10 High-Conviction Purchases by Our Ultimate Stock-Pickers

By Greggory Warren, CFA | Senior Stock Analyst

The market rally continued unabated during the fourth quarter, with the S&P 500 TR Index rising more than 10% to finish the year up more than 30% overall. This was the strongest showing for U.S. stocks since 2009, when the market closed out the year up more than 26% (after rising 60%-plus off its early March 2009 lows), and was the S&P 500's best annual return since 1997. Little seemed to deter the market during 2013, from the rapid rise in interest rates in May/June, as the Federal Reserve announced it would start tapering its asset purchasing program before the end of last year, to the government shutdown in the fall, which once again demonstrated the paralysis created by the hyperpartisanship that dominates our politics. That said, the fact that there was enough bipartisan support to pass a budget deal at the end of 2013, and a clean debt ceiling resolution earlier this month (which does not raise the debt limit by a set amount but does suspend it through March 2015), should be viewed as a near-term positive for the market.

Investors should, however, be concerned about the disconnect that exists between the rapid rise in stocks over the last year and the sluggish recovery in the U.S. economy. While most corporations are sitting at record levels of profitability, much of this has been built on a weaker job market which has left employees with little leverage to demand higher pay, and ongoing cost-cutting measures (as corporations continue to look for ways to improve efficiency, including laying off personnel) rather than growth. With many companies sitting on record levels of cash, we've seen share repurchases and dividends rise to levels not seen since before the 2008-09 financial crisis, adding fuel to the rising stock market last year. As our Ultimate Stock-Pickers closed out 2013, there was mixed sentiment over where the market would go in the near-to-medium term. Patrick English from  FMI Large Cap ((FMIHX)) continues to be a bit less sanguine about the markets, noting the following in his quarterly letter to his fund's shareholders:

The stock market continued to roar ahead in 2013, completely disconnected, or so it seemed, from the underlying fundamentals. The gain and duration of the S&P 500 run since the March 9, 2009 low reached 202.78% and 57 months, respectively, more than double the median return, and 14 months longer than the average bull market cycle. One of the great mysteries of the past several years is the utter failure of the economy to grow at a rate that would justify this kind of stock market run, much less put our government balance sheet and fiscal budget house in order. Perhaps it is even more ironic that the U.S. economy is finally showing a better tone, and this development is being used as further justification for stocks to go even higher.

The stock market seems to be in a no-lose endeavor: stocks go up strongly when the economy is weak and then they go up even more when the economy improves. They go up when the national debt explodes, when the government stops working and when the national health care rollout falters. They go up when an Arab Spring is in the air and they go up when riots, bombings and mayhem permeate the Mideast. They go up when the currency printing presses are running full tilt and even--if a few days in late December are any indication--as the Fed reduces its asset purchases. In our view, this is the anatomy of a market that has suspended fear and is only tangentially connected to reality.

The managers at  FPA Crescent ((FPACX)), who were recognized as Morningstar's Allocation Fund Manager of the Year for 2013, continue to raise concerns about the amount of growth in the market that is being driven by multiple expansion (as opposed to improving fundamentals):

We can’t help but think that the creators of Greek tragedies--those of the ancient variety, not the ongoing, modern ones--would have relished watching the Fed and the stock market the past couple of years and envisioned all kinds of morals to the story. For instance, it was another year of single-digit earnings growth but double-digit gains in multiples. What’s more, our oracles--we call them economists now--failed at the beginning of 2013 to accurately predict what would occur for that year: The U.S. economy grew more slowly than expected and S&P 500 earnings were lower than anticipated and yet the stock market rocketed to its best showing since 1997...Valuation multiples trumping earnings growth cannot continue ad infinitum. In most markets, 2013, like 2012 before it, benefited from the willingness of investors to pay a higher price per dollar of earnings. Earnings growth eventually must carry the day.

While Ronald Canarkis from  Aston/Montag & Caldwell Growth ((MCGIX)) believes the outlook for the market is "generally favorable," he has raised concerns about increased market volatility in 2014:

The outlook for the stock market is generally favorable. A moderate but synchronized global economic recovery and accommodative Central Bank policies throughout the developed world should be supportive of higher share prices. Given fair to full stock market valuations, largely euphoric investor sentiment, and the lack of any meaningful stock market correction in quite some time, however, we do expect a pick-up in stock market volatility during the first half of 2014. This expectation assumes that the Federal Reserve will follow through with its plan to wind down its bond-buying program (the third round of Quantitative Easing, or QE3). We believe the added liquidity to financial markets from QE3 boosted stock prices and reduced investors’ sensitivity to risk. Continued reductions in the size of this program will reduce a major stimulus to higher share prices, likely increase investor perception of risk, and probably be the catalyst to increased volatility in the new year.

