10 High-Conviction Purchases of Ultimate Stock-Pickers
The pickings continue to get slimmer for a proven group of top fund managers as the market continues to trade around its all-time high.
By Greggory Warren, CFA | Senior Stock Analyst
After turning in a blockbuster 2013, market growth slowed during the first quarter of 2014, with the S&P 500 posting a less than 2% return for the period. The market was down more than 3% in January on concerns about growth and currency stability in emerging and developing markets, so it was a big positive for most investors to see the S&P 500 close out the quarter in positive territory.
While aggressive moves by central banks around the globe helped stem the currency slide, many of the underlying fears that led to market sell-off remain unresolved, with China in particular still a major concern on the growth front. Add to that the continued lackluster results coming out of the U.S., and it’s a wonder that the markets have held up as well as they have since the start of the year. From the housing market to manufacturing to jobs, there were signs that the economic recovery was slowing, dampening hopes that had built up at the end of last year that the U.S. economy was truly on the verge of breaking out of its slow-growth rut.
Part of what explains the markets' continued resilience, even after a five-year bull market has lifted the value of the S&P 500 by more than 100%, has been the Federal Reserve's willingness to reassure the markets that it would not make any significant changes to monetary policy until the job market was on solid ground, even as the Fed continues to further reduce its monthly asset purchases.
Another possible reason for the resilience is the renewed interest we've seen in equities over the past year, as investors poured $360 billion into equity funds from the end of March 2013 to the end of the first quarter of 2014. Granted, most of the money has flowed into passive strategies--index funds ($104 billion) and exchange-traded funds ($150 billion)--and international active equity funds ($100 billion). But with most active managers lapping poor five-year performance numbers this year, we see the potential for actively managed equity funds (and for equities overall) to continue to garner interest from investors, especially with the threat of rising interest rates out there.
As our Ultimate Stock-Pickers moved past the first quarter of 2014, there was mixed sentiment over where the market would go in the near-to-medium term, and what it would mean for investors (as well as their own ability to take action). Ronald Canakaris of ASTON/Montag & Caldwell Growth (MCGIX) continues to be a bit less sanguine about the markets, noting the following in his quarterly letter to shareholders:
We have long maintained that as the Federal Reserve unwinds quantitative easing, we are likely to discover unintended consequences throughout the markets. Much of the initial pick-up in volatility seemed instigated by turmoil in the currencies of developing markets, which is emerging as perhaps the first visible consequence of tapering. The volatility was further fueled by a disappointing Christmas retail season and the Russian annexation of Crimea. The quarter ended with a meaningful sell-off in price-momentum stocks, though many still outperformed for the full period. We think the volatility in both Emerging Markets and price-momentum issues may prove to be the canary in the coal mine of broader market volatility as the Federal Reserve ends its purchases of bonds.
Looking ahead, we expect a moderate but synchronized global economic recovery and accommodative Central Bank policies throughout the developed world to continue to support higher share prices. As mentioned above, however, an increase in market volatility has developed, reflecting fair to full stock valuations, largely euphoric investor sentiment, and the lack of any meaningful correction in quite some time. The increase in volatility is likely to persist with the Federal Reserve reducing QE3 as we think the liquidity added to financial markets has contributed to higher stock prices and reduced investor sensitivity to risk. In fact, given that stock market valuations are stretched already, the stock market may become even more volatile as market forces instead of Central Bank manipulation becomes a greater influence on asset prices.
Meanwhile, Todd Ahlsten and Benjamin Allen at Parnassus Core Equity Investor (PRBLX) were a bit more specific about how the market rally has affected their ability to buy and sell securities during the first quarter of 2014:
Though our team spent countless hours searching for the Fund’s next big winner, we didn’t buy a new stock for the portfolio in the first quarter, primarily due to valuation concerns. After last year’s incredible rally, and the first quarter’s modest gain, the S&P 500 has now returned over 21% per year, on average, over the last five years. While this is great news for those of us who’ve been invested in equities during this period, it means that most stocks in our investable universe are simply not attractive at the moment.
In addition to not adding any new stocks to the Fund, we also didn’t sell out of any positions during the quarter. The reason for this is that none of our holdings reached our estimate of intrinsic value. This isn’t surprising given the relatively subdued gains for most of our stocks during the first quarter. While zero portfolio turnover in a quarter is unusual for us, it is in keeping with our long-term focus and disciplined approach.
