Ultimate Stock-Pickers: Top 10 Buys and Sells

By Greggory Warren, CFA | Senior Stock Analyst

While the growing acceptance and use of 401(k) and other defined contribution programs has smoothed monthly flows for U.S.-based mutual funds, there is still some seasonality left in the system. The first quarter of any given calendar year tends to have a greater level of fund sales and redemption activity than the remaining three quarters of the year, as retail-advised, institutional, and even individual investors in retirement-based plans reallocate their holdings to adjust to current and future expected market conditions. That said, total long-term inflows into U.S.-based mutual funds and exchange-traded funds (ETFs) have been a bit lower the last two years than they were in 2013, as the ongoing rally in the U.S. stock market and growing concerns over rising interest rates have had a greater influence on where money was being put to work. Flows into U.S. Equity funds overall dropped into negative territory this year (losing $17.5 billion to outflows during the period) , with Sector Equity funds picking up a more normalized level of flows (at $16.7 billion), and International Equity funds riding a resurgence in interest in the category, with more than $66.6 billion flowing into funds dedicated to global stocks.

Excluding the impact of index funds and ETFs, total outflows from actively managed U.S. Equity funds were $39.9 billion during the first quarter of 2015. This continues the trend we've seen over much of the last decade of investors choosing to put more money to work in passively managed U.S. Equity products than they are in actively managed funds. Some of this can be attributed to the poorer investment performance among active managers, with just 10% of Large Cap Growth funds, 15% of Large Cap Blend Funds, and 40% of Large Cap Value funds beating their respective benchmarks on a 10-year basis at the end of last year. It also reflects the movement of a lot of retail-advised clients to fee-based accounts, which has prompted advisors to pursue lower-cost options that provide market exposure, like index funds and ETFs, over higher-priced active funds that had a more difficult time keeping up with market performance.

That's not to say that active management is dead. Actively managed funds still accounted for 31% of the $14.8 trillion in long-term AUM tracked by Morningstar at the end of April (a figure that includes all assets classes except for money market funds). Even with that total running up closer to 40% in the U.S. Equity category, there was still some $3.8 trillion being managed by active managers at the end of April. Our Ultimate Stock-Pickers remain part of that overall mix, with each of them seeing their own share of outflows over the last few years, as investors have used any performance hiccups as an excuse to walk away from their funds. This has put a greater onus on them to generate better-than-average performance in order to not only keep AUM levels up but improve their investment profile for future investors. After all, the same advisors that have put their clients into beta-driven products like index funds and ETFs have also been on the hunt for managers that can consistently generate alpha.

With constant redemptions a reality for our top managers, though, and the markets being somewhat stretched from a valuation perspective, we've seen our Ultimate Stock-Pickers holding a slightly higher level of cash. As you may recall from our last article, the group of 22 fund managers that we track had an average cash balance of 6% of total AUM (and a median cash balance of 5%) at the end of the first quarter of 2015. This was higher than the average cash balance of less than 5% overall for all U.S. stock funds being tracked by Morningstar. For those managers that have fewer constraints on them about how much they have to have invested in equities at any given time, the average cash balance was closer to 9% (with the median cash balance for these same funds at around 8%). Given the ongoing concerns that our top managers have about where we are in the market cycle, it is not all that surprising to see cash balances creep up, or the level of buying activity among them tapering off (much as it has the last seven calendar quarters).

From the discussion we've already had on the high-conviction and new-money purchases that made up the bulk of our

, our top managers were able to put some money to work in the first quarter. That said, the conviction buying that did take place during the period was focused on high quality names with defendable economic moats—exemplified by a preponderance of wide- and narrow-moat names in our list of top 10 high-conviction purchases last time around. Not surprisingly, seven of the names we highlighted in that article—

this time around. The difference is that we consolidated all of the buying activity in this article, as opposed to looking solely at individual high-conviction and new-money purchases by our top managers.

As for the

, there was a fair amount of outright selling during the period, although most of it (along with the trimming of positions that took place during the period) seemed to be focused on positions that have reached a fair value benchmark for our Ultimate Stock-Pickers. That said, we did have one manager bail on wide-moat rated

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

Company Name

Star Rating

Fair Value Uncertainty

Moat Rating

Current Price (USD)

Price/ Fair Value

Market Cap (USD mil)

# of Funds Holding

Google GOOG

4

High

Wide

532.11

0.74

358,449

16

Microsoft MSFT

3

Medium

Wide

46.86

1.02

374,364

16

WellsFargo WFC

3

Medium

Wide

55.96

0.92

286,868

14

Oracle ORCl

3

Medium

Wide

43.49

0.95

188,322

13

P&G PG

4

Low

Wide

78.39

0.87

210,152

13

BankAmer BAC

3

High

Narrow

16.5

0.97

171,518

8

BerkHath BRK.B

4

Medium

Wide

143

0.85

329,961

8

PepsiCo PEP

3

Low

Wide

96.43

1.02

141,412

10

Apple AAPL

3

High

Narrow

130.28

0.93

742,004

10

J&J JNJ

3

Low

Wide

100.14

1.01

274,920

12

Data as of 05/29/15. Fund ownership data as of funds' most recent filings.

