By Greggory Warren, CFA | Senior Stock Analyst
Outperforming the markets on a consistent basis continues to be a challenge for most active equity managers, and our Ultimate Stock-Pickers have certainly been more adherents than exceptions to this rule in the past couple of years. The lack of consistent outperformance on the part of active managers has been documented by S&P Dow Jones Indices in their 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 41.3% of active large-cap fund managers on average had outperformed their benchmarks during the past 10 calendar years. Even in a good year for the markets like 2013, when a 32.4% gain in the S&P 500 TR Index should have lifted the performance of all fund managers, only 44.2% of U.S.-based large-cap funds outperformed their benchmarks. Data through the first two quarters of 2014 (the latest period for which we have information), was not much better with just 40.2% of large-cap managers beating the S&P 500 on a one-year basis. The results were even weaker when looking at large-cap funds on a three- and five-year basis, with 15.1% and 13.1%, respectively, outperforming the benchmark.
While the near-to-medium term investment performance of the 22 fund managers represented in our Investment Manager Roster has looked much like the industry averages this past year, we think a lot of this has related to where we are in the market cycle. With most stocks trading at or above our analysts' fair value estimates since the middle of 2013, our Ultimate Stock-Pickers have maintained a much more cautious approach to the markets, making it difficult for them to make moves that would lead to outsized returns. While we continue to believe that truly successful managers should be able to consistently generate above-average returns across multiple periods, we understand that some markets make it easier for managers to outperform while others can make it more difficult. That said, we've not swayed from our belief that a fund manager's ability to outperform the market over multiple time frames is the best way to differentiate luck from skill. It's just that in times like this, when near-to-medium term performance is clouding the outlook, that we rely even more heavily on the insight of Morningstar's fund analysts to separate truly successful stock-pickers from the rest of the pack.
Total Return (%) Track Record for Some of Our Better-Performing Managers
Total Return and Morningstar Rating data as of 12-12-14.
When reviewing the performance of the 22 fund managers in our Investment Manager Roster at the end of last week, what stood out most to us was the fact that just three of our Ultimate Stock-Pickers-- Vanguard PRIMECAP VPMCX, Amana Growth AMAGX, and Parnassus Core Equity PRBLX--were beating the S&P 500 on a year-to-date basis. The outperformance ranged from 727 basis points for Vanguard PRIMECAP to 16 basis points for Parnassus Core Equity, with the next closest managers-- Columbia Dividend Income LBSAX and FMI Large Cap FMIHX--on our list a full 100 basis points below the market. This compares negatively with the eight managers we saw beating the market near the midpoint of the year. Much of the falloff in performance was due to the increased volatility seen in global credit and equity markets during September and October. Our top manager performance is tracking the results highlighted by SPIVA for large-cap funds overall in its report for second-quarter 2014, so we would be surprised if the industry data for the third quarter and full year varied much from what we are seeing with our Ultimate Stock-Pickers. The one exception, of course, is with regard to long-term performance, as close to three fourths of our top managers continue to outperform the market on a 10-year basis, well above the norm for large-cap fund managers overall.
It is important to once again stress that the Ultimate Stock-Pickers concept was designed as a stock-picking screen, and 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 that have shown an ability to beat the markets over multiple periods (with an emphasis on longer-term time frames). We then cross-reference the top holdings, purchases, and sales of these top managers against the recommendations of our own cadre of 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 reduces 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 these limitations, our record of finding useful stock ideas has been stronger than one might have expected, especially during the last two years, when most of our top managers have struggled to generate above-average returns. Judging by the performance of the Morningstar Ultimate Stock-Pickers TR Index--originally 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. Through the first 11 months of 2014, the index was up 18.0%, compared with a 14.0% gain for the S&P 500 TR Index, and by the end of last week the Ultimate Stock-Pickers Index had widened its gap over the market to 488 basis points, even though its year-to-date gain declined to 15.4% during the first few weeks of December. Should the Ultimate Stock-Pickers Index close out 2014 on such a solid note, it would mark the second straight year that the index has beaten the market, and help improve its positioning on a three- and five-year basis (it was set back by poor investment performance during 2012). While we'll be discussing the index and its performance in more detail later in this article, we draw attention to these results as they highlight the fact that we're still finding good ideas despite a majority of our top managers currently underperforming.
Top 10 Holdings of the Vanguard PRIMECAP Fund (as of 09/30/14)
Stock Price and Morningstar Rating data as of 12-12-14.
