For the past nine years, the Ultimate Stock-Pickers’ primary goal has been to uncover investment ideas our equity analysts and top investment managers find attractive, in a manner timely enough for investors to gain some value. As part of this process, we scour the quarterly (in some cases, the monthly) holdings of 26 different investment managers, 22 of which manage mutual funds that Morningstar's manager research group covers, and four of which manage the investment portfolios of large insurance companies. As they become available, we attempt to identify trends and outliers among their holdings as well as any meaningful purchases and sales that took place during the period under examination. At the time of writing this report, 25 of our 26 Ultimate Stock-Pickers have reported their holdings for the third quarter of 2018, which we think is a broad enough sample to get an understanding of which stocks these funds found interesting.
In our last article, we walked through some of the buying activity we were seeing from our Ultimate Stock-Pickers. The piece itself was an early read on the individual high-conviction and new-money buys that were made during the third quarter of 2018. In our current article, we take a look at the aggregate buying and selling, rather than the individual buys and sells we looked at in our last article. The Ultimate Stock-Pickers continue on their on their long-standing trend of net selling conviction. We think that this long-standing selling trend is likely influenced by the long-standing shift in assets from actively managed products to passively managed products and is not necessarily indicative of an aggregate bearish stance on the market. Despite the net selling, our Ultimate Stock-Pickers still found mispriced securities in the current market environment and made conviction purchases and sales.
As for sector allocation, our top managers remained meaningfully overweight in basic materials, industrials, and financial services relative to the weightings of the S&P 500 Index at the end of October. Our Ultimate Stock-Pickers also continue to hold meaningfully underweight positions in the utilities and energy sectors. Our Ultimate Stock-Pickers are no longer meaningfully underweight in healthcare, as they are within 100 basis points of the S&P 500. The remaining sectors, technology, real estate, consumer goods, and communication services, are all within 100 basis points of the index.
The recent volatility has allowed the Ultimate Stock-Pickers to demonstrate some value added from active management. As of Nov. 30, the S&P 500 has delivered a 5.1% total return year to date after a volatility shock in October and November, but it appears that the Ultimate Stock-Pickers have deftly navigated these choppy waters and the Ultimate Stock-Pickers index has delivered a 6.6.% total return year to date.
The conviction buying that took place during the third quarter of 2018 (and the beginning part of the fourth quarter of 2018) was once again focused on high-quality names with defensible economic moats, exemplified by a high number of wide- and narrow-moat companies on our list of top 10 (and top 25) high-conviction purchases, although several no-moat names such as Dollar Tree (DLTR), a discount retailer, IAC/InterActive Corp (IAC), an Internet holding company, and Mohawk Industries (MHK), a flooring company, made the top 10 cut. As for the conviction selling activity during the period, most of it seemed to revolve around trimming stakes that already were and continue to remain widely held. Five of the top 10 sales, including wide-moat Oracle (ORCL), Alphabet (GOOGL), Wells Fargo (WFC), Microsoft (MSFT), and Berkshire Hathaway (BRK.B), continue to be on the top 10 conviction holdings list.
Ultimate Stock-Pickers' Top 10 Stock Holdings (by Investment Conviction)
- source: Morningstar Analysts
The overall makeup of the top 10 stock holdings by investment conviction did not change compared with the last period or the period before last—only the order of the stock-pickers' holdings changed. JPMorgan (JPM), Johnson & Johnson (JNJ), and Apple (AAPL) all moved up the list, while Comcast (CMCSA), Bank of America (BAC), Wells Fargo, and Oracle all moved down. Narrow-moat rated Apple continued to move up the list due to persistent purchasing by Berkshire Hathaway and a new money purchase by the Alleghany Corp (Y). Berkshire moved down the list primarily due to a conviction sale by BBH Core Select N (BBTEX) and smaller sales by four other funds.
Four of the top 10 conviction stock holdings, Google, Microsoft, Comcast, and Wells Fargo are trading at material discounts to our analysts' fair value estimates. Johnson & Johnson is the only name on the conviction holdings list that is materially overvalued.
