10 High-Conviction Ultimate Stock-Picker Buys
New-money buying activity was up in the first quarter, despite lower buying activity overall.
New-money buying activity was up in the first quarter, despite lower buying activity overall.
By Greggory Warren, CFA | Senior Stock Analyst
When we relaunched the Morningstar Ultimate Stock-Pickers concept, our aim was to come up with investment ideas that not only reflected the most recent activity of top investors, but that would be timely enough for investors to get some value from them. By cross-checking the most recent valuation work and opinions of Morningstar's stock analysts against the actions of some of the best equity managers in the industry, we'd hoped to uncover ideas that investors would find useful. With more than three quarters of our Ultimate Stock-Pickers having reported their first-quarter holdings, and the equity markets taking a turn to the downside since the end of March (after one of the strongest first-quarter returns for the S&P 500 Index in over a decade), we thought it would be interesting to see what types of purchases our top managers were making during the latest period.
Examining the purchases our Ultimate Stock-Pickers make in any given period, we look closely at both high-conviction purchases and new-money buys. We believe 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 it at any point in time. For example, we assume the managers at FMI Large Cap (FMIHX), which had 5.3% of their stock holdings invested in 3M (MMM) at the end of March, compared with 2.1% in Monsanto , have a higher degree of conviction in 3M than they do in Monsanto. That said, position size can be influenced by how much of a portfolio a manager wants committed to a particular sector (especially when there are only a few truly investable ideas in the sector).
We define high-conviction purchases as instances where managers make meaningful additions to their existing holdings, or make significant new-money purchases in names that were not in their portfolio at the end of the previous quarter, with a focus on the impact these transactions have on the overall portfolio. We believe new-money purchases provide us with the most insight into what our top managers think are the most attractive buying opportunities, as portfolio managers tend to put money to work in new names only when their purchase decision carries a very high degree of conviction. This is based on the belief 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 that the prices our top managers paid for these securities likely will be different from where they are trading today. As such, the stock that had our managers excited in the latest period might end up being less (or more) attractive depending on the direction that the markets or the news flow for the firm has taken. That's why we feel it is important to assess the current attractiveness of a particular security with the measures that our analysts' research provides us with, like the Morningstar Rating for Stocks and the price/fair value estimate ratio.
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 Visa (V) 3 Wide 119.77 1.14 High $96,852 1 Rsrch Mtn (RIMM) 4 None 10.71 0.77 High $5,614 1 Lowe's (LOW) 4 Wide 27.10 0.8 Medium $31,622 1 P&G (PG) 4 Wide 62.57 0.83 Low $173,537 1 RD Shell (RDS.A) 5 Narrow 63.02 0.8 Low $201,921 1 eBay (EBAY) 4 Wide 39.67 0.83 Medium $51,223 2 Walgreen (WAG) 3 Narrow 31.26 0.89 High $26,935 2 Appld Mtrls (AMAT) 5 Wide 10.38 0.55 Medium $13,402 1 PepsiCo (PEP) 4 Wide 68.81 0.96 Low $107,743 2 Prkr Hnnfn (PH) 4 Narrow 84.46 0.80 Medium $12,579 2 Stock Price and Morningstar Rating data as of 05-23-12.Not unlike the fourth quarter of last year, the first quarter was exemplified by a dearth of buying activity (in aggregate) by our Ultimate Stock-Pickers. The list of top 10 high-conviction purchases highlights this fact, as the top stocks purchased during the period had just two managers buying shares, compared with prior periods when there were usually four or five managers buying a security that would ultimately make its way to the top of the list. This doesn't surprise us too much, given that the domestic equity markets put in their best first-quarter performance in more than a decade during the March quarter this year. There was, however, a bit more selling activity, exemplified by a lot of position trimming and a few truly meaningful sales, which tells us that our managers were anticipating an end to the runup in the markets, building up cash to meet redemption requests, as well as for future purchases (in a more reasonably priced market).
It was against this backdrop that both Aston/Montag & Caldwell Growth (MCGIX) and Oakmark Equity & Income (OAKBX) were making meaningful new-money purchases of eBay (EBAY). It was not the only new-money purchase made during the quarter by both of these managers, either, as Ronald Canarkis at Aston/Montag & Caldwell Growth made five new-money purchases--eBay, Amazon.com (AMZN), Las Vegas Sands (LVS), EMC , and Juniper Networks (JNPR)--through the end of April, while Clyde McGregor at Oakmark Equity & Income initiated eight new equity holdings-- Republic Services (RSG), Lear (LEA), Parker Hannifin (PH), eBay, Northrop Grumman (NOC), Staples , Illinois Tool Works (ITW), and TD Ameritrade .
Of his purchase of eBay, Ronald Canarkis noted that the firm "is the operator of the world's largest online marketplace and leader in online payments via its PayPal subsidiary," and that he sees the company "benefiting from the continued robust growth of online commerce and PayPal's proliferation, both online and at point-of-sale and mobile spaces." Clyde McGregor echoed these views in his quarterly letter to shareholders, noting that:
"eBay is well-known for its auction websites, but the company's crown jewel may be Paypal, which it purchased in 2002. As value investors, we always prefer investment opportunities that are propelled by natural economic momentum, and that is certainly the case with eBay. E-commerce appears likely to grow at above-average rates, and eBay should participate in this growth. The Paypal division also benefits from growth in e-commerce, and new payment technologies at physical retailers, especially those involving smart phones, may give Paypal another boost. We had the opportunity to purchase shares at a good price when the company announced a management change. As with most of our March quarter opportunities, however, the best price opportunity did not last for long."
