Top 3 Sector Bets of Our Ultimate Stock-Pickers

By Greggory Warren, CFA | Senior Stock Analyst

When looking at the holdings, purchases, and sales of our Ultimate Stock-Pickers each quarter, we pay close attention to the sector allocation decisions being made by our top managers, especially those instances where they happen to be overweight the market. With the performance of most stock portfolios measured against a benchmark, like the S&P 500 Index, fund managers tend to be very cognizant of the weighting of their portfolios relative to the index. Even our top managers, who by and large are bottom-up stock-pickers, will have an idea of where they are overweight (or underweight) the market and by how much. That's not to say that they are actively managing their portfolios to the benchmark (which is something that some fund managers will do), it's just that they are cognizant of where they are relative to the market.

Bruce Berkowitz, for example, the manager of the  Fairholme (FAIRX) fund, is fully aware of the fact that the equity portion of his investment portfolio is heavily weighted in financial services stocks. The relatively poor performance of his fund last year was a direct result of the fact that he had more than two thirds of Fairholme's stock holdings invested in financials at the beginning of 2011, and as much as 80% invested in the sector by the end of the year. While financial services was the worst-performing sector tracked by Morningstar last year, declining more than 16% on a total return basis compared with a 2% gain for the market, Fairholme fared far worse (posting a more than 32% loss in 2011) due to the large concentrated position Berkowitz held in one of the biggest underperformers in the sector last year,  American International Group (AIG), which was down 52% in 2011. It also didn't help that he came into the year with hefty stakes in  Bank of America (BAC) (down 58%),  Citigroup (C) (down 44%),  Morgan Stanley (MS) (down 44%),  Goldman Sachs (GS) (down 45%), CIT Group (down 26%), and  Regions Financial (RF) (down 38%). While not a financial services name,  Sears Holdings , which accounted for close to 7% of Fairholme's equity portfolio at the beginning of 2011, was also down 57% last year.

Ironically enough, most of these financial stocks were added to Berkowitz's portfolio during 2010, when he was convinced that the worst of the financial crisis was behind many of the firms whose securities he was pouring money into. While hindsight is always 20/20, we were wary of his moves as far back as the second quarter of 2010, when The Morningstar Ultimate Stock-Pickers Team noted that Berkowitz's belief in the undervalued nature of the industry, which was supported by his reasoning that there was little downside in owning certain financial institutions (given the fact that the federal government had shown a willingness to backstop cataclysmic losses, that the financial statements of the largest financial institutions had been thoroughly looked over by regulators, and that lawsuits and regulations wouldn't be as onerous as many were predicting), was a bit shaky.

While we'll cut Berkowitz some slack for many of the events that occurred last year--from the earthquake/tsunami in Japan, to the Arab Spring in the Middle East, the sovereign debt meltdown in Greece, and the political squabbling over the debt ceiling here in the United States--his actions highlight the risk that is inherent in having so much of an investment portfolio in just one single sector of the market, let alone having most of that money allocated to only a handful of somewhat riskier names in that sector. That said, just about every stock we've mentioned in relation to Fairholme is up 20% or more since the start of the year, with Sears actually reporting a 160% gain year to date, which helps to explain why Berkowitz's fund is beating the market by as wide of a margin as it is so far in 2012.

Sector Weights: Ultimate Stock-Pickers and S&P 500 Index (on Dec. 31, 2011)

  % of USP Portfolios % of S&P 500 Index Overweight/ (Underweight) Basic Materials 3.7 2.9 0.8 Communication Services 2.6 4.3 (1.6) Consumer Cyclical 10.1 9.3 0.8 Consumer Defensive 14.8 11.9 2.9 Energy 10.2 12.0 (1.8) Financial Services 16.2 12.6 3.6 Health Care 13.6 11.6 2.0 Industrials 13.2 11.8 1.4 Real Estate 0.6 1.8 (1.2) Technology 14.0 18.0 (3.9) Utilities 0.9 3.7 (2.9) Source: Morningstar Data and Estimates.

Looking at the sector weightings of our Ultimate Stock-Pickers relative to the S&P 500 Index, our top managers were much more heavily overweight in consumer defensive and financial services stocks than securities from any other sector at the start of 2012. Even after backing out Fairholme, arguably the most overweight in financial services of our Ultimate Stock-Pickers, the aggregate holdings of our top managers were still overweight the sector (relative to the benchmark index). This isn't too surprising, given the value bent of many of our managers, and the fact that the financial services sector has traditionally appealed to these types of managers (albeit at a slightly less enthusiastic level of conviction, as was seen prior to the financial crisis). More interesting is the fact that of the nine fund managers on our Investment Manager Roster that are beating the market year to date, seven of them are meaningfully overweight in the financial services sector.

