By Greggory Warren, CFA | Senior Stock Analyst
Every investor would like to see the manager of their own actively managed mutual funds beating the market every year, but investors have been left wanting for much of the past decade. This lack of consistent outperformance has been well documented by S&P Dow Jones indices, in its quarterly and annual S&P Indices Versus Active Funds (SPIVA) U.S. Scorecard. In particular, the index group noted that at the end of last year just 17.9% of active large-cap fund managers on average had outperformed the S&P 500 TR index during the past 10 calendar years. The results were worse for large-cap core and large-cap growth managers, with just 15.7% and 10.5%, respectively, outperforming their benchmarks. Large-cap value managers fared much better, with 41.2% beating the S&P 500 Value index during the past decade.
One would have expected active large-cap equity fund managers to put up better results during 2014--the hurdle set by the S&P 500 index of 13.7% in 2014 was lower than what they faced in 2013 (32.4%) and 2012 (16.0%)--but active managers actually performed worse last year than in the previous two years. This is partially explained by the fact that rising markets tends to lift more boats, exemplified by the fact that 44.2% of active large-cap equity fund managers beat their benchmarks during 2013. In addition, a lot of managers were hit harder by falling oil prices than the index was, and many large-cap managers were underweight Utilities, the best-performing sector last year (barely beating out Health Care for the top spot). In addition, while the S&P 500 has some international exposure in its ranks, it is still purely a domestic index, so managers with exposure to foreign stocks--which underperformed last year due to slowing global growth and a stronger U.S. dollar--had that working against them as well.
Some of this has improved in 2015, but not enough to turn around some of the longer-term figures. Relative long-term performance has been less of an issue for our Ultimate Stock-Pickers, with three fourths of the 22 fund managers on our Investment Manager Roster outperforming the S&P 500 index at the end of 2014 (as well as at the end of last week) over the past 10 years. The remaining underperforming managers all are trailing the market by less than 60 basis points. We continue to believe that truly successful managers should be able to consistently generate above-average returns across multiple periods, while recognizing that individual markets can make it easier or tougher for managers to outperform. That said, we stand by our belief that a manager's ability to outperform the market over multiple periods is the best way to differentiate luck from skill.
As a reminder, the Ultimate Stock-Pickers concept was devised 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 top managers' top holdings, purchases, and sales against the recommendations of our own stock analysts on a regular basis, allowing us to uncover securities that investors might want to investigate further. There will always be limitations to our process, as we focus only on managers that our fund analysts cover, and on companies that our stock analysts cover, which serves to reduce the universe of potential ideas that we can ultimately address in any given period. This 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.
Even with some of the limitations found in the near-term performance of our top managers, our record of finding useful stock ideas has been stronger than one might have expected, especially during the last two calendar years, when most of our top managers have struggled to generate above-average annual returns. Judging by the performance of the Morningstar Ultimate Stock-Pickers TR index--which was constructed to reflect the highest conviction holdings that our top managers are investing in on an ongoing basis--our ability to tap into the best ideas of our top managers has never been better. During 2013, the index beat the market by 165 basis points, posting an annual return of 34.0% compared with a 32.4% gain for the S&P 500 index. Last year, when even fewer large-cap fund managers were beating the market, the Ultimate Stock-Pickers index outperformed the S&P 500 by 558 basis points, posting a 19.3% return for all of 2014.
Outperformance can be fleeting, though, as we've seen so far this year, with the Ultimate Stock-Pickers index underperforming the market by 164 basis points at the end of last month. This is not the first time that we've seen the index underperform since it was constructed--both 2012 and 2007 were poorer performing years when compared with the S&P 500. The underperformance in 2012 was due almost entirely to heavier (and ill-timed) bets on energy stock during the first part of that year, which affected performance in the second and third quarters of 2012. From the fourth quarter of that year until the first quarter of 2015, though, the Ultimate Stock-Pickers index has generated better-than-market performance, even as many of our top managers struggled to beat the S&P 500, so the near-term underperformance does not concern us all that much.
Morningstar Ultimate Stock-Pickers TR Index Performance Relative to the S&P 500 TR Index
Source: Morningstar Direct. Performance Data as of 5/31/15.
The Ultimate Stock-Pickers index was set up to reflect the highest conviction holdings our 26 different managers are investing in on an ongoing basis. It is constructed by taking all of 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 then ranking them by their Morningstar Conviction Score, which measures the level of conviction a manager has in any given holding in their portfolio. The Morningstar Conviction Score is made up of three factors: 1) the overall conviction (number and weighting of a holdings), 2) the relative current optimism (holdings being purchased), and 3) the relative current pessimism (holdings being sold) of each stock that is being assessed.
