10 High-Conviction Purchases by Our Ultimate Stock-Pickers
Our top managers continue to find attractive buying opportunities in wide-moat firms.
By Greggory Warren, CFA | Senior Stock Analyst
After taking a slight hit during the second quarter, following remarks from Fed Chairman Ben Bernanke that the government would start tapering its asset purchasing program as early as the end of this year, the U.S. equity markets regained their footing during the third quarter, rising more than 5% during the period and pushing the S&P 500 TR Index up close to 20% for the first nine months of 2013. Concerns about quantitative easing, as well as the impact of a government shutdown and squabbling over the debt ceiling, did little to slow down the market as it pushed into the fourth quarter, with the S&P 500 TR Index increasing more than 6% since the end of September. If this holds through to the end of the year, U.S. stocks will have advanced in seven of the last nine calendar quarters, with the markets advancing more than 60% since the end of the third quarter of 2011 (the last time Washington was playing games with the debt ceiling).
We're nowhere near an end to the bickering in D.C. (with negotiations over both the debt ceiling and the ongoing funding of the government slated for the first quarter of 2014), but the markets continue to behave as though this is merely a bump in the road. As long as the U.S. economy continues to show signs of improvement and corporate profits expand more than consensus expectations (something we think is unlikely to continue indefinitely), the markets seem to be willing to look the other way. Ronald Canakaris of Aston Asset Management, who runs the Aston/Montag & Caldwell Growth ((MCGIX)) fund, echoed some of these thoughts in his third-quarter commentary to investors, noting that:
The outlook for the stock market continues to be favorable. The risk of a recession is low, monetary policy is very expansive, market valuations are fair to full though not extreme, and investors are optimistic but not euphoric. The market may be more volatile in the near term, however, as consensus economic and earnings expectations remain too high. While the Federal Reserve’s bond buying program should continue to support the stock market, this added liquidity, as noted above, has both reduced investors’ sensitivity to risk and significantly helped boost bond and stock prices. Consequently, the Fed’s stated intention of eventually winding down that program coupled with the uncertainty as to how and when it will do so could also contribute to increased market volatility.
This statement best exemplifies the environment that our Ultimate Stock-Pickers are facing as they manage their portfolios: looking for stocks to buy, making decisions about securities to sell, and negotiating the ongoing trend of outflows from actively managed U.S. equity funds. Not too surprisingly, with more than three fourths of our top managers having reported their third-quarter holdings (and, in some cases, their holdings through the end of October), the trend of selling activity outstripping buying activity that we've seen over the last few calendar quarters continued during the most recent period, as many of our managers take advantage of the market rally to book some gains. That said, we're still seeing higher conviction purchases of stocks with economic moats--particularly those with wide economic moats--as many of our managers continue to seek out high-quality businesses trading at discounts to their estimates of intrinsic value. Unfortunately, the number of purchases has dwindled as the market has moved higher.
When putting together our initial glimpse of the trading activity of our Ultimate Stock-Pickers in any given period, we tend to focus on both high-conviction purchases and new-money buys. We think of high conviction purchases as instances where managers make meaningful additions to their existing holdings (or make significant new-money purchases), focusing on the impact that these transactions have on the overall portfolio. When looking at all of these different stock purchases, it pays to remember that the decision to buy these securities could have been made as early as the start of July, meaning that the prices our top managers paid will likely be different from today's trading levels. So, it pays to assess the current attractiveness of any security mentioned here by looking at some of the measures 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, as the S&P 500 TR Index continues to move higher, setting records along the way. That said, the market as a whole looks to be only modestly overvalued right now, with Morningstar's stock coverage universe trading just above our analysts' estimates of fair value.
Market Fair Value Based on Morningstar's Fair Value Estimates for Individual Stocks
Source: Morningstar. The graph shows the ratio price/fair value for the median stock in the selected coverage universe over time.
