Our Ultimate Stock-Pickers' Top 10 Buys and Sells

After U.S. equity markets rose solidly during the first four months of the year, hitting new record highs in the first half of second quarter 2013, things turned much more volatile in May, June, and July. Fed chairman Ben Bernanke hinted that the government would start tapering its asset purchasing program as early as the end of this year, which had an impact on both equity and credit markets. U.S. equity markets did recover from their June pullback, rising more than 5% in July and hitting record highs in early August. But the return of more volatile equity markets had a negative impact on what had been one of the best periods of investment performance and investor inflows for most actively managed U.S. stock funds. It was against this backdrop that our Ultimate Stock-Pickers were making their buy-and-sell decisions for the second quarter and first part of the third quarter.

There were plenty of outright sales during the most recent period, which have happened a bit more regularly this year as many of our managers who are following value-based methodologies have eliminated positions reaching their fair value estimates. The buying activity of our Ultimate Stock-Pickers during the second quarter and first part of the third quarter suggests that, as a group, they continued to find undervalued companies to put money to work. From a sector point of view, energy and technology garnered the most buying interest from our top managers during the most recent period, with health care seeing the most sales activity. As in past periods, the aggregate holdings of our Ultimate Stock-Pickers in both technology and energy remain underweight relative to the weightings of these sectors in the S&P 500 Index, with our top managers continuing to overweight their holdings in the financial services, industrials, health-care, and consumer defensive sectors.

Also of note is the fact that seven 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 five of the top 10 sales saw one or more managers eliminating the name from their portfolios. Even with all of the buying and selling that we saw during the most recent period, as well as the replacement of  T. Rowe Price New America Growth (PRWAX) with  Morgan Stanley Focus Growth , there was no change in the list of top 10 holdings of our Ultimate Stock-Pickers from the end of the first quarter of 2013, or from the end of last year.

Ultimate Stock-Pickers' Top 10 Stock Holdings (by Investment Conviction)

  Star Rating Fair Value Uncertainty Size of Moat Current Price (USD) Price/ Fair Value # of Funds Holding Microsoft MSFT 3 Medium Wide 33.4 0.95 16 Google GOOG 3 High Wide 846.9 1.1 16 Wells Fargo WFC 3 Medium Narrow 41.08 0.89 14 J&J JNJ 3 Low Wide 86.41 0.96 12 Berk Hath BRK.B 4 Medium Wide 111.22 0.81 8 AIG AIG 3 High None 46.46 0.91 7 P&G PG 4 Low Wide 77.89 0.9 11 Wal-Mart WMT 3 Low Wide 72.98 0.99 14 Pepsi PEP 4 Low Wide 79.73 0.91 10 UPS UPS 3 Medium Wide 85.58 1.01 12

Data as of 08/30/13. Fund ownership data as of funds' most recent filings.

As we noted above, all of 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. That said, the list has seen a few meaningful changes since we relaunched the concept four and a half years ago. For starters, wide moat rated  Microsoft (MSFT) is now the top high-conviction holding of our Ultimate Stock-Pickers, with 16 of our top managers now maintaining stakes in the software giant compared with 13 at the end of the fourth quarter of 2008. Wide-moat rated  Berkshire Hathaway (BRK.A) (BRK.B), which was the highest-conviction holding overall during the depths of the financial crisis, has since slipped down to the middle of the table, as many managers have trimmed their positions as the equity markets have rallied. Of the remaining eight names on our current list, only four of them--wide-moat  Johnson & Johnson (JNJ), wide-moat  Procter & Gamble (PG), wide-moat  Wal-Mart (WMT), and narrow moat rated  Wells Fargo (WFC)--were on the list of top 10 holdings when we relaunched the Ultimate Stock-Pickers concept. The four names we had included back then but are no longer represented today are: wide moat rated  Coca-Cola (KO), Burlington Northern Santa Fe (which Berkshire Hathaway acquired in late 2009), wide-moat  Pfizer (PFE), and narrow moat rated  ConocoPhillips (COP).

Ultimate Stock-Pickers' Top 10 Stock Purchases (by Investment Conviction)

  Star Rating Fair Value Uncertainty Size of Moat Current Price (USD) Price/ Fair Value # of Funds Buying Natl Oil Vrco NOV 4 Medium Wide 74.3 0.87 6 Wells Fargo WFC 3 Medium Narrow 41.08 0.89 7 GM GM 4 High None 34.08 0.66 4 Schlmbrgr SLB 3 Medium Wide 80.94 0.93 4 Intel INTC 4 Medium Wide 21.98 0.88 4 Apple AAPL 4 High Narrow 487.22 0.81 5 ExxonXOM 4 Low Wide 87.16 0.9 5 Apache APA 4 Medium Narrow 85.68 0.78 4 CH Robnsn CHRW 4 Medium Wide 56.87 0.82 3 EMC EMC 3 Medium Narrow 25.78 0.99 4

Data as of 08/30/13. Fund ownership data as of funds' most recent filings.