The index itself is comprised of three sub-portfolios--each one containing 20 securities--which 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 means that the overall index can hold anywhere between 20 and 60 stocks at any given time. In reality, though, the index is usually comprised of 35 to 45 securities. In our view, these stocks represent the best investment opportunities that have been identified by our Ultimate Stock-Pickers in any given period. As of the end of last month, the Morningstar Ultimate Stock-Pickers TR index had 46 total stock holdings, with its top 10 positions accounting for 40.6% (and its top 25 holdings making up 76.7%) of the total invested portfolio. The size and concentration of the portfolio does change, as this is an actively managed index that tries to tap into the movements of our top managers over time. The index's performance over the last couple of calendar years highlights the fact that we can find good ideas even as as many of our top managers are underperforming.
Top 10 Stock Holdings of the Morningstar Ultimate Stock-Pickers TR Index (as of 5/31/15)
Stock price and Morningstar rating data as of 6/12/15.
Looking at the top 10 stock holdings of the Morningstar Ultimate Stock-Pickers index at the end of last month, a few names still trade at a deep enough discount to our analysts' fair value estimates to offer investors a margin of safety. Express Scripts ESRX is the most reasonably priced on a price to fair value estimate basis, trading at 87% of our analyst's $100 per share fair value estimate at the end of last week. Morningstar analyst Vishnu Lekraj notes that Express Scripts is the largest pharmacy benefit manager, with more than 1.3 billion adjusted claims processed in 2014, giving the firm unparalleled supplier pricing power and scale advantages which form the foundation for its wide economic moat. He expects pharmaceutical spending to grow robustly over the next several years, given demographic shifts and the expansion of medical insurance coverage to the currently uninsured, and believes that payers will continue to look to PBMs like Express Scripts to help control spending. The company recently flexed its competitive muscle and garnered deep discounts from some of the most expensive treatment regimens and major retail pharmacy players, highlighting its essential role in minimizing drug benefit costs for payers and solidifying its stalwart competitive position. Lekraj expects Express Scripts to continue to produce top-tier gross and operating profit per adjusted claim, with returns on invested capital remaining well above its weighted average cost of capital for quite some time. Given the company's wide economic moat, solid growth potential, dominant market position, and reasonably priced shares, it is a stock that investors should consider looking at right now, in our view.
Sysco SYY is another name worth considering, with shares currently trading at 88% of our analyst's $42 per share fair value estimate (which includes the impact of the yet-to-be-completed US Foods acquisition). Morningstar analyst Erin Lash believes that the narrow-moat firm's vast distribution scale--with sales more than 2 times its next-largest competitor and operating margins about 3 times the level of other industry heavyweights--is an advantage in an industry that is plagued by high fixed costs. Even excluding the planned tie-up with US Foods, Sysco operates as the undisputed leading food-service distributor in the U.S. and Canada, with about 18% share of the $255 billion market in which it plays. To increase the stickiness of its customer base, Lash notes that the company has made it a priority to consult with clients on how they can drive sales and minimize costs--an advantageous undertaking, given that about 80% of its sales come from smaller customers. She believes that Sysco's scale, together with a focus on realizing further efficiencies, has been the primary reason why the firm's ROICs have consistently exceeded our estimate of its cost of capital. That said, Lash does expect intense competition and a customer mix shift toward larger chain restaurants, which are inherently lower-margin sales, to continue to constrain profits in the near to medium term. However, she highlights that Sysco isn't sitting still, undertaking efforts to improve its supply chain by more efficiently routing deliveries and optimizing product sourcing and supplier relationships. Lash also notes that the firm has been in a holding pattern the past year and a half as its pending deal with US Foods has raised antitrust concerns. While the deal will combine the two largest industry players, with more than $65 billion in annual sales, she thinks that concerns about stifled competition are overstated, and that Sysco will eventually find a way to placate regulators enough to get the deal completed.
