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Ultimate Stock-Pickers: Top 10 Buys and Sells

Ahead of the sell-off, top managers were cautious in adding to positions and continued to sell fully valued, flawed, or more liquid securities to meet redemption requests.

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By Eric Compton | Associate Stock Analyst

Our primary goal for the Ultimate Stock-Pickers concept is to uncover investment ideas that not only reflect the most recent transactions of some of the top investment managers in the business, but also are timely enough for investors to get some value from them. We regularly scour the holdings of these managers as they become publicly available. Our initial read on the buying activity of our Ultimate Stock-Pickers during the fourth quarter of 2015 was spelled out in our last article, which focused exclusively on singular high-conviction purchases and new-money buys. At that time, we noted that the conviction buying activity of our top managers remained muted, making the fourth quarter of 2015 the 10th straight calendar quarter when our Ultimate Stock-Pickers have generated incredibly low levels of buying activity. Despite collecting additional data from nearly all of our top managers and looking more closely at the aggregate buying and selling activity of those that have reported quarterly (and in some cases monthly holdings through the end of January), we continue to see fewer purchases. We are seeing increased selling activity as well, as our managers move out of positions that are either fully valued or fundamentally flawed, in their opinion, or trim more liquid positions to meet redemption requests.

Based on the aggregate data, most of the conviction buying that took place during the fourth quarter (and early part of the first quarter) was focused on high-quality names with defensible economic moats--exemplified by a greater number of wide- and narrow-moat names in our list of top 10 (and top 25) high-conviction purchases during the period. There was also a significant amount of overlap this quarter between the top 10 high-conviction purchases from our last article and the top 10 overall purchases by investment conviction. Of note was the fact that seven different names--wide-moat rated American Express (AXP), VF Corp (VFC) and MasterCard (MA), narrow-moated-rated EOG Resources (EOG), Apple (AAPL) and UnitedHealth Group (UNH), and nonrated Ally Financial (ALLY)--showed up on both lists this time around. We view this as a case where overall volume is not necessarily indicative of relative conviction. The main difference between the two lists is the list of high-conviction purchases (published in our last article) represents an early read on individual high-conviction and new-money purchases (with at best some 85% of our Ultimate Stock-Pickers having posted their holdings for the period). In contrast, the top 10 stock purchases list, and the overall focus of this article, is based on the aggregate data of all of the buying activity of our top managers (which includes not only high-conviction and new-money purchase, but also all other buying activity that took place).

Much like we seen in previous periods, there was a fair number of managers selling during the fourth quarter (and early part of the first quarter), much of which we suspect was driven by sales of more liquid (and better-performing stocks) to meet the redemption requests that no doubt followed the sell-off in the global equity markets during the third quarter. That's not to say that there weren't sales of holdings that had become fully valued in the minds of our top managers, as has been the case in past periods, or where they had lost faith in a company's ability to meet their long-term expectations. We saw a fair amount of commentary that pointed in that direction for some of the outright sales. After considering this most recent bout of buying and selling activity, as well as the changes that we made to the Investment Manager Roster during the first quarter of 2015, our top managers remained underweight in energy, utilities, and communication services relative to the weightings of those sectors in the S&P 500 TR Index at the end of December. They are also now underweight the healthcare sector, which is no doubt a byproduct of the heavier selling activity in both narrow-moat-rated Valeant Pharmaceuticals (VRX) and wide-moat Medtronic (MDT). As for overweight positions, our Ultimate Stock-Pickers have much greater exposure to the financial services, consumer defensive, and technology sectors, while holding moderately overweight positions in basic materials, consumer cyclical, and industrials names, with their exposure to real estate being more or less in line with the index.

While many of our top managers did alter their stakes in some of the top 10 holdings that we track, all of their buying and selling activity caused only one company--wide-moat- rated United Parcel Service (UPS)--to fall off the list, with wide-moat-rated Johnson & Johnson (JNJ) moving up the ranks to take its place. The two biggest sellers of UPS were Amana Growth Investor (AMAGX) and American Century Value (AVLIX), both of which sold their stakes outright but offered no reasoning for their sales. Ronald Canakaris at ASTON/Montag & Caldwell Growth (MCGIX), reduced his stake in UPS by 24% as well, but despite generally being very verbose about his trading activity had little to offer on the name other than to note that it contributed to the weaker performance of his bets in the industrials sector during the fourth quarter. As investor concerns about growth in emerging and developing markets (including China) affected the market, causing the sell-off in the global equity markets during the third quarter, firms like UPS that are leveraged to continued global growth were caught in the downdraft. The fact that the stock was trading near or above our $101 per share fair value estimate during much of the fourth quarter, having rebounded off its third-quarter lows, may have prompted these managers to take money off the table--especially if they were concerned that the issues that drove the market down in the third quarter were still out there, which turned out to be the case as we started out 2016.