After spending much of 2013 with an equity weighting near the Fund’s prospectus maximum of 75%, we have moved the equity allocation down to 65%. Following last year’s strong upward move in the market, we believe valuations are generally less attractive on a risk-adjusted basis, and we are therefore finding more stocks meeting our sell criteria than our buy criteria.
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 during the most recent period our top managers have generated some of the smallest levels of buying and selling activity that we've seen from them during the past five years. Even so, our top managers continue to put money to work in firms with economic moats--particularly those with wide economic moats--when they find high-quality businesses trading at discounts to their estimates of intrinsic value. Unfortunately, the number and similarity of purchases and sales across our top 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 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 portfolio overall. When looking at this buying activity, it should be remembered, though, that the decision to purchase these securities could have been made as early as the start of January, with the prices paid by our top managers different from today's trading levels. As such, investors should 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 right now, with the S&P 500 trading at/near record highs and the market as a whole looking modestly overvalued, with Morningstar's stock coverage universe trading just above our analysts' estimates of fair value.
Before we delve into any conversation about the high-conviction or new-money purchases that were made this period, we note that changes have been made to two of our top managers. As you may recall, one of our goals with the Ultimate Stock-Pickers concept has been to be more proactive with the Investment Manager Roster, believing that this type of flexibility will allow us to maintain a list of top investment managers that can consistently generate high-conviction buy and sell ideas for investors.
That said, we prefer to make changes at most just once a year, gathering data points and other information as we go through each calendar year. As a general rule, we only remove a manager from the Investment Manager Roster if: 1) there is a meaningful change of managers for a fund (and we have little confidence that the succeeding management team will be able to replicate the level of performance historically generated by the fund); 2) a fund closes or merges with another fund, and the fund no longer follows the same investment processes or is no longer run by the same management team; 3) the fund is no longer covered by Morningstar's mutual fund analysts; and 4) the fund's long-term performance has fallen meaningfully below benchmark returns.
Much like in past years, we changed two names in our Investment Manager Roster this year. The first change involves swapping the Morgan Stanley Institutional Growth (MSEGX) fund for Morgan Stanley Focus Growth, after the latter fund was merged into the former. Dennis Lynch and his team at Morgan Stanley have run both funds for quite some time, so there was no need to look for a replacement manager as the surviving fund would not only be run by the same management team but would follow the same investment process. The second change required a bit more effort. We had been willing to sit by as Saul Pannell's gradual retirement from Hartford Capital Appreciation (ITHAX), which started just over a year ago, completed its process. While Pannell still managed about 80% of the fund's assets in April, Kent Stahl is set to become lead manager in June, and will be responsible for managing 50% of the portfolio at that time. With Stahl expected to run the fund differently than Pannell has historically, by allocating assets to eight other managers from the fund's subadvisor Wellington in a multimanager format, our fund team has elected to swap out Hartford Capital Appreciation.
The fund has been replaced with BBH Core Select (BBTEX), which our fund team felt has similar investment characteristics with the manager it was replacing. BBH Core Select's managers--Tim Hartch and Mike Keller--are supported by an 11-person team of analysts whose responsibilities are divided by sector. The managers utilize a fundamentals-focused strategy, emphasizing long-term absolute returns and running the fund as a concentrated, benchmark-agnostic best-ideas vehicle. They screen for companies with strong balance sheets, high free cash flow, and high returns on invested capital. With a penchant for investing in only their best ideas, the fund's portfolio tends to be concentrated. The two managers also regard permanent capital loss, and not volatility, as risk. Even so, performance swings have been relatively modest even with the fund's concentrated portfolio. Combine the two managers' loss-averse philosophy with their stock-selection criteria, and the result has been a portfolio that has been focused on high-quality market dominators--firms whose steady cash flows and predictable revenues lend themselves to the discounted cash flow analysis that drives the team's valuation work. We expect BBH Core Select to be a solid addition to the Investment Manager Roster.