Although not quite as dour as his brethren, Clyde McGregor from Oakmark Equity & Income ((OAKBX)) admits that last year's rise in the market has made it all that much harder to put money to work in the near term:

Several quarters ago we wrote that in the prevailing environment investors should “embrace volatility” rather than hold on to the risk aversion that the 2008 downturn encouraged. 2013 clearly demonstrates that the stock market still offers opportunities for significant positive volatility...After a year such as 2013, investors begin to hear words such as “bubble” or “excessive” from market commentators. Although we have few examples of time periods following +30% years to draw from, this very limited record has been surprisingly positive. We will make no effort here to forecast 2014’s market outcome, but we will admit that after this substantial equity market price increase it is harder to identify dominant investing opportunities.

All these statements serve as a backdrop for the environment that our Ultimate Stock-Pickers have faced as they've managed their portfolios, and explains why the trend of selling activity outstripping buying activity that has been in place for much of the last year continued during the most recent period. Based on the fourth-quarter holdings that have already been filed for more than three fourths of our top managers, our Ultimate Stock-Pickers continued to take advantage of the market rally to book gains, with more outright sales than we can remember seeing in a very long time. That said, our top managers continue to put money to work in firms with economic moats--particularly those with wide economic moats--especially if they can find high-quality businesses that are trading at discounts to their estimates of intrinsic value. Unfortunately, the number and similarity of purchases across managers has dwindled as the market has moved higher.

Market Fair Value Based on Morningstar's Fair Value Estimates for Individual Stocks

Source: Morningstar. The graph shows the ratio price to fair value for the median stock in the selected coverage universe over time.

When looking at the buying activity of our Ultimate Stock-Pickers, we 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 these transactions have on the portfolio overall. When looking at all of this trading activity, though, it pays to remember that the decision to buy these securities could have been made as early as the start of October of last year, with the prices our top managers paid likely to be different from today's trading levels. As such, it pays to assess the current attractiveness of any security mentioned here by looking at some of the measures our stock analysts' research regularly produces, 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 trading near record highs. 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.

Top 10 High-Conviction Purchases Made by Our Ultimate Stock-Pickers

Company Name Star Rating Size of Moat Current Price (USD) Price/ Fair Value Fair Value Uncertainty Market Cap ($ Mil.) # Funds Buying UP (UNP) 3 Wide 180.14 1 Medium 82,662 2 Vdafne (VOD) 3 Narrow 36.81 1.05 Medium 178,406 2 Unilever (UL) 4 Wide 39.56 0.88 Medium 119,725 2 Oracle (ORCL) 3 Wide 37.98 0.95 Medium 168,855 2 PepsiCo (PEP) 4 Wide 78.09 0.89 Low 117,354 2 Accenture (ACN) 3 Wide 82.11 1.01 Medium 54,996 2 Potash (POT) 3 Wide 33.67 0.91 High 29,006 2 Williams (WMB) 3 Wide 40.83 1.07 Medium 27,891 1 Allergan 3 Wide 124.57 1.08 Medium 36,899 1 AmscBrgn(ABC) 4 Wide 68 0.91 Medium 15,611 1

Stock Price and Morningstar Rating data as of 2-14-14.

A quick glance at our list of top 10 high-conviction purchases for the fourth quarter of 2013 demonstrates the weaker buying environment our managers face, as this marks the first period we can remember where we did not have more than two of our Ultimate Stock-Pickers buying a single security with conviction. That said,  Union Pacific ((UNP)),  Vodafone ((VOD)), and  Unilever (/(UL)), each of which were purchased by two of our top managers during the period, stand out from the other names on the list because most of the purchases of these stocks were new-money buys. We would also note than nine of the top 10 high-conviction purchases (and 16 of the top 25 purchases) were tied to wide-moat firms, with the rest being dedicated to companies with narrow economic moats, highlighting our top managers' pursuit of higher-quality names when putting more capital to work in their portfolios.

Looking more closely at Union Pacific, the firm (along with five other railroads) was upgraded to a wide economic moat last year by Morningstar analyst Keith Schoonmaker, based on his belief that the North American Class I rail operators would continue to improve operating ratios, and consequently, returns on invested capital. With three of our top managers already holding the stock at the start of the fourth quarter of 2013, it was encouraging to see two more--  Oakmark ((OAKMX)) and Oakmark Equity & Income--putting new money to work in Union Pacific during the period. Of their purchase of the firm, Bill Nygren and Kevin Grant at Oakmark noted the following in their quarterly report to shareholders:

Union Pacific is the largest freight railroad company in North America, operating primarily in the 23 states west of the Mississippi River. The company’s nearly 32,000 route miles link the Pacific Coast and Gulf Coast ports with the Midwest and eastern U.S. gateways, and it offers several corridors to key Mexican gateways. After decades of real rate decreases, a “rail renaissance” began around 2004 when the regulatory backdrop on pricing became more rail-friendly, service levels improved, and rising fuel prices helped rails compete with trucking. Since then, Union Pacific’s revenues have grown approximately 7% per year, and its operating margin has increased from the low-teens range to the low 30% range. We believe that these positive trends will continue, albeit at a slower pace, due to pricing power that exceeds inflation and moderate volume growth from an improving economy and a recovery in below-trend categories like housing, construction and agriculture. Moreover, the company’s profit margin can still improve further, and we expect Union Pacific to return the vast majority of its free cash flow to shareholders via share repurchases and dividends. We consider the stock to be attractively priced at only 12x our estimate of “normalized” earnings in 2015.

