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Market Update

8 Stocks Top Managers Have Been Buying

Managers from Dodge & Cox, Diamond Hill and Oakmark bought drug manufacturers, chipmakers, and Facebook, among others, last quarter.

Last week, were learned that Berkshire Hathaway (BRK.A) (BRK.B) picked up shares of Teva Pharmaceutical (TEVA),  Monsanto ,  US Bancorp (USB),  Bank of New York Mellon (BK),  Delta Air Lines (DAL), and of course,  Apple (AAPL), during the first quarter.

Warren Buffett and Charlie Munger's disclosure made us wonder: What did some of our favorite managers buy during the volatile first quarter?

The investment committee at Gold-rated  Dodge & Cox Stock (DODGX) uses bottom-up, fundamental research to find undervalued companies with strong management, competitive advantages, and solid growth potential--often taking advantage of bad news to pick up fundamentally sound businesses. The team upped its stake in  Johnson Controls International (JCI) during the quarter and snapped up Roche Holding (RHHBY), too.

In its latest shareholder letter, the team details why it bought more of multi-industrial company Johnson Controls.

"We believe its share price was excessively penalized in reaction to news of impending tariffs. While the company uses steel, aluminum, and copper in its products--such as cooling systems--the financial impact of the tariffs should be minimal because the majority of Johnson Controls' manufacturing is done regionally (not for export), with steel and aluminum sourced from those markets. In our opinion, Johnson Controls is an attractive holding due to its strong franchise, attractive earnings growth profile, and modest valuation relative to peers."

Morningstar analyst Brian Bernard agrees that the franchise is strong.

"We think Johnson Controls' intangible assets, cost advantages, and customer switching costs create sustainable competitive advantages that should support economic profits for at least the next 10 years," he says in his latest report.

As of this writing, Johnson Controls--which earns a narrow economic moat and stable moat trend ratings--trades in 4-star range, suggesting shares are undervalued by Morningstar's metrics.

The Dodge & Cox team also found value in drugmakers in the first quarter.

"Many of these companies have stable businesses with strong balance sheets and attractive growth potential resulting from new drug discoveries and expansion into emerging markets," they note. "During the quarter, the Fund's largest addition within the industry was Roche, a Swiss-domiciled company with strengths in oncology and diagnostics. Roche’s drugs face increasing competition from biosimilars, but we believe its low valuation of 13 times forward earnings does not reflect potential upside from its extensive pipeline of promising compounds as well as its industry-leading research and development budget."

Morningstar healthcare strategist Karen Andersen concurs: Roche is a key player in the field. The company's focus on biologics and innovative pipeline undperpin its wide economic moat rating.

"We think Roche's drug portfolio and industry-leading diagnostics conspire to create sustainable competitive advantages," she points out in her latest report. "As the market leader in both biotech and diagnostics, this Swiss healthcare giant is in a unique position to guide global health care into a safer, more personalized, and more cost-effective endeavor."

The stock is currently trading in 5-star range as of this writing; the shares are a bargain.

The team steering Gold-rated  Diamond Hill Large Cap (DHLRX), led by veteran manager Chuck Bath, takes a classic value approach, buying companies when their market prices are lower than the team's estimates of their intrinsic business values. Bath and team scooped up shares of  Constellation Brands (STZ),  Gilead Sciences (GILD), Texas Instruments (TXN), and  Facebook (FB) last quarter.

In its latest quarterly commentary, the team explains, "Beverage company Constellation Brands presents a unique opportunity to gain exposure to a very high-quality portfolio of irreplaceable brands such as Corona, Modelo, Pacifico, Ballast Point, Meiomi, Black Box, Casa Noble, and High West."

Morningstar assigns Constellation Brands a narrow economic moat and stable moat trend.

"Constellation Brands has experienced substantial growth over the past decade, and we expect its portfolio of premium beer, wine, and spirits brands will allow for further top-line expansion (our outlook calls for nearly 7% compound sales growth over the next five years)," notes analyst Sonia Vora in her latest company report. "With six of the top 15 imported beer brands in the U.S., Constellation maintains entrenched relationships with distributors and retailers that have relied on these brands to drive growth; volumes of imported and craft beers have averaged mid- to high-single-digit growth over the past three years, compared with flat volumes for beer overall. We surmise these relationships will prove valuable as the firm expands its distribution and seeks shelf space for new fare."

The stock trades in 2-star range as of this writing, which means it's overvalued today. 

The Diamond Hill crew also picked up Gilead Sciences, a leader in HIV and HCV treatments.

"We are encouraged by management's use of capital to diversify into high-value areas of research including next-generation oncology therapies, immunology, and liver disease," they note.

Morningstar assigns Gilead a wide economic moat with a stable moat trend.

"Gilead generates stellar profit margins with its HIV and HCV portfolio, which requires only a small salesforce and inexpensive manufacturing," explains Andersen in her latest report. "We think patent protection on newer HIV regimens and Gilead's continued dominance in the hepatitis C market will be enough to ensure strong returns for the next couple of decades."