Although there were no actual big buyers of Johnson & Johnson during the most recent period, three of our top managers-- Columbia Dividend Income (LBSAX), Jensen Quality Growth (JENSX), and no-moat-rated Markel (MKL)--increased their stakes in the firm by at least 5%. The name has been on and off the top 10 holdings list for much of the past seven years, generally moving up the list when another name is pared back--much like we saw this time around with UPS. While none of the top managers that were buying offered any comments on their buying, we would note that Johnson & Johnson is currently trading at a slight premium to our $102 per share fair value estimate, making it difficult to recommend the name at these levels. The stock has traditionally been a more defensive name for investors, and Morningstar analyst Damien Conover currently has a low uncertainty rating on the firm, a reflection of the low levels of volatility in the cash flows Johnson & Johnson derives from a diverse and inelastic product portfolio. He also notes that the company has one of the widest moats in the healthcare sector, supported by intellectual property in its drug group, switching costs in its device segment, and strong brand power in its consumer products group. Conover believes that the diversity of Johnson & Johnson's business lines and the strengths associated with them, the fortitude of its balance sheet, and its stable dividend have all combined to make the stock a more defensive investment. While we don't currently view the shares as being meaningfully undervalued, we think it may pay for investors to keep an eye out for better entry points, especially if the markets continue to be more volatile.

As we noted above, seven of the top 10 stock purchases this time around were also represented on the list of top 10 high-conviction purchases from our last article, which highlighted stock purchases above a certain threshold that were derived from an early read of the data we were receiving from our top managers. Five of the top 10 stock purchases this time around--wide-moat-rated Union Pacific (UNP) and VF Corp (VFC), narrow-moat Aetna (AET) and UnitedHealth Group (UNH), and nonrated Ally Financial--were also new-money purchases for our top managers. For those who may not recall, when we look at the purchase activity of our Ultimate Stock-Pickers each period, we tend to focus on both high-conviction purchases and new-money buys. We think of high-conviction purchases as instances where managers have made meaningful additions to their existing holdings (or make significant new-money purchases), focusing on the impact these that transactions have on their overall portfolios and looking for additions that are more meaningful in nature.

While the insurance portfolio managers at nonrated Alleghany (Y) completely blew out their stake in Union Pacific during the fourth quarter, we saw four different managers-- American Funds American Mutual (AMRMX), ASTON/Montag & Caldwell Growth, Markel, and Oakmark (OAKMX)--buying during the period, with Tom Gayner at Markel actually taking a new stake in the firm. All of the railroads took a hit in the back half of 2015, as there was a marked decline in demand for shipments of coal and other industrial products categories (primarily crude oil), which impact both volumes and revenue. The expectation is that this is likely to persist into 2016, which could leave volumes, revenue and earnings for the current year lower than what we saw during 2015. This belief led Morningstar analyst Keith Schoonmaker to lower the fair value estimates for all of the Class I railroads in early January, as he adjusted his 2016-17 projections to reflect this new reality. While Union Pacific's shares have recovered dramatically off of their more recent lows, the shares continue to trade at less than 85% of Schoonmaker's $95 per share fair value estimate, making them fairly attractive for long-term investors. Union Pacific remains his top pick among the transportation names. Schoonmaker likes the firm for its diverse portfolio (Powder River Basin coal, intermodal franchise at Los Angeles/Long Beach, California, Mexican trade, and fast-growing domestic, high auto exposure, and frac sand), room to improve operating ratio a bit, conservative management, and nearly 3% dividend yield. He believes Union Pacific should be able to maintain its wide-moat rating, which is founded on a duopoly of efficient market structure and low cost compared with competing modes.

As for VF Corp, the apparel and footwear company was purchased by two of our top managers-- Diamond Hill Large Cap (DHLAX) and Parnassus Core Equity Investor (PRBLX)--with the latter's purchase being a high-conviction new-money purchase. Todd Ahlsten and Benjamin Allen, the managers of Parnassus Core Equity Investor, had the following to say about the addition of the name to their portfolio:

In the fourth quarter, we initiated a position in VF Corp., an apparel and footwear company better known by its top brands: North Face, Timberland, Vans and Wrangler. We have long admired this company for its growth potential, commitment to corporate responsibility and excellent management team. We finally got a chance to buy the stock in December, after a disappointing earnings announcement caused a 14% drop in the shares from the pre-report price of $73 to our average cost of $63. We hope to own VF Corp. for many years, as we expect its brands to continue to gain market share domestically and abroad.

