By Greggory Warren, CFA | Senior Stock Analyst
Despite reaching an all-time high midway through the first quarter of 2015, the U.S. equity markets (as represented by the S&P 500 TR index) rose less than 1% during the period. Stocks were fairly volatile at the beginning of the quarter, affected by declining oil prices, which hit a multiyear low during the period (having fallen more than 50% from peak price levels just six months prior). The prospect of lower oil and gas revenue, as well as reduced capital expenditures by energy companies, weighed heavily on not only energy stocks, but the other industrial companies that serve them. Solid earnings results across most other sectors combined with expectations of continued accommodation on the part of the Federal Reserve, more positive views on Europe, and a stabilization in oil prices to lift markets higher midway through the quarter. However, concerns over the strong U.S. dollar and slowing economic growth kept them from gaining much more during the period.
During the last two months the S&P 500 has regained some of its steam, closing out last week with a nearly 4% gain since the start of the year. This, in spite of the fact that global equity, credit, and currency markets remain somewhat volatile, with the near-term outlook for global economic growth being far less certain that it was just a few quarters ago. The possibility of a Greek exit from the eurozone, fears over elevated bond valuations and the prospect of rising interest rates in the U.S. market, and a rapid deceleration of growth and increased monetary easing in China could all weigh on equities in the coming quarter. Concerns that stock valuations have become elevated were also recently highlighted by Janet Yellen, chair of the Federal Reserve, during a conversation with IMF managing director Christine Lagarde.
While our Ultimate Stock-Pickers do not necessarily see the markets as being in bubble territory, they mostly agree that the near-term outlook for equities is less certain than it has been in past periods. Ronald Canakaris, the manager of ASTON/Montag & Caldwell Growth MCGIX reflected on this near- to medium-term disconnect in his most recent quarterly letter to shareholders:
While ongoing global economic expansion and highly accommodative central bank monetary policies across the developed world should continue to support share prices in 2015, the near-term outlook is less certain and could prove more volatile. With stock market valuations stretched and investors generally complacent, less than expected economic and earnings growth, together with uncertainty as to when the Federal Reserve will raise interest rates, could contribute to a choppy stock market environment and even an overdue correction.
Robert Zagunis, the primary manager of Jensen Quality Growth JENSX, also sees market volatility as a likely consequence of the Fed's monetary policy, and pointed out the associated currency impacts on larger multinational corporations in his recent quarterly letter:
We believe market volatility will continue as investors react to global economic developments and to the Fed’s comments regarding potential interest rate increases. During the fourth quarter of 2014, the rapid increase in the value of the U.S. dollar pressured company earnings. If the dollar remains strong, the earnings of U.S. companies with meaningful overseas revenues will most likely continue to be negatively impacted. In this environment, we believe it is important to invest in high quality companies with proven track records of operating successfully when currencies fluctuate significantly.
We can empathize with Jensen's near-term focus on firms capable of working their way through a difficult currency environment. This is an extension of the firm's focus on investing in quality businesses that possess sustainable competitive advantages, which can create value for investors in all market cycles. Our own methodology is based on finding companies with solid and sustainable competitive advantages trading at a discount to our own fair value estimates, believing that these firms are likely to outperform in the long run (even if they are affected by the noise associated with currency swings in the near term).
While Canakaris' and Zagunis' comments reflected the general attitude of most of our top managers, a few--like Pat English from FMI Large Cap FMIHX--remain bearish. English noted the following in his quarterly letter to shareholders:
The six-year bull market, combined with tepid fundamentals, has made stocks remarkably expensive from a historical perspective. The median or “typical” stock is higher than we have ever seen, and even more expensive than during the peak of the technology and telecom craze in 1999. Today there are over seventy start-ups with valuations over a billion dollars compared to less than half of that, inflation adjusted, in the 1999-2000 period. Pharmaceutical companies are brawling with each other to pay 5-10 times multi-year-out hoped-for revenue for phase III or recently approved compounds. Unnaturally-low interest rates foster this behavior. Bond valuations have reached epic levels nearly everywhere with ground-hugging rates here in the U.S., and even negative rates in some countries. A number of real estate sectors, particularly those catering to the wealthy, appear highly inflated, reminiscent of ten years ago. Real estate investment trusts (REITs) are as pricey as we can ever recall. Strangely, the sheer length of this asset inflation cycle has people feeling emboldened to take more risk rather than trimming their sails.