The stock is trading in 4-star range, signifying that it's undervalued relative to Morningstar's fair value estimate.

Bath and his team also purchased chipmaker Texas Instruments.

"The company has a manufacturing advantage over its competitors and enjoys scale benefits, along with having a broad portfolio of products," they maintain. "The company also has an excellent capital allocation strategy and is a beneficiary of the U.S. Tax Cuts and Jobs Act."

Morningstar gives Texas Instruments a wide moat and stable moat trend.

"We remain encouraged with Texas Instruments' relentless focus on higher-margin analog and embedded chips, and when combined with smart operational moves on the manufacturing front, we foresee further gross margin expansion in the years ahead," writes sector director Brian Colello in his latest company report. "We have assigned Texas Instruments a wide economic moat rating, thanks to intangible assets around proprietary analog chip design and manufacturing expertise, as well as switching costs that make it difficult to swap out analog chips for competing offerings once they are designed into a given electronic device."

A 2-star stock as of this writing, Texas Instruments is pricey today based on Morningstar's metrics.

And lastly, Diamond Hill's team bought Facebook last quarter, noting the network effects from which the social networking giant benefits.

"We initiated a position in the company based on our belief that the company’s attractive network economics will remain in place over the long term, and that the current valuation reflects excessive pessimism related to uncertainties around regulation and fines that the company might face," they argue. "We believe these issues are likely to be resolved without impairing the value of the business."

"We assign Facebook a wide moat rating based on network effects around its massive user base and intangible assets consisting of a vast collection of data that users have shared on its various sites and apps," says Morningstar analyst Ali Mogharabi in his latest report. "These network effects serve to both create barriers to success for new social-network upstarts, as well as barriers to exit for existing users who might leave behind friends, contacts, pictures, memories, and more by departing to alternative platforms."

Trading in 3-star range, Facebook's shares are fairly valued today.

Comanagers Bill Nygren and Kevin Grant, who steer Gold-rated  Oakmark (OAKMX), are value investors who favor smart capital allocators running financially healthy companies with growth potential--and they’ll only buy if valuations appear attractive in absolute terms. They also picked up Facebook in the first quarter.

"Without ascribing value to the company’s non-earning assets, which include messaging platforms WhatsApp and Messenger (among others), Facebook is trading at less than 15x next year’s earnings (excluding net cash), a discount to the S&P 500 Index," they explain in their latest commentary. "This is a very attractive valuation for a company that is projected to grow its revenue well in excess of 20% for the foreseeable future. We believe that Facebook's normalized operating margin is substantially higher than what it reports, as the company continues to invest heavily in a variety of growth initiatives."

In addition, duo initiated positions in biotech  Regeneron Pharmaceuticals (REGN) and contract electronics maker Flex (FLEX).

"Recent drug approvals provide a strong path for long-term growth, and we expect that its largest drug, Eylea, will be sustainable for at least several more years," they claim. "Regeneron spends significantly more than its peers on R&D, and its selling, general and administrative (SG&A) spending is elevated, as a result of several recent drug launches. We believe Regeneron's R&D spending provides a great return on investment, and we expect launch costs to normalize over time. Although the company's consensus P/E multiple appears high, if its R&D and SG&A costs are adjusted to average levels, Regeneron would trade at a low-teens P/E. We believe this is a compelling valuation for a growing business with a strong management team that is aligned with shareholders."

Morningstar awards Regeneron a narrow economic moat and a positive moat trend.

"Regeneron has leveraged its leading monoclonal antibody research and development platform to become one of the few biotechs to successfully emerge as a profitable commercial operation and to establish a narrow moat," asserts Andersen. "Although Regeneron will undoubtedly encounter challenges in trials and on the market, we think its diverse pipeline, strong commercialization partners, and scientific leadership should comfort investors."

Shares are fairly valued according to Morningstar's metrics: The stock is trading in 3-star range.

Lastly, there's Flex, which is undergoing a business transformation that should yield higher returns on invested capital, say Nygren and Grant.

"Contract manufacturers have few meaningful competitive advantages in the low-margin manufacturing business, as their main value-add is locating production in low-cost regions," they explain. "However, since Mike McNamara took over as CEO in 2006, Flex has been investing in what it calls ‘sketch-to-scale’ capabilities, in which Flex’s engineers are actually involved in the design phase of customers’ products. This is a better business than contract manufacturing due to higher barriers to entry, stickier customer relationships and higher profit margins. Sketch-to-scale arrangements account for about 23% of revenues today and should almost double to 40% by 2020. In our view, this business shift and the accompanying boosts to both margin and ROIC are not priced into the stock, which trades for less than 14x next year’s consensus EPS after adding back intangible amortization."

Morningstar analysts don't formally cover Flex, but according to our quantitative models, shares are trading in 4-star range.

Susan Dziubinski does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.