For the past eight years, our primary goal with the Ultimate Stock-Pickers concept has been to uncover investment ideas that not only reflect the most recent transactions of our grouping of top investment managers (see here) but are timely enough 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 (or inactions) of some of the best equity managers in the business, we hope to uncover a few good ideas each quarter that investors can dig a bit deeper into to see if they warrant a long-term commitment.
With close to 90% of our Ultimate Stock-Pickers having reported their holdings for the fourth quarter of 2016, we have a good sense of what stocks piqued their interest during the period. While the story of 2016’s third quarter (see here) was one where the equity markets were largely calm (relative to the disruption that was caused by the Brexit vote in late June), the story of the fourth quarter revolved around the runup to—as well as the market’s euphoria following—the unexpected U.S. presidential election results. Our initial thoughts on the actions of our top managers so far is that they're taking a wait-and-see approach to the election results, suggesting to us that it might be difficult right now for many managers to handicap the potential business-friendly tax and regulatory reform that comes with a Trump presidency with his protectionist trade proposals and the economic uncertainty that brings.
While the overall level of buying activity did rise slightly during the fourth quarter, our top managers look to have been net sellers during the period, with overall activity levels continuing to decrease relative to past quarters. In fact, the number of top managers that made new-money purchases decreased slightly during the period. As was the case during the third quarter (see here), many of the positions that were initiated during the fourth quarter were relatively small, with only one security seeing more than one fund making a high-conviction new-money buy during the period. And in a repeat of events from the first three quarters of the year, our top managers were net sellers, although at an appreciably lesser rate than in prior periods.
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 where 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 also recognize that the decision to purchase any of the securities we are highlighting in this article could have been made as early as the start of October, with the prices paid by our managers being much different from today's trading levels. This was much more likely to be the case for these fourth-quarter transactions, given the post-election rally in the equity markets. As such, it is important for investors to assess the current attractiveness of any security mentioned here by checking it against some of the key valuation metrics—like the ratio of the price of each stock relative to our own fair value estimate—regularly generated by our cadre of stock analysts.
Before we dig deeper into the details, we should note that we have dropped Bruce Berkowitz's Fairholme FAIRX, which recently had its Morningstar Analyst Rating reduced to Neutral, from our list of top managers. (See here.) The fund's performance has been anything but stable the past five years, posting top-decile performance in 2012 and 2016 but dwelling near the bottom relative to other large-cap value funds in 2014 and 2015. More troubling for us has been the squeeze on Fairholme's liquidity, with the fund seeing $8.1 billion in outflows the past five calendar years, causing its total assets under management to decline from $7.0 billion at the end of 2011 to $2.9 billion at the end of last year. With manager Bruce Berkowitz raising cash for redemptions by selling more-liquid holdings like Bank of America BAC and Berkshire Hathaway BRK.A/BRK.B, the fund is now left with less-liquid holdings like St. Joe JOE, Fannie Mae FNMA, Freddie Mac FMCC, and Sears Holdings SHLD.
Fairholme was replaced with silver-rated Boston Partners All Cap Value BPAIX, which has been managed by Duilio Ramallo since October 2005. The fund's track record has been pretty impressive, beating the large-cap value category in nine of the past 10 calendar years, and besting the market during four of the past 10 calendar years. Even better, at the end of 2016, the fund bested the S&P 500 TR Index on a one-, three-, five-, and 10-year basis, speaking to Ramallo's ability to beat the benchmark over extended periods of time. The manager looks for companies that he believes are undervalued and that score well on three main pillars: valuation, fundamental factors, and catalysts for change (momentum). The strategy is all-cap, which means that the fund can invest in any market capitalization. Much like most of our other value managers, financials, technology, and healthcare are the portfolio's core sectors, making the fund a solid replacement for Fairholme.