Top 10 High-Conviction Purchases Made by Our Ultimate Stock-PickersCompany Name Star Rating Size of Moat Current Price (USD) Price/ FVE Fair Value Uncertainty Market Cap (USD mil) # Funds Buying Unilever UN 3 Wide 43.45 0.99 Medium 131,431 3 Diageo DEO 3 Wide 128.09 1 Medium 80,410 2 Accenture CAN 3 Wide 78.42 0.97 Medium 63,561 2 Citigroup C 3 Narrow 46.52 0.97 High 139,311 2 Praxair PX 3 Wide 130.36 1 Medium 38,187 2 P&G PG 4 Wide 80.53 0.9 Low 217,911 2 Chevron CVX 4 Narrow 123.81 0.94 Low 235,691 1 CSX CSX 3 Wide 29.07 0.94 Medium 29,197 1 Zoetis ZTS 2 Wide 30.46 1.27 Medium 15,261 1 EXCO XCO - - 5.31 - - 1,448 1
Stock Price and Morningstar Rating data as of 05-15-14.
A quick glance at our list of top 10 high-conviction purchases for the first quarter of 2014 demonstrates the weaker buying environment that our top managers faced, as just six names were purchased with conviction by two or more of our Ultimate Stock-Pickers, and just one stock had three or more managers putting money to work with conviction. That said, we think the results would have been far worse had not concerns about economic growth and currency stability in emerging markets created buying opportunities in a number of high-quality consumer defensive names—namely, Unilever (UN)/(UL), Diageo (DEO), and Procter & Gamble (PG).
Unilever was not only a high-conviction new-money purchase for the managers at BBH Core Select, but saw meaningful additions from the managers at FMI Large Cap (FMIHX) and Markel (MKL), as well as additional purchases of smaller amounts of stock by FPA Crescent (FPACX), Oakmark, and Oppenheimer Global (OPPAX). Of their high-conviction new-money purchase of Unilever, the managers at BBH Core Select noted the following in their quarterly letter to shareholders:
Unilever is one of the world’s largest consumer products companies, operating in the food, home, and personal care markets. The company’s products serve basic consumer needs such as nutrition, fortification, and hygiene for lower income consumers, while at the same time offering more premium and value-added products that offer convenience and performance features for higher income consumers. With roughly 57% of its sales coming from emerging markets, we believe that Unilever has an especially attractive footprint among global consumer staples companies. The company has deep distribution and high brand awareness in key markets such as India, Brazil, South Africa, and Indonesia.
Despite current concerns about the pace of growth in these and other emerging markets, the long-term prospects remain attractive in our view given that these regions represent 80% of the world’s population with strong birth rates, rising incomes, emerging middle classes, and more women entering the workforce--all of which are factors that should boost demand for Unilever’s products both at the low end and the high end. Through organic and inorganic means, the company has been shifting its business mix toward health and personal care categories, where margins, capital intensity, and cash flow characteristics are generally more attractive than is true of the food business. We have a high regard for Unilever’s management team and the way it has instituted a more long-term oriented approach that balances top line growth, productivity, cash flow, and targeted reinvestment.
This echoes the thoughts of Morningstar analyst Erin Lash, who sees Unilever as being about fairly valued right now. She notes that Unilever's wide moat stems from its expansive global distribution platform and portfolio of essential products, and goes on to highlight the fact that the firm is not sitting on its laurels, staying on the offensive by continuing to put resources behind product innovation, marketing, and cost-saving initiatives. She thinks that this spending is driving balanced and profitable growth, in contrast to several of Unilever's peers, with the firm's sales composed of both higher prices and increased volume--a notable achievement in a difficult operating environment. About the only area where she raises a red flag is management's increased focus on acquisitions, especially in emerging and developing markets, where perceived levels of longer growth could drive up price tags and intense competition overall could diminish the value of brands once they have been acquired.
