Our Ultimate Stock-Pickers' Top 10 High-Conviction and New-Money Purchases

For roughly the past decade, our primary goal with the Ultimate Stock-Pickers concept has been to uncover investment ideas that reflect the most recent transactions of our "Ultimate Stock-Pickers" in a timely enough manner for investors to get some value from them. In cross-checking the most current valuation work and opinions of Morningstar's own 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 each quarter that investors can dig into a bit deeper to see if they warrant an investment. With 24 of our Ultimate Stock-Pickers having reported their holdings for the third quarter of 2019, we now have a good sense of the stocks that piqued their interest during the period.

Recall that when we look at the buying activity of our Ultimate Stock-Pickers, we focus on high-conviction purchases and new-money buys. We think of high-conviction purchases as instances when 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 exist in the portfolio in the prior period. New-money buys may be done either with or without conviction, depending on the size of the purchase, and a conviction buy can be a new-money purchase if the holding is new to the portfolio.

We recognize that our Ultimate Stock-Pickers' decisions to purchase shares of any of the securities highlighted in this article could have been made as early as the start of July, so the prices paid by our managers could be substantially different from today’s trading levels. Therefore, we believe it is always important for investors to assess for themselves the current attractiveness of any security mentioned here based on myriad factors, including our valuation estimates and our moat, stewardship, and uncertainty ratings.

At Morningstar’s annual Management Behind the Moat conference, North American director of equity research Jeffrey Stafford led a panel titled, “Equity Market Outlook: Which Sectors Offer the Most Opportunities Today?” Key sectors discussed included consumer goods, healthcare, and technology, which, based on our aggregate analyst price to fair value estimates, appear to offer relatively more opportunity than other sectors. It appears that some of our Ultimate Stock-Pickers would agree as all three sectors were included in our top 10 high-conviction trades. The main factor weighing on these sectors is economic and political uncertainty.

The healthcare sector in particular is affected by concerns over potential U.S. policy changes. Within healthcare, the devices and tools industry is actually trading at a premium, but our analysts still see significant potential for investors in the undervalued biotechnology and pharmaceutical arenas. According to Damien Conover, director of healthcare equity research at Morningstar, pharmaceuticals and biotechnology firms are capable of absorbing policy shocks due to the nature of the market. Large cap firms in this industry are particularly well positioned and have some of the strongest moats based on their ability to produce the next generation of drugs.

These firms should see significant growth over the next five years as they focus on areas targeting unmet medical needs. We will elaborate on this premise later in the article using the examples of Pfizer PFE and Gilead Sciences GILD.

Looking more closely at the top 10 high-conviction purchases during the third quarter of 2019, the buying activity was somewhat concentrated within the financial services, technology, and healthcare sectors. Each of them received at least two high-conviction purchases, with the rest of them going to the consumer and communication services sectors. It is interesting to note that bets are being placed in some sectors that are considered riskier on the back of market volatility. The new-money purchases list displays an even distribution in purchases within the financial services and healthcare sectors, with three stocks each in the top 10 list.

As was the case during prior periods, a majority of the high-conviction buying was focused on high-quality names with defendable economic moats. Morningstar's analysts have concluded that nine out of the 10 companies that received the most high-conviction purchases have either a wide or a narrow economic moat. The three names we find most interesting on the high-conviction purchases list are wide-moat rated Charles Schwab SCHW and Pfizer, and narrow-moat rated Gilead Sciences. Charles Schwab leads with the most convictions with the undervalued Pfizer and Gilead Sciences following close behind.

As mentioned, there was a decent amount of crossover between our two top-10 lists this period, with six names appearing on both lists. This quarter, four stocks received two high-conviction purchases from our Ultimate Stock-Pickers: both Diamond Hill Large Cap A DHLAX and FMI Large Cap FMIHX purchased wide-moat rated Charles Schwab; Diamond Hill Large Cap and T. Rowe Price Blue Chip Growth Fund TRBCX purchased Fidelity National Information Services FIS; American Century Value Fund AVLIX and Parnassus PRBLX purchased Gilead Sciences; and American Century and Jensen Quality Growth Fund JENSX invested in Pfizer. Wide-moat Charles Schwab, and no-moat Southwest Airlines LUV and Alcon ALC all received two new-money purchases each by our Ultimate Stock-Pickers. We note that both of the top-conviction buys for Charles Schwab were new-money purchases as well.

