For the past decade, our primary objective with Ultimate Stock-Pickers has been to uncover investment ideas that both our equity analysts and top investment managers find attractive, in a manner timely enough for investors to gain value. In cross-checking the most current valuation work of Morningstar's own arsenal of stock analysts against the actions of some of the most recognizable equity managers in the business, we look to uncover good ideas each quarter that will be of interest to investors. With 24 of our Ultimate Stock-Pickers having reported their holdings for the second quarter of 2022, we now have a good sense of the stocks that piqued their interest during the period.
While looking at our Ultimate Stock-Pickers' buying activity, we concentrate on high-conviction purchases and new-money buys. We think of high-conviction purchases as occasions when managers have made meaningful additions to their portfolios, as defined by the size of the purchase in relation to the portfolio's size. 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 February, 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 a multitude of factors, including our valuation estimates along with our moat, stewardship, and uncertainty ratings.
Since 2020, headwinds created by the pandemic hampered the markets and sidelined a multitude of industries as the governments across the globe instituted lockdowns and imposed restrictions. And just as the market was looking to slowly recover as pandemic restrictions receded, the Russian invasion of Ukraine threw another wrench into the global economy, elevating energy prices and creating inflationary pressures that have affected food and energy markets. The second quarter of 2022 has been defined by a tumultuous market, including selloffs in tech, inflationary pressure, and lingering fears of a potential recession. The Fed enacted its second consecutive 0.75 of a percentage point interest rate increase in July, from near-zero levels that were in place since the early days of the pandemic to a benchmark rate of 2.25% to 2.5%. Despite market headwinds, Ultimate Stock-Pickers still looks to find value in individual stocks during a period of volatility and uncertainty. These stocks are in a wide range of sectors, such as consumer cyclical, communication services, and technology.
In the top 10 high-conviction purchases list, the buying activity was distributed among a multitude of sectors, including consumer cyclical, communication services, technology, healthcare, and financial services. Nine of the 10 companies on the high-conviction purchases list and seven of the 10 companies on our new-money purchases list received at least a narrow economic moat rating from Morningstar analysts, keeping in line with trends we have witnessed over the past years. The three names we find most interesting on the high-conviction purchases and new-money purchases lists are wide-moat-rated Texas Instruments TXN, narrow-moat-rated Marsh & McLennan MMC, and no-moat-rated Occidental Petroleum OXY.
There was a slight amount of crossover between our two top 10 lists this period, with a few names appearing on both lists. This quarter, Amazon.com AMZN received eight high-conviction purchases from our manager list, with Alphabet GOOGL receiving three. Both companies have wide economic moats and are trading at discounts to their fair value estimates, which indicates that money managers place an emphasis toward blue-chip stocks such as these in a period of uncertainty. The remainder of both lists were populated by names from a multitude of industries, including basic materials and industrials.
One name that stood out for us was wide-moat Texas Instruments, which attracted two high-conviction purchases during the second quarter of 2022. The name currently trades at about $176, near Morningstar analyst Brian Colello’s fair value estimate of $166.
Texas Instruments is the world's largest maker of analog chips, which are used to process real-world signals such as sound and power. The company generates over 95% of its revenue from semiconductors and the remainder from its well-known calculators. Texas Instruments also has a leading market share position in processors and microcontrollers used in a wide variety of electronics applications.
Colello notes that Texas Instruments has spent much of the past decade focusing on its analog chip business, especially by producing its chips on more advanced 300-millimeter silicon wafers. This focus has led to healthy gross margin expansion, and while the "easy" expansion is over, we still foresee additional expansion in the years ahead. Texas Instruments' embedded chip business is a bit more exposed to the automotive and communications infrastructure end markets but should also see healthy growth over the next few years.
Colello assigns Texas Instruments a wide economic moat because it benefits from intangible assets around proprietary analog and embedded chip designs, as well as customer switching costs. Since analog chips are neither particularly expensive, nor do they require cutting-edge manufacturing techniques, high-quality analog chipmakers tend to retain design wins for the life of the product yet maintain healthy pricing and strong profitability on such sales over time. Texas Instruments' size allows the firm to compete across a broader spectrum of industries, without its fortunes tied to a single customer or end market. The size and scale of Texas Instruments' salesforce and field applications engineers allow it to reach a broader customer base than peers, which has translated into a share lead for Texas Instruments in the analog chip market. Texas Instruments generates enough revenue to adequately fund this large sales team that only a handful of chipmakers can match, yet its salesforce helps the firm reach more customers and generate additional chip sales that can fund further sales team expansion, creating a virtuous cycle for the company.
Two of our money managers made high-conviction new-money purchases of Marsh & McLennan, a narrow-moat company currently trading at a premium to Morningstar analyst Brett Horn’s fair value estimate of $130.
