Top 10 Holdings of Our Ultimate Stock-Pickers’ Index

Each year, fund investors would like to see the manager of the actively managed funds they own beat the market, but they’ve been left wanting for well over a decade. The lack of consistent outperformance by large-cap active managers (the main contributors to the Ultimate Stock-Pickers concept) has been well documented by Morningstar’s Active/Passive Barometer. It’s a cutthroat world out there for active managers. For the 20 years ending December 2022, just 5% of active funds in the large growth category managed to survive and outperform their average passive peers.

Actively managed foreign stock funds especially struggled during the year through the end of 2022, falling to a 34% one-year success rate from 37% in 2021. When analyzing U.S. stock funds exclusively, funds’ one-year success rate improved to 49% at the end of 2022 from 43% in 2021, as active small-cap funds delivered a 57% success rate, besting mid- and large-caps’ lingering 46% and 47% rates, respectively. Long-term success rates were lowest among U.S. large-cap funds and highest with real estate and bond funds, similar to our report through June 2022.

In 2022, economic, geopolitical, and logistical headwinds tested the narrative that active funds are generally better able to navigate market volatility and capitalize on uncertainty in down markets than their passive peers. But the data showed that there’s little merit to this notion. Across all 20 categories we examined, just 43% of the nearly 3,500 active funds included in our analysis survived and outperformed their average passive counterparts, down from the 47% rate observed in 2021.

The cheapest funds succeeded over twice as often as the priciest ones (a 36% success rate versus a 16% success rate) over the 10-year period ended Dec. 31, 2022. This not only reflects cost advantages but also differences in survival, as 67% of the cheapest funds survived, whereas 59% of the most expensive endured.

Over the long haul, actively managed U.S. large-cap equity funds have generally succeeded less often than active U.S. mid- and small-cap funds. Over the decade through Dec. 31, 2022, this narrative continued, as just 10% of active large-cap funds lived and outperformed their average passive peers versus 26% and 36% for active mid-cap and small-cap funds, respectively.

It’s worth noting that we devised the Ultimate Stock-Pickers concept 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 managers’ top holdings, purchases, and sales against our own stock analysts’ recommendations regularly, allowing us to uncover securities that investors might want to investigate further. There will always be limitations to our process. 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 emphasis 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.

Overall, 2022 proved to be a volatile year for stocks, as investor optimism following the COVID-19 pandemic quickly dissipated. Just as the market looked to slowly recover as pandemic restrictions were lifted and a return to normality began, the Russian invasion of Ukraine in February 2022 threw another wrench into the global economy and an already backlogged supply chain. In turn, this contributed to inflationary pressures that deeply impacted food and energy markets. In tandem, rolling lockdowns in China elevated input costs, which pressured firms’ margins and squeezed consumers’ pocketbooks. In response, the Fed raised the federal-funds rate to a range between 4.25% and 4.50% by the end of the year, from near-zero levels that had been in place since the early days of the pandemic. As the year progressed, inflationary pressures slightly eased, however, the appreciation of the U.S. dollar emerged as a new headwind, challenging firms’ profitability overseas. Although inflation continues to moderate, 2023 maintains a high degree of uncertainty given inflation’s prolonged strain on consumers’ savings, additional Fed rate hikes (to 5.00%-5.25%), and the lingering threat of a recession.

Our own Morningstar Ultimate Stock-Pickers index has not been immune to the trend of underperformance of active management, as it trails the Morningstar U.S. Market Index year to date.

Aside from tracking the holdings, purchases, and sales, along with 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 25 different managers, a list that includes our 22 top fund managers as well as the investment managers of three insurance companies—Berkshire Hathaway BRK.A/BRK.B, Markel MKL, 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:

• The overall conviction (number and weighting of holdings).
• The relative current optimism (holdings being purchased).
• The relative current pessimism (holdings being sold).

Three sub-portfolios comprise the index—each containing 20 securities—and 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 sub-portfolio when they are reconstituted. This structure 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). The index is usually composed of 35 to 45 securities, holding 35 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. The size and concentration of the portfolio changes, though, as this is an actively managed index that tries to tap into our top managers’ movements and conviction levels over time.

Looking at the top 10 stock holdings of the Morningstar Ultimate Stock-Pickers index, just two of the top 10 are currently trading at approximately a 10% or more discount to our analysts’ fair value estimates. One of these companies is wide-moat-rated International Flavors & Fragrances IFF, which currently trades at a 43% discount to Morningstar analyst Seth Goldstein’s fair value estimate of $140 per share. As this company is both undervalued and a top stock holding on our index, we believe it merits further discussion.

IFF is the largest specialty ingredients producer globally. The company sells ingredients for the food, beverage, health, household goods, personal care, and pharmaceutical industries. IFF makes proprietary formulations, partnering with customers to deliver custom solutions. The nourish segment, which generates roughly half of revenue, is a leading flavor producer and offers texturants, plant-based proteins, and other ingredients. The health and biosciences business, which generates around one fourth of revenue, is a global leader in probiotics and enzymes. Additionally, IFF is one of the leading fragrance producers in the world. Goldstein cites intangible assets and switching costs as the firm’s main moat sources.

In the nourish and scent segments, which combined generate two thirds of EBITDA, Goldstein surmises intangible assets stem from the R&D spending required for the development of highly engineered, proprietary formulations that can’t be precisely replicated. Although customers outline the specific flavor, texture, and fragrance profiles they are looking to achieve, the resulting intellectual property developed by IFF stays with the company. Goldstein notes that this allows the firm to generate economic profit over the lifecycle of the products in which the proprietary formulations are used.