Even with the changes that were made to the Investment Manager Roster during the first quarter of 2015, our top managers remain underweight in Energy, Utilities, Communication Services, and Real Estate relative to the weightings of those sectors in the S&P 500 TR Index. That said, our Ultimate Stock-Pickers continue to hold an overweight position in Financial Services and Basic Materials. They have, however, pulled back on their Consumer Defensive exposure, which is now only modestly overweight relative to the market (much like their exposure to Consumer Cyclical, Industrials, Health Care, and Technology stocks).

Our top managers' overall buying and selling activity during the most recent period also slightly affected the list of top 10 holdings of our Ultimate Stock-Pickers, with wide-moat rated

this time around, with five of the 10 Ultimate Stock-Pickers that held the stock at the beginning of the year selling it during the first quarter. Both

We eliminated the position in Walmart because its share price appreciated toward our estimate of intrinsic value. We also eliminated most of our position in Home Depot, which has performed well for several years and also reached our estimate of intrinsic value.

As for AIG, there was one big seller of the shares—

With his fund's performance the last year or so dropping him from upper-quartile performance (in 2012 and 2013) to the bottom of the barrel (during 2014), Berkowitz has seen outflows pick up in the last couple of quarters. Running a fairly concentrated portfolio, and having already eliminated a lot of smaller holdings that would allow the fund to meet ongoing redemptions requests, Berkowitz may have found it necessary to reduce his stake in AIG's common stock by more than half since the start of the year, closing out the March quarter with just under 24 million shares (and raising more than $1.4 billion by our estimates in the process). For some perspective, the Fairholme fund had $786 million in net outflows during the fourth quarter of 2014, and another $662 million during the first quarter, so there may be a case to be made for raising and maintaining a larger-than-average level of cash in the portfolio.

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

Company Name

Star Rating

Fair Value Uncertainty

Moat Rating

Current Price (USD)

Price/ Fair Value

Market Cap (USD mil)

# of Funds Buying

JPMorgan JPM

3

High

Narrow

65.78

1.06

242,567

5

PrecsnCastpts PCP

3

High

Narrow

211.63

0.91

28,683

5

Verizon VZ

3

Medium

Narrow

49.44

0.99

201,233

2

MasterCard MA

4

Medium

Wide

92.26

0.89

104564

4

Google GOOG

4

High

Wide

532.11

0.74

358,449

7

Citigroup C

3

High

Narrow

54.08

0.95

162,673

4

Honeywell HON

3

Medium

Narrow

104.2

0.99

80,306

2

GE GE

3

Medium

Wide

27.27

0.91

271,191

6

Danaher DHR

2

High

Narrow

86.32

1.18

60,374

2

BerkHath BRK.B

4

Medium

Wide

143

0.85

329,961

2

Data as of 05/29/15. Fund ownership data as of funds' most recent filings.

As we noted above, seven of the top 10 stock purchases—JPMorgan Chase, Precision Castparts, Verizon Communications, Google, General Electric, Danaher, and Berkshire Hathaway—were represented on our list of top 10 high-conviction purchases from

, where we had highlighted stock purchases above a certain threshold based on early data we were receiving for our Ultimate Stock-Pickers. Eight of the top 10 stock purchases this time around were also new-money purchases for our top managers, with only

We have very little clarity on the high-conviction purchases of JPMorgan Chase, with both Alleghany and

Precision Castparts was the recipient of meaningful new-money purchases from two of our top managers, Oakmark and

Precision Castparts Corp. is a manufacturer of complex metal components and products, including castings, forgings, fasteners and aerostructures for aerospace, power generation and general industrial applications. Precision Castparts enjoys what we believe is an outstanding corporate culture and is led by a long-tenured CEO who is known for aggressively pursuing operating efficiencies. For many years, the company’s stock traded at a significant premium to other aerospace and industrial peers, but recent weakness has brought the share price to attractive levels relative to these industry groups and the S&P 500. We believe the current valuation of less than 15x earnings is overly punitive, considering PCP’s organic growth prospects and the company’s ability to add value through acquisitions. PCP is providing more components on key new airplanes, which should allow the company to outgrow its end markets. In addition, management projects $4 billion-$6 billion of acquisition opportunities over the next couple of years with return characteristics similar to its existing business. Finally, the company’s unique technical and process capabilities, coupled with its efficiently run operations, should allow it to continue to generate above-average margins. We are pleased to have the opportunity to add shares of what we consider a best-in-class company at a price that implies it is only average.