Looking more closely at the top 10 high-conviction purchases during the fourth quarter of 2016, the buying activity was spread out among different sectors, but a little more concentrated in the healthcare sector with high-conviction purchases of HCA Holdings HCA, and narrow-moat rated UnitedHealth Group UNH and Edwards Lifesciences EW standing out during the period. Two giants in the technology sector—wide-moat rated Microsoft MSFT and narrow-moat Apple AAPL—also stood out, with the latter seeing a large investment by the portfolio managers at wide-moat Berkshire Hathaway (which nearly quadrupled its stake in Apple) during the fourth quarter. The rest of the purchases were centered in the industrials, consumer defensive, financial services, real estate, and communication services sectors. And not unlike past periods, most of the high-conviction buying activity during the period was focused on high-quality names with defendable economic moats, exemplified by the greater number of wide- and narrow-moat names in our list of top 10 high-conviction purchases (as well as among the top 25 high-conviction purchases).
Top 10 High-Conviction Purchases Made by Our Ultimate Stock-Pickers
There was also a fair amount of crossover between our two top 10 lists this quarter, as was the case the past several quarters, with six of the names—wide-moat Microsoft and Wells Fargo WFC, narrow-moat UnitedHealth Group and Edwards Lifesciences, and HCA Holdings and Liberty Global PLC LBTYK—showing up on both lists. Notably, HCA Holdings was a high-conviction new-money purchase for both American Century Value AVLIX and Oakmark OAKMX, with Oakmark Equity And Income OAKBX also adding meaningfully to its stake.
Top 10 New-Money Purchases Made by Our Ultimate Stock-Pickers
Because of the post-market rally, an even larger number of stocks registered as being fairly valued this time around. While reasonable minds can disagree on the prospects of an underlying security of a firm, the fact that our top managers were once again net sellers, albeit to a lesser degree, coupled with frothier valuations, suggests to us that increased caution might be warranted. Keeping that in mind, there are still a few names on these two lists that we believe could be more attractive in the event of a market correction and may actually warrant addition to an investor’s watch list.
As we noted above, healthcare stocks received slightly more attention during the fourth quarter than other sectors. The director of Morningstar's healthcare team, Damien Conover, has noted in the past that the sector slump represents a buying opportunity, believing that the market has overreacted, with healthcare products tending to be fairly inelastic and regulatory concerns being somewhat overblown. At the end of last week, narrow-moat rated Edwards Lifesciences had one of the lowest price/fair value ratios on both lists, having only marginally recovered from a steep sell-off in late October (when third-quarter revenue growth fell short of consensus expectations). Morningstar analyst Debbie Wang noted at the time that after consistently exceeding management expectations for the last two years, the shares dropped dramatically after Edwards merely met management’s forecast.
Edwards Lifesciences was a high-conviction new-money purchase for Ronald Canakaris at AMG Managers Montag & Caldwell Growth MCGIX during the fourth quarter. Unlike many of the other names on our top 10 lists, which have rallied in the aftermath of the U.S. presidential election, the shares of Edwards Lifesciences have been fairly stagnant the past four months, having bottomed out at around $81 per share at the end of November 2016. Canakaris disagrees with the market's reaction to Edwards Lifesciences shares over the past several months, noting the following in his quarterly letter to shareholders:
The stock had been weak following in-line third-quarter results, which disappointed some investors as the company has beaten expectations for over two years. We still expect the company to grow revenues 20%, driven by accelerated U.S. transcatheter heart valves and the launch of Sapien 3 in Japan. The weighting was increased following the company's Analyst Day, which bolstered our confidence that the outlook for growth is strong, the strategy is solid and innovation in the areas of tricuspid and mitral valve repair and replacement technologies will support growth.