Looking more closely at the purchases during the most recent period, wide moat rated  National Oilwell Varco (NOV) tops our list of high-conviction buys--something we got an early read on during our last article. National Oilwell Varco not only received interest from six of our top managers, but also was the recipient of new-money purchase from three of our Ultimate Stock-Pickers-- Oakmark (OAKMX),  Oakmark Equity& Income (OAKBX), and  Parnassus Equity Income (PRBLX). As we noted last time around, Oakmark's Bill Nygren laid out the following case for buying National Oilwell Varco in his quarterly letter to shareholders:

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.

Morningstar analyst Stephen Ellis agrees with this assessment, believing that National Oilwell Varco's wide moat and dominant position in rig equipment are secure, and that its floating, production, storage, and offshore ambitions as achievable and lucrative. That said, Ellis acknowledges that over the last 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 road map to recovery. 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.

It was also interesting to see new money being put to work in Wells Fargo, which has been a top 10 high-conviction holding for our Ultimate Stock-Pickers over the last four and a half years. New-money purchases by both  Vanguard PRIMECAP (VPMCX) and  Yacktman (YACKX) increased the number of top managers holding the bank's stock from 12 to 14 during the period. While there was no commentary from either manager about their decision to buy Wells Fargo, we did note some interesting thoughts from the managers of Oakmark Equity& Income, which established a brand-new position in  US Bancorp (USB) during the period:

The final new purchase was U.S. Bancorp, the fifth largest U.S. bank in terms of deposits. Seven years ago we determined that investing in banks was too risky for a conservative Fund. Over the past four years the efforts of the Federal Reserve to rehabilitate the banking sector have succeeded to the point that we again feel comfortable increasing the Fund’s exposure to the industry. U.S. Bancorp is a high quality institution in terms of assets, and fees make up nearly half its revenues. The company also has a large payment processing subsidiary, a business deserving of an above average valuation. We perceive management to be both conservative and shareholder-friendly. 

That said, the financial services sector remains the largest single sector for our top managers (accounting for 18% of aggregate holdings compared with 15% for the market as a whole). While  Fairholme's (FAIRX) extremely overweight position of the sector influences some of this--with close to half of that fund's stock holdings tied up in  American International Group (AIG) and 75% of its total stock portfolio dedicated to the financial services sector--most of our top managers have not been averse to holding larger stakes in financial services stocks.

Of greater interest has been the buying and selling activity within the technology sector. As we have noted in past articles, our top managers have been gradually amassing stakes in "old tech" names like Microsoft,  Oracle (ORCL) and  Cisco Systems (CSCO), as well as a few higher-growth names in the sector like  Google (GOOG) and  Apple (AAPL). Since the start of the year, though, we've seen some of these positions get whittled down, even as several of our top managers have been putting new money to work in the sector. The second quarter and early part of the third quarter were no different, as four of our top managers were purchasing Microsoft while seven of them were selling, with two of those sales--by  Jensen Quality Growth (JENSX) and  Sound Shore (SSHFX)--being of fairly high conviction. Meanwhile, Oracle just missed the list of top 10 high conviction purchases, as a significant new-money purchase by Yacktman, and meaningful add-on purchases by  FPA Crescent (FPACX), Oakmark, and Oakmark Equity & Income, helped to elevate its ranking. At the same time, it was being sold by four of our other top managers, with  Hartford Capital Appreciation (ITHAX) cutting its stake by 90% and  Aston/Montag & Caldwell Growth (MCGIX) eliminating its holdings in the software firm.

Cisco was also a bit of a conundrum, as four managers were buying the shares, while the managers at Hartford Capital Appreciation reduced their stake by more than three quarters. It should probably be noted--and this relates to the fund's sale of Oracle as well--that Hartford Capital Appreciation has been reshuffling its portfolio in preparation for the eventual retirement of long-time manager Saul Parnell (of subadvisor Wellington Management, who has successfully run this fund since its inception in 1996). Over the last two quarters, we've seen a lot of reshuffling going on as the fund makes the transition to a multimanager format, with the new group of managers including a mix of both growth and value managers. And, interestingly enough, this transition has not had a detrimental impact on performance, as Hartford Capital Appreciation was the third-best performing fund manager on our list at the end of August (posting a 22.0% gain year to date compared with a 16.2% increase for the S&P 500 TR Index and a 15.8% total return for the Large-Cap Blend category as monitored by Morningstar).

