10 High-Conviction Purchases by Our Ultimate Stock-Pickers
Our managers are still finding attractive opportunities in a more richly valued market.
By Brett Horn | Associate Director
After posting double-digit gains during the first quarter, the U.S. equity markets took a bit of a hit during the second quarter, as hints from Fed Chairman Ben Bernanke that the government would start tapering its asset purchasing program as early as the end of this year sent interest rates higher, the bond market into a tailspin, and reduced the return on the S&P 500 TR Index to a less than 3% for the quarter (after posting 2% gains in both April and May). While the benchmark index rebounded strongly in July, rising more than 5% during the month, investors remain a little skittish (as evidenced by the more than 2% decline in the equity markets this past week). It was against this backdrop that our top managers were making their buy and sell decisions, and with more than three fourths of our Ultimate Stock-Pickers having already reported their second-quarter holdings (and, in some cases, their holdings though the end of July), we've scoured their trading activity to get an early read on how they've been putting money to work in what has been a difficult environment for active managers.
Looking at the purchases that our Ultimate Stock-Pickers make in any given period, we tend to focus on both high-conviction purchases and new-money buys. At Morningstar, we think of high-conviction purchases as instances where managers make meaningful additions to their existing holdings, or make significant new-money purchases, with a focus on the impact these transactions have on the portfolio overall. We believe that new-money purchases provide us with the most valuable insight into what our top managers might believe 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 that is completely new to their portfolio(s).
When looking at all of these different stock purchases, though, 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, so investors should assess the current attractiveness of any security 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. It is especially important in the current environment, with the S&P 500 TR Index moving up fairly steadily throughout 2013 and hitting record levels following the close of the second quarter. While many of our top managers have become more forthright about the difficulties that they (and all investors) face right now, Pat English of FMI Large Cap (FMIHX) made an interesting comparison between today's market and the late 1990s (which will forever be connected in our minds to then Fed Chairman Alan Greenspan's comments about "irrational exuberance"):
Today it is very difficult to find stocks that have defendable business franchises and strong balance sheets, and that trade at attractive valuations. In the late 1990s, even though stock market valuations were at an extreme, most of the excess was confined to a few sectors. It was not difficult to build a diversified portfolio of high-quality businesses at reasonable prices. Similarly, in the middle of the last decade, it was relatively easy to avoid housing-related stocks or complex financial enterprises that were heavily involved in derivative alchemy. Today, this is not the case. There is widespread overvaluation. Many more stocks are overvalued today than in the late 1990s; it's just that the mathematics of market weighted indices doesn't show this. In the late 1990s, highly valued mega market cap names like AOL, Dell, and Cisco made the markets look more expensive than the median multiple would indicate. Today, the median multiple is higher than what it was in 1999, a period that is widely regarded as the most expensive ever.
While Morningstar's stock analysts would certainly agree that valuations have become much less attractive over the last year, they are not quite so pessimistic about the current trading environment. They see the market as only modestly overvalued right now, with Morningstar's stock coverage universe trading just above our analysts' estimates of fair value for much of 2013, and less overvalued than it was at many points prior to the 2008-09 financial crisis.
While there were plenty of outright sales during the quarter--something that has happened a bit more regularly this year as many of our managers following value-based methodologies eliminate positions that have reached their estimates of fair value--the buying activity of our Ultimate Stock-Pickers during the second quarter suggests that, as a group, they've not given up on trying to find undervalued companies. With seven of the top 10 high-conviction purchases that hit our radar so far this period still in 4-star territory, it looks as though some pockets of undervaluation still exist in the markets.
Top 10 High-Conviction Purchases made by Our Ultimate Stock-PickersStar Rating Size of Moat Current Price (USD) Price/ Fair Value Fair Value Uncertainty Market Cap ($ Mil.) # Funds Buying Nat Oilwell Varco NOV 4 Wide 72.73 0.86 Medium 30,718 3 GM GM 4 None 34.38 0.66 High 47,353 3 Wells Fargo WFC 3 Narrow 42.75 0.93 Medium 225,726 3 Devon DVN 4 Narrow 57.38 0.66 High 23,039 3 Apple APPL 4 Narrow 502.33 0.84 High 460,417 2 Oracle ORCL 4 Wide 32.41 0.85 Medium 148,617 2 CH Robinson CHRW 4 Wide 56.13 0.81 Medium 8,984 2 Intel INTC 4 Wide 21.92 0.88 Medium 108,611 2 Accenture ACN 3 Narrow 71.65 0.98 Medium 48,498 2 Apache APA 4 Narrow 78.99 0.72 Medium 30,270 2
Stock Price and Morningstar Rating data as of 08-16-13.
