10 High-Conviction Ultimate Stock-Picker Buys

By Brett Horn | Associate Director

As many of our readers already know, the main aim of our Ultimate Stock-Pickers' articles is to come up with investment ideas that not only reflect the most recent buying and selling activity of top investment managers, but are also timely enough for investors to get some value from them. By cross-checking the most current valuation work and opinions of Morningstar's own stock analysts against the actions of some of the best equity managers in the business, we hope to uncover ideas that investors will ultimately find useful. With more than two thirds of our Ultimate Stock-Pickers having already reported their second-quarter holdings, we've scoured through the trading activity of these managers to see where some of our top managers have been putting money to work.

Looking at the purchases that 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 5.5% of its stock portfolio invested in  3M Company (MMM) at the end of the June quarter, compared with just 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.

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 that 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 only put money to work in new names when their purchase decision carries a very high degree of conviction. This is based on the belief that it is far easier for investment managers to put money to work in holdings that they are already comfortable with than it is for them to make a bet on a name that would represent a new addition 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 a particular firm has taken. With the S&P 500 trading in a range of about 1280 to 1420 during the second quarter, and currently trading at a little over 1,400, it is highly likely that some of the prices our managers paid during the most recent period were better than the prices investors would see today. This is the reason why we feel it is extremely important for investors to assess the current attractiveness of any security they are considering by looking at some of the measures that our stock analysts' research provides us, like the Morningstar Rating for stocks and the price/fair value estimate ratio.

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

 

  Star Rating Moat Size Current Price (USD) Price/ Fair Value Fair Value Uncertainty Market Cap (mil) # Funds Buying Devon (DVN) 5 Narrow 58.97 0.54 High $23,853 5 Thrm Fisher (TMO) 4 Narrow 56.61 0.81 Medium $20,694 2 Ntl Oilwll Vrc (NOV) 4 Wide 78.51 0.75 Medium $33,478 1 PepsiCo (PEP) 3 Wide 73.39 1.02 Low $114,215 1 Am Intl Grp (AIG) 3 None 34.80 0.83 Very High $60,151 2 Expdtrs Intl (EXPD) 4 Wide 38.29 0.75 Medium $8,062 1 Oracle (ORCL) 4 Wide 32.20 0.85 Medium $157,217 2 Exp Scrpts 4 Wide 60.86 0.83 Medium $49,342 1 Kohl's (KSS) 4 Narrow 51.96 0.85 Medium $12,459 1 Google (GOOG) 3 Wide 677.14 0.87 High $221,447 2 Stock Price and Morningstar Rating data as of 08/17/12.

Looking over the list of top 10 high-conviction purchases during the most recent period, one name-- Devon Energy (DVN)--clearly stands out among the rest. It is rare to see five of our Ultimate Stock-Pickers making high-conviction purchases in the same stock during any single period, and the fact that three of the mangers that were buying were building new positions in the name is, in our view, an indication of strong conviction behind the name. According to Morningstar's energy sector analysts, the unfortunate confluence that was seen during the second quarter of a U.S. supply boom with the European debt crisis, along with the reality check that was taking place with regard to growth in developing markets like China and Brazil, helped drive world oil prices down by roughly 20%, impacting the stock prices of just about every firm in the sector. So it wasn't as though there weren't plenty of buying opportunities to be had during the period, making the purchase of Devon stand out even more.

Devon is one of the biggest exploration & production (E&P) companies in the United States, alongside names like  Apache (APA) and  Chesapeake . According to our analyst Mark Hanson, the firm is now focused entirely on North America after shedding $10 billion of offshore and international properties during the past couple of years. Key operating areas include the Barnett Shale, Permian Basin, Cana-Woodford Shale, and the Canadian oil sands, complemented by large positions in emerging areas like the horizontal Mississippian and Ohio Utica Shale.

With Devon's shares still looking very attractive to our analyst, as many as seven of our top managers currently holding the stock, and five of them making high-conviction purchases in the stock during the most recent period, we thought a deep dive into why both our analyst and our top managers are so attracted to Devon was in order. Looking more closely at the managers that were doing some of the heaviest buying during the second quarter, both  Oakmark Equity & Income (OAKBX) and the  Oakmark (OAKMX) fund initiated new, sizable positions in Devon Energy, committing 1.7% and 1.4% of their portfolios, respectively, to the name. With most energy stocks falling during the second quarter, as concerns about slowing economic growth in China, Brazil, and the United States drove global oil prices lower, and the oversupply situation in the North America natural gas market (brought on by shale drilling) kept prices at historically low levels, Clyde McGregor, the manager of Oakmark Equity & Income, noted the following about his fund's purchase of Devon in his quarterly commentary to investors:

"We find it interesting that the financial press often characterizes Devon as a natural gas 'play,' even though most of the company's revenues come from liquids. Over the past three years, the stock has declined in price despite Devon's significant growth in proved and probable reserves, as well as material debt reduction. Devon's management understands capital allocation to be a paramount responsibility and has demonstrated this through savvy asset sales and purchases, and by accessing foreign capital through joint ventures."

