By Greggory Warren, CFA | Senior Stock Analyst
After posting a steady gain of more than 10% during the fourth quarter, the S&P 500 TR Index (which finished up the year up just over 31%) has been slightly more volatile since the start of 2014. Concerns about growth and currency stability in emerging and developing markets led the index to decline more than 3% in January, only to rebound more than 4% in February, allowing the S&P 500 to close out the month at another record high. Given the near-term uncertainty created by the situation in the Ukraine, as well as the gradual realization that the Fed is serious about further reducing what has been a major stimulus for higher stock prices in the past few years as it pulls back on its bond-buying program as the U.S. economy improves, we expect to see more volatility as the year progresses.
Even though the market as a whole looks modestly overvalued, with Morningstar's stock coverage universe trading at 1.04 times our analysts' estimates of fair value at the end of February, a case can still be made for stock market gains in the year ahead. Looking back over the past decade, we've seen the market post further gains in two different years after the S&P 500 rose more than 25% in the preceding year. In 2010, the market increased another 15% after gaining more than 26% during 2009, with Morningstar's stock coverage universe peaking at about 1.10 times our analyst's fair value estimates during the year. It could be argued that in 2010 the S&P 500 was just continuing its climb out of the depths of the 2008-09 bear market, but we saw the same thing happen in 2004. Coming off of a nearly 29% gain in 2003, the market increased close to 11% that year, with Morningstar's stock coverage universe approaching 1.15 times our fair value estimates near the end of 2004.
That said, very few of our Ultimate Stock-Pickers are counting on this in the near term, with most being cautious in the face of a market that is trading at all-time highs. This is being fully reflected in the buying and selling activity of our top managers, as the trend of selling activity outstripping buying activity that we've seen over the past several calendar quarters continued during the most recent period, with many of our managers taking advantage of the ongoing market rally to book 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 relative discounts in a market that (in many of their minds) has become fully valued. While the sheer number of purchases has dwindled as the market has moved higher, we are still seeing some overlapping trades among our top managers.
From a sector point of view, Technology stocks--like wide-moat rated Qualcomm (QCOM ), Oracle (ORCL), and Accenture (ACN)--garnered the most buying interest from our top managers during the period. Both Oracle and Accenture showed up in our list of top 10 high-conviction purchases in our last article as several of our managers made meaningful additions to their holdings. We also saw increased interest during the period in Consumer Defensive stocks--namely, wide-moat rated PepsiCo (PEP) and Unilever (UL)--both of which also showed up in our early read on how our top managers were putting money to work in our last article. As for the higher conviction sales that took place during the period, we saw a mixture of outright sales and meaningful reductions in the holdings of our Ultimate Stock-Pickers, with the selling activity spread among the Technology, Consumer Defensive, and Energy sectors.
As in past periods, the aggregate holdings of our Ultimate Stock-Pickers in Energy, Utilities, Communication Services, 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, Consumer Defensive, and Health Care sectors. 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 eight of the top 10 sales saw one or more manager completely eliminating the name from their portfolios. That said, our top managers’ overall buying and selling activity during the most recent period did little to affect the list of top 10 holdings of our Ultimate Stock-Pickers, with PepsiCo being the only stock to show up on the list this period that wasn't there at the end of the third quarter. Several of our insurance managers have been using wide-moat Johnson & Johnson (JNJ) as a source of cash over the last year or so, with Prem Watsa and his team at Fairfax Financial (FRFHF) being the latest sellers, so we don't expect to see the Health Care stock on our list of top 10 holdings in future periods (at least not in the near term).
Ultimate Stock-Pickers' Top 10 Stock Holdings (by Investment Conviction)
Data as of 02/28/14. 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 five years ago. For starters, wide-moat rated Microsoft (MSFT) and Google (GOOG) have become two of the most widely held stocks of our top managers that are also held with a high degree of conviction. Each security is now held by 15 or more of our 26 Ultimate Stock-Pickers. While a fair amount of this ownership comes from the growth-oriented managers on our Investment Manager Roster, we've seen more than a handful of our large-cap blend and value managers stepping up and investing in the two technology names. Although Microsoft is not necessarily 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. It should also be noted that Google remains the top conviction holding of our Ultimate Stock-Pickers even after six of our managers trimmed their stakes (and one completely eliminated their holdings) in the name during the period.
Ultimate Stock-Pickers' Top 10 Stock Purchases (by Investment Conviction)
Data as of 02/28/14. Fund ownership data as of funds' most recent filings.