The managers at BBH Core Select were also behind the high-conviction new-money purchase of Zoetis (ZTS), which develops, produces, and delivers animal health medicines and vaccines for both livestock and companion animals. Tim Hartch and Mike Keller noted the following about their purchase in their quarterly commentary for the fund:
Zoetis, which was spun out of Pfizer in 2013, is a global leader in the animal health business. The Company provides branded drugs, vaccines, diagnostics and related services to a wide variety of customers who raise and care for animals. Zoetis’ products are used both in the production animal market (roughly 64% of sales) and for companion animals (36% of sales). In our view, the Company holds a strong and durable position in the industry owing to its 1) diverse base of safe and effective products, 2) geographic breadth, 3) direct salesforce with market-specific knowledge, and 4) productive internal R&D organization. We believe that animal health is an attractive segment of the global healthcare market that benefits from favorable secular growth trends such as increased per capita protein consumption and increased ownership and medicalization of pets. Moreover, the animal health market benefits from a relatively benign regulatory environment, minimal influence of government reimbursement, limited competition from generics and sustainable pricing power. With its capable and experienced management team, we believe that Zoetis can sustain and grow its earnings power over time.
Morningstar analyst David Krempa sees Zoetis as the clear leader in the global animal health industry, with its industry-leading revenues, global infrastructure, and huge cost advantage over competitors providing it with the widest moat of all of the players in the market. He goes on to note that the animal health industry has been largely ignored because animal health businesses tend to be buried within larger human health care companies. But the industry itself has many attractive characteristics, including cash-pay buyers, a fragmented customer base, and minimal generic competition, which leaves animal drugmakers with significant amounts of pricing power. Krempa goes on to note that the industry should benefit from favorable growth tailwinds that will allow Zoetis to grow revenue at a high single-digit growth rate over the next five years. He goes on to note that much of this has already been reflected in the company's stock price, with shares currently trading at more than 125% of his fair value estimate.
While the managers at BBH Select Core also put a little bit of money to work in Diageo during the period, it was nowhere near the level of conviction that we saw from both Oakmark and Oakmark Equity & Income during the first quarter. Of their high-conviction new-money purchase of the name, Bill Nygren and Kevin Grant--managers of the Oakmark fund--noted the following in their quarterly letter to shareholders:
Diageo is the world’s largest spirits manufacturer. Diageo has a portfolio of spirits brands that is among the best in the industry, including a leading scotch franchise that is nearly impossible to replicate. These strong brands are supported by the company’s global scale, which allows for meaningful efficiencies in manufacturing, distribution and marketing. As a result of these advantages, we believe Diageo will maintain its excellent competitive position. At the same time, revenues have grown consistently for years due to a combination of pricing power and emerging markets exposure, and this growth should continue for the foreseeable future. We believe this well-managed company is selling at a large discount to intrinsic value. Further, Diageo has a dividend yield of 2.5%.
Our analysts continue to believe that Diageo has built an enviable business empire. The firm's unmatched portfolio of spirits, combined with its vast distribution network (including thousands of dedicated salespeople in the U.S.), would be very difficult and expensive for any competitor to duplicate and results in a wide economic moat. They go on to note that the company is making investments to grow its book of business in emerging markets such as Africa, India, and China. Our analysts expect these seeds of growth to benefit the firm's shareholders longer term as Diageo gains additional distribution scale in these fast-growing regions, and shifts additional global consumers into more premium (and higher-margin) brands. In their view, these competitive advantages and growth prospects justify an earnings valuation for Diageo that is above the market average.
Like its universal bank peers, we think Citigroup is significantly undervalued relative to its normalized earnings power. Unlike its peers, however, it has two hidden sources of value, neither of which is reflected in GAAP earnings: a deferred tax asset and a larger base of excess capital that is growing at a rapid rate. We have long admired Citigroup’s global franchise and its growth potential. One of Citigroup’s key competitive advantages is its unique global reach. Citigroup has more than twice as many country banking licenses and direct local payment network connections as its closest competitor. As a result, we think Citigroup is uniquely positioned to offer corporate clients more visibility into their asset, liability and currency exposures, but requires fewer resources to manage the relationship. We would be remiss not to mention Citigroup’s recent Fed stress test results. Although the qualitative results were disappointing, its quantitative stress test results confirm our analysis that the company has significantly more excess capital than its peers. We expect this capital to eventually benefit shareholders either through capital return or smart balance sheet growth.
