By Greggory Warren, CFA | Senior Stock Analyst
With the market (as represented by the S&P 500 TR Index) up close to 30% through the end of November, and all three of the major U.S. indexes--the S&P 500 Index, the Dow Jones Industrial Average, and the Nasdaq--either hitting or approaching all-time highs this year, it looks like 2013 will go down as the strongest year of U.S. equity performance since the 2008-09 financial crisis. While the case could be made for solid stock market results in the year ahead, as evidenced by the returns generated in 2004 (following a 29% return for the S&P 500 TR Index in 2003) and 2010 (following a 26% return for the market in 2009), the market as a whole looks to be modestly overvalued right now, with Morningstar's stock coverage universe trading at 1.04 times our analysts' estimates of fair value (see the Market Fair Value based on Morningstar's Fair Value Estimates for Individual Stocks graph for more details). That said, in the two years--2004 and 2010--that followed periods with more than a 25% gain for the S&P 500 TR Index, the value of Morningstar's stock coverage universe continued to trade above our analysts' estimates of fair value, approaching 1.15 times our fair value estimates near the end of 2004 and peaking at around 1.10 times our fair value estimates during 2010, so it does not seem like valuation concerns were enough to temper enthusiasm for stocks during those periods (and are unlikely to do so in the year ahead).
As we noted in our last article, there continues to be a bit of dissension among our top managers about the market and the outlook for stocks, with comments from managers like Ronald Canakaris of Aston/Montag & Caldwell Growth MCGIX:
The outlook for the stock market continues to be favorable. The risk of a recession is low, monetary policy is very expansive, market valuations are fair to full though not extreme, and investors are optimistic but not euphoric. The market may be more volatile in the near term, however, as consensus economic and earnings expectations remain too high. While the Federal Reserve's bond buying program should continue to support the stock market, this added liquidity, as noted above, has both reduced investors' sensitivity to risk and significantly helped boost bond and stock prices. Consequently, the Fed's stated intention of eventually winding down that program coupled with the uncertainty as to how and when it will do so could also contribute to increased market volatility.
This is in contrast with comments from managers like Steven Romick from FPA Crescent FPACX at the end of the most recent period:
We would prefer that some of the lunacy we see out there translate into fear as that generally causes investors to sell assets without regard to value ... We'd like nothing more than to shift to a higher gear and increase our exposure, but given the lack of securities offering a genuine margin of safety, we're content to stay out of the fast lane for now ... In the meantime, we've taken advantage of the kindness of others who seem to have plenty of petrol and have bid up many of our investments to a point where we find the risk/reward unattractive. To remain intellectually honest and clinically dispassionate, we have found ourselves with little alternative but to make some sales.
These two statements exemplify the environment that our Ultimate Stock-Pickers have been facing as they've been managing their portfolios--looking for stocks to buy, making decisions about securities to sell, and negotiating the ongoing trend of outflows from actively managed U.S. equity funds. As we mentioned last time, the last few calendar quarters' trend of selling activity outstripping buying activity continued during the most recent period, as many of our managers took advantage of the ongoing market rally to book some gains. That said, we're still seeing a fair amount of high-conviction purchases of stocks representing companies with economic moats--particularly those with wide economic moats--as many of our managers look for higher-quality businesses trading at discounts to their estimates of intrinsic value in a market that (in many of their minds) has become fully valued. Unfortunately, the sheer number of purchases has dwindled as the market has moved higher, limiting the amount of overlap that we tend to see among our top managers.
From a sector point of view, Consumer Defensive stocks--like wide-moat rated PepsiCo PEP and Coca-Cola KO--garnered the most buying interest from our top managers during the most recent period. This isn't too surprising if they're looking for higher-quality firms that are likely to offer them some downside protection in a market slump. There was also heightened interest for Technology stocks--like wide-moat rated Qualcomm QCOM and Oracle ORCL--with the latter also seeing a fair amount of selling activity to accompany the purchases made. As for the higher conviction sales in the period, they were fairly well dispersed among the more economically sensitive sectors, with Industrials seeing the most sales in our list of top 10 high-conviction sales, and Financial Services stocks showing up more heavily when rolling through the top 25 high-conviction sales.