Given the lack of near-term visibility, and the concerns over where the market goes from here, it was not too surprising to see our Ultimate Stock-Pickers continue the trend of lower conviction and new-money purchases during the most recent quarter. This now makes seven straight calendar quarters where our top managers have generated incredibly low levels of buying and selling activity, with cash balances continuing to creep up as a result. Looking at just the 22 fund managers included in our investment manager roster, the group as a whole had an average cash balance of 6% of their total assets (and a median cash balance of 5%) at the end of the most recent period. Those that are less constrained with regard to their cash balances had an average balance of 9% (and a median cash balance of 8%). This compares with an average cash balance overall of less than 5% of fund assets for all U.S. stock funds that Morningstar currently tracks.
Market Fair Value Based on Morningstar's Fair Value Estimates for Individual Stocks
Source: Morningstar. The graph shows the ratio of price to fair value for the median stock in the selected coverage universe over time.
We should note that when we look at the buying activity of our Ultimate Stock-Pickers, we tend to focus on both high-conviction purchases and new-money buys. We think of high-conviction purchases as instances where managers make meaningful additions to their existing holdings (or make significant new-money purchases), with a focus on the impact these transactions have on the portfolio overall. It also pays to remember that when looking at this buying activity, the decision to purchase the securities we are highlighting could have been made as early as the start of January, with the prices paid by our top managers different from today's trading levels. As such, investors should assess the current attractiveness of any security mentioned here by looking at some of the measures our stock analysts' research regularly produces, like the Morningstar Rating for Stocks and the price/fair value estimate ratio. This is especially important right now, with the S&P 500 trading at/near record highs and the market as a whole looking modestly overvalued, with Morningstar's stock coverage universe trading just above our analysts' fair value estimates at the end of last week.
Top 10 High-Conviction Purchases made by Our Ultimate Stock-Pickers
Stock Price and Morningstar Rating data as of 05-15-15.
Our early read on the first quarter's buying and selling activity has revealed a far smaller number of situations where our top managers were buying stocks with conviction, or putting money to work in new names, than we've seen in past periods. The conviction buying that did take place was focused chiefly on high-quality names with defendable economic moats, exemplified by the preponderance of wide- and narrow-moat names in the top 10 list of high-conviction purchases (as well as when the list is expanded out to the top 25 purchases). The conviction buying also focused far more on firms with low and medium uncertainty ratings, a signal to us that our top manager are sticking with established holdings where they think they have more visibility into results over the near-to-medium term when putting more money to work.
That said, lower levels of portfolio turnover overall resulted in fewer overlapping conviction purchases during the most recent period. During the fourth quarter, for example, we saw one name purchased with conviction by four of our top managers, another bought with high conviction by three of our Ultimate Stock-Pickers, and eight more that were purchased with conviction by at least two of our top managers. We also saw a higher number of managers putting new money to work in the same names, something that was less evident during the first quarter. Even so, each of the top four high-conviction purchases-- Verizon Communications VZ, Google GOOG/GOOGL, General Electric GE, and Precision Castparts PCP--in the most recent period was also a new-money buy for at least one of our top managers.
While energy prices stabilized somewhat during the first quarter, our Ultimate Stock-Pickers continued to avoid putting additional money to work in the sector (and were actually still selling several oil and gas firms outright during the period). Instead, they focused on industrial names that traded off in response to the decline in oil prices, as well as more defensive names. This did not surprise us, as many of our top managers continue to look for names that will be able to weather not only a rising interest rate environment but a prolonged slowdown in global economic activity. That said, the top high-conviction purchase during the period--Verizon--went without comment, as it was a meaningful new money purchase for Alleghany Y, and a high-conviction addition for American Funds American Mutual AMRMX, neither of which provides commentary on their quarterly portfolio changes.
While Morningstar analyst Michael Hodel believes Verizon to be fairly valued right now, he notes that the narrow-moat firm has cemented its reputation with customers and its position as the premier U.S. carrier in terms of customer loyalty and profitability by focusing relentlessly on network quality over the years. This has allowed the firm to weather increased competitive intensity, especially in the wireless market, where Verizon Wireless remains the clear industry leader, with 109 million retail customers and coverage of more than 95% of the U.S. population. Although he believes that the planned $4.4 billion acquisition of AOL opens Verizon up to plenty of jokes about the dialup Internet access business--given that AOL still has 2 million such customers--he views this deal as being primarily about the advertising platforms AOL has built up over the past several years, especially around mobile video. That said, he also notes that Verizon is entering a crowded mobile video segment that comes with its own set of risks, such as lack of scale and reach. Even so, it is a relatively small deal for Verizon, and one unlikely to upend the competitive advantages that the firm has built up over the years.