No Ultimate Stock-Pickers discussion on recent purchases would be complete without looking at what Berkshire Hathaway BRK.B has been up to, and this quarter, it seems that the insurance company still sees value in the financial services sector. Even though Berkshire sold a part of its stake in Wells Fargo WFC to keep it below the 10% bank holding company threshold, the bulk of the company’s portfolio remains weighted in financial services. Berkshire made two new-money purchases in the energy and consumer cyclical sectors with Occidental Petroleum OXY and Restoration Hardware Holdings RH, respectively. Although Restoration Hardware is currently overvalued according to Morningstar’s fair value estimates, our analysis shows that Occidental Petroleum is meaningfully undervalued, trading at almost a 20% discount to its fair value.

One high-conviction purchase that is in line with our investment research is Diamond Hill Large Cap and FMI Large Cap’s purchase of wide-moat Charles Schwab, one of the largest investment firms in the United States. This high-uncertainty stock currently trades roughly in line with Morningstar equity research director of financial services Michael Wong’s fair value estimate of $44.50. Wong argues that Charles Schwab has built sustainable economic advantages as a result of its scale and its position as an industry leader in cost efficiency. The company’s position as a leader allows it to sustain harsh competitive pressures, as seen recently with trade revenue falling to $0. Even with commission prices being slashed to nothing, Wong still expects sustainable excess returns on capital over time, supported in part by Charles Schwab’s proprietary products that enable the company to earn higher profits than its competitors, which are reliant on third-party products. Charles Schwab’s scale, reflected in over $3 trillion of client assets, makes it one of the biggest securities trading and wealth management companies in the U.S.

This scalability lowers trade processing costs and generates higher incremental operating margins. Moreover, the company’s banking subsidiary is highly profitable due to lower funding costs, credit costs, and operating expenses. Schwab’s cost advantage and large client base give the company the flexibility to develop comparable or superior products to its peers’ offerings. Schwab’s new online advisory platform will further contribute to these low costs and high client growth, helping maintain profitability over the company’s peers. Charles Schwab also maintains brand power and thus has a strong intangible asset. Finally, the company possesses some network effect due to the relationship between its growing client base and investment product manufacturers. Even so, scale-based cost advantage remains its primary moat source and allows the firm to preserve a wide-moat rating.

Even though Charles Schwab will be one of the dominant players in the investment services industry for years to come, Wong argues that its near-term to medium-term profitability outlook may not be as favorable. One of the biggest sources of the company’s revenue is net interest income, which has recently composed over half of Schwab’s net earnings. However, since late last year, the interest rate outlook in the U.S. has deteriorated, and lower interest rates leading to lower net interest income. According to Wong, this economic uncertainty, combined with the loss of trade commissions will lead to a single-digit fall in revenue.

Even if the economy avoids a recession, lower long-term interest rates will lead to a decline in reinvestment revenue from the company’s bank portfolio. As a result of this environment, it is unlikely that Schwab will be able to materially grow its net interest margin. In spite of this economic uncertainty, other segments of the company’s business, such as asset management and administration, should still see fee growth. Net interest income is indirectly tied to client assets and thus will be supported by any growth in assets, to some degree. Even though the falling rate environment is unfavorable to Charles Schwab in the short term, Wong believes the company will be able to maintain decent operating margins in a downturn and should experience strong revenue growth if the cycle reverses and interest rates start to rise again.

Pfizer is one of the industry leaders in pharmaceutical services. Its large size allows it to generate economies of scale, which are necessary in an industry where product offerings can be a hit-or-miss. Significant investment is required in drug research, development, and trials. Due to Pfizer’s size, the company can invest in drug development on a large scale, allowing high-level research to ensure success. According to Conover, the company’s size and resources will allow it to withstand the patent losses it has suffered on drugs such as Lyrica. Recent divestment decisions will allow Pfizer to improve innovation and withstand the entry of generic drugs in the market. Additionally, the company will soon release potential blockbuster drugs that could combat cancer and other ailments.

