By Greggory Warren, CFA | Senior Stock Analyst
When we relaunched the Ultimate Stock-Pickers concept nearly four years ago, one of our primary goals was to uncover potential investment ideas that not only reflected the most recent buying and selling activity of top investment managers, but would be timely enough for investors to get some value from them. We felt this could be achieved 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. With more than two thirds of our Ultimate Stock-Pickers having already reported their fourth-quarter holdings, we've scoured the trading activity of these top managers to get an early read on how some of them have been putting money to work.
Looking at the purchases that our Ultimate Stock-Pickers make in any given period, we 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 6.0% of its stock portfolio invested in wide-moat-rated Bank of New York Mellon (BK) at the end of the December quarter, compared to just 2.0% in non-rated Willis Group Holdings (WSH), have a higher degree of conviction in Bank of New York than they do in Willis Group. 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 over time.
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 portfolio overall. 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 put money to work in new names only when their purchase decision carries a 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 they are already comfortable with than it is for them to make a bet on a name representing a new addition to their portfolio.
When looking at all of these different stock purchases, however, it pays to remember that the decision to buy these securities was made during a prior period. This means that the prices our top managers paid will likely be different from today's trading levels, increasing the importance that investors assess the current attractiveness of any security that they might be considering for purchase by looking at some of the measures that our stock analysts' research regularly provides us with, 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 Size of Moat Current Price (USD) Price/ Fair Value Fair Value Uncertainty Market Cap ($ Mil.) # Funds Buying TJX (TJX) 2 Narrow 45.01 1.18 Medium 32,678 2 Gilead (GILD) 3 Narrow 41.6 1.04 Medium 63,036 2 AIG (AIG) 4 None 38.35 0.82 High 55,375 2 Bnk Amer (BAC) 3 Narrow 12.03 1.2 Very High 128,591 2 Apple (AAPL) 4 Narrow 460.16 0.77 Medium 426,162 2 Devon (DVN) 4 Narrow 59.25 0.6 High 23,438 2 Oracle (ORCL) 4 Wide 34.81 0.89 Medium 164,376 2 Wells Fargo (WFC) 4 Narrow 35.16 0.84 Medium 184,829 2 Dell (DELL) 3 None 13.81 0.99 High 24,167 2 Coca-Cola (KO) 3 Wide 37.42 0.98 Low 170,477 2
Stock Price and Morningstar Rating data as of 02-15-13.
Unlike many of the quarters we've covered since relaunching the Ultimate Stock-Pickers concept, the fourth quarter of 2012 and early part of 2013 represented a fairly strange mix of buying and selling activity. While outflows from actively managed U.S. stock funds approached $15 billion during December (leaving the fourth quarter of 2012 as the third-worst quarter for outflows since the middle of 2008), flows actually turned positive in January 2013, with close to $5 billion of inflows during the month. This not only marked the first positive period of monthly flows for the category since February 2010, but had some of our managers buying more heavily in January after selling off shares in December to meet end-of-year redemption requests--influenced by the pending fiscal cliff, and more specifically by investors looking to lock in capital gains before tax rates increased.
