Our Ultimate Stock-Pickers' Top 10 Buys and Sells
Interest in Apple is heating up as the price falls, but how deep is the conviction?
Investing Specialists
By Brett Horn | Associate Director
The first quarter of 2013 was arguably one of the best periods for actively managed U.S. stock funds during the last several years, as double-digit gains in both the S&P 500 Index and the Dow Jones Industrial Average combined with the first positive flows for the category since the first quarter of 2011. While flows have diminished since, the domestic markets have gained more ground during the second quarter of 2013, with both the S&P 500 Index and the Dow Jones Industrial Average increasing about 5% since the end of March. As a result, our Ultimate Stock-Pickers have had to operate in an environment where attractive opportunities have become scarcer as the year has progressed. With some of our top managers seeing investor inflows for the first time in a very long time, sitting on their hands was not an option during the first quarter and early part of the second quarter of 2013.
While the buying activity during the period was more notable for its breadth than its conviction--something we noted in our last article--we did see our Ultimate Stock-Pickers demonstrating a preference for a few particular names, and trimming or closing out positions that were no longer attractive to them. Still, in assessing whether or not our managers' actions are still worth investigating, the caveat that they were likely buying and selling at much different prices than investors can realize today bears repeating this quarter. As of last Friday, the market (as represented by the S&P 500 Index) was 10% higher than the midpoint of its trading range (of 1,425 to 1,530) during the first quarter of 2013, with most stocks and sectors rising in the rally. Consequently, the margin of safety on many of the names that our managers found attractive during the period might be meaningfully lower for investors looking at the very same stocks today.
From a sector point of view, health care, technology, and energy drew the most interest from our top managers. Our Ultimate Stock-Pickers' holdings in technology and energy are still underweight relative to the weightings of these sectors in the S&P 500 Index, but an "old tech" theme and an attraction to natural gas names seem to be overcoming our managers' historical aversion to these sectors, a trend which has been fairly consistent over the last year or so. Our top managers continue to overweight the industrials, health care, and consumer defensive sectors, which suggests a somewhat cautious stance even as the market rallies. In addition, while our Ultimate Stock-Pickers remain overweight in financial services, they have been more active about trimming their holdings in this sector as the financial crisis has receded and valuations have become far less attractive. In looking at these sector weightings overall, we see a mix of fear (overweight positions in the health care and consumer defensive names) and greed (growing positions in a beaten down technology sector), which we think nicely illustrates the cautiously opportunistic nature of our current group of managers.
Also of note is the fact that six of the top 10 purchases during the period involved new money being put to work by at least one of our Ultimate Stock-Pickers, while six of the top 10 sales saw one or more manager completely eliminating the name from their portfolios. Even with all the buying and selling that we saw during the most recent period, there was no change in the list of top 10 holdings of our Ultimate Stock-Pickers from the end of last year. That may not be the case in the coming quarter, though, as we now find ourselves in a position where we'll have to rotate out one of our top managers when tabulating data for the current period, given the departure of Joe Milano from T. Rowe Price New America Growth .
Changes to the Investment Manager Roster
As we noted earlier this year, we prefer to make changes to the Investment Manager Roster just once a year (typically during the first calendar quarter), removing a manager from the list if: (a) there is a meaningful change of managers for a fund (and we have little confidence that the succeeding management team will be able to replicate the level of performance historically generated by the fund); (b) a fund closes or merges with another fund, and the fund no longer follows the same investment processes or is no longer run by the same management team; (c) the fund is no longer covered by Morningstar's mutual fund analysts; and, (d) the fund's long-term performance has fallen meaningfully below benchmark returns.
That said, we will rotate out a manager during the course of the year when either of the first two conditions is met. We were fortunate earlier this year to have the departure of RS Capital Appreciation, necessitated by the departure of all three managers--David Carr, Larry Coats, and Christy Phillips--and the merger of the fund's assets into RS Growth , coinciding with our normal annual rotation. Ironically, we replaced RS Capital Appreciation with T. Rowe Price New America Growth, which we are now forced to remove following Milano's departure. We do, however, have a quick replacement handy, given the bullpen of Large Cap Growth managers we maintain, and expect to be adding Morgan Stanley Focus Growth , run by Dennis Lynch, who heads up the growth investing team at Morgan Stanley Investment Management, in the next cycle.
Ultimate Stock-Pickers' Top 10 Stock Holdings (by Investment Conviction)
As we noted above, all the buying and selling that we saw during the most recent period had no real impact on the list of top 10 holdings of our Ultimate Stock-Pickers, which looked much like it did at the end of last year. That said, the list has seen a few meaningful changes since we relaunched the concept just over four years ago. For starters, wide-moat rated Microsoft is now the top high-conviction holding of our Ultimate Stock-Pickers, with 17 of our top managers maintaining stakes in the software giant compared to 13 at the end of the first quarter of 2009. Wide-moat rated Berkshire Hathaway , which was the top high-conviction holding overall back then, has since slipped down to the lower end of the table, as many managers trimmed their positions as the markets recovered in the aftermath of the financial crisis. Of the remaining eight names on today's list, only four of them--wide-moat Johnson & Johnson , wide-moat Procter & Gamble , wide-moat Wal-Mart , and narrow-moat rated Wells Fargo --were on the list of top 10 holdings when we relaunched the Ultimate Stock-Pickers concept. The four names that were on the list back then but are no longer represented today are wide-moat Coca-Cola , Burlington Northern Santa Fe, wide-moat Pfizer , and narrow-moat rated ConocoPhillips .