Conover argues that patents, economies of scale, and a strong distribution network give Pfizer an economic advantage over competitors. With patents comes pricing power and the ability to generate high excess returns. Furthermore, Pfizer can keep competition at bay as it develops a new line of drugs alongside improvements in existing offerings. The company has also developed an excellent distribution network that smaller competitors cannot match. Therefore, smaller competitors usually elect to develop partnerships with Pfizer so they can take advantage of Pfizer’s already existing resources—meanwhile, Pfizer gets a piece of the business.

The company performed better than consensus expectations this quarter, though it remains undervalued as our analysts believe that investors still haven’t priced in the value of recent drug innovations and drug launches, including valuable cancer drugs Ibrance and Xtandi.

Our Ultimate Stock-Pickers continue to invest in companies that Morningstar sees as undervalued, which is what we saw in the case of Gilead Sciences. Both the American Century Value I fund and the Parnassus Core Equity Investor fund made high-conviction purchases into this stock. It is currently trading at a 25% discount to Morningstar analyst Karen Andersen’s fair value estimate.

Similar to Pfizer, Gilead Sciences has a wide-moat rating assigned by Andersen due to existing and new patent protections the company has on various drugs. Gilead Sciences is a biotechnology company that conducts therapeutic research and development to combat life-threatening diseases. The company is one of the lead innovators in the development of drugs combating HIV as well as hepatitis C. It holds patents for both drug regimens, and Andersen believes that these will be sufficient in ensuring strong returns in the long term.

As a leader in HIV treatment, the company maintains a leading market share in spite of the entrance of numerous competitors, mainly due to the convenience, safety, and effectiveness of the treatment. Even though the HIV patents are set to expire in some markets around 2021, Sovaldi and Harvoni, Gilead’s hepatitis C drugs, will still have patent protection and continue to afford the company a wide moat.

Gilead Sciences’ drugs in the HIV and hepatitis C markets allow the company to generate very strong profit margins. The tenofovir molecule (TDF) has historically been the main component in the firm’s single-tablet HIV drugs, including Truvada and Viread. The firm has invested in combo pills that offer higher convenience and affordability to patients, replacing TDF with TAF as the primary molecule. Even though GlaxoSmithKline’s HIV drugs, Juluca and Dovato, pose a threat to Gilead’s foothold in the market, Andersen counters that the company’s existing patents on HIV drugs, Genvoya, Odefsey, Descoy, and Biktarvy will afford it protection till the late 2020s.

This will allow the company to continue to gain market share. Gilead is also diversifying its product pipeline outside of HIV and hepatitis C, through acquisitions like Kite, which developed the CAR-T-cell cancer treatment, Yescarta. The company is also conducting clinical trials for other immunology drugs and is in the midst of a trial for NASH. This expanded research alongside several long-term patents also make Andersen confident that the firm will perform well in the long run.

This quarter, Andersen remains bullish on the long-term potential of HIV drug Descovy as well as Filgotnib, a rheumatoid arthritis treatment expected to launch in 2020. Gilead’s HIV sales have continued to grow as the advent of TAF-based HIV drugs has helped the company remain competitive against firms like GlaxoSmithKline GSK. Even though the company’s cell therapy and hepatitis C offerings underperformed this quarter, the new HIV and rheumatoid arthritis treatments are expected to grow sales in the future, offsetting pressure elsewhere in the business. Furthermore, Gilead is finishing up stage 2b of its clinical trial for a NASH therapeutic treatment, and if successful, would add another essential drug to Gilead’s already impressive portfolio. Bullish investors remain positive that these new drugs, accompanied by better HIV guidelines, will enhance Gilead’s position as an industry leader, while bearish investors believe patent expiration and pricing pressures will weigh on the company’s growth. Due to its newer combination regimen offerings for HIV alongside other potential drugs hitting the market during the upcoming years, Andersen expects Gilead to continue to see sales growth even as patents expire and generic competitors enter the market.

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Disclosure: Nupur Balain and Eric Compton have 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.