Google was another technology name that was both purchased and sold, as four of our top managers added to their holdings in the technology giant, while six of them trimmed their stake. Only Aston/Montag & Caldwell Growth and Parnassus Equity Income truly stood out, though. The former was notable for increasing its stake in Google by 45% during the most recent period; and the latter for eliminating more than one quarter of its holdings in the name. But the biggest controversy during the period was reserved for Apple, which, despite making our list of top 10 high-conviction purchases, was sold with some conviction by a handful of our top managers. On the buying side, we had four of our top managers adding to their existing stakes, with  Diamond Hill Large Cap Growth (DHLAX) making a meaningful purchase in the name, and one manager--Parnassus Equity Income--making a substantial new-money buy (with Apple accounting for 4.4% of the fund's stock holdings at the end of July).

Meanwhile, five of our Ultimate Stock-Pickers were selling shares of Apple, with two of them-- Amana Trust Growth (AMAGX) and Morgan Stanley Focus Growth--making meaningful reductions in their stakes, and two other managers-- Columbia Dividend Income (LBSAX) and Aston/Montag & Caldwell Growth--eliminating their holdings in the firm by the end of July. Ronald Canakaris, the manager of Aston/Montag & Caldwell Growth, explained in his fund's quarterly letter to shareholders his rationale for walking away from Apple: 

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.

While nine of our Ultimate Stock-Pickers continue to have positions in Apple, only two of them--Parnassus Equity Income and  Alleghany --hold position sizes that are greater than the weighting of the stock in the S&P 500 Index. That said, helping most of them from a performance perspective (as shares of Apple were down 6.8% year to date at the end of August relative to a 16.2% increase for the S&P 500 TR Index) is not necessarily a big vote of confidence in the name, at least in the near term.

Ultimate Stock-Pickers' Top 10 Stock Sales (by Investment Conviction)

  Star Rating Fair Value Uncertainty Size of Moat Current Price (USD) Price/ Fair Value # of Funds Selling Schwab SCHW 3 High Narrow 20.88 0.91 5 Pfizer PFE 3 Medium Wide 28.21 0.94 4 J&J JNJ 3 Low Wide 86.41 0.96 5 Microsoft MSFT 3 Medium Wide 33.4 0.95 7 Nestle NSRGY 4 Low Wide 65.45 0.87 2 Chespk Enrgy CHK 4 High Narrow 25.81 0.83 2 Disney DIS 3 Medium Wide 60.83 0.94 4 CncoPhlps COP 3 Medium Narrow 66.3 0.96 1 ADP ADP 2 Medium Wide 71.16 1.25 2 Merck MRK 3 Medium Wide 47.29 0.91 3

Data as of 08/30/13. Fund ownership data as of funds' most recent filings.

Looking at the higher conviction sales that were made during the period, we didn't see any large-scale moves away from any particular name, with most of the selling activity looking like portfolio shuffling, as managers moved money into what they viewed as more attractive opportunities. Narrow moat rated  Charles Schwab (SCHW) saw five managers selling, with Diamond Hill Large Cap Growth and Parnassus Equity Income both cutting their stakes in the firm by about half. This was not too surprising given the jump in interest rates during the quarter, which helped drive the shares up from around $17 at the beginning of May to a high of around $23 in late July. Todd Ahlsten and Benjamin Allen, the managers at Parnassus Equity Income, noted the following about their sale:

Charles Schwab, the San Francisco-based bank and brokerage firm, jumped 20.0% from $17.69 to $21.23 during the quarter, adding 18¢ to the Fund's NAV. The stock is now up an amazing 47.8% for the year to date, mostly due to expectations of a continued rise in interest rates. With higher rates, Schwab can earn much more on their banking assets, money market products and margin loans to brokerage clients than they do today. In February, the company told investors that if interest rates returned to their pre-credit crisis levels of the second quarter of 2008, Schwab's earnings would be almost triple their current 15¢ quarterly rate. We trimmed our Schwab position in response to the big move up, but still held some stock at quarter-end.

It is also interesting to note that three health-care names--Pfizer, Johnson & Johnson, and  Merck (MRK)--were sold with some conviction during the period. While most of our managers who were selling did note that the sales were valuation-based, the managers at Yacktman eliminated their stake in Pfizer, noting the following in their quarterly commentary:

Pfizer was removed from the funds due to price appreciation. The company has struggled to grow over time as it has not has not been able to produce enough new drug revenues to offset major patent expirations like Lipitor. Despite the lack of growth, the stock has appreciated significantly, and we do not think it represents a good value at current prices. 

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Disclosure: Greggory Warren owns shares in the following securities mentioned above: Procter & Gamble. 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.