Morningstar analyst Bridget Weishaar believes that VF Corp has established a broad and growing array of leading lifestyle brands, carefully selected to enhance its presence in high-growth categories and for synergies within existing operating units. She thinks that management will continue to make acquisitions with an eye toward strengthening its brand leadership and will continue to invest heavily in existing brands through branding campaigns, marketing, product development, and in-store experiences--the basis for her wide moat and positive trend ratings. With the shares trading at 83% of her fair value estimate right now, they continue to offer a compelling long-term investment opportunity for investors.

Aetna was actually the recipient of two new-money purchases--by the managers at Diamond Hill Large Cap and Columbia Dividend Income--with the purchase made by the former manager passing the threshold for a high-conviction purchase. Both American Funds American Mutual and Oppenheimer Global (OPPAX) added to existing stakes in the healthcare benefit company. While none of these managers had much to say about their purchases of Aetna, we currently view the shares as overvalued, with the stock trading at 139% of our $79 per share fair value estimate, which is also the case for narrow-moat- rated UnitedHealth Group, a close peer of Aetna's that is trading at 116% of our $105 per share fair value estimate. The managed-care organizations have been viewed as being more defensive of late, with the group up 5% on average since the start of the year compared with a 4% decline for the S&P 500 TR Index. Morningstar analyst Vishnu Lekraj does not, however, think that this is warranted longer-term. While Aetna is well- positioned relative to its peers, the managed-care organization sector faces long-term secular headwinds, including greater competition, Affordable-Care-Act mandated profit caps, and the fact that available membership growth is coming primarily from lower profit cohorts. This, along with uncertainty that continues to surround the sustainability of the individual public exchange market, has led him to assign a negative moat trend to Aetna's narrow moat rating. As for UnitedHealth Group, which also has a negative moat trend, Lekraj thinks that the firm is in a prime long-term competitive position given its large size, diversified insurance lines, and disciplined pricing execution, but expects its core operations to be pressured somewhat over the next several years.

While we don't currently cover Ally Financial, the two Ultimate Stock-Pickers that were buying the stock during the fourth quarter--Oakmark and Oakmark Equity & Income (OAKBX)--had plenty to say about their purchases. Bill Nygren and Kevin Grant from the Oakmark fund had the following to say about the portfolio changes they made during the most recent period:

During the quarter, we added a new position in Ally Financial…and we eliminated positions in Accenture, Amazon and Omnicom Group. Amazon has been a great holding for the Fund, and with the share price more than doubling in 2015, we believe the business is now fairly valued. With minimal reported earnings and a very high P/E ratio, Amazon may have looked like an unusual purchase for a value-based fund when we initiated a position in April 2014. We looked past reported earnings, which were tempered by large investments for future growth, and found that the scale and core earnings power of Amazon's business were quite impressive and under-appreciated. Omnicom Group has also been a strong performer for the Fund. We have held Omnicom since late 2008, and we eliminated the position in the fourth quarter as the share price approached our estimate of fair value.

Ally was founded nearly a century ago as General Motors Acceptance Corporation. Its purpose then was to provide financing to GM dealers and retail customers. Today, Ally's business is largely the same except that it is no longer owned by GM and now serves dealers and customers of many other automobile manufacturers, such as Ford, Chrysler and Toyota. Since Ally's initial public offering in spring 2014, its shares have fallen over 20% while the S&P 500 has returned over 15%. Over this period, some investors have grown concerned that the business is at a cyclical peak, as U.S. auto sales are near record levels and credit losses are below long-term averages; as a result, some believe Ally's earnings have nowhere to go but down. We believe cyclical pressures will be offset by continued internal improvements, such as funding cost reductions (as "legacy" liabilities are replaced with lower cost borrowings) and improving their capital structure. With Ally's stock trading at just 80% of tangible book value, we believe Ally is a compelling addition to the Oakmark Fund.

Clyde McGregor of the Oakmark Equity & Income fund basically reiterated this commentary when talking about his fund's new money purchase of the name during the fourth quarter.

