By Eric Compton | Stock Analyst
Our primary focus with the Ultimate Stock-Pickers concept for the past eight years has been to uncover investment ideas that our equity analysts and top investment managers find attractive and reveal these names in a timely enough manner for investors to gain some value from it. As part of this process, we scour the quarterly holdings of 26 different investment managers as they become available, attempting to identify trends and outliers among their holdings, as well as any meaningful purchases and sales that took place during the period.
In our last article, we walked through some of the buying activity of our Ultimate Stock-Pickers during the third quarter of 2016, which was basically an early read on the third-quarter purchases based on the holdings of around three quarters of our top managers and focusing in on high-conviction purchases and new-money buys. While our Ultimate Stock-Pickers have been net sellers for all three quarters of 2016, they did engage in a fair amount of buying and selling activity during the first quarter, only to have their transaction activity decrease over the second and third quarters of the year.
Now with all but one of our top managers having reported their holdings, we have a nearly complete picture of what everyone was up to during the third quarter. While there were two episodes of significant volatility during the first half of the year, driven primarily by non-U.S. specific events, the third quarter was relatively quiet. The net conviction selling of our top managers during the period, and the tone of their quarterly commentaries, demonstrates an approach to the current environment that can best be described as cautious. That said, within any environment there are always going to be opportunities, and so it was no surprise that Ultimate Stock-Pickers still found some names that piqued their buying interest even as they took advantage of ongoing market gains to trim positions.
Looking more closely at the conviction buying that took place during the latest period, most of the purchases were focused on high-quality names with defendable economic moats as exemplified by the greater number of wide- and narrow-moat companies on our list of top 10 (and top 25) high-conviction purchases for the third quarter. We saw this in our early read on the quarter's buying activity in our last article, with seven of the companies on the list of top 10 high-conviction purchases--wide-moat rated Disney DIS, Twenty-First Century Fox FOX, Analog Devices ADI, along with narrow-moat rated Apple AAPL, Danaher DHR, JPMorgan Chase JPM, and no-moat rated Walgreens Boots Alliance WBA--last time around represented in our list of top 10 high-conviction purchases this time around.
As for the selling activity, most of it looked to be focused on the trimming of larger holdings to manage position size or to simply pare back stakes that more closely approached our top managers' own internal estimates of fair value. There was also likely some selling related to the need of some of our fund managers to raise cash to meet redemption requests. Microsoft MSFT, which remains the second-highest-conviction holding among our top managers (even after the position trimming that took place during the period), was sold by nine of the 16 managers that held it coming into the third quarter, but only two of our Ultimate Stock-Pickers were selling with conviction.
Wide-moat rated Comcast CMCSA and PepsiCo PEP and narrow-moat Cisco Systems CSCO were other names that remained top holdings even after some selling during the quarter, with many of the managers that were selling already having some of the largest exposures to each stock. We should also note that an overwhelming majority of the names on the list of top 10 stock sales are currently rated 2 or 3 stars, indicating that we do not see significant mispricing opportunities for most of them. The one exception is wide-moat rated Nestle NSRGY, which is currently trading at a 14% discount to our analyst's fair value estimate. The most notable sale during the period was Fairholme's FAIRX sale of Bank of America BAC, with manager Bruce Berkowitz nearly eliminating his stake in the name. Fairholme has endured outflows in every month since March 2011, a total of nearly $15.7 billion; thus, Berkowitz has been forced to raise cash by selling more-liquid holdings like Bank of America, wide-moat rated Berkshire Hathaway BRK.B, and no-moat AIG AIG.
Ultimate Stock-Pickers' Top 10 Stock Holdings (by Investment Conviction)
- source: Morningstar Analysts
Even with this activity, our top managers remained underweight in energy, communication services, healthcare, and utilities relative to the weightings in the S&P 500 as of the end of September. Our Ultimate Stock-Pickers also continued to hold significantly overweight positions in the financial services and technology sectors (with their exposure to real estate, consumer cyclical, consumer defensive, basic materials, and industrials being less than 100 basis points from the benchmark index). Compared with last quarter, our managers saw their aggregate holdings shift more into technology, with some smaller shifts out of healthcare, financial services, and consumer cyclical names.
