Our Ultimate Stock-Pickers' Top 10 High-Conviction Purchases
Several funds see value in the technology, healthcare, and energy sectors.
Editor's note: An earlier version of this article contained incorrect information regarding the new-money purchases of Berkshire Hathaway. An earlier version also contained incorrect information regarding the P/FVE ratio. It was updated to reflect the latest price data.
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 25 of our Ultimate Stock-Pickers having reported their holdings for the fourth 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 October, 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.
Over the last few months, the globe has seen its fair share of adversity, including macroeconomic and geopolitical uncertainties. Despite a hazy view regarding interest rate policies, geopolitical conflict, the coronavirus, and the looming U.S. presidential election, U.S. markets have still generally been climbing higher. Our Ultimate Stock-Pickers have tried to find a way to make the increasing uncertainty work to their advantage, investing in financial services, healthcare, and energy stocks. They found value in sectors that were impacted by external factors, investing in financial services when interest rates fell in the last quarter of 2019, the energy sector when geopolitical tensions between Iran and the U.S. rose, and several key U.S. defense companies that have performed well during periods of conflict. With some funds reporting data monthly, we can see the increase in healthcare investment as coronavirus fears rose and healthcare stocks looked more valuable.
Looking more closely at the top 10 high-conviction purchases, the buying activity was distributed among different sectors, with marginally higher purchases in the healthcare, communication service, industrial, and consumer sectors. Each of these sectors received at least two high-conviction purchases, with one healthcare stock (UnitedHealth Group (UNH)) seeing three high-conviction purchases this quarter. It is interesting to note that bets are being placed in some sectors that are considered riskier in the current market environment. As mentioned, the new-money purchases list is somewhat concentrated within the communication services, consumer, and healthcare sectors, with two 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 and new money list are narrow moat rated Anthem (ANTM), Apple (AAPL), and Schlumberger (SLB). Anthem and Apple both have two high-conviction purchases, with Schlumberger following close behind with one new-money purchase.
As already mentioned, there was a small amount of crossover between our two top-10 lists this period, with three names appearing on both lists. This quarter, one stock received three high-conviction purchases from our Ultimate Stock-Pickers: American Funds American Mutual (AMRMX), Vanguard Dividend Growth Investor (VDIGX), and Markel Corp (MKL) made conviction purchases in narrow moat rated UnitedHealth Group Inc. Five stocks received two new-money purchases, as well: FMI Large Cap Investor (FMIHX) and Parnassus Core Equity Investor (PRBLX) purchased Comcast Corp (CMCSA), while Columbia Dividend Income LBSAX and Allegheny Corp (Y) both purchased Northrop Grumman (NOC). Artisan Global Value Investor (ARTGX) and American Funds American Mutual bought Anthem Inc. T. Rowe Price Blue Chip Growth (TRBCX) and Berkshire Hathaway font-family: Verdana, serif;">(BRK.A) purchased United Parcel Service (UPS), and Dodge & Cox Stock (DODGX) and T. Rowe Price Blue Chip Growth purchased State Street Corporation (STT). Wide-moat Comcast and Northrop Grumman, and narrow moat Anthem all appeared on both the high conviction and new money purchase lists. We note that, for these three firms, the high-conviction buys were new-money purchases as well.
No Ultimate Stock-Pickers discussion on recent purchases would be complete without looking at what Berkshire Hathaway 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 several new-money purchases in the consumer, healthcare, and industrial sectors, investing in Kroger (KR), Biogen (BIIB), and United Parcel Services, respectively. According to Morningstar fair value estimates, Biogen is meaningfully undervalued, trading at approximately a 20% discount to its fair value.
One high-conviction purchase that is in line with our investment research is Artisan Global Value Investor's and Markel Corp's purchase of narrow moat Anthem, one of the largest private health insurance organizations in the United States. This medium-uncertainty stock currently trades at roughly a 14% discount to Morningstar analyst Julie Utterback's fair value estimate of $348. Utterback argues that Anthem has built high-quality scale-based advantages in the health insurance industry that support the company's narrow moat rating. Anthem mainly focuses on prioritizing those states in which it has a strong presence due to its licensing of the Blue Cross Blue Shield brand name. In these 14 states, the company is consistently one of the top two players in terms of medical membership, providing insurance services to 1 in 3 people. This allows the company to not only build scale-based cost advantages, but it also helps generate a moat via the network effect.
Anthem is able to build cost advantages due to its aforementioned local market scale. This gives the company more bargaining power with health-service suppliers and service providers when compared with small-scale insurers. Due to this benefit, Anthem can offer lower prices than its competitors and capture greater market share. According to Utterback, this is accompanied by a network effect, especially in areas where the company has higher market share. By offering lower-priced products, accompanied in some cases by increased benefits, Anthem is able to attract more employers, which then brings in more providers, such as hospitals and physician groups. This increases its market share, which gives the company greater negotiating power, generating a constant cycle of higher cost advantages and network growth. Utterback also emphasizes that Anthem's better payment arrangements and market share also creates barriers to entry in communities where the firm has a strong presence, leaving it well poised for the future.