Ultimate Stock-Pickers' Top 10 Stock Purchases (by Investment Conviction)
Looking more closely at the purchases during the most recent period, narrow-moat rated Apple tops our list of high-conviction buys--something that we got an early read on during our last article. The drivers behind the more recent fall in Apple's share price are well-publicized, and drew widespread interest among our Ultimate Stock-Pickers, with six managers buying the name during the quarter (and three of those managers making new-money purchases in the technology giant). It also broke into the list of top 10 widely held securities during the period, with 10 of our 26 top managers now holding a stake in Apple. Some caveats are in order, though, as the level of individual manager conviction behind the name is somewhat less than one might imagine. This was demonstrated in the quarterly commentary made by some of the managers who hold Apple. For example, Bill Nygren at Oakmark , which has 2% of its stock portfolio dedicated to the name, noted that during the first quarter:
Our worst performer was Apple, down 16%, but because our weighting was less than that of the S&P 500, it didn't hurt our relative performance.
The managers at Columbia Dividend Income , which hold an even more modest position (equal to 0.8% of its total stock portfolio), noted the same phenomenon:
Within information technology, an underweight in Apple helped relative performance.
In addition, the managers at Vanguard PRIMECAP , which holds only a nominal stake in Apple, noted that their relative lack of interest in the company helped performance during the first quarter. However, they stopped short of patting themselves on the back by recognizing that they had also missed its spectacular rise:
Within the technology sector, the fund fared well relative to the benchmark index partly because of stocks it didn't own or owned in small amounts. Chief among these was Apple, whose stock dropped about 33% as investors grew concerned about the firm's ability to sustain its high-flying growth given increased competition in the computer and mobile device arena. (Of course, the lack of exposure to Apple has also meant that the fund didn't benefit from the company's soaring stock price over the past few years.)
While 10 of our top managers now have positions in Apple, only four of them-- Amana Trust Growth , Parnassus Equity Income , T. Rowe Price New America Growth, and Alleghany --hold position sizes that are greater than the weighting of the stock in the S&P 500 Index, making them more enthusiastic holders of the name. But this quarter definitely marked an upswing in interest in Apple, with five of our top managers committing meaningful amounts of capital to the name (and in levels that relative to the rest of the buying activity during the period pushed it up to the top of our list). We noted this in our last article, where we also highlighted a deeper dive analysis that Morningstar analyst Brian Colello had put together on the technology giant. Still, only two of the holders of Apple pushed their stake in the firm above its 3.4% weighting in the S&P 500 Index at the end of the first quarter of 2013. While Parnassus Equity Income established a completely new position in Apple equal to 3.8% of its stock portfolio in April, the more bullish move was from Alleghany, which roughly tripled its existing stake in the technology giant, leaving it at 7.4% of its total stock portfolio at the end of the first quarter.
Looking across the rest of our list of top 10 buys, there were only three other stocks--narrow-moat rated Devon Energy , wide-moat CH Robinson Worldwide , and narrow-moat Apache --that our analysts consider to be undervalued right now. The most attractively priced of the three, in our analysts' view, is Devon, which has seen ongoing interest from our managers over the last year or so. Four of our top managers-- Diamond Hill Large Cap , FMI Large Cap , Sound Shore , and Alleghany--were buying the name during the most recent period, but most of them were only modestly increasing existing stakes in the energy firm. Alleghany was the one exception, making a meaningful new-money purchase in Devon, which accounted for 4.5% of its total stock holdings at the end of the first quarter.
In their quarterly letter to shareholders, the managers at FMI Large Cap, which has devoted 3.6% of its stock portfolio to Devon, concisely summed up what we believe is the thesis driving our managers' interest in the energy firm:
Devon faces the near-term taint of being levered to natural gas, which is currently priced very low. We remain optimistic about the long-term prospects.
Our analyst Mark Hanson thinks our managers' interest in the name is well-placed. He recognizes the difficulties that low natural gas and natural gas liquid prices pose for Devon, but also recognizes the long-term value of its assets, and sees the risk-reward tilted in investors' favor over the long run. At present the firm isn't operating any gas-directed rigs, nor does it plan to ramp up activity across its gassy leasehold until prices recover. In the meantime, Devon is keeping busy developing its extensive portfolio of oil- and liquids-rich assets, which includes established regions like Barnett and Cana-Woodford; emerging plays like the Mississippian, Wolfcamp, and Cline; and prospective light oil formations in Canada. While none of these of newer plays will necessarily be game-changers for Devon given its size, they should nonetheless help drive organic growth and thereby mitigate the need for large-scale acquisitions. Other near-term factors to keep an eye on include the possible repatriation of Devon's overseas cash, a possible IPO of the firm's midstream properties, and ongoing improvements in Canadian heavy oil differentials.