Technology stocks garnered the most buying interest from our top managers during the fourth quarter of 2013 and early part of 2014. Following up on increased interest in the name during the third quarter, Qualcomm was purchased by four of our Ultimate Stock-Pickers during the most recent period, with two of these managers-- Hartford Capital Appreciation (ITHAX) and FPA Crescent (FPACX)--making meaningful new-money purchases. The transaction at Hartford, while meaningful, is part of an ongoing shift in the management of the fund, as longtime manager Saul Pannell (of subadvisor Wellington Management) moves closer to retirement and Kent Stahl, who oversees Hartford Capital Appreciation II (HCTAX), a multi-manager fund that relies on picks from several Wellington managers (including Pannell), puts his imprint on the fund. Meanwhile, Steven Romick, the manager of FPA Crescent, noted the following about his fund's purchase of Qualcomm (and several other Technology names) during the period:
Intel, Qualcomm, and Checkpoint are three investments added last year that have not formerly been shown in our reports. None of the three make it into our top ten, but offered us a chance to own market leading companies, possessing fortress balance sheets, at low multiples to current free cash flow.
Each of these three new names accounted for about 2% of FPA Crescent's long portfolio at the end of the fourth quarter, while top holdings Oracle, CVS Caremark (CVS), and Aon (AON) each made up 6% or more of the fund's long equity positions. Romick also took a 2% stake in Vodafone (VOD) during the fourth quarter, which we highlighted in our last article, and made a meaningful addition to his fund's holdings of Oracle. He was not alone in the accumulation of shares of the enterprise software and computer hardware firm, as four different Ultimate Stock-Pickers increased their stakes, with the managers at Yacktman (YACKX) relaying the following about their holdings in Oracle, which they increased by 15% during the fourth quarter:
Oracle Corp. appreciated more than 10% after reporting solid earnings results. We first purchased shares in Oracle Corp. in late June of this year and quickly built a position that today is more than 3% of assets in each Fund. The Oracle Corp. investment demonstrates that new value opportunities can still be found even during a period of significant market appreciation.
As for the other Technology names that we've highlighted, Accenture was purchased by three managers overall, with two of them-- Jensen Quality Growth (JENSX) and Parnassus Equity Income (PRBLX)--making meaningful additions to their holdings. While neither manager offered up much about these transactions, Robert Zagunis at Jensen did talk about his fund's elimination of another Technology name, wide-moat Adobe Systems (ADBE), which made our list of top 10 sales this time around, using the proceeds to help fund a new-money purchase of narrow-moat rated E.I. du Pont de Nemours (DD). He noted the following about these trades:
The Investment Committee decided to sell Adobe from the Jensen Quality Growth Fund during the fourth quarter. The company is transitioning its business to a subscription model which will result in significantly lower earnings for a number of years. Although we see this change as a long term positive for the business, the transition will exclude the company from qualifying for the Jensen Quality Universe as we expect the company to breach our 15% Return on Equity requirement in fiscal 2013. On a positive note, the stock has outperformed the overall market, providing us with a good opportunity to exit our position, realize profits, and invest the proceeds into what we believe are better long-term opportunities for the Fund.
The Jensen Investment Committee decided to add DuPont... a globally diversified science and technology driven company that manufactures some of the most advanced materials in the world. We believe the company’s competitive advantages include economies of scale, innovation, strong brands, and high barriers to entry. In our estimation, DuPont is very good at creating innovative products based on its strong science and research competency. We believe coupling this advantage with the ability to productize these innovations via scale and strong brand management can enable the company to realize strong business returns. The company is focused on long-term growth drivers we find attractive: feeding the world, reducing dependence on fossil fuels, and keeping people and the environment safe. Just as we focus on the long term, we believe these are major opportunities for which DuPont is uniquely positioned to address for a sustainably long time.
With Adobe trading well above Morningstar analyst Norman Young's fair value estimate during the fourth quarter, there is little to disagree with in Zagunis' decision to exit the position when he did. While Young does note that Adobe's shift to a subscription-based pricing model should improve its competitive position in the long run--providing a more predictable recurring revenue stream, an increase in the addressable market, increased customer stickiness, and more manageable upgrade cycles--there are also some risks involved in this transition. As for DuPont, Morningstar analyst Jeff Stafford notes that the firm is widely known as a chemical producer, but that over the years its portfolio has shifted markedly to agriculture, nutrition, and biosciences. He highlights the fact that the agriculture business now makes up about one third of DuPont's operating profit, with the company focused on bringing new genetically modified seed and crop chemical offerings to market, similar to the way that pharmaceutical companies research and develop new drugs. Although Stafford recognizes the stiff competition DuPont faces from wide-moat Monsanto (the industry leader), he sees the gap narrowing, with DuPont actually besting Monsanto in marketing and distribution in recent years with its more regional strategy and direct-selling model. He expects both companies to benefit from the demands that an increasing (and richer) population will put on farmers to grow more food.