Looking more closely at the list, National Oilwell Varco (NOV) was one of four names--with General Motors (GM), Wells Fargo (WFC), and Devon Energy (DVN) being the others--that received interest from three of our top managers during the most recent period. What separated National Oilwell Varco from the rest, though, was the fact that three different managers-- Oakmark (OAKMX), Oakmark Equity& Income (OAKBX), and Parnassus Equity Income (PRBLX)--initiated new positions in the name. In his quarterly letter to shareholders, Oakmark's Bill Nygren laid out the case for buying National Oilwell Varco:
National Oilwell is one of the world's largest providers of equipment for oil and gas drilling. Drill rig equipment accounts for about half its sales with the other half a diverse assortment of pipes, pumps, tools, consumables and a distribution business. Last year the stock reached $90, which was 14 times earnings plus amortization. Earnings in the first half of this year are expected to be down about 5%, primarily due to decreased drilling caused by lower natural gas prices. Despite the relatively small dip in earnings, the stock fell 30% to a low of $63 this past quarter. We expect earnings to begin to recover later this year, and we believe that next year could be the most profitable in the company's history. Earnings growth should be led by a rebound in the global land rig count, continued strong deepwater equipment orders and the benefits reaped from several meaningful acquisitions. Though National Oilwell's stock has recovered somewhat, it is still priced at less than 10 times estimated 2014 earnings plus amortization. Given that National Oilwell controls more than 50% of the deepwater equipment market and the company's very high returns on tangible capital, we believe the current valuation is attractive.
Our analyst Stephen Ellis agrees with this assessment. He believes that National Oilwell Varco's wide moat and dominant position in rig equipment are secure, and its floating, production, storage, and offshore ambitions as achievable and lucrative. He thinks an ongoing shift toward equipment replacement demand for jackups and land rigs, FPSO expansion and equipment aftermarket initiatives, and future acquisition activity are attractive growth and profitability drivers, and the firm remains well positioned to capture economic rents. That said, Ellis acknowledges that over the past year National Oilwell Varco has increasingly struggled with its manufacturing efforts even as its competitive position has remained strong. Broadly, the two halves of its business--North America and offshore--are seeing very different demand levels, creating a suboptimal cost position for the firm.
To rectify the profitability and operational challenges at its rig technology segment, Ellis notes that the company has outlined a roadmap to recovery. The efforts include additional training, trimming supply chain costs, boosting prices, and being more assertive around contract terms such as delivery schedules and costing. He believes that these self-help initiatives combined with a slowly recovering North American market and still robust offshore demand should lead to a greatly improved National Oilwell Varco in 2014. While the company's shares traded in a range of about $64 to $70 during the second quarter, they currently trade at about $73, meaning that investors buying the stock now would be realizing a price higher than what our managers did during the second quarter.
Both Oakmark funds, in addition to Berkshire Hathaway (BRK.A) (BRK.B), were buyers of the only no-moat stock on our list, General Motors, during the quarter. While Berkshire increased its existing holdings in the car manufacturer by 60% during the period, both Oakmark and Oakmark Equity & Income made meaningful new-money purchases in the name. Despite there being little in common between insurance companies and automakers, we detected some similarities between Bill Nygren's bullish take on General Motors and his previous interest in AIG (AIG), two high-profile casualties of the 2008-09 financial crisis that have since rebounded:
General Motors is the largest U.S.-based car and truck manufacturer. A high cost structure and a mountain of employee pension and post-retirement healthcare liabilities put GM into bankruptcy in 2009. A restructured GM--smaller, more efficient, and unburdened of most unfunded off-balance sheet liabilities--came back to the public equity market in 2010 at a price of $33. Despite a strong stock market, GM stock traded at only $27 earlier this year. We have been positive on the prospects for the auto market, believing that many investors focus too much on auto demand cycles in the U.S. and Europe, instead of on the strong secular growth in emerging markets, which now account for more sales than either the U.S. or Europe. And despite GM's struggles, it has built very strong positions in these growing markets while maintaining its dominant, and highly profitable, position in North American pick-up trucks. We believe that with a management team that can now focus on building cars and trucks, instead of serving its retirees, and with a stock priced at less than 8 times 2014 earnings estimates, GM has become an attractive investment.