One of the most dramatic stories on the top 10 conviction holdings list is wide-moat Wells Fargo. We have harped on Wells Fargo in previous editions, as the firm has weathered a material scandal during the past year, but we think that this wide-moat name deserves attention. Morningstar analyst Eric Compton's take is that Wells Fargo is a high-quality name that continues to trade at a 19% discount to its fair value estimate. Compton thinks that Wells Fargo is a bank with structural competitive advantages from its deposit and credit costs and that the Wells banking franchise is not fundamentally impaired, as he expects that the company will make it past its legal and operating woes while maintaining expense discipline.
To Compton, Wells Fargo's funding costs are the key source of the bank's competitive advantage. He notes that Wells Fargo is still one of the top deposit-gatherers in the United States and that, as such, the bank has consistently paid less for balance sheet funding than many of its competitors, which allows it to generate more revenue per dollar of assets than most of its peers. Of the company's tangible assets, 20% are funded by deposits bearing no interest expense. Further, Wells Fargo has a vast and dense branch network, allowing it to maintain the top share in one third of its markets and an oligopolistic position as the second- or third-largest player in another third. The company has increased its deposit market share to 10% or more in 21 states.
Although Wells Fargo’s sales culture overheated in recent years, account closures did not spike during the worst of its sales problems, which demonstrates to Compton that customers are willing to stick with the bank. Compton recognizes that management's choice to increase revenue at all costs by introducing ill-conceived incentive programs for front-line employees directly led to widespread fraud and risked the relationships and reputation that Wells Fargo built over decades. Customers did not abandon Wells Fargo, however, as of third quarter 2018 primary consumer checking customers were up 1.7% year over year and retention rates for these customers reached a five-year high. Compton anticipates that the new programs that are focused on deepening active relationships will actually generate more revenue--and less wasted employee time--than the previous overly ambitious product sales goals.
Berkshire Hathaway is a notable holder of Wells Fargo's common stock, and the insurance company trimmed its holdings of Wells Fargo this quarter. Morningstar Analyst Gregg Warren recognizes the sale in his recent note, "Berkshire Hathaway Increases Bet on Banks and Other Financial Services Firms in 3Q," but Warren believes that Buffett is selling shares simply to avoid hitting this 10% ownership threshold as Wells Fargo buys back its shares. This thesis is supported by Buffett defending his long-term view of Wells Fargo in a May 7 CNBC interview with Betty Quick. In the interview, when asked if he wished he purchased other bank stocks rather than Wells Fargo, Buffett stated:
The answer is, of course I wish I wish I'd bought the other stocks--bank stocks--and then sold them now so I'd be buying Wells Fargo now. I mean, Wells Fargo actually is buying in a lot of shares. And you can argue that they are improving the per share value because they had this bad news they're buying it cheaper. But I think 10 years from now, I think if you look at the 10-year record of Wells Fargo 10 years from now you will--you're very likely to find that it outperforms most of its competitors.
Although poor underwriting is one of the primary risks to bank equity-holders, Compton contends that credit costs have seldom been a problem for Wells Fargo's bottom line. The bank successfully navigated severe real estate downturns in California (its largest market) in 2009 and the early 1990s. Most recently, net charge-offs peaked at 2.71% of loans in the fourth quarter of 2009, yet Wells Fargo was still able to report a profit. Compton does not believe the company has become a more aggressive underwriter in the ensuing years, which gives him confidence that credit losses are likely to remain under control over the course of an economic cycle.
Compton thinks that this wide-moat name is attractively priced because the market is not fully appreciating Wells Fargo's potential to reduce costs as the company weathers its scandal. Quarterly results are supporting this thesis, as the bank announced no new legal issues and expenses remained well within Compton's projections. Compton argues that even with little to no revenue growth, if the bank controls expenses and eliminates legal charges, then Wells Fargo is looking attractive at today's prices.
