Top 10 Holdings of Our Best Performing Ultimate Stock-Pickers
While a majority of our top fund managers are outperforming this year, three of them truly stand out from the rest given their ability to outperform the market over all time periods.
By Greggory Warren, CFA | Senior Stock Analyst
With the U.S. equity markets up by double digits since the start of 2013, more than a handful of our top managers have been able to pick up enough steam to surpass the returns of the S&P 500 Index. As of the end of last week, 12 of the 22 mutual fund managers on our list of Ultimate Stock-Pickers are beating the benchmark, which has increased more than 15% on a total return basis since the start of the year. The extent of the outperformance ranges from 25 basis points for Parnassus Equity Income (PRBLX) to more than 400 basis points for Sound Shore (SSHFX). This is all the more impressive when considering the fact that the majority of actively managed U.S. stock funds are underperforming the broader market this year, after two thirds of domestic managers underperformed during 2012 and more than three fourths underperformed during 2011--something that has weighed heavily on fund flows the last few years.
While nearly all of the Ultimate Stock-Pickers that are beating the market during 2013 are also outperforming on a one-year basis (with the average level of outperformance being 550 basis points), relatively few of these same managers have done better than the benchmark over the last three- and five-year periods. All 12 of them have, however, beaten the market over the past 10 years (with the average level of outperformance being about 200 basis points). Of these, only two managers-- Oakmark (OAKMX) and Sequoia (SEQUX)--have outperformed the index in all times frames, with a third manager-- Vanguard PRIMECAP (VPMCX)--just a hair off achieving the same goal (its three-year performance is coming in at 16.7% versus the market at 16.8%).
Total Return (%) Track Record for Our Best-Performing Managers
Looking more closely at these three managers, there are relatively few similarities between them. Oakmark, for example, is considered a Large Blend manager, even though fund managers Bill Nygren and Kevin Grant have a bit more of a value bent to their process. Meanwhile, Sequoia and Vanguard PRIMECAP are listed as Large Growth managers, and their processes tend to follow this mold. That said, Sequoia runs the most concentrated portfolio of the three managers, with its top 10 holdings accounting for two thirds of its total stock portfolio (and its top 25 holdings making up a little over 92%) at the end of the March quarter. The managers at Vanguard PRIMECAP are fairly concentrated as well, with their top 10 holdings accounting for 43% of the fund's total stock portfolio (and their top 25 holdings making up 70%) at the end of the first quarter of 2013. Meanwhile, Oakmark runs a less concentrated portfolio, with its top 10 accounting for just over 25% of its total stock portfolio (and its top 25 holdings making up a little over 58%) at the end of the most recent period.
Each fund has also been able to beat the market while focusing on different sectors of the market. Oakmark continues to bet big on Financial Services, which accounted for close to 29% of its total stock holdings at the end of the first quarter, compared to 15% for the S&P 500 Index, with Bank of America (BAC), JPMorgan Chase (JPM), American International Group (AIG), and Capital One Financial (COF) all represented in its top five stock positions. While the fund was also overweight in Industrials and Technology, the spread between Oakmark and the market was nowhere near as wide as it was with Financial Services. The managers were, however, underweight in Consumer Defensive, Energy, Utilities, Real Estate, and Health Care stocks.
Sequoia was also overweight in Industrials and Financial Services, but reserved its biggest bets for Health Care and Consumer Cyclicals. The fund's largest holding-- Valeant Pharmaceuticals (VRX)--accounted for 16% of its total stock holdings at the end of the March quarter, contributing greatly to its 23% commitment to Health Care stocks (with the sector accounting for 12% of the S&P 500 Index). As for their bet on Consumer Cyclicals, the managers at Sequoia are also well overweight the market, with three of their top 10 holdings-- TJX Companies (TJX), Mohawk Industries (MHK), and Advance Auto Parts (AAP)--accounting for three fourths of the 25% that the sector makes up of the fund's stock positions. While Sequoia was also overweight in Industrials and Financial Services, the spread between the fund's holdings and the market were nowhere near as large as with Health Care and Consumer Cyclicals. The managers were, however, underweight in Consumer Defensive, Technology, Energy, Communication Services, Utilities, and Real Estate stocks.