This echoes some of the thinking of Morningstar analyst David Whiston, who thinks that GM's car models are of the best quality and design in decades, and that with the company already a leader in truck models, its more competitive lineup and much smaller cost base should allow it to print money as vehicle demand recovers. With General Motors trading in a range of about $28 to $35 per share during the second quarter, and currently trading at around $34, investors looking at the stock today would likely realize a price higher than our top managers did. At 66% of our analyst's fair value estimate, though, it is the cheapest stock on a price to fair value estimate of the top 10 high-conviction purchases we've seen so far from our Ultimate Stock-Pickers this year.
Looking more closely at the last two names that were purchased with higher levels of conviction by our top managers, Wells Fargo drew interest from Columbia Dividend Income (LBSAX), Yacktman (YACKX), and Alleghany . Columbia Dividend Income increased its stake in the bank by close to 40%, while Yacktman made a meaningful new-money purchase in the name. Even though Alleghany did have an established position in Wells Fargo, its purchase of 1.175 million shares (which raised its total stake to 1.210 million shares) should be viewed as a new-money purchase, in our view. The managers at Columbia Dividend Income appear to have been attracted to the opportunity to grab a high-quality company facing improving market conditions, noting in their quarterly letter to shareholders that Wells Fargo "produce[s] industry leading returns on assets and [is] levered to an improving U.S. economy." As for Devon Energy, the company has had a consistent presence on our high-conviction purchase lists over the last year, and we've discussed it at length in past articles. During the most recent quarter, Oakmark, Alleghany and Oppenheimer Global (OPPAX) all added to their existing positions.
With regards to some of the other names on the top 10 list of high-conviction purchases, Apple (AAPL) is another name that has had a consistent presence on our lists of top buys during the last year, and the trend continued during the most recent period as two managers--Parnassus Equity Income and Diamond Hill Large Cap Growth (DHLAX)--made meaningful purchases in the name. Having discussed in previous articles the difficulties of judging our managers' conviction in this particular technology name given its predominance in the S&P 500 index, Parnassus Equity Income's stake seems to have some conviction behind it, as the new-money purchase accounted for more than 4% of the fund's equity holdings at the end of July. That said, we also saw two of our top managers--Columbia Dividend Income and Aston/Montag & Caldwell Growth (MCGIX)--completely eliminate their positions in Apple during the most recent period. Ronald Canakaris, the manager of Aston/Montag & Caldwell Growth, explained his rationale for walking away from Apple in his fund's quarterly letter:
We sold the portfolio's position in Apple after the company reported in-line second-quarter earnings but materially reduced guidance, resulting in negative estimated earnings growth and collapsing relative momentum. Lackluster sales of the iPhone 5 and a mix shift toward legacy models in both developed and emerging markets are pressuring average selling prices and gross margin for the iPhone, while the success of iPad Mini is having the same impact on the iPad category. Longer term, we are concerned that the aforementioned mix shifts will have a permanent impact on gross margins as market saturation of high-end smartphones is evident, and Apple's lack of product differentiation versus prior models will result in lackluster demand until mid-2014.
C.H. Robinson (CHRW) was another name that stood out during the period, with the shares being snapped up by both Parnassus Equity Income and Yacktman during the most recent period. Discussing his fund's interest in C.H. Robinson, which accounted for close to 5% of Parnassus Equity Income's equity holdings, Todd Ahlsten said the following in his quarterly letter:
C.H. Robinson was the Fund's largest holding as of June 30. The stock dropped this quarter because the company's net revenue margin fell below expectations. Weak margins have been plaguing the company since early 2010, primarily for two reasons. The first is that C.H. Robinson has been brokering more low-margin, predictable shipments versus high-margin, rush deliveries, as compared to their historical mix. This is a result of the economy's subdued recovery from the 2008-2009 recession. Simply put, when consumer demand is tepid, retailers don't require as many rush deliveries to refill their shelves. The second issue is that some large competitors have decided to aggressively pursue market share gains by accepting lower brokerage margins.