For the flavors and fragrances businesses, widespread acceptance on customer core lists serves as an additional intangible asset, in Goldstein’s opinion. The large multinational consumer packaged goods, or CPG, companies, and increasingly midsize companies, use core lists for their flavor and fragrance suppliers. A core list is a select list of typically two to four authorized suppliers. Goldstein points out that suppliers that are not on a customer’s core list typically will not have the opportunity to bid on its business. Only the top four flavor and fragrance companies have truly global operations, and Goldstein sees competition for multinational customers as largely limited to them.

Goldstein’s evidence for switching costs is supported by the fact that IFF’s volume represents specialty solutions rather than commoditized ingredients. IFF manufactures customized solutions for the food, beverage, personal care, and household products industries, providing specialized taste, texture, and aroma profiles for a wide variety of consumer products. He notes that other ingredient blends such as emulsifiers and plant-based protein mixtures are also custom-made. If a customer were to switch suppliers, Goldstein believes it would risk losing the highly specific characteristics provided by IFF’s products, potentially impairing its own brand equity. This is a particularly risky proposition for many CPG companies, given the substantial amount of their own capital they invest in building and marketing their brands. This concern typically leads to sticky business relationships, according to Goldstein. He believes that once a customer selects a specific taste, texture, or aroma solution, it is generally unwilling to switch suppliers based on cost alone.

Looking at the Morningstar Ultimate Stock-Pickers index’s year-over-year performance, we note that four of the top 10 names are undervalued according to Morningstar analysis (trading in 4- or 5-star territory). The list seems to be modestly diverse by industry, with names in financial services, technology, and consumer sectors. Today we’ll look at narrow-moat NXP Semiconductors NXPI, which is one of the undervalued names on our list. The stock currently trades at a discount to Morningstar analyst Brian Colello’s $225 fair value estimate.

NXP is one of the largest suppliers of semiconductors for the automotive market and a significant force in the analog and mixed signal chip markets. Colello believes the firm has a durable position in the automotive, industrial, mobile, and communications infrastructure markets due to a combination of switching costs and intangible assets. Although he notes that the company sells into cyclical industries, the strength of these competitive advantages gives him confidence that the firm will generate excess returns over the cost of capital over the next decade.

Colello posits that the merger of Freescale and the former NXP in 2015 has led to a powerhouse in automotive semiconductors, which makes up about 50% of NXP’s total revenue. Like many of its chipmaking peers, he believes NXP is well positioned to benefit from safer, greener, smarter cars in the years ahead. NXP is among the market leaders in automotive semis, especially in microcontrollers (MCUs) that serve as the brains of a variety of electronic functions in a car. Colello is optimistic about NXP’s development of products used in active safety systems, such as 77-gigahertz radar modules and battery management systems in upcoming electric vehicles, most notably from Volkswagen VWAPY/VWAGY.

Colello suggests that NXP’s prospects are also bright within its industrial and Internet of Things segment, thanks to its legacy strength in MCUs and embedded processors, along with its development of newer “crossover” MCUs, which combine some of the benefits of each.

In communications infrastructure, he believes NXP should remain a key supplier of power amplifiers into 5G wireless infrastructure equipment. While Colello does detail that NXP is a little behind some competitors in gallium nitride-based PAs, he thinks the firm will catch up and earn its fair share of GaN-based 5G designs over the next decade. Finally, he argues NXP’s mobile wallet solutions should remain the industry’s gold standard and the backbone of mobile payment technologies offered by Apple AAPL, Google GOOG, and others.

While lists of top-performing stocks are often composed of stocks that have already run up, our top detractors list can sometimes be a good area to pick through the wreckage. Although these names might not be performing well, there could be some value plays in the long run. From our current list, we will highlight narrow-moat Revvity RVTY, which currently trades at about a 26% discount to Morningstar analyst Julie Utterback’s $162 fair value estimate. Revvity provides instruments, tests, services, and software solutions to the pharmaceutical, biomedical, chemical, environmental, and general industrial markets.

With myriad acquisitions in the past few years, Revvity (formerly PerkinElmer) has been in a constant state of evolution since 2016 when the company made the transition into two new business segments, diagnostics (immunodiagnostics, reproductive health, and applied genomics, and discovery) and discovery and analytical solutions, or DAS (life science, industrial, environmental, and food applications), according to Utterback. She notes that with the recent divestment of its Applied, Food, and Enterprise Services business in early 2023, the company is operating under a new name and will focus solely on the life sciences and diagnostics business. Utterback is confident that the firm’s renewed strategic focus on improving its diagnostic product mix and life sciences business will maintain returns over cost of capital and produce tangible benefits for shareholders in the long run.

The diagnostics business is led by the immunodiagnostics business, followed by reproductive health and finally applied genomics. The immunodiagnostics business is characterized by Euroimmun, the global leader in autoimmune testing, allergy testing, and infectious disease. Despite declining birthrates globally, Utterback notes the firm still holds leading positions in newborn testing worldwide and continues to grow through menu expansion and contributions from its Vanadis NIPT offering. She believes the applied genomics segment should see continued growth as the cost of sequencing goes down, increasing sequencing by genetic labs and a need for Revvity’s products. The life sciences business is characterized by demands in preclinical discovery and research. In Utterback’s view, Revvity has been able to offer a more complete workflow to customers in this segment, building off the strength of its small molecule offering and increasing its large molecule focus since the acquisition of BioLegend. While Utterback remains cautious as to whether management’s capital allocation strategy will create value, she believes the company has taken steps to accelerate further product offerings and enhance its financial profile.

After continued success in its two major business segments, Revvity has earned a narrow moat, in Utterback’s opinion, based on intangible assets and switching costs in its diagnostics business segment and switching costs and minor intangible assets in its DAS business segment.

Disclosure: Ari Felhandler has an ownership interest in Volkswagen. 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.