Ultimate Stock-Pickers' Top 10 Stock Purchases (by Investment Conviction)
- source: Morningstar Analysts
Taking a closer look at the high-conviction buying that we uncovered during the most recent period, there was little overlap with the same list last quarter. The only name appearing on both this list and last quarter's list is wide-moat Facebook. The conviction purchase by the Sequoia Fund (SEQUX), and non-conviction purchases by Diamond Hill Large Cap A (DHLAX), Oppenheimer Global A (OPPAX), and Markel Corporation MKV allowed this stock to remain on our top 10 conviction purchases list. Facebook (FB) was one of the worst performers for several of these funds, but a few of these funds actively defended their holding. Diamond Hill Large Cap A noted:
Shares of social media company Facebook, Inc. (Cl A) declined as the company provided a downside outlook for the second half of 2018 and guided for declines in operating margins as it invests heavily in improving security and privacy on its social-media and messaging platforms. Facebook is trading at a discount to our estimate of intrinsic value, and we expect the company to retain its attractive network economics and manage user privacy concerns well without impairing the value of the business over the long term.
Oppenheimer Global A also defended its position in Facebook by stating:
Facebook Inc. has been weak this year, after the Cambridge Analytica controversy in the spring and lowered guidance following its Q2 earnings report. Despite this, we find appeal in the shares and see no reason to alter our thinking about its long-term potential. The shares are now very cheap. Some clarity about the durability of its business model will likely be seen in coming earnings releases, and we expect the share price will likely respond accordingly.
This analysis agrees with Morningstar analyst Ali Mogharabi's thesis on the wide-moat company, as Mogharabi maintains that the shares of the wide-moat, high-uncertainty name have been oversold, with the company's shares now trading at a material 24% discount to his fair value estimate of $186. The investment argument is that Facebook's sustainable network effects remain intact and that advertisers will continue to pay for access to Facebook's users.
Mogharabi argues that Facebook has built sustainable economic advantages as the largest social network in the world, with more than 2 billion monthly active users. The growth in users and user engagement, along with the valuable data that they generate, makes Facebook attractive to advertisers in the short and long term. The combination of these valuable assets and expected continuing growth in online advertising bode well for Facebook, as the firm generates strong top-line growth and remains cash flow positive and profitable. Mogharabi contends that the company’s offerings, consisting mainly of Facebook, Instagram, Messenger, and WhatsApp, have generated network effects for the firm, where all of these platforms become more valuable to its users as people both join the networks and use these services. 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.
Beyond network effects, Mogharabi also believes that Facebook has developed additional intangible assets. Unlike any other online platform in the world, Facebook has accumulated data about each individual with a Facebook and/or an Instagram account. Facebook has its users’ demographic information. It knows what and who they like and dislike. It knows what topics and/or news events are of interest to them. In addition, without the need for cookies enabled on desktop or mobile browsers, and based on the Facebook Login, the firm knows its users’ browsing history on many non-Facebook sites or apps. With access to such data and to billions of photos and videos uploaded by its users, Facebook continues to enhance the social network by offering even more relevant content to its users. This virtuous cycle further increases the value of its data asset, which only Facebook and its advertising partners can monetize.
Mogharabi's thesis posits that Facebook will continue to benefit from an increased allocation of marketing and advertising dollars toward online advertising, more specifically mobile and social-network ads where Facebook is especially well positioned. Mogharabi supports this thesis through the facts that Facebook app, along with Instagram, Messenger, and WhatsApp, are among the world’s most widely used apps on both Android and iPhone smartphones. Facebook is taking steps to further monetize its various apps, such as launching interactive video ads and chatbots. Recent quarterly results demonstrate that demand for Facebook’s ad inventory remained high as shown by the 7% increase in ad prices while ad load sold was up 25%. While ad inventories sold will likely continue to increase as Facebook begins to more aggressively monetize Instagram, IGTV, Stories, and Facebook Watch, Mogharabi expects slower average revenue per user growth as ads on those other platforms are priced lower than ads on the News Feed.