While not a new-money purchase, Apple (AAPL) inspired the most funds to make purchases during the most recent period, with five different managers adding to their stakes. Dennis Lynch's team at Morgan Stanley Institutional Growth A (MSEGX) made the largest conviction buy during the period, more than doubling the fund's stake in the technology firm. While the insurance portfolio managers at Alleghany trimmed their position in Apple, selling more than a third of their stake, it remains their twelfth largest holding, accounting for 4% of their total equity portfolio. Apple is ever in the spotlight, and rightly so as it is the largest company in the world by market capitalization. The company is held by at least 11 of our top managers, with both growth and value managers in our Investment Manager Roster holding stakes in the name.

That said, there is some debate about whether Apple's best days are behind it as innovation has seemed to slow and competition has increased as the first-mover advantage that the firm had in smartphones wears off. Morningstar analyst Brian Colello believes that Apple is currently undervalued, trading at 73% of his $133 per share fair value estimate. While the firm's most recent results, as well as its near-term outlook (which emphasized reduced growth due to sluggish macroeconomic conditions and currency headwinds), may seem to support the bear case, Colello argues that the long-term story isn't as gloomy as some may believe. He does not see a premium "iPhone killer" emerging anytime soon, and notes that current iPhone customers remain satisfied and loyal to the brand. While the replacement cycle for current users has lengthened, putting some pressure on near-term sales, Colello believes that the lengthening of replacement cycles could portend pent up demand in the future, especially once global economic conditions improve, which means that the current demand lag is likely more cyclical in nature than secular. On top of that, Apple's ability to maintain premium pricing on the iPhone within a smartphone market where virtually no other OEM can earn excess returns on capital remains in place. While the future of Apple may be up for debate, it remains a cash flow machine today and trades well below our current fair value estimate, making this an attractive entry point for long-term investors.

As for the top 10 sales by investment conviction this time around, there continued to be a fair amount of outright selling, driven by holdings either becoming fully valued in the minds of our top managers or where the fundamentals of the company had changed meaningfully from the selling manager's original investment thesis. With six of the top 10 sales--wide-moat-rated Accenture (ACN), General Electric (GE) and Medtronic (MDT); narrow-moat-rated Valeant Pharmaceuticals (VRX), and Chubb (CB), and nonrated Canadian Natural Resources CNQ--seeing one or more of our top managers eliminating their stakes during the most recent period, we were curious to see how much information the selling managers would provide about their decision to sell.

While the managers at Oakmark noted that they had eliminated their stake in Accenture, they had very little else to say about the sale:

During the quarter, we added a new position in Ally Financial…and we eliminated positions in Accenture, Amazon and Omnicom Group. Amazon has been a great holding for the Fund, and with the share price more than doubling in 2015, we believe the business is now fairly valued. With minimal reported earnings and a very high P/E ratio, Amazon may have looked like an unusual purchase for a value-based fund when we initiated a position in April 2014. We looked past reported earnings, which were tempered by large investments for future growth, and found that the scale and core earnings power of Amazon's business were quite impressive and under-appreciated. Omnicom Group has also been a strong performer for the Fund. We have held Omnicom since late 2008, and we eliminated the position in the fourth quarter as the share price approached our estimate of fair value.

Todd Ahlsten and Benjamin Allen at Parnassus Core Equity Investor, which also blew out its stake in Accenture, had nothing to say about the sale. With the managers at ASTON/Montag & Caldwell Growth, FMI Large Cap (FMIHX), and Jensen Quality Growth also making high-conviction sales during the period, we went looking for details, but found only the following comments from Pat English at FMI Large Cap:

A strong return from Accenture, Henkel, and SMC Corp. also helped to boost relative performance. Overall, we are generally pleased with the results, especially when considering that growth has outperformed value over this time horizon.

The shares were up more than 10% through the end of September 2015, and increased close to 18% overall last year, so it's not too surprising to see some managers cashing in, especially if they had other opportunities to put the money to work in (which was at least the case with Oakmark). This also looked to be the case with Alphabet ((GOO)/(GOOGL)), with half of the 16 Ultimate Stock-Pickers holding the name taking advantage of the 45% runup in the stock last year (and 24% gain in the fourth quarter) to take some profit. Timothy Hartch and Michael Keller of BBH Core Select (BBTEX) summed up this sentiment exactly with the following statement in their quarterly letter to shareholders:

