After increasing more than 32% during 2013, market growth slowed during the first six months of 2014, with the S&P 500 TR Index posting a 7% return for the period. Most of the market gains during the first half of the year came during the second quarter, after investors shrugged off concerns they had during the first quarter about growth and currency stability in emerging and developing markets. They also warmed back up to technology and other momentum-driven stocks, having pulled money out of these equities in droves during March and early April. It also didn't hurt to have the European Central Bank announce that it would be providing additional liquidity to struggling markets in that part of the world. That said, for most of our Ultimate Stock-Pickers there remains an undercurrent of concern about where the markets are headed from here. While investors have been willing to increase their appetite for risk over the last year or so, evidenced by the amount of capital that has flowed into equity funds overall during that time, we continue to believe that we are in the same risk aversion cycle that has persisted since the 2008-09 financial crisis, with investors gradually increasing their risk appetite during stable and expanding markets, only to pull back dramatically during market declines.
With that in mind, we found the following comments from Clyde McGregor in his second-quarter letter to shareholders of Oakmark Equity & Income OAKBX of interest, particularly with regards to the notion that temperate economies can still produce extreme market volatility:
The June quarter in the securities markets proved to be a time of quiet advance. In fact, the quarter’s low volatility completely belied the many disruptive factors affecting international political conditions. As the quarter proceeded, market commentators returned again and again to this apparent contradiction We also cannot explain why volatility, as well as trading activity, remains quiescent. Certainly central banks’ constant monetary stimulus has helped sustain securities prices. Worldwide economic activity has also shown moderate growth, although many of us remember other time periods when temperate economies have produced extreme market volatility (cf. the crash of 1987). One year ago we wrote that investors should “embrace volatility,” but we admit that it is difficult to identify volatility to embrace today.
We were also intrigued by the commentary put forth by Steve Romick at FPA Crescent FPACX about the impact that quantitative easing worldwide has had on riskier assets:
Disappointing economic growth offers a silver lining, in that it discourages central banks from becoming less accommodative, despite jawboning to the contrary. The Federal Reserve continues to keep interest rates low and to quantitatively ease albeit with some negligible tapering. This effort clearly hasn’t had much of an economic impact but it has continued to elevate the price level of risk assets around the globe…With yields remaining artificially low, we observe zero interest-rate policy perverting capital allocation decisions. Money continues to flow around the globe in a quest for yield, instigating a continued rise in risk assets. Many who have been accustomed to the lower risk of high-grade bonds and Treasuries are now finding themselves looking elsewhere. There is no better example of this than the first six months of this year when global stock markets, high-yield bonds, gold, oil and long-dated Treasury bonds all saw their value increase in chorus, a real rarity. As yields have declined, the expectations and spending needs of investors appear to have remained constant, leading them to assume additional risk in varied asset classes around the world. Whereas many past bull-market rallies have been greed-based, this one seems more need-based.
In addition, we thought the following comments from the managers at Tweedy, Browne Value TWEBX did a good job of tapping into the difficult position many of our top managers find themselves in with the equity markets at such elevated levels:
Whether or not we have reached bubble territory is subject to debate, but investors should be cognizant that, if risk is indeed largely predicated on the price one pays for a security, it is no time for complacency. As you well know, we are not about to make forecasts because in our mind, we are not sure from an investment standpoint that they are much better than random guesses. We think of ourselves as being in the business of chasing value, not performance, and we do know that we have to pay, on average, a whole lot more for a dollar of value today. Our experience has taught us that if we keep looking, and exercise some patience, opportunities will turn up.
Against this backdrop, our Ultimate Stock-Pickers have been managing their portfolios, and it explains why over the last four calendar quarters our top managers have produced some of the lowest levels of buying and selling activity that we've seen from them during the last five-and-a-half years. It also explains the growing cash balances at some of our top managers, primarily those that are not constrained by investment mandates requiring them to be fully invested at all times. While the group of 22 fund managers included in our investment manager roster had an average cash balance of 9% (and a median cash balance of 5%) at the end of the most recent period, the unconstrained funds had an average cash balance of 12% (and a median cash balance of 10%). This compares with an average of less than 5% for all U.S. stock funds tracked by Morningstar. Despite the risk aversion apparent on the part of some of our Ultimate Stock-Pickers, many of our top managers continue to put money to work in firms with economic moats--particularly those with wide economic moats--when they are able to find high-quality businesses trading at discounts to their estimates of intrinsic value. Unfortunately, the number and similarity of purchases and sales across our top managers has dwindled as the market has moved higher, making it difficult to find strong buy and sell signals across multiple managers.