Our analyst Debbie Wang recently noted that the shares have remained depressed, despite posting strong fourth-quarter results. On top of that, she saw little in the fourth quarter that would alter her assumptions about the narrow-moat firm, noting that her projections for 2017 remain close to the range of management’s estimates. Wang goes on to note that Edwards Lifesciences' past success has been built on sticking to what it does best—tissue health valves. In her view, the company has not only maintained its dominance in surgical heart valves, but has pioneered new minimally invasive heart valve therapy, which is one of the hottest areas in cardiac devices. Wang also praises the company for shedding noncore business and refocusing on higher-margin products, which has allowed Edwards Lifesciences to post an improbable 2700-basis-point gross margin improvement since being spun off from Baxter in 2000. While the company is dwarfed from a revenue perspective by its nearest competitors—wide-moat rated Medtronic MDT and St. Jude Medical—she notes that Edwards Lifesciences is the global leader in tissue heart valve sales, commanding over 60% of the global market.
Wang anticipates that the 29% growth rate for global transcatheter aortic valve sales seen during the fourth quarter should slow as penetration of replacements continues. However, she believes that Edwards Lifesciences can still maintain a double-digit growth rate in that product over the next four years. Wang is also not surprised to see further cannibalization of aortic valves with rival Medtronic. She believes that while Edwards Lifesciences has a robust transcatheter aortic valve pipeline, it also benefits from its leadership in developing a transcatheter mitral valve product. In her view, the company is poised to “ride the wave” as new technology shifts more valve replacements to the transcatheter approach, even considering the potential bumps on the road and less attractive economics of this business. Lastly, Wang is encouraged by stable pricing and lack of market penetration in transcatheter valve sales in Europe, providing what she believes is a continuing opportunity in the Old World continent.
Wide-moat rated Monsanto MON ended last week trading at a similar price/fair value multiple as Edwards Lifesciences, despite being the recipient of a $66 billion all-cash purchase offer from German drug manufacturer Bayer BAYRY. Both Berkshire Hathaway and Fairfax Financial Holdings FRFHF, two of the four insurance company portfolios on our list of top managers, first stepped into the name after news of the proposed acquisition broke during the third quarter. Monsanto was also owned by Markel MKL, another insurance company portfolio, and American Funds American Mutual AMRMX, which scooped up additional shares during the fourth quarter, albeit at a lower threshold relative to its overall portfolio than Berkshire and Fairfax.
Morningstar analyst Jeffrey Stafford believes that the market is showing a fair amount of skepticism about the deal actually closing. This, in his view, was reflected in the 18% discount to the deal price that the shares traded at on the day that President Trump met with the CEOs of Bayer and Monsanto in early January to discuss the proposed purchase. Even with greater confidence on some investors’ part that the deal will close, the shares continue to trade at around a 15% discount to the proposed deal price of $128 per share. Stafford believes the deal will ultimately overcome any regulatory and antitrust hurdles, placing a 75% probability on it closing. Even assuming the deal does not close as planned, Stafford believes the company's fair value estimate would dip only to $120 a share on the strength of Monsanto's research and development pipeline, which he views as one step ahead of competitors. In Stafford's view, farmers value Monsanto's products for eliminating the need for pesticides, while at the same time producing time savings and ensuring yield protection. Stafford adds that 90% of the soybeans and 80% of the corn grown in the U.S. contain a Monsanto trait, which the company achieved by snapping up seed companies and rolling out an extensive licensing program (which licenses its traits to competitors and leads to rapid adoption). Stafford believes the firm's seed portfolio will continue to drive growth as its pipeline of new products rolls out new offerings and sees expansion into international markets, especially in Brazil and Argentina, providing additional sales growth in the long run.
Wide-moat rated Microsoft and Wells Fargo were the only other names on both lists trading at an appreciable discount to our analysts' fair value estimates, even if it was only around 5% at the end of last week. Of its meaningful new-money purchase of Microsoft during the fourth quarter, AMG Montag & Caldwell Growth manager Ronald Canakaris had the following to say about the name:
We re-established a position in Microsoft after multiple quarters of stable reported results. Examining the outlook for cloud growth over the next several years suggests Microsoft has the potential to accelerate earnings growth from here as revenues expand, capex investment stabilizes and utilization increases as scale drives substantial gross margin leverage. As Microsoft works through the licensing and cloud transitions, it offers cash return through dividends and share repurchases. We increased the weighting after Amazon's Web Services late-2016 re:Invent conference re-affirmed workloads will continue to shift to public cloud, benefiting both it and Microsoft as the top two vendors.