As in past periods, the aggregate holdings of our Ultimate Stock-Pickers in Energy, Communication Services, Utilities, and Real Estate remain underweight relative to the weightings of these sectors in the S&P 500 TR Index, with our top managers continuing to hold overweight positions in the Financial Services, Health Care, and Consumer Defensive sectors, while positions in Basic Materials, Consumer Cyclical, Industrials, and Technology stocks remain within 100 basis points of the index. Also of note is the fact that six of the top 10 purchases during the period involved new money being put to work by at least one of our Ultimate Stock-Pickers, while five of the top 10 sales saw one or more manager eliminate the name from their portfolios. That said, the overall buying and selling activity of our top managers during the most recent period did little to affect the list of top 10 holdings of our Ultimate Stock-Pickers, with Oracle being the only stock to show up on the list this period that wasn't there at the end of the second quarter. It should be noted, though, that wide-moat rated United Parcel Service UPS, Oracle, and PepsiCo have rotated in and out of the bottom of the table over the last year or so as our managers have adjusted their weightings to these securities. What stands out most about Oracle this time around, though, is the fact that four managers made meaningful purchases in the name at the same time that three of our Ultimate Stock-Pickers were making meaningful sales of the security (and six managers overall were reducing their stakes in the software giant).
Ultimate Stock-Pickers' Top 10 Stock Holdings (by Investment Conviction)
Data as of 11/29/13. Fund ownership data as of funds' most recent filings.
As we noted above, all the buying and selling that we saw during the most recent period had very little impact on the list of top 10 holdings of our Ultimate Stock-Pickers. That said, the list has seen a few meaningful changes since we relaunched the concept nearly five years ago. For starters, wide-moat rated Microsoft MSFT and Google GOOG are now the two largest holdings of our top managers. Each security is also held by 16 of the 26 Ultimate Stock-Pickers, making them the most widely held stocks of our top managers during the most recent period. While a fair amount of the ownership comes from the more growth-oriented managers on our Investment Manager Roster, we also see these securities being held by our large-cap blend and value managers, as well as a couple of the insurance company portfolio managers, highlighting the attractiveness of these wide-moat technology firms across a broad spectrum of investment disciplines. While Microsoft is not new to the list, being held by 13 of our 26 Ultimate Stock-Pickers at the end of the fourth quarter of 2008, Google didn't really hit the radar until the latter half of 2011 and didn't make the list of top 10 holdings until the first quarter of 2012.
Looking back, wide moat rated Berkshire Hathaway BRK.A/BRK.B was the highest-conviction holding overall during the depths of the 2008-09 financial crisis, but has since slipped to the lower end of the table, as many managers have trimmed their positions as the equity markets have rallied. That said, we remain impressed with the firm's ability to generate growth in book value per share in excess of its benchmark, believing it will take some time before Berkshire Hathaway succumbs to the impediments created by the sheer size and scale of its operations, as well as the longevity of Warren Buffett and Charlie Munger. We note that the company's shares continue to trade at a discount to our fair value estimate, and are the best relative bargain on our list of top 10 holdings for our Ultimate Stock-Pickers. We would also note that Berkshire has effectively created a floor under the company's stock price by announcing that it would buy back both Class A and Class B shares at prices up to 120% of reported book value (which stood at $126,766 per Class A share and $84.50 per Class B share at the end of the third quarter of 2013), implying downside protection for investors at prices 10%-15% below current trading levels.
Of the remaining eight names on our list of top 10 holdings, only four of them--wide-moat Johnson & Johnson JNJ, Procter & Gamble PG, and Wal-Mart WMT, along with narrow-moat rated Wells Fargo WFC--were reflected in our Ultimate Stock-Pickers' top holdings when we relaunched the Ultimate Stock-Pickers concept five years ago. The four remaining names that were on the list back then but are no longer represented were wide-moat rated Coke and Pfizer PFE; narrow-moat rated ConocoPhillips COP; and, Burlington Northern Santa Fe (acquired by Berkshire Hathaway in late 2009). Of those names, Coke is the only one that continues to linger around the top 10 holdings, aided (no doubt) by the increased buying activity that was seen in the name during the third quarter.
Ultimate Stock-Pickers' Top 10 Stock Purchases (by Investment Conviction)
Data as of 11/29/13. Fund ownership data as of funds' most recent filings.
