Our Ultimate Stock-Pickers Top 10 New-Money Purchases

By Eric Compton | Associate Stock Analyst

For the past seven and a half years, our primary goal with the Ultimate Stock-Pickers concept has been to uncover investment ideas that not only reflect the most recent transactions of a select group of top investment managers but are timely enough for investors to get some value from them. By cross-checking the most current valuation work and opinions of Morningstar's cadre of stock analysts against the actions of some of the best equity managers in the business, we hope to uncover a few good ideas for investors each quarter.

With two thirds of our Ultimate Stock-Pickers having reported their holdings for the second quarter of 2016, we've gotten a sense of what stocks piqued their interest during the period. Thus far, the story of the year has been one of market volatility, as the initial sell-off at the start of the year resulted in a strong recovery, which was subsequently affected by the sell-off associated with the Brexit vote at the end of June (which was followed by a market recovery in July). While we'd seen an increase in buying and selling activity by our top managers during the first quarter, with the sell-off in the market creating opportunities for our Ultimate Stock-Pickers, it looks like the buying activity during the second quarter was much lower than we've seen in previous periods.

When looking at the buying activity of our Ultimate Stock-Pickers, we focus on both high-conviction purchases and new-money buys. We think of high-conviction purchases as instances where managers have made meaningful additions to their portfolios, as defined by the size of the purchase in relation to the size of the portfolio. We define a new-money buy strictly as an instance where a manager purchases a stock that did not previously exist in his or her portfolio. New-money buys may be done either with or without conviction, depending on the size of the purchase. Similarly, a conviction buy can be a new-money buy if the holding did not previously exist in the portfolio.

We also recognize that the decision to purchase any of the securities we are highlighting could have been made as early as the start of April, with the prices paid by our top managers being much different from today's trading levels. As such, it is important for investors to assess the current attractiveness of any security mentioned here by checking it against some of the key valuation metrics--like the Morningstar Rating for Stocks and the price/fair value estimate ratio--that are generated regularly by our stock analysts' ongoing research.

Looking more closely at the top 10 high-conviction purchases during the second quarter of 2016, the buying activity was pretty well spread out among the financial-services, healthcare, technology, and consumer cyclical sectors. Not too surprisingly, given the track record of our top managers, most of the buying activity during the period was also focused on high-quality names with defendable economic moats--exemplified by the greater number of wide- and narrow-moat names in the list of top 10 high-conviction purchases (as well as among the top 25 high-conviction purchases) this time around.

It is also interesting to note that most of the high-conviction buys during the second quarter were also new-money purchases, with nine of the top 10 high-conviction purchases being the recipients of new-money investments during the period. Crossover between the lists is rarely this high. Only the high-conviction purchase of narrow-moat-rated

The financial-services sector received a lot of attention during the first quarter, with banks trading off in response to global growth concerns, as well as the realization that interest rates were likely to remain low for longer, so it was not too much of a surprise to see interest spring up again during the second quarter. That said, banking continues to remain an area of controversy and uncertainty, in large part due to unprecedented central bank measures throughout the world and the resultant effects on interest rates (which are now negative in some parts of the globe).

Wide-moat-rated

We decided to buy Wells Fargo after many years of waiting for the right entry point. At the time of our purchase, the stock was trading at a slight discount to other regional banks, and at a major discount to the overall stock market. In addition, the company had just lowered guidance for important return-on-capital measures at its May investor day. We think the company will meet or exceed these new targets, which should provide support for the stock over our three-year investment horizon. As for the quality of the company, simply put, we think Wells Fargo is the best large bank in the country. It has an enviable balance of fee income and net interest income, a widely diversified customer base and a culture that emphasizes risk management.

Morningstar analyst Jim Sinegal views Wells Fargo's dominant market position as its largest structural advantage. He notes that it is the largest deposit gatherer in major metropolitan markets across the country, with more than one third of the bank's deposits coming from markets in which Wells Fargo is the pre-eminent player, and more than two thirds of its deposits gathered in markets in which the company ranks among the top three players. Sinegal believes that Wells Fargo's long-standing focus on cross-selling has helped it to lock in customer relationships, as well as access to low-cost funding. The bank builds on its funding advantage, in his view, through efficient operations and solid underwriting, which minimizes costs at the same time that it maximizes the revenue associated with every dollar held on its balance sheet.