The overall makeup of the top 10 stock holdings by investment conviction did not change all that much during the third quarter, with only one company--narrow-moat Bank of America—falling off the list, primarily due to the heavy selling from Berkowitz's Fairholme fund. None of the eight other top managers that held the name coming into the third quarter were selling it with conviction during the period. Bank of America was replaced by wide-moat rated MasterCard MA on the list of top 10 conviction holdings. There was no extraordinary buying of MasterCard during the quarter, with the decline of ownership in Bank of America being the primary catalyst for the name to appear on the list this time around. MasterCard is one of four names on our list of top 10 conviction holdings that is trading at a meaningful enough discount to our analyst's fair value estimate to be attractive to long-term investors.
Morningstar analyst Jim Sinegal believes that MasterCard's latest results support his thesis that the company is poised for continued growth in the years to come, as revenue expanded by 14% during the September quarter. He also notes that MasterCard is continuing to invest for the future as payment technology rapidly evolves, with adjusted operating costs growing by 12% during the year. This should allow the firm to continue its growth as well as compete in a payments space where many new companies are trying to carve out their own niches. MasterCard was able to keep advertising and marketing expenses flat for the year, though, which supports the argument that the firm’s strong brand allows it to increase revenue without having to significantly increase these expenses. In addition to MasterCard's growing revenue and focus on the future, Sinegal also likes the company's ability to increase net income while returning essentially all of its generated capital to shareholders. Roughly half of net income for the September quarter went toward share repurchases, with the other half funding MasterCard's dividend. While these were all positives for MasterCard and its shareholders, the payments space isn't without its long-term risks. Mobile technology and a changing payments environment may potentially disrupt longstanding standards within the industry, hurting the players who currently dominate the space. Ever more influential merchants would also love to use their increasing bargaining power to lower the costs of the current payment paradigm. Despite these risks, Sinegal argues that MasterCard is still worthy of a wide moat rating and assigns a fair value estimate of $120 per share.
Taking a look at the high-conviction buying during the quarter, seven of the 10 names that showed up on our list of top 10 conviction purchases during the third quarter were also represented on our list of top 10 high-conviction purchases produced for our last article. For those who may not recall, when we look at the buying activity of our Ultimate Stock-Pickers, we tend to focus on 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.
Ultimate Stock-Pickers' Top 10 Stock Purchases (by Investment Conviction)
- source: Morningstar Analysts
Our list of top 10 conviction stock purchases favored consumer cyclical names, with stocks like Twenty-First Century Fox, Disney, MGM Resorts MGM, and Johnson Controls JCI all making the cut. Apple was again the most notable high-conviction purchase, topping this list for two straight quarters (and getting a lot of attention from Berkshire's foray into the name during the first quarter). Having covered many of the names that showed up in our list of top 10 conviction stock purchases list—including Apple, Danaher, Disney, and Twenty-First Century Fox—in our last article, we will focus here on several of the names that we've not highlighted recently. Among the top five conviction purchases, we've not spent much time on JPMorgan Chase. And further down the list Wells Fargo WFC not only made the list but was the only new name to the list that is trading at a meaningful discount to our analyst's fair value estimate. While Wells Fargo did appear on our list of top 10 conviction purchases last quarter, there have been several material developments that have made the name worth revisiting.
While the election of Donald Trump was an unexpected event, it has caused a universally positive reaction among our U.S. bank coverage, with most names having increased 10% or more following the election. In many ways, the election of Trump and a Congress that will be Republican-controlled should be a positive over the long run for U.S. financial firms. With higher government spending a possibility and Trump generally being negative toward major owners of U.S. bonds, such as China, we could see a combination of higher inflation expectations and more selling of U.S. Treasuries--all of which would steepen the U.S. yield curve. This would help increase net interest margins for banks and therefore boost profitability for a sector that has been pressured by historically low interest rates since the 2008-09 financial crisis.