While many of our top managers have been forthright about the difficulties they (and all investors) face right now, Steven Romick from FPA Crescent ((FPACX)) had some great comments about the current trading environment:
We would prefer that some of the lunacy we see out there translate into fear as that generally causes investors to sell assets without regard to value ... We’d like nothing more than to shift to a higher gear and increase our exposure, but given the lack of securities offering a genuine margin of safety, we’re content to stay out of the fast lane for now ... In the meantime, we’ve taken advantage of the kindness of others who seem to have plenty of petrol and have bid up many of our investments to a point where we find the risk/reward unattractive. To remain intellectually honest and clinically dispassionate, we have found ourselves with little alternative but to make some sales.
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 Oracle ORCL 3 Wide 34.38 0.9 Medium 156,685 4 Exxon Mobil XOM 3 Wide 93.22 0.96 Low 407,233 2 Philip Morris PM 3 Wide 90.7 0.95 Medium 145,316 2 Coca-Cola KO 4 Wide 40.21 0.89 Low 177,564 2 PepsiCo PEP 3 Wide 86.39 0.98 Low 132,488 2 Qualcomm QCOM 3 Wide 71.22 0.95 Medium 120,322 2 Apache APA 4 Narrow 92.13 0.84 Medium 36,782 2 UnitedHealth UNH 3 Narrow 71.44 0.94 Medium 71,923 2 AmerHomes AMH - - 16.55 - - 3,070 1 Xylem XYL 2 Narrow 34.38 1.32 Medium 6,343 1
Stock Price and Morningstar Rating data as of 11-14-13.
Looking more closely at our list of top 10 high-conviction purchases, Oracle ((ORCL)) stands out more than any other name, with four of our top managers-- Alleghany ((Y)), Oakmark Equity & Income ((OAKBX)), Yacktman ((YACKX)) and FPA Crescent ((FPACX))--making conviction purchases of shares of the company's common stock during the most recent period. That said, Ronald Canarkis at Aston/Montag & Caldwell Growth did sell his remaining stake in Oracle during the period, noting the following about the sale:
We sold the small remaining position in Oracle ... during the quarter. The shift to a cloud-based model (fewer capital expenditures, more operating expenses) means less upfront revenue for Oracle and more revenue spread out over time. Thus, we concluded that revenue growth is limited to the low- to mid-single digits absent acquisitions, which will need to be large-scale in order to have an impact--raising the risk profile of the company.
Morningstar analyst Rick Summer acknowledges that average annual internal revenue growth is likely to decline from a mid-to-high single-digit rate during the next five years, as Oracle gains share of enterprise IT spending in on-premise data centers, to a lower rate of growth during the latter half of the decade, as subscription-based cloud solutions become a larger portion of the revenue mix. However, he still thinks that Oracle's installed base, high switching costs, and product road maps will reinforce its market-leading position. As the company's existing customers push to purchase software in the cloud, he believes that many of them will appreciate the ability to choose hybrid installations (mixing cloud and on-premise solutions), and that Oracle's flexibility will provide a better solution for many risk-averse customers. While Summer does see cloud computing as being a potentially disruptive force in the software world, he thinks that the high switching costs inherent in Oracle's business will provide it with time to successfully implement its own unique suite of cloud applications.
While it is a positive event to see four or more of our top managers making high-conviction purchases during the period, we were intrigued by that fact that two or more of our managers were buying wide-moat names like Exxon Mobil ((XOM)), Philip Morris International ((PM)), Coca-Cola ((KO)), PepsiCo ((PEP)), and Qualcomm ((QCOM)). Exxon made the headlines this week by virtue of Berkshire Hathaway's ((BRK.A)/(BRK.B)) $3.5 billion new-money stake in the firm, which represented the insurer's single largest investment in a security since Warren Buffett put $10.7 billion to work in IBM ((IBM)) back in 2011. That's not to dismiss the work of Buffett's two lieutenants--Todd Combs and Ted Weschler--who have built up a $2.2 billion stake in DirecTV ((DTV)) and a $1.8 billion stake in DaVita ((DVA)). It is, however, a recognition that the last time Berkshire made a single bet of this size, the "Oracle of Omaha" was involved in the decision. Buffett was joined in this move by the managers at the Yacktman fund, who actually had a hand in four of the six wide-moat names--Oracle, Exxon Mobil, Coca-Cola, and PepsiCo--that were purchased with high conviction during the quarter. While commentary on the first two names was nonexistent, the managers did note that consumer companies on a relative basis were more attractively priced during the quarter, leading them to increase their stakes in both PepsiCo and Coke.