Looking over the list of top 10 high-conviction purchases we've seen so far during the most recent period, it is interesting to note that all 10 names had two managers making high-conviction purchases. Of these, narrow-moat-rated TJX Companies (TJX) stands out not only because the two high-conviction purchases were also new money buys, but because the name was also sold outright by one of our top managers. Looking more closely at the purchases, both Diamond Hill Large Cap (DHLAX) and Jensen Quality Growth (JENSX) made high-conviction new money purchases of TJX Companies. Of their purchase of the off-price retailer, the managers at Diamond Hill Large Cap--Chuck Bath, Bill Dierker, and Chris Welch--noted that they "expect TJX Cos. to benefit from increased market share by capitalizing on growth opportunities for the HomeGoods concept domestically, e-commerce, and Western Europe store growth," and that they believe that the "company is led by an excellent management team which has proven to be good stewards of capital." The managers at Jensen Quality Growth were a bit more verbose, noting the following about the firm and its shares in their quarterly newsletter:
TJX Companies ("TJX") is the largest off-price retailer in the world. The company operates over 2,900 stores throughout the U.S. and in five other countries. Well known store concepts operated by TJX include T.J. Maxx, Marshalls, and HomeGoods. In each of these concepts, the company offers name-brand apparel and merchandise at everyday prices that are generally 20% to 60% below prices for similar goods at department and specialty stores. TJX's buying operation consists of over 700 buyers that work with more than 15,000 vendors in over 60 countries throughout the world. Size is an important factor in TJX's off-price buying in that it creates bargaining power with apparel manufacturers. Additionally, size often gives TJX's buyers the important "first call" from potential suppliers that allows them to have the first look at available merchandise. Importantly, we believe that the scale and scope of TJX's buying operation would be difficult to replicate for a potential new entrant.
TJX's business model has produced strong and resilient historical results, and we expect that steady growth should continue into the future for TJX as a result of new store openings and continued same-store-sales growth. However, TJX does face competition from a variety of existing and emerging competitive threats, perhaps the most dynamic of these being the emergence of e-commerce. At present, there are a variety of e-commerce sites that attempt to create an on-line version of off-price retailing; however, we remain skeptical that the off-price business model can flourish on-line on a standalone basis. Although TJX's stock price has been strong this year, we are optimistic about the future prospects for the company and believe that the stock is attractively valued even when using conservative estimates in our valuation models.
These thoughts echo the thinking of Morningstar analyst Jaime Katz, who notes that TJX remains a leader in off-price retailing, with revenue 3 times greater than its closest competitor, Ross Stores (ROST). In her view, the firm's robust store base of almost 3,000 stores globally makes it an attractive outlet for apparel manufacturers and retailers looking to dispose of excess inventory. Through long-standing partnerships with apparel manufacturers like Polo Ralph Lauren (RL), Katz notes that TJX is able to buy brand-name goods at rock-bottom prices, passing the savings on to consumers. With well-established vendor relationships and increasing economies of scale, she believes that TJX has contained competition and developed a narrow economic moat. While Katz does note that the firm's domestic growth prospects are limited by its current size, she believes that TJX still has tremendous international growth opportunities and will maintain its dominant position in the off-price channel, generating returns on invested capital in excess of our estimated cost of capital. That said, the company's common stock has traded above her fair value estimate for much of the last year, making it more difficult for her to recommend the shares on a valuation basis. These thoughts are echoed by Clyde McGregor of Oakmark Equity & Income (OAKBX), who noted that he'd sold the name simply because he believed that it was no longer substantially undervalued.
While McGregor was also a seller of Boston Scientific (BSX) and VCA Antech (WOOF) during the period, he initiated stakes in five new equity holdings-- Bank of America (BAC), BorgWarner (BWA), Principal Financial Group (PFG), Kaydon (KDN), and Crane Company (CR). Of his purchase of narrow-moat-rated Bank of America, which was also a new money purchase for Steven Romick at FPA Crescent (FPACX), McGregor noted that it was his fund's first investment in the banking industry in over six years, believing that investments in the industry were not suitable for the Equity & Income Fund, given its positioning as the most risk-averse in the Oakmark family of funds. Speaking more directly to his purchase of Bank of America in light of that changes that have taken place in the industry over the last six year, McGregor noted that:
Bank investment has been fraught with many hard-to-quantify risks, including opaque financial reporting, exposure to low-quality mortgages and the overall housing market, negatively evolving regulatory rules, substantial litigation and the industry's high degree of financial leverage, which amplifies the impact of all risks. But with each passing year since the nadir of the financial crisis, the industry has made progress addressing these issues. Regulators and auditors are scrutinizing banks' books with newfound vigor, bad mortgage balances have declined, the housing market is more stable, the broad strokes of many important regulatory rules have been established, considerable litigation reserves have been built and leverage has diminished. Over the past few quarters in particular, these issues have resolved such that bank stocks can once again compete for space in the Fund.