As for Google, it also was purchased with conviction by Alleghany, and was a meaningful new-money purchase for the managers of Diamond Hill Large Cap DHLAX. Chuck Bath from Diamond Hill Large Cap noted the following about his fund's first-quarter purchase of 118,000 shares of Google in his quarterly letter to shareholders:
We initiated a position in Google, Inc., a high quality media/technology company with a dominant position in worldwide search advertising, including mobile search through its Android operating system. The company has consistently shown an ability to innovate, its acquisition record has been very good, and the success of its Android operating system should help the company continue to succeed even as an increasing percentage of searches move to mobile devices. Finally, the continued shift of advertising dollars from traditional media to digital will continue to provide a solid tailwind.
While Google has seen its stock price appreciate since the start of the year, it continues to trade at about a 25% discount to our fair value estimate. Morningstar analyst Rick Summer notes that wide-moat rated Google maintains an enormous presence in search advertising, which he believes will continue to benefit the company as emerging and developing markets attain higher levels of Internet access. He also notes that there is still a large gap between time spent online and dollars allocated to Internet advertising spending, and that as branding advertising becomes more effective there should be greater increases in online ad spending. Summer sees opportunities for the firm to put its sizable cash to work in its mobile business as well, focusing on the Android mobile operating system, and a variety of applications such as Google Maps, allowing it to maintain a strong foothold no matter the conduit of digital ad spending in the future. While he believes that Google's operating margins could expand well above 40% of sales were the firm to reduce its spending on research and development, Summers thinks it's more likely that the firm will continue to defend its wide economic moat through innovation, seeing only a slight increase in its profit margins over time.
General Electric, which like Google had been a top 10 conviction purchase during the fourth quarter, made the list again during the first quarter, with the managers of FPA Crescent FPACX making a meaningful new-money purchase in the name, and the managers at Oakmark OAKMX adding to their relatively new stake in the conglomerate. While Steve Romick at FPA Crescent had very little to say about his fund's purchase of wide-moat General Electric, we can at least point to the comments that Bill Nygren and Kevin Grant at Oakmark made about their new-money purchase of the stock back in the fourth quarter:
General Electric is a company with businesses we have always admired, but we have questioned management’s focus on returns when making capital allocation decisions. However, the appointment of a new CFO in mid-2013 ushered in significant changes. Since then, GE has, in our view, acquired assets cheaply (Alstom) and sold assets at good prices (Synchrony and its appliances division). In 2015 the company plans to totally revamp its variable compensation plan for thousands of employees, emphasizing factors that drive return on invested capital, which should boost future results. We believe there is substantial opportunity to improve gross margins, and the stock trades for just under a market multiple on 2016 earnings. Some investors may have a stale opinion of GE after the past 15 years of persistent underperformance, but we believe it’s a good investment at the current price.
Morningstar Analyst Barbara Noverini remains positive about GE’s outlook, particularly as the firm recently accelerated its efforts to sell the majority of GE Capital, only keeping the specialty finance businesses that directly support its wide-moat industrial businesses. She thinks that GE’s core industrial segments still share the common theme of infrastructure development that served as the foundation for its business a century ago, but that powering the "industrial Internet" has come to symbolize the company’s future growth platform. Noverini further notes that GE’s resilience in the face of uncertain global macroeconomic conditions supports her belief that, despite increased concentration on industrials, the portfolio’s end markets and geographic exposure are well diversified. Noverini expects persistent weakness in oil prices to continue to affect order growth and sales in the Oil & Gas segment, but remains optimistic that demand in Power & Water, Aviation, Transportation, and Health Care will continue to produce solid results for GE in 2015. Given the hesitant outlook held by many of our managers, the reappearance of a well-diversified incumbent like GE comes as no surprise, with the firm still somewhat attractive from a valuation perspective, trading at about a 10% discount to our fair value estimate of $30 per share.
