and demonstrating what has been a long-standing interest in energy names. Morningstar analyst Mark Hanson understands the appeal of the name. He believes that Devon's portfolio--composed of an established base of U.S. natural gas assets, a number of emerging unconventional oil and gas plays, two Canadian oil sands complexes, and various other plays throughout North America, along with a sizable network of midstream assets--offers compelling full-cycle economics across a variety of oil and gas price scenarios, and he's encouraged to see Devon near the tail end of its strategic repositioning. During the fourth quarter, Devon's shares traded in a range between about $53 and $69. While the stock currently trades at around $73 per share, Hanson believes Devon is still materially undervalued, and with a Consider Buy price of $63, it wouldn't take too big of a move down for the stock to reenter 5-star territory.

 Charles Schwab (SCHW) takes the number-two spot on our list of top purchases and is the only name among the top buys during the most recent period that currently has a 5-star rating from our analysts. This brokerage giant has been struggling against historically low interest rates for the last several years, and with the Federal Reserve first announcing this past summer that it was unlikely to push the federal funds rate above zero until mid-2013, followed by an announcement in January of this year that it would keep the federal funds rate at exceptionally low levels at least through late 2014, investors with shorter-term time horizons have fled for the hills. Morningstar analyst Gaston Ceron thinks the current stock price vastly underrates the company's earnings potential in a more normalized interest rate environment. Our top managers appear to agree that the stock price is attractive and aren't sitting on the sidelines waiting for signs that the interest rate environment will improve, with four of our Ultimate Stock-Pickers buying the stock with conviction during the most recent period. While Parnassus Equity Income (PRBLX) was the only manager to establish a new position in the name, its purchase of Schwab qualified, in our view, as a high-conviction buy, with the stock now accounting for a little over 3% of Parnassus' portfolio.

While Matrix Advisors Value (MAVFX) did not make a new-money purchase during the most recent period, it made a significant addition to the position that it had started in Schwab during the third quarter, when manager David Katz noted:

"Schwab has a strong business, and is not subject to the mortgage/credit issues which garner so many of the negative headlines in the financial services world. Schwab was purchased for a significant discount to its normal valuation, a discount that does not correlate to the continued success of the business, but rather reflects the across the board anxiety directed at any financial services company."

During the fourth quarter, Schwab's shares traded in a range between about $11 and $13. While the stock currently trades at around $14 per share, Ceron believes the margin of safety is still sufficient at the current price for long-term investors.

Of all of the names on the list,  Procter & Gamble (PG) and  Johnson & Johnson (JNJ) are two securities that our top managers already held with high conviction. Three of the Ultimate Stock-Pickers holding Procter & Gamble at the beginning of the third quarter were buying shares during the most recent period, with Parnassus Equity Income making a high-conviction purchase in the name. The fourth manager buying the stock during the quarter was Sound Shore (SSHFX), which made a meaningful new-money purchase in Procter & Gamble during the fourth quarter. We sense a hint of defensiveness in our top managers' ongoing attraction to this stock, with 12 of them holding positions in the firm at the end of the most recent period. Our analyst Lauren DeSanto notes that an unparalleled brand portfolio, more than $5 billion in cash on its balance sheet, and an AA Morningstar Credit Rating make the company a safe, long-term holding. During the fourth quarter, Procter & Gamble's shares traded in a range between about $61 and $67. The firm recently announced a major restructuring initiative with the aim of generating $10 billion in savings by 2016. While there may be some modest upside to the stock from its current $72 fair value, DeSanto does not believe it is materially undervalued, despite the defensive nature of the name.