That said, Sinegal also notes that recent results have been less than ideal for Wells Fargo, with profits being essentially flat over the past 12 months, as provisioning for loan losses more than doubled (due to weakness in energy portfolios and expansion of the company's allowance for car and auto loans). However, he does not think investors should read too much into these short-term trends, believing that the size and direction of rate changes will have a bigger impact. In the meantime, charge-offs remain negligible, nonperforming loans are actually falling, and the home lending group has actually benefited from lower rates as more people have either bought houses or refinanced their current ones. Sinegal notes that investing in banks is not easy right now, and with increasing deposit costs, as well as a slight decrease in assets under management, during the quarter, Wells Fargo has its share of headwinds to navigate. With the shares of the wide-moat bank currently trading at 79% of his $61 per share fair value estimate, the stock is not quite as cheap as it has been at times during the first and second quarter, but does represent good value for long-term investors.

On the healthcare front,

We initiated a position in Perrigo, a leading manufacturer of store-brand, over-the-counter (OTC) medications and difficult-to-produce generic prescription drugs. Perrigo fits well with our Core Select investment criteria, and we believe that it is well positioned in the healthcare industry given its focus on products that offer quality, affordable healthcare alternatives to consumers. We expect the Company to benefit over time from: i) increases in pharmaceutical usage as global populations age, ii) increasing penetration of store brands for OTC medications, and iii) the transition of existing drugs from prescription-only sales to OTC availability. A sharp decline in Perrigo's shares during April (following the announcement of a management transition and reduced earnings guidance for 2016) facilitated our purchase.

Morningstar analyst Michael Waterhouse believes the shares, currently trading at 86% of his recently revised $100 per share fair value estimate, remain undervalued, but that investors may need to wait longer for a turnaround at the firm. The company, in his view, has been the victim of both bad news and poor results, which have helped drive the price of the shares down considerably since the middle of last year. Waterhouse believes, at this point, that things are unlikely to get much worse, but the volatility in the firm's prescription topicals business, as well as the ongoing integration issues for the Omega branded consumer health business, has further eroded his confidence in management's ability to improve performance. The ongoing market share losses for Perrigo's prescription topicals business and further evidence of competitive pricing pressures has led Waterhouse to consider removing Perrigo's narrow moat rating as the projected returns on capital continue to decline. Aside from lowering his fair value estimate from $130 per share, he also increased the firm's uncertainty rating to high from medium, given the decreased visibility he has into Perrigo's future performance.

Of the technology names that made our two lists,

in the past, most notably last quarter after wide-moat

We established a position in Apple as we believe that the iPhone 7 will outperform the 6S cycle as it will anniversary the launch of the 6 two years ago, be the first anniversary of Apple's new annual iPhone replacement program, and be up against easy comparisons. The company's services business currently stands at around 10% of total revenue and is growing at 10-15% which should provide revenue and earnings stability and garner a higher multiple. Qualcomm was increased following first quarter results that exceeded expectations for revenues and operating profits. Microsoft was initially trimmed after the company provided updated guidance that pushed out the earnings recovery for another year as the growth in cloud has yet to reach sufficient scale to offset the gravitational pull of the decline in legacy transactional business. The position was subsequently eliminated as the company's exposure to Europe presents a new headwind following the UK vote to exit the European Union.

The managers of Parnassus Core Equity Investor also made a high-conviction purchase of Apple during the quarter, adding to an established position, and had the following to say about the buy:

The stock dropped after the company reported weaker-than-expected earnings, driven by a shortfall in iPhone unit sales. This news sparked investor concerns that iPhone profits have peaked and that the company will be challenged to grow over the long term. We expect Apple to keep expanding its already massive customer base while adding new products and services to its lineup. Furthermore, the company's balance sheet and cash generation continue to be very healthy, supporting continued share repurchases and dividend growth.