The shares have rallied some 10% off of their more recent lows, leaving the stock trading at about 91% of our fair value estimate. Morningstar analyst Keith Schoonmaker believes that the outlook for the firm remains positive. He notes that Precision Castparts is one of only a few providers of certain large, highly complex castings used in aircraft jet engines and power turbines that maintain structural integrity under intense thermal and pressure conditions. This creates high switching costs, leaving the firm with a solid narrow economic moat around its operations. The company also has fine-tuned its manufacturing process over the years. CEO Mark Donegan has been instrumental in efforts that extracted and shared cost savings with customers, and improved the firm's operating margins from 12% in fiscal 2001 to nearly 28% in fiscal 2014. While Precision Castparts' recent results have been affected by falling oil and gas prices, the business appears poised to benefit from tailwinds in aerospace production.

Although we also have very little in the way of commentary on Verizon, which was a high-conviction new-money purchase for Alleghany during the period, Morningstar analyst Michael Hodel believes that the firm is fairly valued right now, trading at 99% of his fair value estimate. He notes that the narrow-moat firm has cemented its reputation with customers and its position as the premier U.S. carrier in terms of customer loyalty and profitability by focusing relentlessly on network quality over the years. This has allowed Verizon to weather increased competitive intensity, especially in the wireless market, where Verizon Wireless remains the clear industry leader, with 109 million retail customers and coverage of more than 95% of the U.S. population. Hodel believes the planned $4.4 billion acquisition of AOL is all about the advertising platforms that that firm has developed the past few years, especially around mobile video, but notes that it does expose Verizon to a crowded mobile video segment that comes with its own set of risks. That said, it is a relatively small deal for Verizon, and one unlikely to upend the competitive advantages the firm has built up over the years, in his view.

As for MasterCard, the shares represented a high-conviction new-money purchase for Ronald Canakaris at

We think MasterCard, along with long-time Fund holding Visa, will benefit from the global shift to electronic payments. The business is inherently scalable and offers high absolute and incremental margins.

True to his word, Canakaris also made a meaningful addition to his fund's stake in Visa, increasing his stake in that credit card issuer by close to 25% (on a split-adjusted basis) during the period. Most of this was funded by the elimination of another credit card company, American Express, from the portfolio, with sales of that firm's shares taking place gradually, starting in November of last year and finishing up before the end of April. Canakaris was not the only one to sell off American Express, as the managers of

In financial services, we reduced our U.S. Bancorp position and exited American Express. While banks in the United States remain in strong financial shape given excess liquidity and capital, low rates remain a headwind to profit growth and there is little remaining in the way of loan loss reserve releases to augment profits. We maintain a position in U.S. Bancorp, which is a quality franchise, but it is among the most expensive regional bank stocks. In the case of American Express, we chose to exit the position for a number of reasons. The loss of the Costco business hurts profit growth for the next two years and the company plans to spend more on marketing. In addition, the company is seeing increased competition for its high net worth customer base, which we believe will force the company to spend more on its rewards programs.

The fund did not have stakes in either MasterCard or Visa at the end of the first quarter, though, so its moves did not mirror those of ASTON/Montag & Caldwell Growth. That said, American Express looks to be the better bargain right now, trading at around 84% of our analyst's fair value estimate, compared with 89% and 100%, respectively, for MasterCard and Visa.

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

Company Name

Star Rating

Fair Value Uncertainty

Moat Rating

Current Price (USD)

Price/ Fair Value

Market Cap (USD mil)

# of Funds Selling

Wal-Mart WMT

4

Low

Wide

74.27

0.92

237,775

5

AIG AIG

3

High

None

58.61

0.86

77,046

1

WellsFargo WFC

3

Medium

Wide

55.96

0.92

286,868

7

OccidPetroleum OXY

3

High

Narrow

78.19

1.03

60,415

4

Schlumberger SLB

3

Medium

Wide

90.77

0.96

115,406

4

Novartis NVS

3

Low

Wide

102.73

1.03

242,818

4

Oracle ORCl

3

Medium

Wide

43.49

0.95

188,322

4

AmEx AXP

4

Medium

Wide

79.72

0.84

80,605

3

Costco COST

2

Low

Wide

142.59

1.04

62,010

3

UPS UPS

3

Medium

Wide

99.22

0.98

88,840

3

Data as of 05/29/15. Fund ownership data as of funds' most recent filings.