Several other funds also remarked on the name during their most recent commentary, particularly on the crux of a double-digit gain in the stock since the start of the fourth quarter and on the heels of a successful execution of its cloud strategy. The managers at Jensen Quality Growth JENSX specifically commented on Microsoft's hybrid cloud offering, which it believes has been a key to success in implementing their cloud strategy. They believe this compromise offering, which allows customers to migrate from existing onsite systems to the cloud at their own discretion, has created widespread acceptance in the market. The managers at AMG Yacktman YACKX praised the company for returning cash to shareholders in the form of dividends and share repurchases and noted that Microsoft could be a significant beneficiary of any U.S. corporate tax reform. Stephen Yacktman also lavished praise on Microsoft's transition under CEO Satya Nadella.
Morningstar analyst Rodney Nelson recently commented positively on both the company and Nadella's leadership. Nelson believes Microsoft has embraced changes that will leave the firm better positioned for long-term sustained success. In his view, the company has become nimbler and more user-friendly under Nadella's leadership—labels that he believes would never have been applied to the pre-Nadella Microsoft. He sees this transition as a positive that should allow the firm to maintain its status among technology's elite for years to come. Nelson's valuation for Microsoft is largely driven by his cloud computing thesis, noting that Azure, the firm's public cloud service, has established itself as one of the most important players in the space—second only to Amazon. He believes the platform should continue to garner significant user growth as the company leverages Azure-hosted software such as Office 365 and Dynamics. In Nelson's view, public cloud computing represents a monumental opportunity for Microsoft as new workloads increasingly shift to the cloud. He believes the firm has also curated a rich set of software and tools that will help keep developers in its ecosystem, driving revenue that should offset other declines. While he admits that visibility into the company's Azure-specific performance is low, he expects revenue to grow at an exceptional rate the next several years. Nelson believes that Microsoft is best positioned to handle hybrid cloud models, given its foothold in existing on-premises data centers. He envisions eventually yielding revenue and operating profit contributions of 25% to 30%.
Meanwhile, Wells Fargo, which we have highlighted in previous articles, has appreciated over 30% since hitting its 52-week low in early October, in the wake of the bank’s fraudulent account opening scandal coming back into the limelight. Morningstar analyst Jim Sinegal believes that the bank’s January business update supports his thesis that the impact of what amounted to companywide sales fraud will be relatively short lived. In support of his view, Sinegal notes that consumer checking account openings exceeded closings, deposit balances grew at a healthy rate, and reported customer satisfaction metrics are closing in on pre-scandal levels. He adds that branch interactions were only down 4% from the first month of 2016 and that account closings are up only 4% over the same period, which he sees as an indication that normal customer activity is resuming. That said, Sinegal is concerned that new customers appear to be reluctant to choose Wells Fargo over its competitors, as new account openings were down 31% from January 2016, leading to an even bigger drop in net new accounts. Sinegal is also concerned about the bank’s inexplicable inability to provide an acceptable failure resolution plan to regulators on its second attempt. That said, he ultimately believes that both issues are temporary and manageable and that the damage to bank’s brand will fade with time—with most indicators already moving in the right direction.
Sinegal notes that Wells Fargo’s consistent strategy on retail banking and cross-selling over the past 30 years has made it resistant to disruption; a strategy that remains fundamentally intact. He expects the bank to generate pretax, preprovision returns on tangible common equity over 30% on average the next five years, providing plenty of protection against potential losses as well as a significant margin of safety should macroeconomic conditions turn out to be less favorable than his expectations. Sinegal’s base-case projections, which form the foundation for his $62 per share fair value estimate, should generate long-term returns on equity of 13%, well in excess of the bank’s 9% cost of equity.
Disclosure: As of the publication of this article, Joshua Aguilar had a position in Apple, while neither Eric Compton nor Greggory Warren has 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.