Marsh & McLennan is a professional-services firm that provides advice and solutions in the areas of risk, strategy, and human capital. The company operates through two main segments: risk and insurance services and consulting. Horn notes that Marsh & McLennan is something of a tollbooth business. Its leading position in the brokerage industry would be difficult to displace, and its sticky customer relationships allow it to benefit from a relatively stable level of insurance transactions, although it does have exposure to the insurance pricing cycle. Horn views Marsh & McLennan’s long-term future as largely resembling its past, with moderate growth and attractive profitability, although the coronavirus has created some near-term ups and downs.
In 2018, Marsh & McLennan saw a modest headwind turn into a tailwind. Because the firm generally takes a percentage of premiums as commission, it is exposed to the direction of the insurance pricing cycle. In 2019, pricing momentum picked up, and this positive trend accelerated in 2020 as the coronavirus appeared to have acted as an additional spur to pricing. Pricing increases haven't been this strong in almost 20 years. This has boosted growth recently and helped offset the negative impacts the coronavirus had on the more discretionary areas of the business. With discretionary services bouncing back as the pandemic recedes, Marsh & McLennan saw unusually strong growth in 2021 and carries some tailwinds into the year ahead. However, over the long run, the firm remains tied to a mature insurance industry, and some of its consulting operations are centered on low-growth areas.
Horn argues that Marsh & McLennan's strong customer relationships and global footprint place a narrow moat around its business. The insurance brokerage segment represents about 60% of revenue. Insurance brokers such as Marsh & McLennan are uniquely positioned to serve a necessary risk-management function. Brokers can search the insurance market more efficiently than individual buyers, helping clients compare insurers' skills, financial strengths, and reputation. During the matching process, brokers also help insurers solve problems related to asymmetric information, such as adverse selection and moral hazard. The complexity of these services creates switching costs, as the value of changing providers is not clear to customers and there is perceived value for the client in continuing to work with a broker that has experience in managing its risk.
Horn adds how the company’s global presence limits potential competition at the top end of the corporate market, as it allows Marsh & McLennan to effectively serve multinational customers that smaller brokers cannot. Among the larger brokers, Marsh & McLennan's customer mix skews most heavily to large, multinational customers. Additionally, the scale and breadth of its operations allows the company to build out a wider set of data and experience, which improves the value of its services even at the middle-market level.
Our Ultimate Stock-Pickers also made two new-money purchases in no-moat Occidental Petroleum, an independent exploration and production company with operations in the United States, Latin America, and the Middle East. At the end of 2021, the company reported net proved reserves of 3.5 billion barrels of oil equivalent. Net production averaged 1,174 thousand barrels of oil equivalent per day in 2021 at a ratio of 75% oil and natural gas liquids and 25% natural gas.
Occidental Petroleum currently trades at a premium to Morningstar analyst Dave Meats’ fair value estimate of $44. Meats notes that Occidental Petroleum has cut the chaff from its upstream portfolio in the past few years, shedding noncore assets to focus on core holdings in the U.S. and the Middle East. The portfolio was further transformed by the 2019 acquisition of Anadarko Petroleum. This transaction bolstered the firm's unconventional footprint in the Permian Basin and augmented its U.S. midstream portfolio with a stake in WES Midstream (which it subsequently reduced to 51%). It also gave the firm entry into the DJ Basin, where Anadarko was a leading operator, as well as adding assets in the Gulf of Mexico and Algeria.
Meats views the Anadarko deal as a huge undertaking for Occidental, which itself had an enterprise value of about $50 billion at the time the deal was announced. The cash portion was partly financed with a $10 billion equity investment from Berkshire Hathaway along with the proceeds from the sale of Anadarko’s Mozambique assets (which Total purchased for $3.9 billion in late 2019). Despite these arrangements, the deal left Occidental with significantly higher financial leverage, preventing it from adopting shareholder-friendly capital return initiatives like peers (despite being a historical leader in this, with a peer-leading free cash yield). But the firm has turned the corner. Leverage ratios have dramatically improved, and the firm has resumed dividends. Management intends to continue supplementing this with substantial share repurchases.
According to Meats, Occidental has done a better job of generating returns for shareholders than most upstream oil and gas producers, but this record was derailed by the downturn in global crude prices that began in late 2014. Like peers, Occidental eventually adapted to lower prices by cutting costs and is now able to generate substantial free cash flows and earn economic profits on the incremental dollars it invests, even in a $50-$60 oil price environment (West Texas Intermediate). However, it further delayed the potential for excess returns at the corporate level by entering a very large and expensive corporate acquisition in 2019. The target, Anadarko Petroleum, did not itself warrant a moat, and the company paid a substantial takeover premium. The cost of the acquisition will directly flow to invested capital while the benefit will accrue over time, as the company progresses the development of Anadarko's assets. Meats believes the firm has turned the corner and is on the cusp of consistently earning its cost of capital again, but the margin of safety is too thin to award a moat rating.
Disclosure: Eden Alemayehu, Verushka Shetty, 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.