We think that these problems will prove to be temporary, though it's impossible to predict exactly when they will be resolved. We also believe that the stock price adequately reflects the margin-related concerns. Over the last two years, C.H. Robinson has dropped 31% from its all-time high of $81 to its quarter-end price of $56, which is one dollar less than our average cost and well below our intrinsic value estimate.
Ahlsten's view is in sync with that of Morningstar analyst Matthew Young, who notes that C.H. Robinson has seen persistent gross margin compression for more than a year, weighing on its net revenue growth. He does, however, expect margins to stabilize in the years ahead, and thinks this wide-moat truck brokerage specialist remains well positioned for gradual third-party logistics industry consolidation. Young expects the firm to benefit from market share gains and rising demand for top-tier providers with access to flexible capacity and sophisticated IT infrastructure. Overall, he believes that the stock trades at an attractive discount to his fair value estimate, in part because of the near-term gross margin headwinds. C.H. Robinson traded in a range of about $54 to $62 per share during the second quarter, and currently trades at around $56, so investors looking at the stock today would realize a price on par or a bit below the price that our top managers realized during the second quarter.
Top 10 New-Money Purchases made by Our Ultimate Stock-PickersStar Rating Size of Moat Current Price (USD) Price/ Fair Value Fair Value Uncertainty Market Cap ($ Mil.) # Funds Buying Nat Oilwell Varco NOV 4 Wide 72.73 0.86 Medium 30718 3 GM GM 4 None 34.38 0.66 High 47353 2 Coach COH 4 Narrow 51.9 0.82 High 14428 2 Apache APA 4 Narrow 78.99 0.72 Medium 30270 2 Suncor SU 4 Narrow 34.18 0.66 High 51750 2 AvalonBay AVB 3 None 122.79 1.01 Medium 15560 2 Herman Miller MLHR NR - 27.44 - - 1615 2 DISH Netwk DISH 2 Narrow 44.5 1.48 High 20418 2 Apple AAPL 4 Narrow 502.33 0.84 High 460417 1 Potash Corp POT 4 Wide 30.39 0.8 High 25645 1
Stock Price and Morningstar Rating data as of 08-16-13.
There wasn't much overlap between our list of top 10 high-conviction purchases and those designated as top 10 new-money buys during the most recent period, with only National Oilwell Varco, General Motors, Apple, and Apache Corporation (APA )making their way on to both lists. The inclusion of Herman Miller (MLHR), which was purchased by both Oakmark Equity & Income and Hartford Capital Appreciation (ITHAX), is probably the biggest surprise, given that it is unusual to see a company with such a small market capitalization make our lists of top holdings, purchases, or sales. These were also relatively minor positions for both funds, with Herman Miller accounting for less than 0.2% of each fund portfolio. Commenting on his fund's purchase of the name, Oakmark Equity & Income's Clyde McGregor noted the following in his quarterly letter to shareholders:
Herman Miller [is] one of the largest manufacturers of office and institutional furniture in the world, perhaps best known as the maker of the iconic Eames lounge chair and Aeron desk chair. Herman Miller is a high quality business that generates impressive returns on capital in normal times, aided by its asset-light assembly model and returns-based incentive programs. But with roughly half of its sales coming from "project" business (tied to new office openings, relocations and major remodels), the company is highly cyclical, which can be seen in the peak-to-trough sales decline of 34% that occurred in fiscal years 2007 through 2009. While sales have begun to bounce back, office furniture spending tends to lag behind broad economic trends, so the industry hasn't fully recovered from the recent recession. When sales return to more typical levels, we believe management's earnings target--which is more than 50% higher than current earnings--will be eminently achievable.
Herman Miller traded in a range of about $24 to $29 per share during the second quarter, and currently trades at around $27, so investors looking at the stock today would realize a price on par or a bit above the price that our managers realized during the most recent period.
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Disclosure: Brett Horn has an ownership interests in the shares of 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.
The Morningstar Ultimate Stock-Pickers Team has a position in the following securities mentioned above: DVN. Find out about Morningstar’s editorial policies.