To Mogharabi, Facebook is now transitioning from complete dependency on its News Feed to providing more options for its users that could improve monetization in the long run for a few reasons. First, he thinks that with a strong network effect moat source, Facebook will be able to attract users to its Stories (whether on Facebook or Instagram), Facebook Watch, and Instagram and its IGTV. As the firm maintains more users on its overall platform, Mogharabi predicts that user engagement will stay at the current levels, which have been stable for some time. Second, with stability seen in user engagement, Mogharabi remains confident Facebook can effectively monetize its new products to partially offset deceleration in News Feed ad revenue growth during the next 12-24 months. While ad prices on Stories and Instagram currently trail those of News Feed, with further user adoption, Mogharabi anticipates that demand for the ads will grow, possibly driving prices higher. And third, he thinks that there is further room for growth in ad inventories sold on Stories and Instagram. Although the firm is experiencing a slowdown in ad revenue and user growth, monetization of users on News Feed remains impressive as shown by the 20% year-over-year growth in revenue generated per user.
Ultimate Stock-Pickers' Top 10 Stock Sales (by Investment Conviction)
- source: Morningstar Analysts
Breaking a long-standing trend, Microsoft was no longer the stock with the most conviction sales, as Oracle took its number one spot. Eight of the 12 managers that held it coming into the fourth quarter sold it, but one of the most legendary Stock-Pickers, Warren Buffet, added a conviction new-money purchase into the wide-moat company this quarter. As usually tends to be the case, many of the most widely sold securities tended to remain top holdings despite seeing a fair amount of selling during the period, with many of our top managers who were selling already having large exposures to each stock.
From a valuation perspective, the conviction sale that was most in line with Morningstar's analysis was FPA Crescent Fund's (FPACX) and Diamond Hill Large Cap Fund's conviction sale of Thermo Fisher Scientific (TMO), a producer of analytical technologies, specialty diagnostic products, and lab products and services. Morningstar Analyst Alex Morozov's take on the firm is that although the company has had a better-than-expected operational environment, the results have not been good enough to justify the expensive share price, as shares are trading at a lofty 23% above his fair value estimate.
Quarterly results show that the lab and reagent producer's end markets still show favorable conditions across the board. The pharma customer base delivered high-teens growth, with strength in products like chromatography and mass spectrometry equipment. The academic and government grew in the midsingle digits, benefiting from the improved funding in the U.S. The industrial and applied segment delivered high-single-digit growth, led by strong performance across the analytical instruments business. All geographies delivered good growth: Europe and North America grew in the high single digits while Asia-Pacific delivered growth in the low-teens, with China leading at more than 20% growth in the quarter. In China, precision medicine and molecular microscopy centers drove demand in the quarter for life-sciences technologies. Thermo continues to enjoy strong tailwind from its end markets, but we are cognizant of increasingly challenging comparisons as the demand upswing, particularly from biopharma customers, had been uncharacteristically long in duration and we are starting to see some evidence of its slowing.
Morozov thinks that Thermo Fisher Scientific tends to purchase growth with the ultimate goal of becoming a go-to provider of life science instruments and consumables. This strategy has produced rapid growth but introduces risks. While Thermo Fischer Scientific's acquisition strategy has allowed the firm to significantly broaden its product offering, Morozov remains skeptical and notes that investors have yet to see evidence that the more than $30 billion the company spent on acquisitions since 2010 has yielded any benefits to its returns on invested capital. With such an aggressive and clearly stated acquisitive capital-deployment strategy, there remains a risk that the firm could overpay for yet another sizable deal, fueled by cheap financing. That said, the ever-expanding presence in virtually all areas of life science research, in part achieved by acquisitions, affords Thermo Fisher an opportunity to capitalize on the strong secular growth we expect in this sector over the next decade.
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Disclosure: Burkett Huey has no ownership interests in any of the securities mentioned here. Eric Compton has no ownership interests in any of the securities mentioned here. 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 shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.