Meanwhile, Ronald Canarkis, who was buying both Philip Morris and PepsiCo (and to a lesser extent Qualcomm) during the period, noted that his fund "added to Pepsico twice during the period as (he thinks) well-publicized activist shareholder proposals are likely to result in a restructuring or breakup of the company, which should unlock shareholder value." Morningstar analyst Thomas Mullarkey notes that while speculation occasionally surfaces that PepsiCo will break into two separate businesses, he does not believe it will happen in the near term. The company's CEO, Indra Nooyi, has remained steadfast in her belief that the combined firm benefits from the "Power of One," with PepsiCo generating about $1 billion a year in synergies by keeping its food and beverage operations under the same roof. Mullarkey does, however, think there is a slight chance that PepsiCo could make a move to acquire Mondelez International ((MDLZ)), which was spun off from Kraft Foods ((KRFT)) last year. Modelez's portfolio includes several well-known brands (such as Oreo, Cadbury, Nabisco, Trident, and Tang), which could be pushed through Frito-Lay's direct-store-delivery network. Mullarkey thinks a combined PepsiCo-Mondelez could generate at least $1.8 billion a year in synergies, with the firm expanding its dominance of the snack-food sector if the deal ever does come to fruition.
As for Aston/Montag & Caldwell Growth's move into Qualcomm, Canarkis had the following to say in his quarterly letter to shareholders:
We initially reduced Qualcomm based on reports of order cuts at Taiwan Semiconductor from Qualcomm and its competitors, reflecting weak high-end smart phone sales. We subsequently added back to the position, however, given increased confidence that declines in average selling prices due to competition at the high end of the smart phone market would be offset by consumers in Emerging Markets shifting from feature phones to smart phones. In addition, the company stands to benefit from higher royalties from China Mobile as the company moves to the LTE standard. We further increased the position after the company announced a new $5 billion share repurchase authorization to replace the nearly completed prior $5 billion program. This announcement strengthens confidence in near-term fundamentals and highlights a growing focus on returning capital to shareholders.
Some additional purchasing points were brought up by Bill Nygren and Kevin Grant at Oakmark following their fund's new-money buy of the stock during the period:
Qualcomm is the global leader in wireless technology licensing and mobile device chipsets. Qualcomm has dominant market share in both businesses, and it uses the strong recurring cash flow from its licensing business to reinvest in its chipset business. The company owns intellectual property that defines many of the standards used for 3G and 4G wireless communication, which allows it to collect royalties from handset providers that license these ubiquitous standards. Qualcomm’s licensing business accounts for only a third of the company’s revenue, and it is often underappreciated. However, its licensing business has unusually high profitability and represents close to two thirds of Qualcomm’s profits. The majority of the world’s mobile handset users are still using older 2G technology, which is not a focus area for Qualcomm, so when these customers upgrade to 3G and 4G, Qualcomm should be well positioned to enjoy robust incremental revenue. The company is also the leading provider of chipsets, which function as the brains for wireless devices. Qualcomm’s industry-leading product breadth and peer-leading R&D investment should drive the company’s chipset growth. We expect Qualcomm to earn over $4.50 per share in a couple of years, and after adjusting for $20/share of cash, this high-quality business is priced at a forward P/E of just 11x.
This echoes some of the thoughts of Morningstar analyst Brian Colello, who notes that as the innovator of CDMA network technology, which is the backbone of all 3G networks, Qualcomm has dug a fairly wide economic moat with this intellectual property. Mobile phones are basically unable to connect to 3G networks without paying a royalty (about 3%-5% of the price of the handset) to the company, and as more and more 3G-capable smartphones hit the market, and carriers expand their 3G networks, Colello thinks that Qualcomm is poised for strong licensing revenue growth for at least the next few years. While the company does not have the same dominant IP portfolio in 4G technologies like LTE, Colello believes that it has generated enough essential patents to enable the firm to strike new deals with many large handset makers. He does, however, note that for at least the next decade the overwhelming majority of 4G handsets will likely be backward-compatible with 3G technologies, which should enable Qualcomm to collect higher 3G royalty rates. Colello views the firm's chip segment as less moaty, but still expects solid revenue growth from the operations as the smartphone market expands, allowing Qualcomm to sell more advanced processors and additional chip content into these high-end devices. He also notes that Qualcomm has done a good job of distributing cash to shareholders, buying back almost $1.5 billion in stock in calendar 2012 and over $4 billion so far in fiscal 2013, with the firm authorized to buy back another $5 billion in the future (and planning to use at least $4 billion of this authorization over the next 12 months).