As for Precision Castparts, the company was the recipient of meaningful new-money purchases from two of our top managers: Oakmark and Oakmark Equity & Income OAKBX. While both sets of managers commented on their purchase of the narrow-moat firm during the first quarter, the explanation from Bill Nygren and Kevin Grant at Oakmark was more detailed:
Precision Castparts Corp. is a manufacturer of complex metal components and products, including castings, forgings, fasteners and aerostructures for aerospace, power generation and general industrial applications. Precision Castparts enjoys what we believe is an outstanding corporate culture and is led by a long-tenured CEO who is known for aggressively pursuing operating efficiencies. For many years, the company’s stock traded at a significant premium to other aerospace and industrial peers, but recent weakness has brought the share price to attractive levels relative to these industry groups and the S&P 500. We believe the current valuation of less than 15x earnings is overly punitive, considering PCP’s organic growth prospects and the company’s ability to add value through acquisitions. PCP is providing more components on key new airplanes, which should allow the company to outgrow its end markets. In addition, management projects $4 billion-$6 billion of acquisition opportunities over the next couple of years with return characteristics similar to its existing business. Finally, the company’s unique technical and process capabilities, coupled with its efficiently run operations, should allow it to continue to generate above-average margins. We are pleased to have the opportunity to add shares of what we consider a best-in-class company at a price that implies it is only average.
The shares have rallied some 10% off of their more recent lows, leaving the stock trading at about 92% of our fair value estimate. Morningstar analyst Neal Dihora believes that the outlook for the firm remains positive. He notes that Precision Castparts is one of only a few providers of certain large, highly complex castings used in aircraft jet engines and power turbines that maintain structural integrity under intense thermal and pressure conditions. This creates high switching costs, leaving the firm with a solid narrow economic moat around its operations. The company also has fine-tuned its manufacturing process over the years. CEO Mark Donegan has been instrumental in efforts that extracted and shared cost savings with customers, and improved the firm's operating margins from 12% in fiscal 2001 to nearly 28% in fiscal 2014. While Precision Castparts' recent results have been affected by falling oil and gas prices, the business appears poised to benefit from tailwinds in aerospace production.
We also note that Danaher DHR and Johnson & Johnson JNJ were high-conviction new-money purchases during the quarter. In the case of narrow-moat Danaher, which was picked up by the managers at Parnassus Core Equity Investor PRBLX, there was little discussion of the purchase, which looked to be made in April. With the shares currently trading at 118% of our fair value estimate, it is difficult to see a valuation rationale for buying the stock, which has increased in value about 6% since the end of last month. Morningstar Analyst Barbara Noverini notes that the shares have moved up steadily since the firm announced it will buy Pall Corporation PLL, then split itself into two separate publicly traded companies. One of the companies will focus on its industrial operations (including its test and measurement and automation businesses), and the other on its science and technology operations, which will comprise Danaher’s diagnostics, dental, and water quality businesses, including the assets acquired in the Pall deal. While Noverini believes the price paid for Pall was not particularly cheap, she notes that acquisitions are core to Danaher’s growth strategy, which has a solid record of trimming expenses and improving margins after transactions are completed. That said, at current price levels, it looks like most of this has already been baked into the company's stock price, making it difficult to recommend purchasing the shares.
As for wide-moat rated Johnson & Johnson, it was a meaningful new-money purchase for the managers at Jensen Quality Growth, which had the following to say about the transaction:
The Jensen Investment Committee added a new name to the Jensen Quality Growth Fund, Johnson & Johnson. JNJ is a globally diversified healthcare conglomerate with businesses in pharmaceuticals, medical devices and equipment, and consumer healthcare. We believe JNJ benefits from powerful competitive advantages across its businesses including size/scale, brand equity, intellectual property, and entrenched relationships with global healthcare organizations. In addition, we maintain a positive view of the company’s revenue diversity, exceptional balance sheet (JNJ remains one of only three companies in the world with AAA credit ratings), and relatively stable end markets. We expect JNJ to grow steadily due to increasing global healthcare demand, new product development, and acquisition activity. This view incorporates our expectation that growth will be partially tempered by patent exposures in the company’s pharmaceutical franchises.
Morningstar analyst Damien Conover notes that Johnson & Johnson stands alone as a leader across the major health-care industries. He sees the company's ability to maintain a diverse revenue base, with a developing research pipeline, and exceptional cash flow generation capabilities as being central to its wide economic moat. Johnson & Johnson faces few patent losses over the next five years, and its diversification across health-care segments insulates it from downturns in the economy. While it is sometimes hard for individual segments to move the needle substantially, given the company's size, Johnson & Johnson's breadth allows it to remain more resilient than less diversified competitors in each segment where it competes. This has made it an attractive defensive growth opportunity for many investors (especially those in search of a stable dividend payer). Unfortunately, from a valuation perspective, Johnson & Johnson trades just above our fair value estimate, making it slightly less attractive than other names on the list.