Our second best contributor in the quarter was Alphabet (the parent company of Google), whose Class C shares rose by 25%. The shares benefited from the Company's October announcement of strong quarterly results and the initiation of a $5.1 billion share repurchase program. Alphabet's robust top-line growth continued to be driven by mobile search, YouTube and programmatic advertising, as well as a continued narrowing of the ‘cost per click' gap between desktop and mobile-initiated queries. Better expense discipline throughout 2015 coupled with benefits from weaker foreign currency translation have led to slower-than-expected growth in operating expenses and slightly improved operating margins. While the share repurchase announcement marked a significant shift in Alphabet's financial strategy, we believe Management continues to view capital expenditures and acquisitions as the top priorities for capital allocation, and the Company's significant holdings of cash and securities ($72.8 billion at the end of the third quarter) as a strategic asset. However, given the substantial free cash flow generation of the core business and current liquidity that likely exceeds the medium term investment needs of the business, we welcome the decision to return part of this excess cash to shareholders. Following sizable gains in 2015 that pushed Alphabet's shares closer to our estimate of intrinsic value per share, we elected to reduce our position for Core Select during the fourth quarter.

While both Dodge & Cox Stock (DODGX) and Markel eliminated their stakes in General Electric during the quarter, and the managers at American Century Value reduced their holdings in the Industrials giant by nearly a fifth, there was little information to be had about the motive for the sales, with Dodge & Cox only offering up the following for its fund investors:

As valuations became more attractive, we added selectively to existing holdings, including Baker Hughes, Bank of America, Cigna, EMC Corp., HP Inc., and MetLife. We also identified 8 new investment opportunities (including American Express, Anthem, Concho Resources, and VMware) and exited 13 holdings (including Chevron, General Electric, and PayPal).

What's interesting is that while Dodge & Cox was adding to its stake in narrow-moat rated Bank of America (BAC), Bruce Berkowitz at Fairholme Capital Management was making a significant reduction to his stake in the U.S. bank, almost single-handedly pushing the name up to the top of our list of sales by investment conviction. While Berkowitz sold off 86% of his common stock holdings in Bank of America, he continues to hold on to around 3.9 million shares, and has 18.3 million rights to purchase the bank's shares at exercise prices below $13.50 per share). The sale itself appears to have been particularly well timed, as it preceded the ensuing sell-off in the company's shares in 2016 (once investors realized that rates were likely to remain lower for longer, prolonging any sort of recovery in net interest margins). Other concerns have included fears over energy-related credit losses, global deflation, and potential interbank contagion. Morningstar analyst Jim Sinegal, who covers the Big Four U.S. Banks, believes that the dour outlook is premature and that some banks have been getting unjustly penalized amidst the general mayhem. In particular, he notes that Bank of America's exposures to the energy sector are more than manageable, and that even when pricing in losses of 30% on those loans, the bank's equity would not be substantially harmed. Sinegal also highlights the fact that the typical asset makeup of U.S. banks has changed since the 2008-09 financial crisis, being tilted toward more conservative short-term liquid assets rather than the idiosyncratic illiquid holdings that prevailed prior to the crisis. On top of that, he does not expect to see the same type of counterparty risk and notional derivative exposures that caused much of the capital destruction in 2008-09. While Sinegal does recognize that it has been an unsettling start to the year for the banks, he believes that the headwinds facing firms like Bank of America are already full priced into their shares. With the company trading at 75% of his $17 per share fair value estimate, he feels that they are attractively priced for long-term investors. That said, there are still short-term factors that could hurt earnings in 2016, so asking for a wider margin of safety (which is embedded in his high uncertainty rating) makes sense.

As for Medtronic, which was sold outright by Jensen Quality Growth, the managers of the fund noted the following about the liquidation:

Medtronic PLC (MDT) manufactures and markets a broad range of medical devices. We sold the position as its fiscal 2015 financial performance resulted in Return on Equity of less than 15%, a breach of our requirement for Fund inclusion. Medtronic issued equity during the year to fund a portion of a large acquisition, resulting in the decline in Return on Equity. In our view, the acquisition was strategically sound, but our analysis indicates that the company may be burdened with low returns on capital for some time to come.

The managers at Jensen Quality Growth have a simple and rigorous stock selection criterion. The fund only invests in companies that have earned a 15% return on equity every year for the past 10 years, with the point of this exercise being to limit the fund's holdings to companies that are consistent value creators. As a result, it is not unusual to see periods like we just saw where the managers liquidated positions wide-moat-rated Equifax (EFX), Varian Medical Systems (VAR) and Medtronic, using the capital to initiate positions in wide-moat MasterCard (MA), and Stryker (SYK).