While Vanguard PRIMECAP was also overweight in Industrials, the managers of the fund reserved their biggest allocations for Health Care and Technology. Five of the fund's top 10 holdings-- Biogen Idec (BIIB), Amgen (AMGN), Eli Lilly (LLY), Roche Holding AG, and Novartis AG (NVS)--are Health Care names, which accounted for 33% of Vanguard PRIMECAP's stock holdings at the end of the first quarter of 2013. The fund's next largest bet was on Technology stocks, which accounted for 31% of its portfolio (with the sector accounting for 18% of the S&P 500 Index). Four of Vanguard PRIMECAP's top 10 holdings-- Google (GOOG), Texas Instruments (TXN), Microsoft (MSFT), and Adobe Systems (ADBE)--were Technology stocks at the end of the first quarter. Because of this, the fund is more concentrated by sector than the other two funds, remaining underweight in Consumer Defensive, Financial Services, Energy, Consumer Cyclicals, Utilities, Real Estate, and Communication Services stocks.
Top 10 Stock Holdings at Oakmark (as of March 31, 2013)
Oakmark's performance results have been boosted this year by its picks in Financial Services and Technology, which is a strange mix for a manager like Bill Nygren, who has a strong reputation as a value manager. Speaking at the 2013 Morningstar Investment Conference, Nygren noted that he thinks that "investors have a misperception that value managers don't like growth. We love growth; we just don't want to pay as much for it as most people will pay. The reason is because investors tend to stretch their time frames out too long. They think they see a company that's growing at a high rate in the short term and they assume that can continue for a decade or two."
Morningstar fund analyst Shannon Zimmerman notes that Nygren pursues the same absolute value strategy that drives stock selection at Oakmark overall, but that any company can be a bargain for the manager if the gap between its share price and its estimated intrinsic value is sufficiently wide. This approach allows Nygren and the other managers of the fund to invest wherever they see bargains, which is the reason why more traditional value holdings--like Financial Services--and growth holdings--like Technology stocks--can both be represented in the firm's top 10 stock holdings.
Nygren did, however, spend more time during the conference talking about Technology stocks, despite the fact that his fund is far more overweight in Financial Services, which led to some interesting conversations. While not a top 10 stock holding (or even a top 25 holding) at the end of the first quarter, Google (which is now held by 16 of our 26 Ultimate Stock-Pickers) was on his mind, noting in an interview with Zimmerman that:
"We think Google is one of the exceptions to the mean reversion in the near term, where there is a very strong tailwind of advertising shifting from traditional media to online, and Google being the leader in the online-advertising category, likely to remain the leader for years, and online has a very small percentage of advertising dollars today. You talk to almost any consumer product company and their marketing department, and they will tell you that five years from now, 10 years from now they expect to spend substantially more of their advertising budget on the Internet than they do today. We think Google is very well-positioned to have an above-average growth rate for a very long time."
His thoughts on Apple (AAPL), which has seen more interest from our Ultimate Stock-Pickers this year, including Oakmark (which increased its stake by 50% during the first quarter), were interesting as well, noting during a general session with Steve Wymer, manager of Fidelity Growth Company (FDGRX), entitled "Active Share, Active Managers," that:
"I like growth, I just don't want to pay up for it. Despite its high growth rate, Apple sells at 8 times earnings when you strip out cash. That's cheaper than Cummins (CMI), and yet no one would say, 'How could a value manager own Cummins?'"
What is also noteworthy is the fact that Apple, which was held by 10 of our top managers at the end of the first quarter, has not detracted from the performance of most of our managers (despite being down 18% year to date and 23% year over year), because most of them have not really held stakes in the firm until the fourth quarter of last year and most of their position sizes are relatively small. What has helped Oakmark even more, though, has been the 20%-plus gains it has seen with Technology holdings like TE Connectivity (TEL), Intel (INTC), Dell (DELL), and Microsoft since the start of the year. It also hasn't hurt to have some of the fund's largest Financial Services holdings--like JPMorgan Chase and American International Group--significantly outperform the market.