Top 10 New-Money Purchases Made by Our Ultimate Stock-PickersStar Rating Size of Moat Current Price (USD) Price/ Fair Value Fair Value Uncertainty Market Cap ($ Mil) # Funds Buying Biogen BIIB 3 Wide 237.58 1.07 Medium 56,119 2 AmerHomes AMH - - 16.55 - - 3,070 1 Exxon Mobil XOM 3 Wide 93.22 0.96 Low 407,233 1 Xylem XYL 2 Narrow 34.38 1.32 Medium 6,343 1 Marsh McLenn MMC 2 Narrow 46.96 1.34 Medium 25,771 1 Priceline.com PCLN 2 Narrow 1,137.44 1.25 High 58,496 1 Gilead Sci GILD 3 Narrow 68.98 0.97 Medium 105,770 1 Qualcomm QCOM 3 Wide 71.22 0.95 Medium 120,322 1 Staples SPLS 2 None 15.75 1.21 High 10,402 1 Nestle NSRGY 3 Wide 73.1 0.96 Low 235,733 1
Stock Price and Morningstar Rating data as of 11-14-13.
Qualcomm was not the only new-money purchase for Oakmark during the period, as the fund also built up a new stake in Nestle ((NSRGY)), noting the following about the purchase in its quarterly letter to shareholders:
Nestle is a global leader in packaged foods with $100 billion of revenue and operations in over 70 countries. The company has more than 25 brands with sales over $1 billion, with leading market share in most of their product categories. With broad exposure to high-growth emerging markets, Nestle has enjoyed strong and consistent revenue growth. Like many of our holdings, Nestle generates more cash than they need to run the business, so the company has used a significant portion of its excess cash to repurchase shares and pay dividends. Over the past four years, Nestle has reduced their share count by over 10%. We think this is a high quality, stable business that deserves to sell at a premium, so we initiated a position when Nestle was priced at a discount to other global consumer products companies due to concerns about Europe.
With that in mind, managers Bill Nygren and Kevin Grant are unlikely to be too upset about Nestle's recent decision to sell the bulk of its Jenny Craig business, acquired in 2006 for $600 million, to a private equity firm (for an undisclosed amount). Morningstar analyst Erin Lash views this move as appropriate, considering Nestle's desire to dispose of underlying brands that are not performing up to expectations (believing that portions of its frozen foods business could be next on deck to get the ax). She thinks it is essential that the firm's vast resources--both financial and personnel-related--are focused on the highest-return opportunities, which will only increase the amount of cash flow Nestle can consistently generate. While acquisitions (with a focus on health and wellness brands, as well as emerging and developing markets) are always a possibility, Lash expects the firm to continue to return cash to shareholders through dividends and share repurchases. She also wouldn't be surprised to see Nestle liquidate its 30% ownership stake in L'Oreal next year, a transaction that could raise more than $20 billion.
In addition to his high-conviction purchases of Philip Morris and PepsiCo, Ronald Canarkis also made five new-money buys-- Priceline.com ((PCLN)), Gilead Sciences ((GILD)), F5 Networks ((FFIV)), Teradata ((TDC)), and Franklin Resources ((BEN))--during the most recent period. With regards to Priceline.com, he noted the following in his quarterly shareholder letter:
Within Consumer Discretionary, we purchased Priceline.com, a leading travel service company. The firm has low exposure to air transactions and a heavy skew to faster growing international markets. European, Asian Pacific, and Latin American countries continue to migrate to online hotel bookings, and the company's acquisition of KAYAK Software brings a diversified stream of advertising revenue and allows direct competition with other meta-search providers.