Top Financial Services Holdings of Our Ultimate Stock-Pickers (on Dec. 31, 2011)                           

  Star Rating Current Price (USD) Price/Fair Value Fair Value Uncertainty Moat Size # of Funds Holding Wells Fargo (WFC) 4 $31.66 0.77 Medium Narrow 12 Brkshr Hthwy (BRK.B) 4 $79.41 0.89 Medium Wide 8 Amrcn Exprss (AXP) 3 $53.20 0.99 High Wide 8 MasterCard (MA) 3 $419.52 1.06 High Wide 8 JPMorgan (JPM) 4 $41.03 0.80 High Narrow 6 Data as of 03/02/12. Fund ownership data as of funds' most recent filings.

 Wells Fargo (WFC) continues to not only be the most widely held financial services stock of our top managers, but it is also held with the most conviction. With 16% of its total stock holdings dedicated to Wells Fargo at the end of the fourth quarter, Berkshire Hathaway (BRK.A) (BRK.B) has a bit more of an influence on this conviction rating. Even with it being such a big holding for the insurer (accounting for 20% of Berkshire's stock holdings at the end of 2010), Warren Buffett saw nothing wrong with throwing additional money at the holding, snatching up another 41.1 million shares of the bank (which declined in price just 10%) last year, increasing Berkshire's position in the firm by 12%. Morningstar analyst Jim Sinegal continues to be positive on the name as well, noting that it is one of the premier financial institutions in the United States, thanks to its nationwide base of low-cost deposits and relentless focus on customer service and efficiency, not to mention its plain vanilla banking model. This narrow-moat firm continues to trade at a meaningful discount to his fair value estimate, and Wells Fargo is likely to receive approval for further dividend increases and share repurchases by mid-2012, which would provide a positive catalyst for the stock price in the near term.

Our managers have also not been lightening up on the financial services sector, with  Charles Schwab (SCHW) taking the number-two spot on our list of top purchases during the most recent period. The 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.

Top Consumer Defensive Holdings of Our Ultimate Stock-Pickers (on Dec. 31, 2011)

  Star Rating Current Price (USD) Price/Fair Value Fair Value Uncertainty Moat Size # of Funds Holding Procter&Gamble (PG) 4 $66.93 0.93 Low Wide 12 Wal-Mart (WMT) 3 $60.08 0.98 Low Wide 13 Coca-Cola (KO) 3 $69.51 1.01 Low Wide 8 PepsiCo (PEP) 4 $63.15 0.88 Low Wide 9 CVS Caremark (CVS) 2 $45.64 1.14 Medium Narrow 8 Data as of 03/02/12. Fund ownership data as of funds' most recent filings.

At close to 15% of their aggregate holdings (on a conviction basis), our top managers remain overweight in consumer defensive names, with the top four holdings from this sector also making the list of top 10 holdings of our Ultimate Stock-Pickers. Given that the sector is up less than 7% year to date (according to Morningstar's index data), it comes as no surprise to us that none of the nine fund managers on our Investment Manager Roster that are beating the market this year are overweight consumer defensive stocks. That said, of the two managers on our list-- Oakmark (OAKMX) and  Yacktman (YACKX)--that have actually beaten the market over the last one-, three-, five-, and 10-year time periods, Yacktman has done so with an overweight position in the sector. At the end of 2011, the fund had close to 35% of its stock holdings dedicated to consumer defensive names, with PepsiCo (PEP) being its largest single holding (at 12% of the total stock portfolio).

Fund managers Donald and Stephen Yacktman have noted on more than a few occasions their propensity for investing in well-capitalized firms that have dominant franchises and are run by good management teams, putting together the following succinct commentary on their take on companies that fit this bill in their 2009 semiannual report:

"Generally, the market does not fully appreciate these securities, as people fail to appropriately value their superior business models or simply think they are not exciting enough. Our willingness to hold these positions and watch grass grow while the world spins around us has resulted in superior returns over time. Many of these companies have held dominant positions for decades and, in some cases, for more than a century. While occasionally we may buy a clunker that can be fixed up, we prefer to drive around in classics (like Coca Cola, PepsiCo, and Procter and Gamble), that do not go out of style. We like to own these classics when we believe that they will provide similar or better return prospects than lower quality businesses."