Devon traded in a range of about $52 to $61 during the first quarter and currently trades at about $57. So, investors looking at the stock today would likely be realizing a price on par with prices our managers realized during the first quarter. Looking more closely at Apache, another energy firm that has seen ongoing interest from our top managers, three of our Ultimate Stock-Pickers--Diamond Hill Large Cap, Mutual Shares , and Alleghany--added to existing stakes in the company during the most recent period. Once again, Alleghany set for the mark for highest conviction, increasing its position 60% to the point where it represented 8.2% of its stock holdings at the end of the first quarter. Diamond Hill's buying looked to be more opportunistic, as the fund took advantage of a dip in the share price to bolster its position, and noted in its quarterly letter that:
Oil and gas exploration and production company Apache Corp. fell after management downgraded expectations for medium-term production growth. Operations in Egypt have continued uninterrupted, but this issue likely also remains an overhang for the stock.
But where some of our managers saw opportunity during the quarter, another saw more downside. Oakmark Equity & Income completely eliminated its position in Apache during the first quarter, apparently having thrown in the towel on the company's ability to generate value. Manager Clyde McGregor noted his disappointment in his quarterly letter to shareholders:
Apache was the signal disappointment within this group of sales [this quarter]. When investors consider exploration and production company stocks, they are increasingly looking for companies that can find and produce oil and gas efficiently and at low cost. For many years, Apache was seen by its peers as a cost leader, but the company's statistics have been eroding meaningfully, which has limited its ability to grow intrinsic value per share, a characteristic that we demand in our investments.
Apache traded in a range of about $73 to $85 during the first quarter and currently trades at about $82. So, investors looking at the stock today would likely be buying shares at the higher end of what our managers realized during the first quarter. While CH Robinson Worldwide has not received quite as much interest as Devon and Apache, its shares have perked up some since the start of the year, with two of our top managers--Parnassus Equity Income and Yacktman --making high-conviction purchases, and two making new-money purchases-- Hartford Capital Appreciation and Yacktman--during the most recent period. Even better, there has been more widespread purchasing of the shares since the start of the year, with five managers overall--Hartford Capital Appreciation, Jensen Quality Growth , Parnassus Equity Income, T. Rowe Price New America Growth, and Yacktman--investing capital in CH Robinson Worldwide during the first few months of 2013.
Our analyst Matthew Young agrees that the stock is undervalued. In his view, CH Robinson dominates the $40 billion-plus U.S. highway brokerage market. Its massive network of shippers and carriers bestows a wide economic moat capable of defending long-run economic profits. Shippers enjoy lower transportation costs and multimodal solutions, while carriers gain access to a vast supply of freight opportunities. Since the firm does not own transportation equipment, it minimizes capital intensity and operating leverage (75% of operating costs are tied to variable compensation). Additionally, carrier rates adjust faster than pricing to shippers, driving gross margin expansion when freight markets weaken (though the opposite occurs when demand strengthens and/or capacity tightens, as seen throughout 2012). Altogether, CH Robinson is less vulnerable to cyclical downturns than asset-intensive truckers, as evidenced by its enviable history of above-average profitability. The company's shares traded in a range of about $56 to $68 during the first quarter, and fell sharply after fourth quarter results were released. With the stock currently trading at about $57, investors looking at the stock today would likely be buying at prices on par with what our managers realized during the first quarter.
Ultimate Stock-Pickers' Top 10 Stock Sales (by Investment Conviction)
It was only one year ago that I wrote of the eBay purchase, so this idea came to investment maturity quite rapidly. In January 2012, we had what proved to be a fleeting opportunity to purchase eBay shares after the announcement of an unexpected management departure. We took advantage of the opportunity based on our belief that the company's PayPal unit was a "crown jewel" that investors did not fully appreciate. We sold our shares in eBay at close to our target sell price after holding the position for a little more than one year.
The announcement in mid-February that Berkshire Hathaway and 3G Capital had teamed up to buy narrow-moat rated Heinz led both Columbia Dividend Income and Oakmark (which were the only two managers holding the stock coming into 2013) to sell their stakes, with both managers believing that there was relatively little upside left in the shares. Bill Nygren at Oakmark went further to note that he saw management as a key ingredient in Heinz's success over the years, and seemed to be pleased with the buyout price:
At Oakmark, we believe in the importance of investing with managers that act like owners and maximize returns to their shareholders by taking advantage of whatever opportunities the market presents them with. Most managements talk about improving shareholder value, but Heinz management walked the walk. Bill Johnson and his team added value through cutting costs, investing in their brands, acquiring growth platforms, spinning off underperformers, repurchasing inexpensive stock, and paying out an above-average percentage of their earnings in dividends. Most importantly, when they were presented with an offer that they believed fully valued Heinz, they didn't worry about protecting their own jobs; they focused on doing the right thing for their shareholders...We at the Oakmark Fund couldn't have been more pleased with the Heinz acquisition announcement, and we sold our stock that same day.
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Disclosure: Brett Horn owns shares in the following securities mentioned above: Devon Energy. 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.