Meanwhile, famed investor Bill Nygren noted in his letter to Oakmark fund investors that it was these same market misconceptions, as well as the strength of Devon's management team, that ultimately drove him to the stock, noting the following in his quarterly commentary:

"With nearly 60% of its reserves in natural gas, Devon is widely perceived to be a gas company, and its stock price has traded down with natural gas prices. However, 80% of Devon's revenues and over 80% of our business value estimate stem from the company's oil and liquids business. Based on our estimates, the stock is now trading at just over half of its 2013 asset value. And we are not assuming any oil price recovery in our numbers. An additional reason we are attracted to Devon is the way management allocates capital. It seems that most oil and gas managements have a 'bigger is better' mentality. Devon instead focuses on per-share value. In the past two years, Devon has used excess cash to reduce its share base by 10%. Selling at less than 10 times expected earnings, at half of estimated asset value, and with a history of repurchasing its shares, we are pleased to add Devon to our portfolio."

As for the other Ultimate Stock-Picker that built up a sizable new position in Devon during the second quarter-- RS Capital Appreciation --the fund devoted 2.4% of its total equity portfolio to the E&P firm, with the three managers of the fund--David Carr, Larry Coats, and Christy Phillips--seeming to share Oakmark's take on Devon and its executives:

"Management has shown impressive financial discipline in recent years as it has rebalanced its portfolio of future opportunities while strengthening its balance sheet in order to fund the pursuit of those opportunities…Since 2004, the company has reduced its balance sheet leverage by $4 billion while reducing its share count by more than 20% and increasing its dividend more than 8-fold…Devon has a balanced portfolio of reserves and operations that, combined with an active hedging program, allow it to opportunistically adapt its production in response to volatile commodity prices. Though the company's production mix in North America has historically tilted toward natural gas, Devon projects this business (approximately 29% of total company revenues) will remain relatively flat in the next few years as it accelerates towards the more profitable NGL and unconventional oil production. With more than a third of the company's production revenues coming from its Canadian operations, its operating plan calls for its oil sands production to accelerate meaningfully in the next few years. Devon also owns a profitable and strategically important midstream operation that includes over 15,000 miles of pipeline that facilitates the company's distribution and delivery while providing important end-market intelligence."

Morningstar analyst Mark Hanson couldn't agree more with the views of these top managers, expecting Devon to direct almost all of its capital spending over the next several years toward its oil- and liquids-rich acreage, with natural gas declining to less than 60% of production volumes by 2015. He feels that two recently signed joint venture agreements, and one of the best balance sheets in the E&P space, should provide Devon with the flexibility required to ramp up production across its most promising leaseholds. Longer-term, the firm retains exposure to a recovery in natural gas prices thanks to its sizable holdings in plays like the Horn River, Haynesville, and Carthage. In Hanson's view, Devon's management has demonstrated good stewardship over the years, with a focus on maximizing per-share reserves, production, and cash flow--all while maintaining a strong financial position.

In short, while Devon may not generate the eye-popping growth numbers of some of its smaller peers going forward, he believes that the E&P firm should continue to generate solid production gains and strong returns on capital over the next several years, with a balanced production mix that provides leverage to price moves in both oil and natural gas, and a conservative approach that helps minimize franchise risk. Hanson's fair value estimate is $110 per share, and he thinks that the margin of safety is sufficient enough to award the stock a five-star rating. During the second quarter, Devon traded in a range of about $54 to $76, and currently trades at about $59 per share, so investors looking at the stock today are likely to realize a price on par with (or possibly below) the price our managers paid during the most recent period.

Thermo Fischer Scientific Draws Heavier Interest During the Quarter

 Thermo Fischer Scientific (TMO) is another stock that drew the interest of our managers during the second quarter, with RS Capital Appreciation building a new stake in the name, and  FPA Crescent (FPACX) increasing its stake in the firm by 40%, such that it accounted for 3.0% of its long stock positions at the end of the most recent period. The managers at RS Capital Appreciation were attracted by the company's global reach, wide product portfolio, and what they see as a value-creative growth strategy at the firm:

"[Thermo Fischer] has successfully executed a long-term growth strategy that is based on a balance of organic growth and acquisitions. We expect future acquisitions to be focused on filling product or geographic "gaps" that will support the company's global value proposition for its customers and leverage its distribution and sourcing network, while being value accretive for its shareholders."

Morningstar analyst Alex Morozov also likes the company, and while he also believes that it is undervalued, he would like to see a larger margin of safety before recommending it for purchase. With the stock trading in a range of about $49 to $58 during the second quarter, and currently priced at about $57 per share, it is likely that our managers who were buying realized a better price than can be achieved today, such that investors may want to wait for another pullback before committing capital to the name. 