As for Google, it was purchased with conviction by Alleghany, and was a meaningful new-money purchase for the managers of

We initiated a position in Google, Inc., a high quality media/technology company with a dominant position in worldwide search advertising, including mobile search through its Android operating system. The company has consistently shown an ability to innovate, its acquisition record has been very good, and the success of its Android operating system should help the company continue to succeed even as an increasing percentage of searches move to mobile devices. Finally, the continued shift of advertising dollars from traditional media to digital will continue to provide a solid tailwind.

While Google has seen its stock price appreciate since the start of the year, it continues to trade at about a 25% discount to our fair value estimate. Morningstar analyst Rick Summer notes that wide-moat rated Google maintains an enormous presence in search advertising, something which he believes will continue to benefit the company as emerging and developing markets attain higher levels of Internet access. He also notes that there is still a large gap between time spent online and dollars allocated to Internet advertising spending, and that as branding advertising becomes more effective there should be greater increases in online ad spending. Summer sees opportunities for the firm to put its sizable cash to work in its mobile business as well, focusing on the Android mobile operating system, and a variety of applications such as Google Maps, allowing it to maintain a strong foothold no matter the conduit of digital ad spending in the future. While he believes that Google's operating margins could expand well above 40% of sales were the firm to reduce its spending on research and development, Summers thinks that the more likely outcome is that the firm will continue to defend its wide economic moat through innovation, seeing only a slight increase in its profit margins over time.

Narrow-moat rated

Industrial giant Honeywell has been a beneficiary of increased emerging market energy demand and stricter worldwide environmental regulations. We expect operating margin improvement to continue and the company has ample financial flexibility to raise its dividend payout ratio and buy back shares. The company’s fourth quarter earnings report exceeded expectations for both revenue and earnings.

Morningstar analyst Keith Schoonmaker believes Honeywell's renewed focus on efficiency and stronger operating principles has helped the company to improve its profitability, and thinks that it remains well positioned to take advantage of growth in its end markets. He applauds the improvements that CEO Dave Cote has brought to the firm over the last 13 years, bolstering the company’s operations and building a portfolio of businesses with strong market positions, as well as reinvigorating Honeywell's culture. His only qualm with management is that they've often elected to use cash and non-cash gains for restructuring activities, rather than rewarding shareholders through share repurchases or dividend increases. He sees the shares, trading at 99% of his fair value estimate, as being fairly valued.

Wide-moat General Electric, another big industrial name, was a meaningful new-money purchase for FPA Crescent, a larger-than-average addition for Oakmark, and the recipient of additional buying by four of our other Ultimate Stock-Pickers. While Steve Romick at FPA Crescent had very little to say about his fund's purchase of the firm, Morningstar Analyst Barbara Noverini remains positive about GE’s outlook, particularly as the firm recently accelerated its efforts to sell the majority of GE Capital, only keeping the specialty finance businesses that directly support its wide-moat industrial businesses. She thinks that GE’s core industrial segments still share the common theme of infrastructure development that served as the foundation for its business a century ago, but that powering the "industrial Internet" has come to symbolize the company’s future growth platform. Noverini further notes that GE’s resilience in the face of uncertain global macroeconomic conditions supports her belief that, despite increased concentration on industrials, the portfolio’s end markets and geographic exposure are well diversified. Noverini expects persistent weakness in oil prices to continue to affect order growth and sales in the Oil & Gas segment, but remains optimistic that demand in Power & Water, Aviation, Transportation, and Health Care will continue to produce solid results for GE in 2015. Given the hesitant outlook held by many of our managers, the reappearance of a well-diversified incumbent like GE comes as no surprise, with the firm still somewhat attractive from a valuation perspective, trading at about a 10% discount to our fair value estimate.

Danaher was the other high-conviction new-money purchases during the period, being picked up by the managers at Parnassus Core Equity Investor. Unfortunately, there was little discussion of the purchase, which looks to have been made in April. With the shares currently trading at 118% of our fair value estimate, it is difficult to see a valuation rationale for buying the stock, which has risen more than 5% over the last month (compared with a 1% gain for the S&P 500 and a 2% increase for diversified industrials). Noverini notes that the shares have moved up steadily since the firm announced it will buy Pall Corporation PLL, then split itself into two separate publicly traded companies. One of the companies will focus on its industrial operations (including its test and measurement and automation businesses), and the other on its science and technology operations, which will comprise Danaher’s diagnostics, dental, and water quality businesses, including the assets acquired in the Pall deal. While Noverini believes the price paid for Pall was not particularly cheap, she notes that acquisitions are core to Danaher’s growth strategy, which has a solid record of trimming expenses and improving margins after transactions are completed. That said, at current price levels, it looks like most of this has already been baked into the company's stock price, making it difficult to recommend it here.

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Disclosure: Greggory Warren owns shares in the following securities mentioned above: American Express, Citigroup, and Synchrony Financial. 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.