Looking closer at Johnson & Johnson, 11 of our top managers were holding the stock at the start of the fourth quarter, with four of them adding to their positions during the most recent period.  Fairfax Financial Holdings (FRFHF) was the biggest purchaser during the quarter, increasing its stake in Johnson & Johnson by more than 15%. There was, however, a detractor in the bunch, as  Berkshire Hathaway (BRK.A) (BRK.B) unloaded 8.4 million shares of the health-care giant during the fourth quarter. Johnson & Johnson is a long-term holding of Berkshire's that Warren Buffett has been both buying and selling with fairly regular frequency over the last three years. His most recent sale further reduced Berkshire's stake in the health-care giant to 29 million shares (from a peak of 43 million in the second quarter of 2010, but basically in line with its holding at the end of the fourth quarter of 2008). In a recent interview on CNBC, Buffett noted that Johnson & Johnson "has messed up in a lot of ways in the last few years," but that it still has "a lot of wonderful products and it's got a wonderful balance sheet." Yet Buffett does not see Berkshire adding to its stake any time soon, despite the fact that Johnson & Johnson remains "an attractive business at its price," an opinion held by Morningstar analyst Damien Conover, who considers the firm to be "one of the best-positioned companies in the pharmaceutical industry." Buffett would also not be averse to selling more shares of Johnson & Johnson if he needed to raise capital, something that he has been doing more of lately to build up cash stakes for Todd Combs and Ted Weschler to put to work.

Ultimate Stock-Pickers' Top Sales

  Star Rating Fair Value Uncertainty Moat Size Current Price (USD) Price/Fair Value # of Funds Selling Exxon Mobil (XOM) 4 Low Wide 86.33 0.87 3 ConocoPhllps (COP) 4 Low Narrow 77.65 0.91 4 HJ Heinz 3 Medium Narrow 52.98 0.96 1 Dell 3 Medium None 17.36 0.96 3 Brkshr Hthwy (BRK.B) 4 Medium Wide 78.29 0.88 4 Citigroup (C) 4 Very High Narrow 34.10 0.66 2 eBay (EBAY) 4 Medium Wide 36.25 0.86 4 PartnerRe 4 High None 64.18 0.76 2 Pfizer (PFE) 4 Medium Wide 21.41 0.79 5 JPMorgan (JPM) 4 High Narrow 40.63 0.80 4

Data as of 03/02/12. Fund ownership data as of funds' most recent filings.

When looking at the list of top conviction sales during the most recent period, we see a lot of trimming activity, but very little in the way of outright sales.  ExxonMobil (XOM) tops our list of high-conviction sales due primarily to a significant sale by Alleghany, where the energy giant accounted for more than 40% of the insurer's stock holdings at the end of the third quarter. But given that ExxonMobil still accounts for over 30% of Alleghany's stock portfolio, we don't think the sale reflects any great discomfort with the name, but rather was a move by the firm to raise cash for its upcoming acquisition of Transatlantic Holdings , a top 10 global property and casualty reinsurer that Alleghany purchased for $3.4 billion, with the intent being to merge Transatlantic into its own operations.

 ConocoPhillips (COP) was a sale that had a bit more conviction behind it, with four funds selling during the most recent period. Sound Shore completely eliminated their stake in the name, and Alleghany reduced its position to almost nothing (and likely zeroed it out during the first quarter of 2012). With the stock trading at less than a 10% discount to our analyst's fair value estimate, it's quite possible that these managers saw little remaining upside. Looking through the rest of the list, Fairholme (FAIRX) trimmed its positions in Berkshire Hathaway and  Citigroup (C), but we would hesitate to make too much of these sales, given the performance issues Fairholme faced last year, which led to close to $7 billion in outflows from the fund in 2011 (equivalent to 36% of its assets under management at the end of 2010). Despite the fact that Bruce Berkowitz's fund is up close to 30% year to date, we still view Fairholme as a huge bet on the financial sector. It should also be noted that Berkowitz's sale of Citigroup ran contrary to meaningful new money purchases made by two of our managers--FPA Crescent (FCPAX) and Mutual Shares (TESIX)--during the fourth quarter. Morningstar analyst James Sinegal notes that despite all of the risks, Citigroup is a profitable, well-capitalized bank trading at far less than tangible book value, which may make it too cheap to ignore for long-term investors.

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