Vanguard PRIMECAP is no stranger to our list of best-performing managers. This should come as no real surprise, as the fund has generated outsized returns in five of the last 10 calendar years, and was within 400 basis points of the market in those years when it underperformed. It is also the only manager in our Investment Manager Roster that is currently beating the market across all time frames. While it is typically listed as a Large Growth fund, the managers at Vanguard PRIMECAP--Theo Kolokotrones, Joel Fried, Al Mordecai, and M. Mohsin Ansari--have demonstrated some contrarian aspects in their stock-picking process over the years. The fund itself is divided into four main sleeves that are managed independently by each of the listed managers, with a few senior analysts getting smaller sleeves to run. This should lead to a more broadly diversified portfolio, but given that the different managers interact frequently and tend to look at the market in similar ways, the portfolio is often significantly tilted toward similar sectors and industries. The Health Care and Technology sectors currently account for eight of the top 10 holdings in the fund.
Vanguard PRIMECAP is more concentrated in its top 10 holdings (which accounted for 43.1% of its stock holdings at the end of September) than either Amana Growth or Parnassus Core Equity (at 34.3% and 36.5%, respectively, at the end of November), However, the concentration of its top 25 holdings is more on par with the two other outperforming funds (about 70% on average). The fund's turnover rate has increased some this year (to 11% in December from 5% in June), but its top 10 holdings remains populated with stocks that were first bought more than a decade ago. This fits with the description of the process that Morningstar fund analyst David Kathman has highlighted, noting that the managers of Vanguard PRIMECAP look for companies that have grown rapidly in the past, have good potential to continue that growth in the future, and have become temporarily cheap for some reason. They're also willing to wait for a company's stock to rebound, so long as nothing has changed fundamentally at the firm. When the managers trim or sell a holding it is generally for valuation reasons, but as we noted above they will eliminate a stock from the portfolio when something fundamental about the company or the economic environment has changed.
With the fund performing so strongly this year and last, and given the process followed by the managers, it should come as no surprise that Vanguard PRIMECAP made just one change to its top 10 holdings during the most recent period, selling 1.3 million shares of Novartis NVS during the third quarter. This did little to reduce its exposure to the Health Care sector, which continued to account for 31.5% of the fund's total stock holdings at the end of September (compared with a 13.9% weighting in the S&P 500). Vanguard PRIMECAP also maintains an overweight position in the Technology sector, accounting for 32.0% of the fund's total stock holdings at the end of last quarter (compared with a 17.5% weighting for the benchmark). These overweight positions have paid off handsomely, though, as the Health Care sector was up 25.6% on a year-to-date basis at the end of last week, while the Technology group reported a 16.1% gain. Even so, Vanguard PRIMECAP's best-performing stock this year has been an Industrials name, Southwest Airlines LUV, which is up more than 120% on increased demand for air travel and lower fuel costs.
Top 10 Holdings of the Amana Growth Fund (as of 11/30/14)
Stock Price and Morningstar Rating data as of 12-12-14.
After failing to generate market-beating performance the last three calendar years, Amana Growth has picked up enough steam in the back half of 2014 to surge past the S&P 500. As we've noted in past articles, the two Amana funds--Amana Growth and Amana Income AMANX--managed by Nicholas Kaiser and Scott Klimo have a slightly higher hurdle to get over than most of the other managers on our Investment Manager Roster. The two funds were designed for Muslim investors and are managed in accordance with Islamic law, which prohibits it from owning stocks of companies that get more than 5% of their revenue from alcohol, tobacco, gambling, pornography, or pork products. It also prohibits the managers from owning many stocks in the Financial Services sector, given the Islamic prohibition on paying or receiving interest, and companies with a debt/market cap ratio greater than 30% are generally excluded as well.
Despite these constraints, Morningstar fund analyst David Kathman notes that the Amana Growth fund has put together an outstanding long-term record, with 10- and 15-year returns that rank in the Large Growth category's top 5% as of the end of last week. The fund has done this by following a very patient strategy that involves finding fundamentally strong stocks that are likely to grow faster than the market, and a willingness to hold on to them for a long time. The fund's turnover rate of less than 1% is indicative of this--since the end of June, the only change among its top 25 holdings has been a slight reduction of its stake in Amgen AMGN. The downside to this approach is that the fund is prone to periods of underperformance when its style is out of favor. Kathman notes that that has mostly been the case in the past few calendar years, when a liquidity-driven bull market has boosted risky, leveraged stocks and left this fund badly trailing its peers.
Given the constraints on the portfolio, it is not surprising to see that the fund had 39.2% of holdings invested in Technology stocks and another 24.1% invested in Health Care stocks at the end of November. While these two sectors accounted for an almost identical weighting in the Vanguard PRIMECAP fund, the heavier weighting in Health Care stocks has allowed the Vanguard fund to outperform both the Amana Growth fund and the S&P 500 this year. The Amana Growth fund has also not benefited from a top 10 holding increasing more than 120% this year, like Vanguard did with Southwest Airlines. That said, it has seen a more than 35% gain from a handful of names, including Amgen, Apple AAPL, Union Pacific UNP, and Eli Lilly LLY.
Top 10 Holdings of the Parnassus Core Equity Fund (as of 11/30/14)
Stock Price and Morningstar Rating data as of 12-12-14.