Top 10 Stock Holdings at Sequoia (as of March 31, 2013)
Sequoia has blazed a slightly different path to its outperformance this year, with Valeant Pharmaceuticals not only being its largest holding (at 16% of its total stock holdings) but one of its best performing (increasing more than 40% this year). Other meaningful contributors have been Berkshire Hathaway (BRK.A)/(BRK.B) and Mohawk Industries. According to Morningstar fund analyst Kevin McDevitt, the co-managers of the Sequoia fund, Bob Goldfarb and David Poppe, prize companies with sustainable competitive advantages and talented management teams that are effective capital allocators. He notes that their portfolio has traditionally been quite concentrated, but that they take a prudent approach to their allocation (preferring to stick with companies with strong balance sheets and franchises). He also notes that the portfolio is somewhat less concentrated than it was six years ago, when the fund tended to be comprised of 20-25 holdings, compared to 40-50 stock positions today.
Once Goldfarb and Poppe add a stock to the portfolio, management is reluctant to sell, which is reflected in the fund's low turnover--typically well below 25%. McDevitt notes that sell decisions tend to be driven more by changes in a company's competitive strength than by valuation (which was the main reason cited by most of our top managers for their selling activity during the first quarter). He also notes that the fund typically has an underweight position in commodity-oriented businesses, which shows up in its sector weightings. As we noted above, Sequoia was underweight in Consumer Defensive, Technology, Energy, Communication Services, Utilities, and Real Estate stocks at the end of the first quarter of 2013, with its biggest bets reserved for Health Care and Consumer Cyclicals, with lesser exposure to Industrials and Financial Services.
Top 10 Stock Holdings at Vanguard PRIMECAP (as of March 31, 2013)
According to Morningstar fund analyst David Kathman, Vanguard PRIMECAP's patient strategy is finally paying off again, and in a big way (with the fund up 19% year to date and 33% year over year). He notes that the fund has achieved one of the industry's best records over the past 30 years with a contrarian growth strategy that has, at times, required quite a bit of patience. This was the case in 2010, 2011, and 2012, when Vanguard PRIMECAP underperformed the market--part of the reason why its three-year performance is slightly below the return of the market. Kathman notes that the Vanguard PRIMECAP management team looks for companies with good growth potential but temporarily depressed valuations, and that they're willing to hold on to these stocks while they wait for them to turn around. The managers are also willing to make significant sector bets in areas where they see a lot of potential, noting that the fund has been overweight in Health Care and Technology stocks the last several years.
Vanguard PRIMECAP's overweight position in Health Care stocks has paid off handsomely this year, with top 25 stock holdings like Biogen, Medtronic (MDT), Johnson & Johnson (JNJ), and Life Technologies (LIFE) all up more than 25% since the start of 2013. The fund has also benefitted from its overweight position in Technology stocks, as some of their largest holdings in the sector--Google and Microsoft--are also up more than 20% year to date. It has also done well by having a smaller stake in Apple than the S&P 500 Index, with the technology giant accounting for 0.1% of its total stock holdings at the end of the March quarter, compared to 3.4% for the benchmark. The fund has also benefited from its holdings in DirecTV (DTV), Honeywell (HON), Charles Schwab (SCHW), and Southwest Airlines (LUV), all of which are up more than 20% since the start of the year. With the Vanguard PRIMECAP portfolio divided into sleeves that are managed independently, it is not too surprising to see holdings outside of Health Care and Technology, which accounted for close to two thirds of the fund's holdings at the end of the first quarter, making meaningful contributions to the fund's performance.
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Disclosure: Greggory Warren has ownership interests in the shares of the following securities mentioned above: Medtronic. 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.
The Morningstar Ultimate Stock-Pickers Team does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.