Morningstar analyst Brian Colello has long held that the current worries about Apple have been overblown and that the shares have been more or less pricing in these worries since the beginning of the year, giving an asymmetrical risk/reward opportunity for investors if recent iPhone softness didn't end up being as bad in the long term as many have believed. This view was largely informed by Colello's view of Apple's narrow moat rating, which he argues is still intact. He remains confident in his long-term thesis that most of Apple's iPhone customers today will continue to stick with the ecosystem and continue to buy iPhones. This is in stark contrast to many of the bears, who believe Apple will soon be competing on price exclusively as customers begin leaving the ecosystem for lower-priced competitors. Colello believes Apple's sluggish iPhone sales in recent quarters are a function of lengthening replacement cycles rather than premium smartphone market share loss to Android-based competitors, which would be far more concerning and represent a deterioration of Apple's narrow moat.

The company has noted that the upgrade rate for the iPhone 6s resembled the 5s two years ago, and that the iPhone 6 upgrade cycle was an anomaly, likely boosted by both the introduction of a large screen device and Apple's carrier partnership with China Mobile. Looking ahead to the iPhone 7 launch, Colello thinks investors should watch carefully for signs that Apple's iPhone upgrade cycle is either speeding up or facing another year of deceleration. Even if replacement cycles stay at recent levels, Colello thinks Apple's iPhone business is more resilient than what the market is giving the company credit for. At some point, whether it is the iPhone 7 this year or the next version of the phone to be launched in the Fall of 2017, he anticipates that customers will replace their aging iPhones with newer iPhones rather than depart the platform for competitors. In the long term, if Apple can avoid the loss of its moat, shares are likely underpriced at today's levels. In the meantime, the firm is a cash cow willing to buy back shares, of which it recently finished buying back $24 billion worth of stock through the first three quarters of fiscal 2016.

One other company that caught our attention this period was wide-moat

We added two stocks to the Fund in the quarter. The first is The Walt Disney Company, a global enterprise with businesses that include media networks, movie studios, theme parks and consumer products. The stock reached a high of $122 in August of 2015, just before management announced subscriber declines at ESPN, one of Disney's most valuable assets. However, the stock quickly recovered in December in anticipation of the release of Star Wars: The Force Awakens. We bought the stock in May at an average price of $103, when investors again were focused on the threats related to ESPN. We acknowledge these threats, but think that there are plenty of other good things going for Disney to offset the risk.

Disney is a classic example of a well-known media company, which is basically a household name, whose stock price can be largely affected by headlines, such as the popularity of a single movie. The question investors should be asking of firms like Disney, in our view, is what is in the price, not necessarily what is in the news. Disney also highlights the difficulty in predicting trends 10 or more years out, especially within changing industries. Morningstar analyst Neil Macker generally agrees with Ahlsten and Allen that the positives do outweigh the negatives at this point for Disney. He notes that a large part of the threat to the firm comes from the trend of cord cutting, leading to lost subscribers, which when combined with increasing costs of programming, such as the sporting content of ESPN, has threatened margins. Macker points out that Disney is responding to industry changes, with its recent investment into BAMTech, one of the leading online live-streaming companies and online platforms operators, being one example, and a recently announced deal with DirecTV OTT being another.

While the changing landscape of entertainment certainly opens up new threats and uncertainties to Disney's business model, Macker highlights that the unique content on ESPN and Disney Channel should provide the firm with a softer landing than its peers as viewing transfers to an over-the-top world during the next decade. Disney's unique content is a large driver of its wide economic moat. This, combined with the profitability of its other businesses, such as its theme parks, leads Macker to believe that the shares, trading at 73% of his $134 per share fair value estimate, are undervalued, offering an attractive entry point for investors with a longer-term investment horizon. He goes on to note that Disney is in a class of its own when it comes to monetizing its own brand and stable of characters and franchises across multiple platforms, which should bode well for the future.

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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.