Ultimate Stock-Pickers: Top Holdings of Top-Performing Managers

By Greggory Warren, CFA | Senior Stock Analyst

Every investor would like to see the manager of their own actively managed mutual funds beating the market every year, but investors have been left wanting for much of the past decade. This lack of consistent outperformance has been well documented by S&P Dow Jones indices, in its quarterly and annual S&P Indices Versus Active Funds (SPIVA) U.S. Scorecard. In particular, the index group noted that at the end of last year just 17.9% of active large-cap fund managers on average had outperformed the S&P 500 TR index during the past 10 calendar years. The results were worse for large-cap core and large-cap growth managers, with just 15.7% and 10.5%, respectively, outperforming their benchmarks. Large-cap value managers fared much better, with 41.2% beating the S&P 500 Value index during the past decade.

One would have expected active large-cap equity fund managers to put up better results during 2014--the hurdle set by the S&P 500 index of 13.7% in 2014 was lower than what they faced in 2013 (32.4%) and 2012 (16.0%)--but active managers actually performed worse last year than in the previous two years. This is partially explained by the fact that rising markets tends to lift more boats, exemplified by the fact that 44.2% of active large-cap equity fund managers beat their benchmarks during 2013. In addition, a lot of managers were hit harder by falling oil prices than the index was, and many large-cap managers were underweight Utilities, the best-performing sector last year (barely beating out Health Care for the top spot). In addition, while the S&P 500 has some international exposure in its ranks, it is still purely a domestic index, so managers with exposure to foreign stocks--which underperformed last year due to slowing global growth and a stronger U.S. dollar--had that working against them as well.

Some of this has improved in 2015, but not enough to turn around some of the longer-term figures. Relative long-term performance has been less of an issue for our Ultimate Stock-Pickers, with three fourths of the 22 fund managers on our Investment Manager Roster outperforming the S&P 500 index at the end of 2014 (as well as at the end of last week) over the past 10 years. The remaining underperforming managers all are trailing the market by less than 60 basis points. We continue to believe that truly successful managers should be able to consistently generate above-average returns across multiple periods, while recognizing that individual markets can make it easier or tougher for managers to outperform. That said, we stand by our belief that a manager's ability to outperform the market over multiple periods is the best way to differentiate luck from skill.

As a reminder, the Ultimate Stock-Pickers concept was devised as a stock-picking screen, not as a guide for finding fund managers to add to an investment portfolio. Our primary goal has been to identify a sufficiently broad collection of stock-pickers who have shown an ability to beat the markets over multiple periods (with an emphasis on longer term periods). We then cross-reference these top managers' top holdings, purchases, and sales against the recommendations of our own stock analysts on a regular basis, allowing us to uncover securities that investors might want to investigate further. There will always be limitations to our process, as we focus only on managers that our fund analysts cover, and on companies that our stock analysts cover, which serves to reduce the universe of potential ideas that we can ultimately address in any given period. This is also the main reason why we focus so much attention on large-cap fund managers, as they tend to be covered more broadly on the fund side of our operations, and their stock holdings overlap more heavily with our active stock coverage.

Even with some of the limitations found in the near-term performance of our top managers, our record of finding useful stock ideas has been stronger than one might have expected, especially during the last two calendar years, when most of our top managers have struggled to generate above-average annual returns. Judging by the performance of the Morningstar Ultimate Stock-Pickers TR index--which was constructed to reflect the highest conviction holdings that our top managers are investing in on an ongoing basis--our ability to tap into the best ideas of our top managers has never been better. During 2013, the index beat the market by 165 basis points, posting an annual return of 34.0% compared with a 32.4% gain for the S&P 500 index. Last year, when even fewer large-cap fund managers were beating the market, the Ultimate Stock-Pickers index outperformed the S&P 500 by 558 basis points, posting a 19.3% return for all of 2014.

Outperformance can be fleeting, though, as we've seen so far this year, with the Ultimate Stock-Pickers index underperforming the market by 164 basis points at the end of last month. This is not the first time that we've seen the index underperform since it was constructed--both 2012 and 2007 were poorer performing years when compared with the S&P 500. The underperformance in 2012 was due almost entirely to heavier (and ill-timed) bets on energy stock during the first part of that year, which affected performance in the second and third quarters of 2012. From the fourth quarter of that year until the first quarter of 2015, though, the Ultimate Stock-Pickers index has generated better-than-market performance, even as many of our top managers struggled to beat the S&P 500, so the near-term underperformance does not concern us all that much.