This echoes many of Schoonmaker's own thoughts on the railroad, noting that Union Pacific has tremendously improved its on-time arrivals, velocity, terminal dwell, employee productivity, and overall operating ratio over the last decade. He goes on to highlight the fact that more than any other railroad, Union Pacific has upside potential remaining in the repricing old contracts, some of which lack effective fuel surcharges or fail to fully capitalize on the pricing power rails have enjoyed since around 2004, but does note that the year ahead will be light in legacy repricing activity. Despite continued weakness in demand for coal (which remains an important category for Union Pacific), Schoonmaker expects modest volume growth overall to combine with solid core price improvements to lift firm-wide revenue in 2014, with profitability improving as well. He continues to be impressed by that progress that Union Pacific has made over the last decade and projects more record-setting margins in coming years.

While Vodafone remains a narrow-moat firm, Morningstar analyst Allan Nichols points out that it is one of the largest wireless phone companies in the world, with more than 400 million proportionate customers (excluding Verizon Wireless) and a network that spans the globe. In his view, the scale advantages provided by its expansive operations are the foundation for its narrow economic moat. That said, it looks like the biggest driver of interest in Vodafone during the most recent period was the firm's announcement in early September that it would be selling its 45% stake in Verizon Wireless back to  Verizon ((VZ)), receiving $130 billion (GBP 84 billion) in total value for the holdings, including around $60 billion in cash and $60 billion in Verizon common stock. Nichols thinks that Vodafone received a good price for its stake at 9.4 times trailing enterprise value/EBITDA, and was particularly impressed by the firm's ability to reduce the expected tax hit on the transaction to $5 billion.

Once the deal is completed (later this month), Vodafone will be distributing the Verizon shares and $23.9 billion in cash in a special dividend to shareholders. It will then adjust its share count on an approximate 1-for-2 basis in order to maintain the share price, and will also increase the dividend to GBX 11 per share on the smaller base with plans for annual dividend increases thereafter. Nichols remains pleased that Vodafone is distributing most of the proceeds rather than using more of the money for acquisitions (with the firm planning to spend only about GBP 6 billion on purchases over the next three years). Coming into the fourth quarter of 2013, five of our Ultimate Stock-Pickers already held stakes in the European wireless carrier, so it was encouraging to see two more of our top managers-- FPA Crescent and  Columbia Dividend Income ((LBSAX))--making new money purchases in Vodafone during the period. The managers at Columbia Dividend Income significantly reduced their stake in  AT&T ((T)), over concerns that increased competition in the U.S. wireless business could potentially hurt margins and free cash flow in the near term, and redeployed the proceeds into Vodafone, based on the significant cash infusion that the firm will receive from the sale of its 45% stake in Verizon Wireless.

Steven Romick at FPA Crescent was even more forthcoming about his fund's purchase of Vodafone, noting the following in his quarterly letter to shareholders:

Vodafone was taken off the shelf for the second time since the fund’s inception. In addition to being the largest wireless company in Europe, Vodafone jointly owns with Verizon (VZ) the largest wireless phone carrier in the U.S., Verizon Wireless, and also has wireless operations in India, Egypt, and South Africa.

In early 2013, the market valued Verizon at ~8x EBITDA10, including its 55% share of Verizon Wireless. Vodafone’s 45% ownership of Verizon Wireless should have been, in theory, also valued at the same multiple of 8x proportionate EBITDA. But Vodafone was trading at $25.70, which was only 4.8x its consolidated 2012 EBITDA. If we valued the 55% Verizon Wireless stake at 8x EBITDA, the implied multiple for everything else at Vodafone was just 3.1x. 

In the past, Verizon’s trading multiple had averaged out to about 6x EBITDA, and Vodafone to about 7x EBITDA. It seemed logical to us that the multiples would converge over time given that 40% of both company’s EBITDA was the same asset--the Verizon Wireless business--and because nearly 90% of the free cash flow at VZ was coming from Verizon Wireless. We were able to arbitrage this opportunity by going long Vodafone and short Verizon. Said differently, by investing in Vodafone, we were either buying Verizon Wireless at a discount, or the remainder of Vodafone at a discount.