As we noted above, Consumer Defensive stocks--like PepsiCo and Coke--garnered the most buying interest from our top managers during the most recent period, with the former being bought by four of top managers and the latter seeing increased interest from three of them. The managers at the Yacktman YACKX fund were the only ones to buy both names during the period, with Donald Yacktman noting in his fund's quarterly commentary that consumer companies on a relative basis were more attractively priced during the quarter, leading them to increase their stakes in both PepsiCo and Coke. Meanwhile, Canarkis, who was buying both wide-moat rated Philip Morris PM and PepsiCo during the period, noted that his fund "added to PepsiCo twice during the period as (he thinks) well-publicized activist shareholder proposals are likely to result in a restructuring or breakup of the company, which should unlock shareholder value."
When we talked to Morningstar analyst Thomas Mullarkey the last time, he noted that speculation occasionally surfaces about PepsiCo breaking into two separate businesses, but he doesn't believe this will happen in the near term. What's more probable, in his view, is a move by the snack food giant to acquire wide moat rated Mondelez International MDLZ, which was spun off from narrow moat rated Kraft Foods KRFT last year, and which would add several well-known brands--including Oreo, Cadbury, Nabisco, Trident, and Tang--to PepsiCo's portfolio.
Looking more closely at the list of top purchases, it is interesting to note that seven of the 10 names were purchased by four or more of our top managers during our most recent period. That said, when looking at high-conviction purchases, only Oracle was bought with a meaningful level of conviction by four or more of our Ultimate Stock-Pickers, with Alleghany Y, FPA Crescent FPACX, Oakmark Equity & Income OAKBX, and Yacktman all adding to existing stakes in the software giant. While none of these managers provided any insight into their purchases, the stock got hammered at the end of June, following the release of disappointing fiscal fourth-quarter results, with the shares trading at around $30 per share at the beginning of the third quarter (down from $35 per share in mid-June), so it looks like several of them stepped up to add to their stakes in response to the drop in the stock price.
That said, we saw a slightly different reaction from three of our top managers--Aston/Montag & Caldwell Growth, Amana Trust Growth AMAGX, and Jensen Quality Growth JENSX--each of which reported meaningful sales of their holdings in Oracle during the period. Of his sale of the stock, which was eliminated from his portfolio, Canarkis noted the following in his quarterly commentary to investors:
We sold the small remaining position in Oracle ... during the quarter. The shift to a cloud-based model (fewer capital expenditures, more operating expenses) means less upfront revenue for Oracle and more revenue spread out over time. Thus, we concluded that revenue growth is limited to the low- to mid-single-digits absent acquisitions, which will need to be large-scale in order to have an impact--raising the risk profile of the company.
Morningstar analyst Rick Summer acknowledges that average annual internal revenue growth is likely to decline from a mid- to high-single-digit rate during the next five years as Oracle gains share of enterprise IT spending in on-premise data centers, to a lower rate of growth during the latter half of the decade as subscription-based cloud solutions become a larger portion of the revenue mix. However, he still thinks that Oracle's installed base, high switching costs, and product road maps will reinforce its market-leading position. As the company's existing customers push to purchase software in the cloud, he believes that many of them will appreciate the ability to choose hybrid installations (mixing cloud and on-premise solutions), and that Oracle's flexibility will provide a better solution for many risk-averse customers. While Summer does see cloud computing as a potentially disruptive force in the software world, he thinks that the high switching costs inherent in Oracle's business will provide it with time to successfully implement its own unique suite of cloud applications.
Qualcomm was another name that received heightened levels of attention from our top managers. Three of our Ultimate Stock-Pickers-- Oakmark, Parnassus Equity Income PRBLX, and Sound Shore SSHFX--made meaningful purchases, with the Oakmark fund making a significant new-money purchase in the name. Of their purchase of the technology firm, managers Bill Nygren and Kevin Grant had the following to say in their quarterly letter to shareholders:
Qualcomm is the global leader in wireless technology licensing and mobile device chipsets. Qualcomm has dominant market share in both businesses, and it uses the strong recurring cash flow from its licensing business to reinvest in its chipset business. The company owns intellectual property that defines many of the standards used for 3G and 4G wireless communication, which allows it to collect royalties from handset providers that license these ubiquitous standards. Qualcomm's licensing business accounts for only a third of the company's revenue, and it is often underappreciated. However, its licensing business has unusually high profitability and represents close to two-thirds of Qualcomm's profits. The majority of the world's mobile handset users are still using older 2G technology, which is not a focus area for Qualcomm, so when these customers upgrade to 3G and 4G, Qualcomm should be well positioned to enjoy robust incremental revenue. The company is also the leading provider of chipsets, which function as the brains for wireless devices. Qualcomm's industry-leading product breadth and peer-leading R&D investment should drive the company's chipset growth. We expect Qualcomm to earn over $4.50 per share in a couple of years, and after adjusting for $20/share of cash, this high-quality business is priced at a forward P/E of just 11x.