While there has been some investor concern over potential reform in the American Healthcare system, Utterback believes the probability of major reform with regard to a Medicare for All policy is 5% or lower. For such a scenario to play out, there would have to be major political shifts that accompany the presidential election, namely a Democratic majority in the Senate large enough to prevent filibusters, accompanied by the election of a Democratic president who is a proponent of such a plan. This is because most Republicans are strongly opposed to this plan, and it would require a significant power shift in order for it to become a reality. A more likely scenario than the abolishment of private healthcare is one in which companies like Anthem have to work with government entities such as Medicaid managed care and Medicare Advantage to provide healthcare benefits. This system is supported by approximately three quarters of the population, generating decent Republican support as well. Even if this system takes hold, Utterback maintains her view that there is a place for private healthcare insurers like Anthem to perform well and continue to generate returns in the long term.
Apple Inc. is one of the most recognizable household names and a giant in the technology industry. This narrow moat stock currently trades at a premium to Morningstar analyst Abhinav Davuluri's fair value estimate of $240. Even so, our Ultimate Stock-Pickers saw value in this formidable name, with T. Rowe Price Blue Chip Growth and Markel Corp both making high-conviction purchases in it.
Apple earns its narrow moat rating via customer switching costs supported by its recognizable brand intangible. Apple offers a wide variety of interconnected products that enhance the user experience, such as iPads, iPhones, Apple Watch, etc., that are backed by several interconnected services such as FaceTime and Apple Pay. Most Apple product users are accustomed to the company's iOS software, the thousands of iOS app offerings, and an interface that is integrated into most product offerings by the company. It would take a series of missteps to have these customers switch to a perceived "inferior" interface in the form of Android OS, giving Apple a stable, if not growing, pool of customers. Most Apple devices are interconnected, with products such as the Apple Watch and AirPods dependent on iPhone use in order for users to enjoy full functionality. A December 2018 poll by Kantar showed that 90% of American iPhone users do not foresee switching loyalties to a different company. According to Davuluri, these factors help establish a case for switching cost advantages for Apple.
This is supported by the company's brand intangible, which Apple's unique user experience and software and hardware expertise have helped cement for the firm. Davuluri cautions that this brand asset is generated as a result of its hardware and software offerings and is not the cause of it. He believes Apple would not be able to charge premium prices on inferior products even if they were accompanied by the Apple logo.
The coronavirus outbreak in China has been a cause for conern for some investors. Even though Apple does have suppliers in Wuhan, the source of the outbreak, the company has other sources and is working on mitigating this disruption. In other areas of China, the company faces more elevated uncertainty as factory openings have been pushed back and Apple has closed a retail store. Retail store closings and slower foot traffic could weigh on sales in the short term.
Our Ultimate Stock-Pickers continue to invest in companies that Morningstar sees as undervalued, which is what we saw in the case of Schlumberger Ltd.—Allegheny Corp made a high-conviction, new-money purchase into this stock. It is currently trading at roughly a 45% discount to Morningstar analyst Preston Caldwell's $60 fair value estimate.
As the world's largest oil and gas products and services supplier, Schlumberger enjoys a narrow moat rating based on low product costs and intangible assets in the form of intellectual property, branding, and data. Schlumberger has delivered strong returns as a result of its differentiated product and service offerings in the oilfield services industry, with new product development ensuring high margins and constituting a large proportion of revenue. The creation of these new products is fairly low cost and generates a high return on research and development. The firm enjoys economies of scope as a result of these R&D investments and focuses more on R&D than all of its competitors put together. Schlumberger has also driven product development due to its knowledge in Reservoir Characterization as well as in other segments such as Drilling and Production. The firm further enjoys economies of scale from its international service lines. All this helps the company maintain a cost advantage that supports Caldwell's narrow moat rating of the firm.
Schlumberger's intangible assets include thousands of existing patents with hundreds of new ones filed every year that will allow the company to provide unique products and services for a long time and maintain its narrow moat. What makes the firm's intangible assets somewhat distinct is the use of human capital. Schlumberger utilizes its human capital in a superior manner, creating an exceptional platform for engineering and scientific talent, which is especially true in its international markets. The firm effectively uses local talent on an international scale, which is cheaper, and often more well suited to learn and apply technology to local settings.
Schlumberger has long been a standout performer among its peers and has generated strong economic profits for decades. Company management places a strong emphasis on innovation and research, which has helped position the firm better than some of its competitors. Looking forward, the firm is focused on lowering cost per barrel of oil & gas development by providing more integrated, performance-focused services. Caldwell believes positive early signs of technological development and a gradual shift toward a more integrated business model will continue to help move Schlumberger toward greater oilfield efficiency and reservoir productivity.
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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.
Nupur Balain has a position in the following securities mentioned above: AAPL. Find out about Morningstar’s editorial policies.