Looking more closely at the Consumer Defensive stock purchases, PepsiCo garnered increased interest from five of our Ultimate Stock-Pickers, with both Yacktman and Jensen making meaningful additions to their holdings in the snack food giant. While neither fund manager offered up information about these transactions, they coincide with increased interest in the firm on the part of activist investor Nelson Peltz, which Ronald Canarkis at Aston/Montag & Caldwell Growth (MCGIX) noted as a reason for investing in the firm back in the third quarter. Morningstar analyst Thomas Mullarkey continues to believe that PepsiCo's strong endorsement of its "Power of One" strategy, which the company's board reiterated in a recent response to Peltz's written request to the board that the firm be split into two separate businesses, makes it less likely that the activist investor will get his way. He sees a more likely outcome being a move by the snack food giant to acquire wide-moat rated Mondelez International (MDLZ)--spun off from narrow-moat rated Kraft Foods (KRFT) in 2012--which would add several well-known brands, such as Oreo, Cadbury, Nabisco, Trident, and Tang, to PepsiCo's portfolio.
As for the other Consumer Defensive name, we highlighted Unilever as a top 10 high-conviction purchase in our last article. With all the data in for our top managers, we see that there were three purchasers of the stock during the fourth quarter, with both Pat English at FMI Large Cap (FMIHX) and Tom Gayner at Markel (MKL) putting new money to work in the name. With little in the way of explanations behind these trades, we have to rely on the insight of Morningstar analysts Erin Lash and Philip Gorham, who continue to see some value in Unilever, which is trading at about a 10% discount to their fair value estimates, depending on which share class investors are viewing. Unilever PLC ADR is trading at 91% of fair value and Unilever NV ADR (UN) is trading at 88%.
Ultimate Stock-Pickers' Top 10 Stock Sales (by Investment Conviction)
Data as of 02/28/14. Fund ownership data as of funds' most recent filings.
Looking at the list of top 10 sales, the selling managers provided very little commentary about these particular transactions. In most cases (and where commentary exists), managers were selling because stock prices had exceeded their valuation. Google was interesting in that six managers sold the stock, three of them making meaningful reductions-- Morgan Stanley Focus Growth (AMOAX), Aston/Montag & Caldwell Growth, and Tweedy Browne Value (TWEBX)--and another that represented an outright sale-- Mutual Shares (TESIX). Even so, the stock remains a top 10 conviction holding for our Ultimate Stock-Pickers. About the only name providing more than the standard, "The stake was sold because the company's stock price reached our estimates of intrinsic value," as the rationale behind an outright sale was with FMI Large Cap's elimination of Sysco (SYY). Pat English noted the following in his quarterly letter to shareholders:
We sold seven stocks in 2013, including a spin-off business from Covidien. All of the sales except for Omnicom Group and Sysco Corp. were due to stretched valuations. Omnicom was sold because we felt strongly that the pending merger with Publicis is a mistake, and Sysco Corp. was sold on their announcement to acquire U.S. Foods.
While there is plenty to be concerned about with Sysco's $3.5 billion purchase of U.S. Foods, which involves the issuance of $3.0 billion of common stock, the use of $500 million of cash, and the assumption of $4.7 of debt, Morningstar analyst Erin Lash continues to view the deal favorably. In her view, adding U.S. Foods will bolster Sysco's position as the leading player in the industry, as the combined entity will control just under 30% of the $235 billion North American food-service distribution market, generating more than $65 billion in annual sales (more than 5 times the size of the next-largest player). This addition to Sysco's already expansive scale and reach not only supports our wide-moat rating on the firm, but according to Lash was the impetus behind the increase in our fair value estimate for Sysco to $45 per share (from $38 previously). She continues to believe that the market is underestimating the long-term potential of Sysco's proposed merger with U.S. Foods, its blueprint to improve relationships with higher margin locally managed customers, and other business-transformation initiatives (including technology enhancements to drive productivity improvements at a number of Sysco facilities and improved category management).
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Disclosure: Greggory Warren owns shares in the following securities mentioned above: Procter & Gamble and Mondelez International. 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.