Top 10 Holdings of Our Ultimate Stock-Pickers' Index

Every fund investor would like to see the manager of the actively managed funds that they own beat the market every year, but they've been left wanting for well over a decade. The lack of consistent outperformance on the part of large-cap active managers (the main contributors to the Ultimate Stock-Pickers concept) has been well documented by the S&P Indices Versus Active Funds (SPIVA) U.S. Scorecard. For the five-year period ending in December 2018, the index group noted that 82.14% of large-cap managers have lagged the S&P 500. The results over this five-year period have been similar across all investing styles. A paltry 7.65% of large-cap core managers have outperformed their index over the past five years versus 20.92% of large-cap value managers and 12.5% of large-cap growth managers outperforming their respective benchmarks over the same time period.

While five-year results have been poor for active management, there are some recent bright spots, particularly in large-cap value. Large-cap growth funds underperformed their index during the second half of 2018, which included a massive sell-off in December and November. Morningstar's own large-cap core (5.48%), large-cap growth (6.07%), and large-cap value (6.12%) one-year index returns (as of June 15, 2019) reveal that value stocks are starting to pick up to carry momentum into 2019 as active management outperformed the S&P 500 Value index.

The fund managers represented in our Ultimate Stock-Pickers concept have had their own issues with relative long-term performance. Only three of our 22 top fund managers were beating the S&P 500 on a 10-year basis at the end of last week. However, 2019 may have better things in store, as eight of our 22 fund managers were beating the S&P year to date. The  Morgan Stanley Inst Growth (MSEGX) fund and the  T. Rowe Price Blue Chip Growth Fund (TRBCX) were both beating the S&P for both time periods we measured.

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 try to focus on managers that our fund analysts cover and on companies that our stock analysts cover, which reduces 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. That said, by limiting themselves to the largest and most widely followed companies, our top managers may miss out on some big ideas on small companies that have the potential to generate greater outperformance in the long run.

The overall market is still trying to digest the volatility of late December 2018. After a massive rally in early 2019, returns have essentially stalled out in May and June. Markets dipped far below our analysts' fair value estimates in December and then rebounded back toward their fair values in January through April. May was a tough month for stock investors, and valuations again dipped below our analysts' fair value estimates. Right now, our aggregate market price to fair value ratio is .97, which means that we see the market as slightly undervalued, but still well within the realm of reasonableness.

Taking a look at the cyclically adjusted price/earnings, or CAPE, ratio, which divides the current market price by the average of 10 years of earnings (adjusted for inflation), it currently stands at around 29.66, above where it was when we wrote the last article (28.78). This is compared with a historical mean of 16.63 and median of 15.72, with Shiller relying on market data from both estimated (1881-1956) and actual (1957 onward) earnings reports from companies represented in the S&P 500 Index. Today's levels are relatively in line with levels seen before events such as Black Tuesday and higher than levels seen before the Great Financial Crisis. The CAPE ratio is generally used to assess potential returns from equities over longer time frames, with higher-than-average CAPE values implying lower-than-average long-term annual returns going forward, which is what we're gleaning from the current ratio. While not intended to be an indicator of impending market crashes, it has provided warning signs for investors in the past.

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

Aside from tracking the holdings, purchases, and sales as well as the ongoing investment performance of our Ultimate Stock-Pickers, we also follow the makeup and results of the Morningstar Ultimate Stock-Pickers TR Index. For those who may not recall, the Ultimate Stock-Pickers index was set up to track the highest-conviction holdings of 26 different managers, a list that includes our 22 top fund managers as well as the investment managers of four insurance companies— Berkshire Hathaway (BRK.B),  Markel (MKL),  Alleghany (Y), and  Fairfax Financial (FRFHF). It is constructed by taking all 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 ranking them by their Morningstar Conviction Score. The Morningstar Conviction Score is made up of three factors: 1) the overall conviction (number and weighting of holdings), 2) the relative current optimism (holdings being purchased), and 3) the relative current pessimism (holdings being sold).

The index itself is composed of three subportfolios--each one containing 20 securities--that 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 subportfolio when they are reconstituted. This means that the overall index can hold anywhere between 20 and 60 stocks at any given time (because some stocks may remain as the highest-conviction score holders in any given period, meaning there can be overlaps in the holdings, reducing the total number of different stocks held).

In reality, the index is usually composed of 35 to 45 securities, holding 41 stocks in all at the end of May. These stocks should represent some of the best investment opportunities that have been identified by our Ultimate Stock-Pickers in any given period. It can also have more concentrated positions than one might find in a typical mutual fund, with the top 10 (25) holdings in the index accounting for 44.8% (82.5%) of the total invested portfolio at the end of last month. The size and concentration of the portfolio does change, though, as this is an actively managed index that tries to tap into the movements and conviction levels of our top managers over time.

Top 10 Stock Holdings of the Morningstar Ultimate Stock-Pickers TR Index

Looking at the top 10 stock holdings of the Morningstar Ultimate Stock-Pickers index at the end of May, there are currently only a couple of names trading at a 15% or more discount to our analysts' fair value estimates. No-moat-rated  American International Group (AIG) is one of these three names and it trades at a 30% discount to Morningstar analyst Brett Horn's $76 per share fair value estimate at the end of last week. The other two undervalued names were wide-moat rated  Gilead Sciences (GILD) and narrow-moat rated  FedEx (FDX).