Morningstar Ultimate Stock-Pickers TR Index Performance Relative to the S&P 500 TR Index

Trailing Total Returns

YTD

1-Year

2-Year

3-Year

4-Year

5-Year

Mstar Ult Stock-Pickers TR Index

1.6

13.5

16.8

20.6

13.8

16.5

S&P 500 TR Index

3.2

11.8

16.1

19.7

14.3

16.5

Annual Total Returns

YTD

2014

2013

2012

2011

2010

Mstar Ult Stock-Pickers TR Index

1.1

19.3

34

8.6

3.9

15.1

S&P 500 TR Index

2.7

13.7

32.4

16

2.1

15.1

Source: Morningstar Direct. Performance Data as of 5/31/15.

The Ultimate Stock-Pickers index was set up to reflect the highest conviction holdings our 26 different managers are investing in on an ongoing basis. It is constructed by taking all of the stock holdings of our Ultimate Stock-Pickers that are not only covered by Morningstar stock analysts but have either a Low or Medium Uncertainty Rating, and then ranking them by their Morningstar Conviction Score, which measures the level of conviction a manager has in any given holding in their portfolio. The Morningstar Conviction Score is made up of three factors: 1) the overall conviction (number and weighting of a holdings), 2) the relative current optimism (holdings being purchased), and 3) the relative current pessimism (holdings being sold) of each stock that is being assessed.

The index itself is comprised of three sub-portfolios--each one containing 20 securities--which are reconstituted quarterly on a staggered schedule. As such, one third of the index is reset every month, with the 20 securities with the highest conviction scores making up each sub-portfolio when they are reconstituted. This means that the overall index can hold anywhere between 20 and 60 stocks at any given time. In reality, though, the index is usually comprised of 35 to 45 securities. In our view, these stocks represent the best investment opportunities that have been identified by our Ultimate Stock-Pickers in any given period. As of the end of last month, the Morningstar Ultimate Stock-Pickers TR index had 46 total stock holdings, with its top 10 positions accounting for 40.6% (and its top 25 holdings making up 76.7%) of the total invested portfolio. The size and concentration of the portfolio does change, as this is an actively managed index that tries to tap into the movements of our top managers over time. The index's performance over the last couple of calendar years highlights the fact that we can find good ideas even as as many of our top managers are underperforming.

Top 10 Stock Holdings of the Morningstar Ultimate Stock-Pickers TR Index (as of 5/31/15)

Company Name

Star Rating

Moat Rating

Current Price (USD)

Price/ FVE

Market Cap (USD mil)

% Stock Holdings

Buying/ Selling

Dover DOV

3

Narrow

73.13

0.98

11,689

5

( - )

Praxair PX

3

Wide

123.18

0.99

35,497

4.8

+

TE Connec TEL

2

None

68.81

1.32

27,816

4.7

( - )

MasterCard MA

4

Wide

93.77

0.9

106,094

3.9

+

Schlumberger SLB

3

Wide

90.15

0.95

113,809

3.8

+

Gilead Sci GILD

3

Wide

117.66

1.03

170,780

3.8

+

Sysco SYY

4

Narrow

36.92

0.88

21,798

3.8

+

Omnicom OMC

3

Narrow

72.5

0.99

17,562

3.6

+

ExpScripts ESRX

4

Wide

87.41

0.87

63,255

3.6

( - )

Deere DE

3

Wide

92.56

1.02

30,688

3.6

+

Stock price and Morningstar rating data as of 6/12/15.

Looking at the top 10 stock holdings of the Morningstar Ultimate Stock-Pickers index at the end of last month, a few names still trade at a deep enough discount to our analysts' fair value estimates to offer investors a margin of safety.

Wide-moat rated

Top 10 Contributors to the Performance of the Ultimate Stock-Pickers Index (6/1/14-5/31/15)

Company Name

Star Rating

Moat Rating

Current Price (USD)

Price/ FVE

Market Cap (USD mil)

Holding Period Return (%)

Year to Date Return (%)

Eli Lilly LLY

2

Wide

84.21

1.3

90,883

35.7

23.5

Williams WMB

4

Wide

46.99

0.8

34,787

27.7

7.2

Allergan AGN

-

-

-

-

-

31

-

Medtronic MDT

3

Wide

75.52

0.99

106,639

27.3

5

BectonDicknsn BDX

4

Narrow

139.6

0.85

28,969

19.8

1.2

CSX CSX

3

Wide

34.75

0.94

34,116

18.9

-3.2

Aon AON

3

Narrow

102.23

1.01

28,534

18.4

8.4

Accenture CAN

3

Wide

96.1

1.04

62,233

20.8

8.7

Omnicom OMC

3

Narrow

72.5

0.99

17,562

8.6

-5.1

Progressive PGR

3

Narrow

27.77

1.03

16,258

19.7

5.4

Stock price and Morningstar rating data as of 6/12/15.