Market Fair Value Based on Morningstar's Fair Value Estimates for Individual Stocks
Source: Morningstar Analysts
When looking at the buying activity of our Ultimate Stock-Pickers, we tend to focus on both 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), focusing on the impact these transactions have on the portfolio overall. When looking at this buying activity, though, it should be noted that the decision to purchase these securities could have been made as early as the start of April, with the prices paid by our top managers different from today's trading levels. As such, investors should assess the current attractiveness of any security mentioned here by looking at some of the measures our stock analysts' research regularly produces, like the Morningstar Rating for Stocks and the price/fair value estimate ratio. It is especially important right now, with the S&P 500 trading at/near record highs and the market as a whole looking modestly overvalued, with Morningstar's stock coverage universe trading just above our analysts' estimates of fair value.
Top 10 High-Conviction Purchases Made by Our Ultimate Stock-Pickers
Stock Price and Morningstar Rating data as of 08-15-14.
A quick glance at the high-conviction purchases that were made by our Ultimate Stock-Pickers during the second quarter of 2014 underscores the weaker buying environment our top managers continue to face in this market. Just 12 of the top 25 conviction purchases that were made during the period had more than one of our top managers involved. This compares with periods prior to 2013 when the top half of our list of top 10 high-conviction purchases in any given quarter tended to have four or more of our Ultimate Stock-Pickers making meaningful stock purchases.
With all 10 names this time around being purchased by just two of our top managers, it is difficult to highlight one name over another. That said, our list of top 10 high-conviction purchases is ranked on relative conviction levels, so we can say that Amazon AMZN was purchased with more conviction that Wal-Mart WMT, but the difference in conviction between the two was actually fairly small. With regards to Amazon, the stock was not only bought with conviction by Oakmark OAKMX and Morgan Stanley Institutional Growth MSEGX, but was a new-money purchase for the former fund, with manager Bill Nygren having the following to say about his purchase of the stock (which one would not typically consider to be a value name):
That brings me to our newest position, which will no doubt make some question our credentials as value investors: Amazon. Consensus forward earnings for Amazon are a little over a dollar. At the median forward P/E multiple, Amazon would be priced in the low $20s. So, even though the stock fell $124 from its January high of $408 to a May low of $284, its P/E ratio remained in nosebleed territory. But we have never believed the P/E ratio was the be-all and end-all for valuation. Amazon is a retailer – a very efficient retailer. When we compare stocks in the same industry, we often compare their market caps to their sales rather than their earnings. Since 2001, Amazon has generally traded at a cap-to-sales ratio of two to four times that of the average bricks-and-mortar retailer. Having fallen to just under two recently, one might say that, as an advantaged retailer, Amazon looks somewhat attractive.
But that metric misses an important change in Amazon’s business. Third-party sales (sales on amazon.com where the seller is not Amazon) have grown more rapidly than Amazon’s direct business. And on those transactions, accounting rules credit only Amazon's commission as revenue. So if you buy a $100 item on amazon.com from a third party, Amazon is only allowed to show about $13 of revenue, nearly all of which is gross profit. For third-party sales, Amazon is effectively functioning as the mall owner, collecting a percentage of sales as rent. Amazon earns less gross profit on that sale than an average retailer would, but it is also a much lower risk endeavor. For that reason, we think a dollar of third-party sales should be worth about the same as a dollar that Amazon sells directly.
It gets interesting when we adjust our cap-to-sales ratio comparison to include estimated gross third-party sales. Instead of selling at twice the ratio to sales of the average bricks–and-mortar retailer, Amazon is selling at only 80%. So, relative to gross sales, Amazon's stock would have to increase 25% to be priced consistent with the very companies whose survival Amazon is threatening. On that metric, Amazon has never been cheaper.
Should Amazon sell at a discount on sales? The answer largely rests on what Amazon could earn if it wasn’t investing so heavily for future growth. For most asset heavy businesses, growth investment is primarily on the balance sheet, and is slowly expensed on the income statement as depreciation throughout its useful life. In an asset-lite business like Amazon, however, most growth spending gets directly expensed to the income statement, creating a much larger immediate reduction in income. We believe that if Amazon sharply curtailed its growth spending so that it only grew at the rate other retailers grow, it could produce similar operating margins. But we don't want them to do that. We believe that management is maximizing value by investing heavily for super-normal organic growth. So, yes, Amazon is a rapidly growing business. But at this price, we believe it is also a value stock.