He also had the following to say on Gilead Sciences:
Biotech firm Gilead Sciences ... rounded out the new purchases. The acquisition of Pharmasset in 2012 accelerated Gilead's timeline to develop the first all-oral Hepatitis C treatment as the company remains focused on the development of small molecule drugs for the treatment of infectious diseases.
Morningstar analyst Karen Andersen expanded further on this commentary, noting that while she thinks that Gilead paid a steep premium to bring Pharmasset's hepatitis C pipeline under its wing, the deal put the firm in a prime position to introduce the first all-oral drug regimen in 2014. Andersen thinks that Gilead could see peak hepatitis C sales in 2020 of $10 billion, 41% of Morningstar's global market estimate for that year, and that this new franchise should allow Gilead to counter maturing HIV sales beyond 2022. While the firm's HIV franchise is still a dominant force in a high-margin, high-growth market, and continues to represent the bulk of its product portfolio, Andersen thinks that if Gilead can prove that it can extend its competitive advantages to other parts of the market that the firm could expand on its narrow economic moat.
While the two managers-- Oppenheimer Global ((OPPAX)) and Hartford Capital Appreciation ((ITHAX))--that made new-money purchase of Biogen Idec ((BIIB)) during the period did not comment at all on their purchases, Andersen notes that this wide-moat biotech firm has achieved strong profitability on the success of three marketed products in the fields of oncology and neuroimmunology, and that the introduction of Tecfidera secures the firm's dominant share of the MS market. She thinks that the barriers to entry for potential biosimilars to Biogen's products are high, and that the firm has a strong R&D strategy for maintaining its leadership in MS--where pricing power is strong, patient need for novel therapies is high, and the pipeline has been particularly productive. Andersen estimates that free cash flow at Biogen could grow to about $4 billion annually within the next five years, with its net cash position and ample financial flexibility providing it with plenty of ammunition for shareholder-friendly activities and acquisitions. While Biogen is authorized to repurchase about 4 million shares right now (at a cost of about $1 billion based on current prices), Andersen does not see this as the best use of cash right now, with the firm's shares continuing to trade at a premium to her fair value estimate.
Even though the managers at Diamond Hill Large Cap ((DHLAX)) made two new-money purchases-- Marsh & McLennan ((MMC)) and Staples ((SPLS))--during the period, their commentary on new positions was limited to the latter (as the former was picked up during October). Of their new stake in Staples, the managers at Diamond Hill Large Cap--Chuck Bath, Chris Welch, and Rick Snowdon--noted the following in their quarterly commentary to shareholders:
We initiated a new position in office products retailer Staples, Inc. Our view is that the company has a market leading position, the ability to generate strong free cash flow, and a strong balance sheet. Additionally, strategic initiatives to close stores and focus efforts on driving sales online and industry consolidation further support our thesis.
Morningstar analyst Liang Feng is less sanguine in his view of the firm, believing that Staples will have a difficult time maintaining high-single-digit margins in its domestic operations, as increased competition from nontraditional office distributors, such as Amazon.com ((AMZN)), and the secular decline of traditional office products limits its ability to grow organically. While all three office supply superstores--Staples, Office Depot ((ODP)), and OfficeMax (which has merged with Office Depot)--have adjusted to the more difficult operating environment by reducing their cost structures, downsizing their store footprints, and expanding beyond traditional office categories, Feng expects these initiatives to be largely offset by pricing headwinds, especially as more and more consumers migrate their office supply spending to online platforms. While he is willing to acknowledge that Staples has been reducing its risk profile by actively diversifying its product offerings, repaying debt obligations, and downsizing its store footprint (which should decrease its total lease obligations), Feng thinks that much of the good news is already built into the stock price. He also thinks the shares do not fully reflect the vulnerability of the office product retailers, which were hit hard during the recession that accompanied the 2008-09 financial crisis, and have yet to see demand for office supplies recover.
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Disclosure: Greggory Warren has ownership interests in the shares of the following securities mentioned above: Philip Morris International and Mondelez International. 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: PM, MDLZ. Find out about Morningstar’s editorial policies.