In particular, Berkshire Hathaway BRK.A/BRK.B is trading at 86% of our fair value estimate, making it one of the more reasonably priced defensive names in the group. Morningstar analyst Greggory Warren continues to be impressed by Berkshire Hathaway's ability to generate high-single- to double-digit growth in its book value per share, believing it will take some time before the firm finally succumbs to the impediments created by the sheer size and scale of its operations. He also believes that the ultimate departure of Warren Buffett and Charlie Munger will have far less of an impact on the business than many investors anticipate. Warren notes that much of Berkshire’s success over the years has been derived from the fact that its operating companies are managed on a decentralized basis, eliminating the need for layers of management control and pushing responsibility down to the subsidiary level (where managers are empowered to make their own decisions). When capital can’t be put to work sufficiently in opportunities that generate adequate returns for the subsidiaries, it is moved up to corporate for reallocation in the best investment opportunities available in the organization.
Warren doesn't expect much to change in that regard once Buffett and Munger depart the scene. Where the firm will be lacking, in his view, is in having capital allocators of their caliber, with the knowledge and connections they’ve acquired over the years, running this part of the business. That said, Warren continues to be encouraged by the work being done by Buffett's two lieutenants--Todd Combs and Ted Weschler--who have gotten more involved in the operating subsidiaries (as opposed to just focusing on the stocks they invest in for the insurer's equity portfolio). He also likes that the two current front runners for the CEO job--Ajit Jain (head of Berkshire Hathaway Reinsurance Group) and Greg Abel (head of Berkshire Hathaway Energy)--have bountiful amounts of capital allocation experience. Warren comments further that regardless of who succeeds the pair longer term, the managers that run Berkshire will not need to do anything heroic as long as they continue to earn more than the firm's cost of capital (which is extremely low) with the businesses that make up the whole of the firm.
Top 10 New-Money Purchases made by Our Ultimate Stock-Pickers
Stock Price and Morningstar Rating data as of 05-15-15.
Of the five other names that made our list of top 10 new-money purchases this time-- Helmerich & Payne HP, Honeywell HON, Cerner CERN, MasterCard MA, and Cognizant Technology Solutions CTSH--the managers at ASTON/Montag & Caldwell Growth were involved in four of them. Ronald Canakaris noted the following about his fund's purchases in his quarterly letter to shareholders:
The Fund established six new positions during the quarter across a number of sectors. Healthcare IT firm Cerner has a large strategic footprint and we think stands to benefit from the adoption of electronic medical records and the increased interconnectivity with medical devices. In addition, the company's recent acquisition of Siemens Health Services increases its geographic exposure. Industrial giant Honeywell has been a beneficiary of increased emerging market energy demand and stricter worldwide environmental regulations. We expect operating margin improvement to continue and the company has ample financial flexibility to raise its dividend payout ratio and buy back shares. The company’s fourth quarter earnings report exceeded expectations for both revenue and earnings.
Other new names included MasterCard, Cognizant Technology Solutions, and Dollar General. We think Mastercard, along with long-time Fund holding Visa, will benefit from the global shift to electronic payments. The business is inherently scalable and offers high absolute and incremental margins. Cognizant is a provider of information technology, consulting, and business process outsourcing services. We expect the company's organic growth rate to reaccelerate to the mid-teens driven by a rich mix of consulting and outsourcing services into the financial services and healthcare sectors. Dollar General plans to accelerate its square footage growth as merging competitors Dollar Tree and Family Dollar consolidate, and may be able to acquire stores that their rivals must pest. The firm also initiated a dividend and plans to buy back $1.3 billion of its stock.
Helmerich & Payne, an oil and gas drilling firm, was a new-money purchase for both the managers at American Century Value AVLIX, and the Hamblin Watsa Investment Council at Fairfax Financial Holdings FRFHF. Neither manager offered up much commentary about their purchases, but American Century Value did note that its fund's "largest overweight is in the energy sector, where holdings are focused in integrated and exploration and production energy companies with significant potential for free cash flow to turn positive, and where there has been a sell-off in commodity price." This would make them the exception more than the rule among our Ultimate Stock-Pickers, many of which got stung in 2012 when they bought into a decline in oil in gas prices only to see things deteriorate further from there. At some point, though, things will turn around, and perhaps the recovery will be strong enough to allow the managers of American Century Value to improve the fund's overall performance.
If you're interested in receiving e-mail alerts about upcoming articles from The Ultimate Stock-Pickers Team, please sign up here.
Disclosure: Greggory Warren has 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.