Morningstar analyst Jim Sinegal notes that Citigroup's truly global presence differentiates the bank from nearly all of its peers. With a large portion of its revenue coming from Latin America and Asia, he believes that the bank is poised to ride the growth of these economies over the coming decade, while its competitors will struggle with lackluster loan demand in the U.S. and Western Europe. Sinegal goes on to note that Citigroup is recapitalized and refocused under new management, which does not appear to be chasing growth at any cost. On top of that, he thinks that the bank's shrinking balance sheet, falling expenses, and a harsher regulatory environment provide a perfect combination for capital return over the next five years. The problem for investors, much as we have seen with other names on the list, is that the shares are basically trading at our fair value estimate, requiring patience for an opportunity that would provide a much wider margin of safety for new-money purchases.
Top 10 New-Money Purchases Made by Our Ultimate Stock-PickersCompany Name Star Rating Size of Moat Current Price (USD) Price/ FVE Fair Value Uncertainty Market Cap (USD mil) # Funds Buying Verizon VZ 3 Narrow 47.96 1.07 Medium 198,403 2 Chevron CVX 4 Narrow 123.81 0.94 Low 235,691 1 CSX CSX 3 Wide 29.07 0.94 Medium 29,197 1 Zoetis ZTS 2 Wide 30.46 1.27 Medium 15,261 1 ColgatePalm CL 2 Wide 66.41 1.11 Low 60,308 1 Cameron CAM 3 Narrow 64.64 1.08 Medium 13,006 1 Walgreen WAG 2 None 68.11 1.22 Medium 64,526 1 Diageo DEO 3 Wide 128.09 1 Medium 80,410 1 Wells Fargo WFC 3 Narrow 49.03 1 Medium 257,025 1
Stock Price and Morningstar Rating data as of 05-15-14.
There was no such restraint from Ronald Canakaris, the manager of ASTON/Montag & Caldwell Growth, who was responsible for the new-money purchase of Walgreen (WAG), noting the following about several different transactions that he had initiated during the first quarter:
We established three new positions in the portfolio during the quarter--Union Pacific, Yum Brands, and Walgreen. We believe that railroad operator Union Pacific will benefit from a recovery in agricultural and commodity volumes. Continued pricing discipline and productivity gains should also drive healthy incremental profit margins. Yum Brands operates the Kentucky Fried Chicken, Taco Bell, and Pizza Hut fast-food franchises. We think the company will experience a recovery in China after suffering sales declines due to concerns about the Chinese chicken supply chain last year. In addition, the company should experience margin expansion given its shift in most geographies to a franchise model. Drugstore chain Walgreen is the largest in the U.S. and one that we think stands to enjoy synergies from a 2012 merger with Alliance Boots that benefits from its 10-year strategic distribution agreement with AmerisourceBergen. Demographics favor cost-effective pharmaceutical treatments, while the company can benefit from ongoing branded drug patent expirations and an incrementally larger insured population under health reform. We reduced the Fund’s position in AmerisourceBergen to fund the Walgreen position, as we see the latter as a better combination of valuation and earnings growth.
While not quite as expansive as Canakaris, we did get a feel for the reasoning behind Clyde McGregor's purchase of Wells Fargo (WFC) in his quarterly letter to the shareholders of the Oakmark Equity & Income fund:
We added two new stocks of significance to the portfolio: Knowles and Wells Fargo. With Knowles, a supplier of acoustic solutions to mobile phone makers and hearing aid manufacturers, we didn’t buy the shares on the open market, but rather received them through a tax-free spin-off from longtime Oakmark Equity and Income Fund holding Dover Corporation… Our other material addition, Wells Fargo, is the second-largest deposit bank in the United States, holding over 10% of the nation’s deposits. We think Wells Fargo has one of the best franchises in retail banking, driven by high local market shares and a relentless focus on cross-selling other banking products like mortgages and credit cards, which increases customer “stickiness.” Due to its low-cost deposit base and strong management team, Wells Fargo has earned consistently high returns on equity and, through its purchase of Wachovia (a geographically complementary bank), it was one of the few financial companies able to take advantage of the financial crisis to grow its earning power per share. We believe that its significant capital base and relatively simple business model should enable Wells Fargo to continue to produce strong results.
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Disclosure: Greggory Warren has ownership interests in the following securities mentioned above: Citigroup, Colgate-Palmolive, and 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.
The Morningstar Ultimate Stock-Pickers Team has a position in the following securities mentioned above: CL, C, PG. Find out about Morningstar’s editorial policies.