McGregor also committed new capital to Parker Hannifin, a diversified manufacturer of motion and control technologies primarily used in machinery and vehicles. In his quarterly commentary, he noted that the company "has persistently improved its key financial characteristics, and management recently instituted an aggressive share repurchase program" when discussing his new-money purchases during the quarter. His cohorts Bill Nygren and Kevin Grant at the Oakmark (OAKMX) fund went into far more elaborate details about their purchase of Parker Hannifin, noting that:
"Parker Hannifin is the world's leading producer of motion and control technologies. Its business is diversified across industries (machinery, trucks and aircraft) and geographies (earnings outside the U.S. account for over half of its total earnings). Priced at just over 11x expected 2012 earnings (plus goodwill amortization), Parker is valued like other highly cyclical businesses. However, the overwhelming majority of Parker's profits come from its replacement parts business. This business is more profitable and more stable than the company's original equipment business, and its branded Parker stores give it a large footprint and durable competitive advantage. Therefore, we think it should be valued at a much higher multiple than more cyclical companies. We are impressed with management's track record as excellent operators and we like the way the company spends shareholder capital."
Nygren and Grant also made several new-money purchases during the quarter, picking up Franklin Resources (BEN) and Goldman Sachs (GS) in addition to Parker Hannifin, believing Franklin to be attractively priced when adjusting its earnings for all of the cash and investments on its books, and Goldman's franchise value to be worth much more than its current book value. One common theme evident in the commentaries from all of the Oakmark managers is the notion that each of these firms is viewed as being a good steward of investor capital. For those that may not be aware, Morningstar recently introduced a new stewardship rating system, the Morningstar Stewardship Rating for Stocks, which focuses heavily on the quality and depth of a company's management and board of directors in their roles as stewards of investor capital.
Looking more closely at the two other high-conviction purchases where more than one manager was putting money to work, Parnassus Equity Income (PRBLX) made a new-money purchase of PepsiCo (PEP), while the Yacktman (YACKX) fund continues to add to its position in the snack foods giant, which was its single-largest holding at the end of the first quarter (accounting for 11% of its holdings). PepsiCo was one of five new holdings for Parnassus during the most recent period, as the fund also picked up shares of Walgreen (WAG), Shaw Communications , Applied Materials (AMAT), and Compass Minerals (CMP). And Parnassus was not alone in buying Walgreen, as the managers at Markel (MKL) tripled their stake in the drug store chain during the quarter.
As for the remaining high-conviction purchases, Alleghany made a meaningful new-money purchase in Visa (V), along with significant new-money buys of Lowe's Companies (LOW) and MasterCard (MA), during the quarter. Meanwhile, Prem Watsa at Fairfax Financial Holdings (FRFHF) continues his headlong dive into Research in Motion (RIMM) , picking up 14 million additional shares of the struggling Canadian maker of the Blackberry cell phone. At the end of the first quarter, Watsa had 19% of his stock portfolio invested in Research in Motion, which was offset by a 19% portfolio stake in Johnson & Johnson (JNJ). As for the final two high-conviction purchases, Yacktman increased its stake in Procter & Gamble (PG) by more than 70%, while Tweedy Browne Value (TWEBX) made a meaningful new-money purchase of Royal Dutch Shell (RDS.A).
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 Visa (V) 3 Wide 119.77 1.14 High $96,852 1 Lowe's (LOW) 4 Wide 27.10 0.80 Medium $31,622 1 RD Shell (RDS.A) 5 Narrow 63.02 0.80 Low $201,921 1 eBay (EBAY) 4 Wide 39.67 0.83 Medium $51,223 2 Appld Mtrls (AMAT) 5 Wide 10.38 0.55 Medium $13,402 1 Prkr Hnnfn (PH) 4 Narrow 84.46 0.80 Medium $12,579 2 Amazon (AMZN) 3 Wide 215.24 0.86 High $96,971 1 LV Sands (LVS) 4 Narrow 47.89 0.65 Very High $39,450 1 Rpblc Srvcs (RSG) 4 Narrow 26.66 0.76 Medium $9,768 1 Cmpss Mnrls (CMP) 4 Wide 72.40 0.79 Medium $2,416 1 Stock Price and Morningstar Rating data as of 05-23-12.With so many of the high-conviction purchases during the quarter also registering as new-money purchases, there were no names on our list of top 10 new-money purchases that didn't either make the list of high-conviction purchases or that weren't purchased as part of a spate of new-money activity by the handful of managers--Aston/Montag & Caldwell Growth, Oakmark Equity & Income, and Alleghany--we mentioned above.
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Disclosure: Greggory Warren owns shares in the following securities mentioned above: Procter & Gamble and Johnson & Johnson. 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.
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