Bank of America stands out as having the most compelling prospective return. For years, it was the poster child for all that was troubling about banks. But like the industry as a whole, Bank of America has made tremendous progress simplifying and "de-risking" its business. For instance, in just the past few quarters, it has gone from being one of the worst capitalized big banks to the best. (For perspective, the company's tangible common equity ratio is 64% higher than it was in 2006, which was before the crisis.) Although investors have started to reward the company for its progress and brought the stock up from its lows, it is still being valued at a sizable discount to its peers. The discount derives both from stale perceptions of the company's relative risk profile and its relatively depressed near-term earnings. We expect this discount to close with time, as investors re-evaluate the "new" Bank of America and its profitability catches up.
Morningstar analyst Jim Sinegal is a bit more sanguine in his approach to the name, noting that it may take some time before Bank of America is running on all cylinders. In addition to the facing the same difficulties as its systemically important peers--increased regulation, low interest rates, depressed capital markets activity, and weak demand for loans--Sinegal notes that Bank of America is also attempting to outrun a sizable but difficult-to-quantify liability resulting from its past mortgage indiscretions, all while attempting to build capital in order to comply with Basel III. While he believes that the tail risk associated with mortgages is receding as Bank of America builds capital and improves profitability, Sinegal cautions that the company still has a long road to go before it is back to full health. With Bank of America's shares currently trading at 1.20 times his fair value estimate of $10 per share, they lack the margin of safety that Sinegal would prefer to see before recommending the name given all of the headwinds the bank is facing.
Top 10 New-Money Purchases made by Our Ultimate Stock-Pickers Star Rating Size of Moat Current Price (USD) Price/ Fair Value Fair Value Uncertainty Market Cap ($ Mil.) # Funds Buying TJX (TJX) 2 Narrow 45.01 1.18 Medium 32,678 2 Bnk Amer (BAC) 3 Narrow 12.03 1.2 Very High 128,591 2 Cisco (CSCO) 4 Wide 20.99 0.87 Medium 111,441 1 PACCAR (PCAR) 3 Narrow 48.09 1.05 High 16,949 1 Google (GOOG) 3 Wide 792.89 1.07 High 263,069 1 Kroger (KR) 3 None 27.89 0.93 Medium 14,280 1 Morg Stnly (MS) 3 Narrow 23.87 1.04 High 47,206 1 Expeditors (EXPD) 4 Wide 42.26 0.83 Medium 8,802 1 Interpublic (IPG) 3 Narrow 12.57 0.97 Medium 5,457 1 BrgWrnr (BWA) 3 None 76.11 0.95 High 8,915 1
Stock Price and Morningstar Rating data as of 02-15-13.
Unlike previous periods, there was not much overlap between our list of top 10 high-conviction purchases and those listed as top 10 new-money buys during the most recent period, with only TJX Companies and Bank of America making their way on to both lists. With relatively few bargains in the market during the most recent period, exemplified by the fact that stocks under Morningstar coverage were trading at more than 90% of fair value (using a market-capitalization-weighted average) coming into 2013, we we're not surprised by the lack of depth in both the high-conviction and new-money purchases that we've seen so far. In fact, in order to find anything that our analysts would be recommending more heavily, we had to expand the list our to 25 names in both lists before we found any stocks-- J.C. Penney (JCP) and WellPoint (WLP)--that were trading below our analysts' Consider Buy prices. We have seen an increase in buying activity in January (for those firms that report monthly holdings), as those funds that are seeing an increase in inflows have had to put the money to work, but it looks like most of the buying is centered on names that were already in their portfolios, and lack the level of conviction that would make us take notice. In essence, these managers seem to be spreading the additional capital around their portfolios, much like they might trim their portfolios more broadly in times when they're looking to raise cash levels in periods of more stable markets.
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Disclosure: Greggory Warren own shares in the following securities mentioned above: VCA Antech. 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.