While Morozov does go on to note that he believes that Thermo Fischer Scientific's near-term top-line growth is likely to be hampered by weak government and academic spending, the long-term trends for the business remain favorable, and the firm is well-positioned to gain market share in the analytical instruments and consumables markets due to its strong global footprint and low-cost advantage as a one-stop shop. He believes that Thermo Fischer Scientific's narrow moat comes from both its scale and the scope of its business--enormous manufacturing, sales, and distribution infrastructure and broad product offerings from scientific instruments and lab equipment to software and services.

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

 

  Star Rating Moat Size Current Price (USD) Price/ Fair Value Fair Value Uncertainty Market Cap (mil) # Funds Buying Devon (DVN) 5 Narrow 58.97 0.54 High $23,853 3 JPMrgn (JPM) 4 Narrow 36.98 0.73 High $140,478 2 Ntl Oilwll Vrc (NOV) 4 Wide 78.51 0.75 Medium $33,478 2 Am Intl Grp (AIG) 3 None 34.80 0.83 Very High $60,151 2 Dell 5 None 12.22 0.68 Medium $21,373 1 St Jude 4 Wide 37.45 0.76 Medium $11,758 1 Life Tech 4 None 46.48 0.80 Medium $8,148 1 CVS Crmrk (CVS) 3 Narrow 45.31 0.99 Medium $57,645 1 Abcrmb&Ftch (ANF) 4 None 35.93 0.86 High $2,966 1 Gap (GPS) 1 None 35.99 1.64 Medium $17,607 1 Stock Price and Morningstar Rating data as of 08/17/12.

While there was very little overlap between our list of top 10 high-conviction purchases and those listed as top 10 new-money buys during the second quarter, with only Devon Energy,  National Oilwell Varco (NOV), and  American International Group (AIG) falling into that category, it was the latter purchase that raised the most interest in our eyes. This was mainly due to the fact that it is fairly unusual to see our top managers moving into lower-quality companies like AIG, which was one of the most high-profile firms to have collapsed during the financial crisis. Up until now, only Bruce Berkowitz at  Fairholme (FAIRX), Saul Pannell at  Hartford Capital Appreciation (ITHAX), and the managers at  Mutual Shares (TESIX), have been willing to commit any capital to the name, with Berkowitz actually holding the most shares, with his stake making him the second-largest shareholder in AIG behind the federal government. With two other managers--Oakmark and FPA Crescent--making new-money purchases in the name during the second quarter, the number of Ultimate Stock-Pickers holding stakes in AIG has risen to five.

That said, other than Berkowitz's commitment of more than one quarter of his portfolio to the name, the stakes held by the four remaining managers are somewhat smaller, with FPA Crescent's and Oakmark's positions accounting for 2.1% and 1.2% of their equity portfolios, respectively. Oakmark's Bill Nygren appears to believe the company has hit something of an inflection point, and he senses an opportunity as market perception of the company shifts:

"We believe AIG has made remarkable progress under the leadership of CEO Robert Benmosche. The government loans have been completely repaid, and the stock currently trades above the government's break-even point of $29. Two years ago, we found it almost impossible to estimate the value of AIG's equity. The analysis involved guessing at proceeds from sales of businesses and valuing large, opaque, levered loan portfolios. Today the analysis is the same as it would be for any insurer: What is its future earnings outlook? How good are its reserves? How will its capital be invested? Chartis went through a difficult period of writing unprofitable business just to grow revenues. That has stopped, and we believe that for the past several years Chartis has focused on only writing profitable business even if growth suffers. Reserves have been boosted to a level that we think is consistent with other high-quality insurers. Capital is being invested primarily in share repurchase--with AIG selling at just over half of book, this is nicely accretive to the company's per-share book value…We believe that AIG is priced as if its future looks like its past. We expect the current discount to other insurers will diminish as the memory of the financial crisis fades."

Morningstar analyst Jim Ryan is a bit less optimistic about the prospects for AIG's business. While he agrees that the company has made significant strides in its recovery, from an economic moat perspective he feels that AIG fails the test in almost all regards, believing that the road to re-establishing its competitive position will be long and extremely difficult. He feels the firm's Chartis subsidiary has underperformed the property and casualty insurance industry where it competes, and that AIG's life insurer, SunAmerica, operates in a commodity-like industry in which economic moats are almost impossible to establish. While Ryan does agree that the shares are materially undervalued, compared to his own valuation (which assumes nothing more than mediocre results over time), he would like to see a larger margin of safety before plunging into the stock--going on to note that plenty of uncertainty still remains around the proceeds that AIG will ultimately realize from selling its noncore businesses (specifically the aircraft leasing business and its interest in Pan-Asian insurer AIA). During the second quarter, the stock traded in a range of about $27 to $35, and currently trades at $35 per share, so finding a price close to what our top managers likely paid for their shares is going to be difficult in the near term.

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Disclosure: Brett Horn does not own shares in any of the securities mentioned above. 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.