While we had very little information about the conviction sales of no-moat Canadian Natural Resources and narrow-moat-rated Chubb, we can guess that the latter was tied more to the runup in the stock price as we moved closer to the closing of the merger with Ace, which is expected in the first half of 2016, with Ace assuming the Chubb name and stock ticker. As for Valeant Pharmaceuticals, which was sold outright by the managers at Morgan Stanley Inst Growth and Alleghany, we have very little to go on from the selling managers. That said, we did some insight from Robert Goldfarb and David Poppe at Sequoia (SEQUX), where Valeant accounted for more than 28% of their portfolio at the end of September 2015 (before dropping down to 21% of the fund's equity holdings at the end of 2015):

Sequoia turned in its second straight year of poor results in 2015.Teasing out the source of our underperformance doesn't take much work. We began the year with a 20% weighting in Valeant Pharmaceuticals. Valeant rose by more than 80% through the summer, driving very strong gains for the Fund. But the price collapsed in the fall amid revelations and allegations about the company's business practices. Ultimately, Valeant declined 29% for the year and by more than 70% from its 52-week high to its low. We bought more shares in October, and we calculate that Valeant contributed -6.3% to Sequoia's return of -7.3% for the year.

At its peak price, Valeant constituted more than 30% of the Fund's assets. We've been criticized for allowing the holding to grow so large, but our feeling before the crisis erupted was that Valeant was executing well on its business model. Earnings were growing rapidly and we believed the company was making intelligent acquisitions that were creating shareholder value. Valeant was taking outsized price increases on a portion of its drug portfolio, but the entire branded pharmaceutical industry routinely has taken substantial annual price increases on drugs for more than a decade.

As you are no doubt aware, Valeant was rocked in the fall by the closure of an affiliated specialty pharmacy, Philidor, after health care payers said they would not reimburse Philidor for claims it submitted. It has been further buffeted by subpoenas from Congress over its pricing strategies and by regulatory and law enforcement scrutiny over practices at Philidor. A committee of Valeant's board of directors is investigating the relationship with Philidor. Valeant recently said it would restate prior earnings as it improperly accounted for sales to Philidor in late 2014.

As these inquiries continue and Valeant remains a subject of intense scrutiny, the share price is very unstable. For the stock to regain credibility with long-term investors, Valeant will need to generate strong earnings and cash flow this year, make progress in paying down some of its debt, demonstrate that it can launch new drugs from its own development pipeline and avoid provoking health care payers and the government. The company has committed to doing all of these things and we are confident interim CEO Howard Schiller and interim board chairman Robert Ingram are focused on the right metrics. Before CEO J. Michael Pearson went out on an extended medical leave, he also seemed committed to this path.

In the end, Valeant's ability to grow earnings over a period of years will determine the stock price. A few months ago, the consensus cash earnings estimate from Wall Street analysts for Valeant in 2016 was about $16 per share. Today, estimates are closer to $13.50. This represents material deterioration, but still good growth over 2015 results. And with strong performance from its gastrointestinal drug Xifaxan and a slate of new product releases in 2016, Valeant has the potential to grow earnings for several years driven more by organic volume increases than price hikes.

As the largest shareholder of Valeant, our own credibility as investors has been damaged by this saga. We've seen higher-than-normal redemptions in the Fund, had two of our five independent directors resign in October and been sued by two Sequoia shareholders over our concentration in Valeant. We do not believe the lawsuit has merit and intend to defend ourselves vigorously in court.

Needless to say, it has been a rough ride for Valeant recently. Morningstar analyst Michael Waterhouse has the difficult job of trying to make sense of the situation, and states that the bottom-line effect of the current restatements looks relatively minor, and doesn't expect this issue to have any material effect on his free cash flow forecasts. That said, as Valeant continues to work through the fallout of its discontinued relationship with Philidor, it is likely, in Waterhouse's view, that near-term performance will remain depressed, including the possibility of impairments and restructuring charges. Regardless, he still thinks that Valeant's narrow economic moat and long-term opportunities remain intact--that is, as long as he doesn't begin to see material weaknesses in other parts of the company's operations, especially the more attractive ophthalmology and gastrointestinal segments, as well as its international operations. It would be an understatement to call this a difficult situation, which is why Waterhouse reiterates the high uncertainty rating he has on Valeant's shares.

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Disclosure: Eric Compton has no 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.

The Morningstar Ultimate Stock-Pickers Team does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.