Looking at the year-over-year performance of the Morningstar Ultimate Stock-Pickers index (from May 31, 2014, to May 31, 2015), a period where the index outperformed the S&P 500 by 165 basis points, the top 10 contributors to that outperformance included a handful of health care names. Wide-moat rated

Wide-moat rated

While the $12.2 billion transaction represented a departure from Becton Dickinson's long-held preference for tuck-in deals and conservative capital deployment, Carefusion derives a large portion of its revenue from products for which it is the market leader, such as intravenous infusion pumps, medication dispensers, respirators, ventilators, and infection-control products. It also benefits from high product switching costs as well as substantial barriers to entry in many of these product categories. Morozov notes that Carefusion's business requires a much different approach to selling than Becton Dickinson is used to, having traditionally relied on its massive scale to offset relentless pricing pressure from price-sensitive consumers for fairly commodified products. Carefusion's product portfolio is more sophisticated and faces far different industry dynamics, which he thinks adds more complexity to integrating the two businesses. That said, Morozov believes that the deal could be moat-enhancing over the long run, and that there is value to be had from bringing the two firms together. His current $165 per share fair value estimate provides enough margin of safety for investors to consider looking at the shares right now.

The only other attractive name among the top 10 contributors to the outperformance of Morningstar Ultimate Stock-Pickers index over the last year is wide-moat rated

Top 10 Detractors From the Performance of the Ultimate Stock-Pickers Index (6/1/14-5/31/15)

Company Name

Star Rating

Moat Rating

Current Price (USD)

Price/ FVE

Market Cap (USD mil)

Holding Period Return (%)

Year to Date Return (%)

Emerson EMR

3

Wide

59.63

0.92

39,513

-8.3

-1.9

Chevron CVX

4

Narrow

99.87

0.87

185,482

-9.8

-9.1

Eaton ETN

2

Narrow

71.88

1.11

33,256

-13.4

7.4

Occidental OXY

3

Narrow

77.78

1.02

58,904

-13.7

-1.7

NatOilwellVarco NOV

4

Narrow

48.3

0.73

18,622

-16

-24.9

AmEx AXP

4

Wide

79.53

0.84

80,012

-14.9

-14

Qualcomm QCOM

3

Wide

67.03

0.89

108,293

3.4

-8.6

Apache APA

3

None

58.18

0.92

21,951

3

-6.4

Colg-Palm CL

4

Wide

66.29

0.92

59,730

-4.2

-3.1

Praxair PX

3

Wide

123.18

0.99

35,497

-10.6

-3.8

Stock price and Morningstar rating data as of 6/12/15.

While our top managers avoided jumping into energy stocks too early during the correction in oil prices this time (unlike what happened in early to mid-2012), there was still enough exposure--via holdings in

As for narrow-moat rated National Oilwell Varco, Morningstar analyst Jason Stevens notes that the firm dominates the drilling equipment space, making nearly every component that goes into a drilling rig, as well as the supplies and tools used in the drilling process. He points out that the firm is either first (or a close second) in nearly every product line in which it competes, and expects it to remain so for years to come. That said, demand for deep-water drilling has fallen off amid a glut of newbuilds and lower global oil prices. Stevens also expects unconventional activity to be sluggish, given the sharp drop in North American rig counts and the likelihood of slowing shale production growth. He believes that a recovery from the current oil price downturn will take time, particularly for National Oilwell Varco's leading rig systems segment. Once oil prices rebound and producers begin allocating capital to deep-water projects, it will still take several years before demand for newbuild rigs--and therefore rig equipment--begins to rise meaningfully. That said, Stevens believes that National Oilwell Varco is well positioned longer term to be the leading equipment supplier as the world increasingly seeks oil production from offshore and unconventional reservoirs.

If you're interested in receiving e-mail alerts about upcoming articles from The Ultimate Stock-Pickers Team, please sign up here.

Disclosure: Greggory Warren has ownership interests in the shares of the following companies mentioned above: American Express, Becton Dickinson, Medtronic, and Colgate-Palmolive. 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.