Unlike Vanguard PRIMECAP and Amana Growth, which are Large Growth funds, the managers at Parnassus Core Equity--Todd Ahlsten and Ben Allen--tend to follow a more income-oriented strategy. The two managers run the portfolio in separate sleeves, with each manager responsible for half of the fund's 40 or so holdings, but they both focus on companies with wide or increasing economic moats that sell increasingly relevant products or services, and which are guided by good management. Ahlsten, who took over as fund manager in 2002, maintains a senior role and has the final say on all stock picks. However, he and Allen (who joined Parnassus as a senior research analyst in 2005 and became co-manager in 2012) are generally of a like mind when it comes to buying and selling stocks. Both managers are hands on and regularly adjust their position sizes as valuations and risk profiles change.
Morningstar fund analyst Laura Lallos continues to be impressed by Parnassus Core Equity's ability to outperform, given the restrictions that the managers face. The fund must keep 75% of assets in dividend-paying stocks, and has placed more emphasis on environmental, social, and governance criteria in its stock selection process. That said, there is no particular emphasis on high-dividend payers or dividend growth, and the managers believe that companies that score well on corporate governance, employee benefits, stakeholder relations, products, environmental impact, and customer and supply chain relationships are more likely to outperform industry peers. While the managers do not make top-down sector calls, there can be sector biases in their portfolio (especially in periods when the market underappreciates a particular industry or sector). At the end of the most recent period, Parnassus Core Equity was overweight in Industrials (18.2% of the portfolio compared with an 11.9% weighting for the market), Health Care (20.4% of the portfolio compared with a 14.4% weighting for the S&P 500), and Technology (19.4% of the portfolio compared with a 17.6% weighting for the benchmark index).
Allergan AGN, which has been the subject of a takeover battle, with Valeant Pharmaceuticals VRX on one side with a $180 per share bid and Actavis ACT on the other side with a $219 per share offer, has been Parnassus Core Equity's best-performing stock this year. The fund has also seen a more than 35% gain from a handful of names during the year, including Applied Materials AMAT, Iron Mountain IRM, Apple, and Gilead Sciences GILD. Even so, its year-to-date performance is only marginally better than the performance of the S&P 500 TR Index, as top holdings like Motorola Solutions MSI, Pentair PNR, and Qualcomm QCOM have generated negative returns during 2014.
Top 10 Holdings of the Morningstar Ultimate Stock-Pickers TR Index (as of 11/30/14)
Stock Price and Morningstar Rating data as of 12-12-14.
In the past, readers have been interested in the Morningstar Ultimate Stock-Pickers TR Index data points, as well as details on the construction and maintenance of the index. As of the end of last month, the index had 41 total stock holdings, with its top 10 positions accounting for 45.6% (and its top 25 holdings making up 83.7%) of the total invested portfolio. This level of concentration makes the index a bit more concentrated than the three managers we highlighted above as beating the market so far this year. The size and concentration of the portfolio does change over time, though, as this is an actively managed index that tries to tap into the movements of our top managers over time.
The Ultimate Stock-Pickers index was set up to reflect the highest conviction holdings that 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 index can hold anywhere between 20 and 60 stocks at any given time. In reality, though, it has tended to be 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. The performance of the index over the past couple of years highlights the fact that we're still finding good ideas even as a majority of our top managers are underperforming.
Morningstar Ultimate Stock-Pickers TR Index Performance Relative to the S&P 500 TR Index
Source: Morningstar Direct. Performance Data as of 11/30/2014.
As of the end of November, the Morningstar Ultimate Stock-Pickers TR Index was outperforming the S&P 500 TR Index by 399 basis points on a year-to-date basis, and by 366 basis points on a year-over-year basis. In four of the last five calendar years, the Ultimate Stock-Pickers index has beaten the S&P 500, with 2012 being the only exception, when the index trailed the market by 742 basis points. This was due almost entirely to heavier (and ill-timed) bets on energy stock during the first part of 2012 that sank performance in the second and third quarters of that year. Since the fourth quarter of 2012, though, the Ultimate Stock-Pickers index has generated outsized performance, even as many of our top managers were struggling to beat the market.
The performance of the index continued to be strong through the end of last week, even as the market sold off during the first two weeks of December, with the index generating a 15.4% year-to-date return (compared with a 10.5% return for the S&P 500). This level of performance left the index outperforming all but one of our top managers since the start of 2014, and all but two of our Ultimate Stock-Pickers over the past year. The three- and five-year trailing performance of the index also leaves it in fairly decent company, with just a handful of our top fund managers beating the results of the benchmark. We think that much of this has to do with the fact that the index continues to hone in on names with economic moats and lower levels of uncertainty (which tends to protect results in more volatile markets), and is influenced by the collective conviction of a broad spectrum of investment managers.
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Disclosure: Greggory Warren has no ownership interests in any of the shares of the companies 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.