Wide-moat rated MasterCard MA is also worth considering, with the company's shares trading at 90% of our analyst's $104 per share fair value estimate. Morningstar analyst Jim Sinegal believes that a powerful network effect that is supported by a trusted brand has allowed MasterCard to both generate excess economic profits and dig a wide economic moat around its operations. He notes that the MasterCard network functions as a tollbooth on financial transactions, generating a small amount of revenue from every transaction that runs through its network, and every dollar of payments made using the MasterCard brand. With about 85% of global transactions still conducted in cash, Sinegal envisions MasterCard (and other credit card firms) as processing a much larger share of these transactions over the long run, resulting in healthy top-line growth for years to come. He believes that MasterCard's global presence--well over half of revenue is generated outside the U.S.--strengthens this tailwind even further. As the economies of developing nations grow faster than those of developed nations over the next decade, with consumer spending growing along with those economies, he believes that consumers in those markets will move away from cash-based transactions more quickly. Sinegal sees little that can stand in the way of MasterCard's expansion in the near to medium term. The rise of mobile payments has created concerns for some investors, but he thinks that the transition to mobile payments, aided by "digital wallets," will only increase the volume running through MasterCard's network. Sinegal notes that numerous companies are fighting to connect merchants and consumers for this purpose, but does not believe that all of them are chomping at the bit to enter the highly regulated (and smaller) market for payments. He highlights the fact that Apple has found initial success by cooperating with networks and issuers, further cementing the value of the MasterCard network and brand.
Top 10 Contributors to the Performance of the Ultimate Stock-Pickers Index (6/1/14-5/31/15)
Stock price and Morningstar rating data as of 6/12/15.
Looking at the year-over-year performance of the Morningstar Ultimate Stock-Pickers index (from May 31, 2014, to May 31, 2015), a period where the index outperformed the S&P 500 by 165 basis points, the top 10 contributors to that outperformance included a handful of health care names. Wide-moat rated Eli Lilly LLY was the biggest contributor, generating a 35.7% return during the holding period. That said, its shares are currently trading at 129% of our analyst's fair value estimate, having run up 23.5% since the start of the year. Even with the advantages that come with its patents, economies of scale, and a powerful distribution network, the firm is just trading at too high of a premium to our fair value estimate to warrant consideration for purchase right now. Allergan also needs to be removed from consideration, as Actavis' ACT bid to acquire the firm was completed in mid-May, leading to a 31.0% holding period gain for the Ultimate Stock-Pickers index. That said, Morningstar analyst Michael Waterhouse remains keen on Actavis, believing that the market continues to underappreciate the wide-moat firm's earnings growth potential from deal-making cost synergies; the marketing advantages that come with the company's broad product portfolio; and the future attractive growth opportunities in ophthalmology, aesthetics, gastroenterology, and biosimilars. Trading at 91% of his $330 per share fair value estimate, Waterhouse believes Actavis is reasonably priced right now for long-term investors.
Wide-moat rated Medtronic MDT was the fourth-largest contributor to performance during the last year, generating a 27.3% gain during the holding period. While Morningstar analyst Debbie Wang believes that Medtronic's acquisition of Covidien has created a company that will be a force to reckon with in the med-tech landscape, the shares are already reflecting much of that, trading at 99% of her $76 per share fair value estimate at the end of last week. A more reasonably priced alternative is narrow-moat Becton Dickinson BDX, which Morningstar analyst Alex Morozov has always liked for its basic surgical products segment, which has accounted for more than half of the company's business in the past. As the largest manufacturer of needles/syringes, the firm enjoys scale that most of its competitors cannot come close to matching, making competing on price very difficult. The firm has also had a solid narrow-moat diagnostic business, with high switching costs. Unfortunately, these two businesses are becoming commodified, which could explain the more recent acquisition of Carefusion, which Morozov has gradually warmed up to since the deal was first announced in October 2014.
While the $12.2 billion transaction represented a departure from Becton Dickinson's long-held preference for tuck-in deals and conservative capital deployment, Carefusion derives a large portion of its revenue from products for which it is the market leader, such as intravenous infusion pumps, medication dispensers, respirators, ventilators, and infection-control products. It also benefits from high product switching costs as well as substantial barriers to entry in many of these product categories. Morozov notes that Carefusion's business requires a much different approach to selling than Becton Dickinson is used to, having traditionally relied on its massive scale to offset relentless pricing pressure from price-sensitive consumers for fairly commodified products. Carefusion's product portfolio is more sophisticated and faces far different industry dynamics, which he thinks adds more complexity to integrating the two businesses. That said, Morozov believes that the deal could be moat-enhancing over the long run, and that there is value to be had from bringing the two firms together. His current $165 per share fair value estimate provides enough margin of safety for investors to consider looking at the shares right now.