We also believed that catalysts existed to unlock the value in Vodafone’s ownership in Verizon Wireless. Specifically, Verizon, at the Holdco level, generated almost zero free cash flow but paid $5.4 billion in annual dividends to Verizon shareholders. For the past few years, those dividends had been funded via an intercompany debt repayment. But, as of 2012, there was almost no more intercompany debt left outstanding. 

So in order for Verizon to continue to upstream cash from Verizon Wireless and pay dividends to the Verizon common shareholders, Verizon would have to either: (1) start paying massive dividends from Verizon Wireless to Verizon Holdco, in which case Vodafone would receive a large cash windfall via its 45% share of such dividends or, (2) buy-out Vodafone’s 45% interest. Indeed, in September of 2013, Verizon offered to buy Vodafone out of its 45% share for $130 billion, which was an implied multiple of almost 10x Vodafone’s ownership in Verizon Wireless, and far more than the 8x we had factored into the original analysis.

Currently, with Vodafone priced around $39, the Vodafone stub (after backing out the cash and stock which Vodafone shareholders will receive in Q1 2014) still trades at just 5x, less than the 7x historical multiple, and less than the 8-9x multiple the market is pricing into other comparable wireless companies. Although not as inexpensive as it was in early 2013, this still seems below fair value for the leading European wireless franchise.

As forthcoming as Romick was on his fund's purchase of Vodafone, he had little to say about the 40%-plus increase FPA Crescent made in its holdings of Unilever during the period. The managers at FMI Large Cap were equally as quiet, despite making a meaningful new-money purchase in the name. And, as always, there was little word at all coming out from the managers at Markel Gayner Asset Management, who handle the investment portfolio for  Markel ((MKL)), one of four insurance companies that we have included in our Investment Manager Roster, regarding their relatively small new-money purchase of the name. That said, Morningstar analyst Erin Lash and Philip Gorham continue to see value in Unilever, which is trading at more than a 10% discount to their fair value estimates, depending on which share class investors are looking at, with  Unilever PLC ADR ((UL)) trading at 88% of fair value and  Unilever NV ADR () trading at 85%.

Top 10 New-Money Purchases Made by Our Ultimate Stock-Pickers

Company Name Star Rating Size of Moat Current Price (USD) Price/ Fair Value Fair Value Uncertainty Market Cap ($ Mil.) # Funds Buying UP (UNP) 3 Wide 180.14 1 Medium 82,662 2 Vdafne (VOD) 3 Narrow 36.81 1.05 Medium 178,406 2 Unilever (UL) 4 Wide 39.56 0.88 Medium 119,725 2 Green Mt. - - 116.03 - - 16,598 2 Williams (WMB) 3 Wide 40.83 1.07 Medium 27,891 1 Allergan 3 Wide 124.57 1.08 Medium 36,899 1 Twitter 1 Narrow 57.44 2.05 High 31,825 1 AmsrcBrgn(ABC) 4 Wide 68 0.91 Medium 15,611 1 Check Pt (CHKP) 3 Narrow 66.93 1.06 Medium 13,402 1 MrshMcLenn (MMC) 3 Narrow 47.67 1.06 Medium 26,370 1

Stock Price and Morningstar Rating data as of 2-14-14.

Looking more closely at the list of top 10 new-money purchases during the period, we would note that Green Mountain Coffee Roasters () is currently not covered by Morningstar analysts and that there was little information provided about the transactions from the two managers-- Morgan Stanley Focus Growth () and  Hartford Capital Appreciation ((ITHAX))--that made new-money buys during the fourth quarter. The same could be said for  Williams Companies ((WMB)), which was another high-conviction purchase, picked up by the investment managers at Alleghany (), during the period. And while we did get some commentary on  Parnassus Equity Income's ((PRBLX)) high-conviction new-money purchase of  Allergan (), it was limited to the following details:

The latest addition to the Fund is Allergan, a pharmaceutical company based in Irvine, California. Half of the company’s sales comes from its eye care division, and the other half comes from cosmetic products. We’re excited about the long-term prospects of this business.

While Allergan is currently trading above our current fair value estimate, Morningstar analyst Michael Waterhouse believes that the firm's product pipeline continues to support long-term growth potential for the company. He thinks that therapeutic indications for Botox in osteoarthritis, premature ejaculation, and depression--in addition to new Botox formulations in development and the partnership with  Medytox () for a liquid injectable neurotoxin--should support Allergan's growth trajectory and market share in the neuromodulator market. Waterhouse also notes that in addition to a new Restasis formulation in clinical trials, the firm has three other dry-eye products in development, which should support Allergan's future dominance in the category.

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Disclosure: Greggory Warren does not have ownership interests in any of the securities mentioned above. 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.