This echoes some of the thoughts of Morningstar analyst Brian Colello, who notes that as the innovator of CDMA network technology, which is the backbone of all 3G networks, Qualcomm has dug a fairly wide economic moat with this intellectual property. Mobile phones are basically unable to connect to 3G networks without paying a royalty (about 3%-5% of the price of the handset) to the company. As more and more 3G-capable smartphones hit the market, and carriers expand their 3G networks, Colello thinks that Qualcomm is poised for strong licensing revenue growth for at least the next few years. While the company does not have the same dominant IP portfolio in 4G technologies like LTE, Colello believes that it has generated enough essential patents to enable the firm to strike new deals with many large handset makers. He does, however, note that for at least the next decade the overwhelming majority of 4G handsets will likely be backward-compatible with 3G technologies, which should enable Qualcomm to collect higher 3G royalty rates. Colello views the firm's chip segment as less moaty, but still expects solid revenue growth from the operations as the smartphone market expands, allowing Qualcomm to sell more advanced processors and additional chip content into these high-end devices. He also notes that Qualcomm has done a good job of distributing cash to shareholders, buying back almost $1.5 billion in stock in calendar 2012 and more than $4 billion so far in fiscal 2013, with the firm authorized to buy back another $5 billion in the future (and planning to use at least $4 billion of this authorization over the next 12 months).
Ultimate Stock-Pickers' Top 10 Stock Sales (by Investment Conviction)
Data as of 11/29/13. Fund ownership data as of funds' most recent filings.
Before delving too deeply into the selling activity, we note that Prem Watsa with Fairfax Financial Holdings has been involved in a battle to take over the ailing BlackBerry for much of the year (which ultimately fell apart in early November). As a result, he had been selling off holdings--like Johnson & Johnson JNJ, Level 3 Communications, Dell, U.S. Bancorp USB, Wells Fargo, Wal-Mart, Ryanair Holdings, and Hewlett-Packard HPQ--to raise capital for the buyout. While this has had an outsized impact on several of the names that showed up in our top 10 high-conviction sales, there was only one instance--namely, Level 3 Communications--where Fairfax was the sole seller of the stock.
We would also note that the sales of Dell that took place during the quarter were in advance of that company's buyout by its founder, Michael Dell, near the end of October, propelling that name to the top of our list of high-conviction sales. In looking at the list overall, though, there was very little commentary from the selling managers about these particular transactions. In most cases (and where commentary exists), managers were selling because stock prices had exceeded their valuation. Clyde McGregor at Oakmark Equity & Income went a step further, noting the following about his fund's buy and sell disciplines:
To review our process, as value managers we establish buy and sell targets for the stock of any company that is voted onto our firm’s approved list. Buy targets are normally set at 60% of our estimate of the company’s intrinsic value and sell targets at 90%. Of course, our targets are not static. With new information and the passage of time, our targets evolve to reflect a business’ current fundamentals better. Generally, when a stock approaches the sell target we begin to reduce the size of the holding because its relative attraction has diminished. Its higher price makes it less able to compete for portfolio space.
And in response to Oakmark Equity & Income's sale of Flowserve, McGregor noted the following:
Last, but hardly least, is Flowserve, a leading manufacturer of pumps, valves and seals. Flowserve served the Equity and Income Fund well during its nearly three years in the portfolio, and we wish to thank our recently retired long-time partner John Raitt for this successful idea (as well as many others). We did not enjoy eliminating any of these five holdings from the portfolio as each company had been performing well and meeting or exceeding expectations. Nevertheless, our discipline demands that we move on whenever price and our estimate of intrinsic value per share come together.
TE Connectivity, 3M and AmerisourceBergen were all up significantly in the period. Monsanto, Kimberly-Clark, Automatic Data Processing Inc., Ingersoll Rand and Omnicom were among those sold over the past year. Most of these sales were due to the stocks reaching or exceeding our determination of full value.
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Disclosure: Greggory Warren owns shares in the following securities mentioned above: Procter & Gamble, Mondelez International, Philip Morris International, and Amana Trust Growth. 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.