AIG has been a deep-value play by many of our Ultimate Stock-Pickers, seven of our 22 Stock-Pickers hold it in their portfolios. Though none of the Ultimate Stock-Pickers gave quarterly commentary on the name, the  FPA Crescent (FPACX) Funds' letter to shareholders noted how it thinks about the name:

Others, like AIG, Ally Financial, CIT, and RBS, operate less differentiated businesses or are undergoing corporate turnarounds, and in these cases, we rely more heavily on tangible book value when thinking about value.

Morningstar analyst Brett Horn sees the name as finally emerging from their historically poor performance. In his August 2018 Select report, "Outlining AIG's Path to Mediocrity," he made his thesis on the battered name clear--the company does not need to create a dramatic improvement to stop destroying shareholder value, it only needs to move from a negative outlier to merely subpar. In the report, Horn estimated that if AIG could improve its commercial P&C combined ratio, a measure of an insurer's operational profitability, to a level that is only modestly worse than its peer group, then the name would be substantially undervalued.  Horn then explains that it is reasonable to assume that AIG can improve its operational profitability because its CEO, Brian Dupperrault, was arguably the primary architect in developing ACE (now  Chubb (CB)) from a small operator into one of AIG's best competitors. He further notes that ACE, under Dupperrault's leadership, was quite successful in the very thing that hamstrings AIG, operational profitability in commercial property and casualty insurance. Overall, although Horn recognizes it will take some time to solve AIG's problems,  given the company's size, the magnitude of its issues, and the inherent delay between implementing better underwriting practices and their appearance in reported results, he thinks that the market is not giving the insurer enough credit for their improved prospects.

Recent results provided some evidence that the long-hoped-for improvement in the company’s underwriting results may have arrived. Critically, the company's combined ratio improved enough that AIG generated a quarterly operating profit, which is a big step forward. AIG also benefited from fairly strong investment results due to a bull equity market and credit spreads narrowing. That said, Horn does not think that investment results will be sustainable going forward. In Horn's view, the company still has a long way to go to before it can reliably generate adequate returns, but the quarter represented good progress toward that goal and evidence that Dupperreault and his team are capable of building a better AIG.

Top 10 Contributors to Morningstar Ultimate Stock-Pickers TR Index Performance

Looking at the year-over-year performance of the Morningstar Ultimate Stock-Pickers index from June 1, 2018, to May 31, 2019, many of the highest-performing stand-outs came from the technology sector, which supplied three names to the Top 10 Contributors list, and the healthcare and consumer cyclical sectors each contributed 2 names to the list. None of the names are trading at a material discount to our analyst's fair value estimates, which makes sense because these are the stocks that have been bid up over the past few months. One name that our research indicates is substantially overvalued is wide-moat rated Intuit.

Although Morningstar analyst Andrew Lange believes that Intuit is a great business and gives the company a wide moat rating, he does not think the stock is a great value. Lange thinks that Intuit has built high switching costs and positive network effects around its business. Many readers are likely familiar with Intuit's tax services, TurboTax. Lange recognizes that both of Intuit's flagship products, QuickBooks and TurboTax, enjoy strong customer loyalty, top market share and switching costs that make transferring to a new provider challenging. Lange believes that customers' familiarity with Intuit's products, aversion to learning a new package, and the risks of transferring information to competing applications discourage end users from switching to another provider. Lange thinks the market fully understands the quality underlying this wide-moat business, and in fact may be giving the firm too much credit, as he views shares as trading at a considerable premium to their fair value, so he recommends that investors seek a wider margin of safety before considering it for investment.

Top 10 Detractors From Morningstar Ultimate Stock-Pickers TR Index Performance

While lists of top-performing stocks would expectedly be largely composed of stocks that have run up, our top detractors list can sometimes be a good area to pick through the wreckage. All of these stocks have been given moats by Morningstar equity analysts, which indicates that despite a recent poor performance, we are confident in the underlying businesses capacity to generate excess returns over the long run.  As we have already highlighted several of the most undervalued names in recent issues of Ultimate Stock-Pickers, we will highlight narrow-moat rated  Walgreens Boots Alliance (WBA), which, while not the cheapest, is still trading at a material discount to our analyst's fair value estimate.

Morningstar analyst Soo Romanoff sees Walgreens as a leading pharmacy retailer that distributes about a quarter of United States prescriptions. Romanoff notes that historically, the company’s strategy was based on footprint expansion, but since the company has now established a scalable infrastructure, the focus has evolved, and the concentration has shifted to improving store utilization and strategically aligning with healthcare partners to address the macro trend of localized community healthcare. She anticipates that the retailer will be able to leverage its existing scale and foster beneficial partnerships to better utilize its stores, and thus abate commodity pricing pressure and offset negative reimbursement trends.

Romanoff recognizes that Walgreens' scale has given it some structural cost advantages, specifically the ability to negotiate with suppliers and the ability to better manage fixed costs. Romanoff supports this with the fact that Walgreens is given favorable pricing from several suppliers and is able to shift overhead costs onto distributors, both of which save money for Walgreens. She also uses the fact that the company generates almost double the revenue per store than the average pharmacy to support her thesis that the company has the best locations. She anticipates that the above-average sales will likely allow the company to better manage the fixed costs inherent in retail better than subscale peers.

Although Romanoff thinks that the company has sustainable cost advantages, she anticipates that they will get weaker over time which is reflected in her negative moat trend rating. She anticipates that Walgreens' cost advantage will deteriorate somewhat due to increasing reimbursement pressures from the public and private third-party payors and increased online competition in the pharmacy business.

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Disclosure: Burkett Huey has an ownership interest in Berkshire Hathaway. Eric Compton has no ownership interests in any of the securities mentioned. 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.