There is also the expectation that regulation of the financial services sector will be more lenient than it was during the Obama administration, with the executive branch and lawmakers potentially looking to weaken Dodd-Frank and even abolish the Consumer Financial Protection Bureau. Broadly, this would be beneficial for the banks as it would reduce regulatory compliance costs as well as ease future regulatory capital rules. Lower future tax rates, another possibility under Trump, would also benefit not just the banks but all firms paying the relatively high current U.S. corporate tax rate.
While the actual actions that Trump and the Republicans will take remain theoretical right now, we should note that the election took place after the latest holdings (and hence the high-conviction purchases of JPMorgan Chase and Wells Fargo) were reported by our managers. We'll be curious to see what sort of impact the U.S. election and subsequent rally in the financial services sector have on transactions during the fourth quarter.
Looking more closely at Wells Fargo, the managers at Parnassus Core Equity Investor PRBLX made a significant conviction purchase in the name, increasing their previous stake by more than 50% during the third quarter. This made Parnassus the third-largest holder of the stock among the managers we follow, behind Berkshire Hathaway and Dodge & Cox Stock DODGX. Being the largest shareholder in the bank already, holding 10% of Wells Fargo's outstanding shares, Berkshire did not make any moves with regard to its stake during the third quarter.
But that does not mean that the firm would not like to buy more; at the start of the third quarter the firm applied to the Federal Reserve for approval to expand its stake in Wells Fargo, having reached the 10% threshold that requires regulatory review. The requirement that investors seek the permission of the Fed to hold more than 10% of a financial institution is a provision of the Change in Bank Control Act used by the regulators to monitor activity between banks and non-financial institutions as well as to prevent acquisitions that might be harmful to customers and/or the public. In its filing with the Fed, Berkshire noted that the firm is "seeking permission to retain its current ownership position in Wells Fargo and to acquire additional shares of common stock of Wells Fargo for investment purposes." The Fed will generally allow investors to take double-digit stakes when they are not designed to exert a "controlling influence," while the Treasury department tends to allow stakes above 10% if they don't result in "control" of a big bank and the investor agrees in writing to limits on its involvement.
Despite the recent scandal that has engulfed Wells Fargo, Berkshire held on to its stake during the third quarter, with CEO Warren Buffett (who remained quiet throughout the scandal and during the period leading up to the U.S. election) out there recently noting it was his favorite bank stock post-election:
It's a great bank that made a terrible mistake. Every great institution [that employs 280,000 employees makes mistakes]…they made a particularly egregious mistake. It was a dumb incentive system which, when they found it was dumb, they didn't do anything about it. If you put in incentives, incentives have terrific power, and they've got power to do good things and bad things. Everybody uses incentives…there is nothing wrong with incentives. But if you find out that an incentive is producing perverse behavior to what you intended, you've got to change it. It's not unknown to misgauge the effective incentives, and Wells Fargo made and designed a system that produced bad behavior. When you find that out, you've got to do something about it, and Wells Fargo didn't do anything about it...[but] you've got an incredible institution. In terms of the impact on business, it's minor. They weren't making any money on the program, they were losing money, it isn't something like they were doing that is hugely profitable.
The managers at BBH Core Select BBTEX, which trimmed about 7% of its stake in Wells Fargo in July and August, expressed similar views in their most recent quarterly letter:
Wells Fargo remains highly profitable, well-capitalized, and liquid. Even taking into consideration the likely increase in legal and regulatory costs and new business headwinds associated with this [fraudulent account openings] issue, we believe the Company's long-term earnings power is likely to remain robust. At quarter end, Wells Fargo was trading at a similar price-to-book multiple as it did during the Financial Crisis and at a substantial discount to our intrinsic value estimate.
Morningstar analyst Jim Sinegal dug a little deeper into Wells Fargo's relationship with its customers after the scandal reached its pinnacle in the third quarter, examining data from the Consumer Financial Protection Bureau that highlighted the bank's good numbers in terms of its customer relations. While the CFPB database did contain more than 10,000 customer complaints related to issues with the bank's accounts and services, it represented only nine complaints for every $1 billion of customer deposits held by Wells Fargo. Sinegal compared these results to other financial institutions in our coverage universe and noted that rates at other large regional competitors were often over 50% higher than those at Wells Fargo. In his view, this helps to support his thesis that the company's culture and management have generally done quite well for customers over time; thus, he doesn't expect massive client defections to occur. Sinegal believes that the issues at Wells Fargo, while inexcusable, probably didn't warrant the bank immediately losing 10% of its market cap. He also points out that the fake accounts didn't really benefit Wells Fargo financially, as most of the accounts generated zero revenue for the firm, which will limit the immediate financial impact of discontinuing the incentive program that led to the scandal.