The only other attractive name among the top 10 contributors to the outperformance of Morningstar Ultimate Stock-Pickers index over the last year is wide-moat rated Williams Companies WMB, an energy infrastructure company tied to the U.S. natural gas market. Morningstar analyst Jason Stevens believes that the midstream and downstream integration Williams has pursued should allow the company to sustain excess returns for years. With a core franchise asset--the Transco pipeline--and a dominant midstream position in the Marcellus Shale region, he thinks that Williams is positioned exceptionally well to win the race to build out infrastructure for the nation's most prolific gas play. When thinking about competitive advantage for midstream companies, Stevens notes that asset quality matters, and that Williams' legacy interstate pipelines are wide-moat assets, served by multiple producing regions and reaching growing demand centers with consistently high utilization. More than 70% of the company's cash flows are derived from fee-based revenue, lending predictability and stability for investors. The company has also moved more recently to consolidate its holdings in Williams Partners WPZ, where it already acted as general partner and held 60% of that entity's outstanding equity, a move that should support higher dividend growth for Williams longer term. The deal did not change any of Stevens' operational assumptions for the firm, but the recognition of lower cash equity costs and sustained high dividend growth that will result from the simplification merger with Williams Partners was enough for him to raise his fair value estimate for Williams to $59 per share from $53.
Top 10 Detractors From the Performance of the Ultimate Stock-Pickers Index (6/1/14-5/31/15)
Stock price and Morningstar rating data as of 6/12/15.
While our top managers avoided jumping into energy stocks too early during the correction in oil prices this time (unlike what happened in early to mid-2012), there was still enough exposure--via holdings in Chevron CVX, Occidental Petroleum OXY, National Oilwell Varco NOV, and Apache APA--to affect performance over the last year. Of those four names, Chevron and National Oilwell Varco are both trading at meaningful enough discounts to our analysts' fair value estimates to warrant attention. Morningstar analyst Allen Good has noted that narrow-moat rated Chevron's oil portfolio has led to peer-leading margins and returns on capital. He expects new production from the Gulf of Mexico, West Africa, Western Australia, and the Gulf of Thailand to preserve the firm's liquids price exposure and serve as a growth engine for years to come, setting Chevron up for peer-leading growth during 2015-18. That said, Good also acknowledges that elevated capital spending and lower oil prices will likely result in lower returns in the near to medium term, and suggest that investors secure a margin of safety that they are more comfortable with before investing.
As for narrow-moat rated National Oilwell Varco, Morningstar analyst Jason Stevens notes that the firm dominates the drilling equipment space, making nearly every component that goes into a drilling rig, as well as the supplies and tools used in the drilling process. He points out that the firm is either first (or a close second) in nearly every product line in which it competes, and expects it to remain so for years to come. That said, demand for deep-water drilling has fallen off amid a glut of newbuilds and lower global oil prices. Stevens also expects unconventional activity to be sluggish, given the sharp drop in North American rig counts and the likelihood of slowing shale production growth. He believes that a recovery from the current oil price downturn will take time, particularly for National Oilwell Varco's leading rig systems segment. Once oil prices rebound and producers begin allocating capital to deep-water projects, it will still take several years before demand for newbuild rigs--and therefore rig equipment--begins to rise meaningfully. That said, Stevens believes that National Oilwell Varco is well positioned longer term to be the leading equipment supplier as the world increasingly seeks oil production from offshore and unconventional reservoirs.
American Express AXP also stands out among the top 10 detractors from the outperformance of Morningstar's Ultimate Stock-Pickers index, given that it is a wide-moat firm trading at 84% of our analyst's fair value estimate. Morningstar analyst Jim Sinegal notes that American Express has relied on powerful network effects and its valuable brand to generate excess economic profits. Over the years, the firm has created a virtuous cycle, with its collection of upscale cardholders being desirable to merchants, who have been willing to pay higher transaction fees to access this client base, which ends up funding reward programs and services for cardholders. Sinegal notes, though, that this model has come under pressure recently as competitors have targeted its cardholder base with ever-increasing levels of rewards and services, while charging merchants lower fees than American Express does. The company also saw its image of exclusivity take a hit earlier this year when Costco COST ended a 16-year relationship with the firm, a move that affects one in 10 American Express cards in circulation, and which will affect results this year and next. While the stock has taken a hit, down 14.0% on a year-to-date basis, Sinegal thinks that management is doing a reasonably good job steering the company through tough times, and expects the firm to move past these near-term headwinds as time moves on.
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Disclosure: Greggory Warren has ownership interests in the shares of the following companies mentioned above: American Express, Becton Dickinson, Medtronic, and Colgate-Palmolive. 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.