During the fourth quarter, Yacktman continued to add to its holdings in consumer defensive names, buying significantly more shares of  Avon Products , while making meaningful additions to its stakes in PepsiCo,  Procter & Gamble (PG), and Sysco (SYY). Yacktman is now the sole holder of Avon among our top managers, after the three other managers holding shares of the multilevel marketing company at the beginning of 2011 walked away from the stock in light of the sales and execution problems that emerged last year at the firm. While our analysts are less sanguine about Avon's prospects, given the myriad challenges facing the firm, the shares are trading at 74% of our fair value estimate, making them attractive to long-term investors willing to wait as Avon works to fix its structural problems.

Top Health-Care Holdings of Our Ultimate Stock-Pickers (on Dec. 31, 2011)

  Star Rating Current Price (USD) Price/Fair Value Fair Value Uncertainty Moat Size # of Funds Holding Jhnsn & Jhnsn (JNJ) 4 $64.74 0.84 Low Wide 11 Pfizer (PFE) 4 $21.48 0.80 Medium Wide 9 Novartis (NVS) 5 $54.43 0.79 Low Wide 8 Abbott Labs (ABT) 4 $57.95 0.83 Low Wide 8 Amgen (AMGN) 3 $68.01 1.00 Medium Wide 6 Data as of 03/02/12. Fund ownership data as of funds' most recent filings.

While not quite as overweight in health care as they were in financial services and consumer defensive names, our top managers have always shown a more heightened interest in the sector. Much like the consumer defensive sector, the health-care sector is also underperforming the market this year (according to Morningstar's index data), and, as such, has not been a significant contributor to the portfolios of the managers that have been beating the S&P 500 in 2012. Just one of the names listed above-- Johnson & Johnson (JNJ)--was a top 10 holding of our managers at the end of the most recent period. The name also made our list of top purchases during the fourth quarter, along with  Gilead Sciences (GILD), a biotechnology firm focused on therapies for life-threatening infectious diseases.

Looking even 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 fourth quarter, increasing its stake by more than 15%. There was, however, one detractor in the bunch, as Berkshire Hathaway unloaded 8.4 million shares of the health-care giant during the period. 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). While Buffett does not see Berkshire adding to its stake any time soon, despite the fact that Johnson & Johnson remains an attractive business at its current price, he would be willing to sell more shares if he needed to raise capital--something he has done a bit more of lately in order to build up cash stakes for Todd Combs and Ted Weschler to work with within the Berkshire portfolio.

Top Technology Holdings of Our Ultimate Stock-Pickers (on Dec. 31, 2011)

  Star Rating Current Price (USD) Price/Fair Value Fair Value Uncertainty Moat Size # of Funds Holding Microsoft (MSFT) 3 $31.99 0.91 Medium Wide 16 Cisco (CSCO) 4 $19.80 0.76 Medium Wide 12 Google (GOOG) 4 $600.25 0.77 High Wide 10 Oracle (ORCL) 4 $30.13 0.73 Medium Wide 9 Int'l Bsnss Mchns (IBM) 2 $200.62 1.10 Low Wide 6 Data as of 03/02/12. Fund ownership data as of funds' most recent filings.

One area of increasing interest for our top managers has been the technology sector, with  Cisco Systems (CSCO) making our list of top 10 holdings during the most recent period. We've noted on a number of occasions in past articles over the last year and a half 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 Yacktman may not have added to their position in Cisco during the most recent period, Donald and Stephen Yacktman recently offered the following about their stake (which they started to build in the fourth quarter of 2010):

"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."

If the purchases of Cisco continue to expand in 2012, the stock may actually challenge  Microsoft (MSFT) for top technology holding of our top managers. With the shares trading at 76% of our fair value estimate, and Morningstar analyst Grady Burkett believing that the firm can outperform its management's three-year revenue growth target of 5%-7% and earnings growth target of 7%-9% in 2012, Cisco may garner more attention from our Ultimate Stock-Pickers. That said, Microsoft may hold one slight advantage over Cisco--its shares are expected to yield 2.5% this year compared with a 1.6% projected dividend yield for the networking giant.

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Disclosure: Greggory Warren owns shares in the following securities mentioned above: Procter & Gamble and Avon Products. 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.