After looking at Wells Fargo's third-quarter results, Sinegal noted that the company's numbers showed little impact from the scandal. He thinks the company is off to a good start in dealing with the problems created by the inappropriate sales incentives and has maintained his wide moat rating and exemplary stewardship rating for the firm--reflecting Wells Fargo's superior capital allocation more than its corporate behavior. The company's impressive returns on tangible common equity (14% in the third quarter) and healthy capital return program bolster his argument. Sinegal has seen little evidence so far that the aggressive and occasionally fraudulent sales practices--or the media and regulatory attention around them--have driven customers away from the bank and notes that Wells Fargo's corporate business has unsurprisingly not been affected by these issues within its retail operations. While the bank's shares have increased more than 15% since the U.S. election, Sinegal still believes they are moderately undervalued. His fair value estimate is $62 per share, about 18% above current prices.
As for the other Big 4 bank on our list of top 10 conviction purchases, JPMorgan Chase was a high-conviction new-money purchase for the managers at FMI Large Cap FMIHX. In his quarterly letter to shareholders, Pat English noted that his fund took advantage of a runup in Comerica's CMA stock price to swap it with JPMorgan Chase, which he felt was a superior franchise trading at a similar multiple.
Morningstar analyst Jim Sinegal believes that JPMorgan Chase shares are fairly valued right now. While he believes that the bank's conservative management and growing scale advantages should produce fair returns—and reasonable cash capital returns—for shareholders, he notes that investors should not expect the firm to consistently fire on all cylinders. Because the bank is so massive and operates in a heavily regulated industry, it will inevitably be exposed to different legal issues along the way. While investors often focus on recent scandals, Sinegal reminds investors that the bank had recorded billions in legal expenses in the years leading up to the financial crisis and sees no reason to believe that this pattern will suddenly stop. On top of that, JPMorgan Chase's capital-market-driven businesses, including trading, investment banking, and asset management, are cyclical, as is the bank's core lending business. Sinegal believes there are limits to diversification and as such, the company should generally command a valuation consistent with its position in a slow-growing, cyclical, and heavily regulated industry.
Ultimate Stock-Pickers' Top 10 Stock Sales (by Investment Conviction)
- source: Morningstar Analysts
As for the top 10 sales by investment conviction, the largest transaction by far was Fairholme's sale of nearly all of its common stock holdings in Bank of America. As we noted above, the fund has endured outflows in every month since March 2011; therefore, manager Bruce Berkowitz was forced to raise cash by selling more-liquid holdings like Bank of America. Berkowitz initiated his position in Bank of America in 2010, after selling a large stake in wide-moat rated Pfizer and putting much of the proceeds to work in the financial services sector, which he believed had a much more attractive risk/reward trade-off than other sectors. He not only made significant new-money purchases of Bank of America but picked up shares of Regions Financial RF, CIT Group CIT, Berkshire Hathaway, Citigroup C, and AIG.
Berkowitz continued to add to his stake in Bank of America well into 2011 and was able to hold on to nearly 100 million shares of the common stock until the end of 2014. During 2012-14, the bank's value increased more than 50% (compared with a nearly 45% gain for the S&P 500 Index), so Berkowitz did generate a positive relative gain from the holding. But sales since the start of 2015 have reduced Fairholme's stake significantly at a time when the bank continued to outperform the market. Morningstar analyst Jim Sinegal believes the company's shares are nearly fully valued right now, like many financial services firms. That said, he sees the shares of Wells Fargo as being moderately undervalued and remains positive on narrow-moat rated Citigroup, currently trading at a 23% discount to his $70 per share fair value estimate.
Disclosure: Eric Compton does not have an ownership interest 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.