Morningstar analyst R.J. Hottovy couldn't agree more, noting that Amazon is trading at 83% of his fair value estimate in a market where stocks overall are trading at 101% of our analysts' fair value estimates, and consumer cyclical stocks like Amazon are trading on par with our analysts' fair values. He notes that Amazon has played a prominent role in the structural shift away from brick-and-mortar retail, and that--aided by the network effect inherent in 250 million active users, and recent investments in fulfillment infrastructure, technology, and content--the firm owns one of the wider economic moats in the consumer sector and will likely remain a disruptive force within the retail, digital media, and cloud computing categories. While Hottovy believes that valuation metrics like price/earnings and enterprise value/EBITDA metrics are less meaningful right now, given the impact that investments will have on near-term margins, he still thinks that Amazon warrants a premium valuation based on its wide economic moat, meaningful avenues for growth, and longer-term margin expansion potential.
Oakmark also made a high-conviction purchase of Monsanto MON during the period, joined again by the managers at Morgan Stanley Institutional Growth, with Bill Nygren noting the following about their interest in the stock, which was a new-money purchase as well:
Monsanto is a leading global provider of seeds, biotechnology traits, herbicides and data analytics for farmers. We believe Monsanto is a very high quality company with above-average growth prospects and an exceptionally strong competitive position in a large and consolidated industry. In our view, Monsanto’s lead is likely to widen as successful traits are combined and as the company maintains its distribution advantages. Additionally, Monsanto’s precision agriculture platform, led by its recent purchase of The Climate Corporation, could provide significant upside and further differentiate Monsanto from its competitors, since growers are only in the early stages of using this technology to improve yields. For the past year and a half, management considered a more aggressive capital structure, and they recently announced a plan to add leverage to the balance sheet while using the proceeds for a large share repurchase program. Low corn prices, challenges in valuing their biotech pipeline and the difficulty of quantifying upside from precision agriculture have caused Monsanto to sell for materially less than our estimate of its intrinsic business value.
While not as cheap as Amazon right now, the shares are trading at close to a 10% discount to our $130 fair value estimate, compared with a basic materials sector that is trading a bit closer to fair value. Morningstar analyst Jeff Stafford believes that Monsanto's portfolio of patented traits forms the basis of its wide economic moat, much in the same way that patent-protected drugs form the foundation for moats at pharmaceutical firms like Pfizer. Stafford further notes that the firm's success at selling and distributing its patented traits continues to throw off cash that can be invested each year in research and development for next-generation offerings, further continuing its cycle of successful product innovation. He views Monsanto's recently announced two-year $10 billion share repurchase program as being value-neutral, given that the stock is trading relatively close to his fair value estimate. However, he believes it will limit the potential for the firm to go out and do a value-destroying acquisition, especially with rumors floating around more recently that Monsanto was looking to buy rival Syngenta (which in his view has an inferior seed portfolio) for more than $40 billion.
Although both Oakmark and Morgan Stanley Institutional Growth were involved in the purchases of two other names-- Visa V and MasterCard MA--on our list of top 10 high-conviction purchases, they did not rise to the level of commentary that we saw with Oakmark's new-money purchases. We did, however, get some insight from the managers at Diamond Hill Large Cap DHLAX about their new-money purchases of MetLife MET and Noble Energy NBL, who had the following to say in their quarterly letter to shareholders:
We initiated new positions in several companies during the quarter. Global life insurer MetLife, Inc. was trading at a significant discount to our estimate of its intrinsic value due to uncertainty regarding capital requirements that may result from MetLife being designated as a non-bank “systemically important financial institution” (SIFI). In addition, the stock price did not seem to reflect the steady improvements in MetLife’s risk profile since CEO Steve Kandarian took over in 2011.
Noble Energy, Inc. is a well-managed and well-positioned oil and gas exploration and production company. The price during the quarter provided an opportunity to establish a new position. We believe that Noble has a very attractive asset base concentrated in the DJ Basin, Marcellus, Gulf of Mexico, and Eastern Mediterranean that provides a long runway of development opportunities.
We were somewhat less fortunate in getting details from Pat English at FMI Large Cap FMIHX about his fund's new-money purchases of Progressive PGR, Ross Stores ROST, and Omnicom OMC, as he noted only the following about these transactions:
We repurchased Omnicom after selling it last July when they announced a merger with the French advertising giant, Publicis. We thought this was a mistake and apparently the managements of both firms eventually came to the same conclusion, as the deal was scuttled; we’re confident the company will favor the organic growth route they previously embraced, and we were able to reestablish our position at favorable relative prices. Small positions in Progressive Corporation and Ross Stores were purchased in the quarter. We will have more to say about these companies in future letters.
While we wait to see what information he has for us with regards to these transactions, we would note that of the three names Ross Stores is the only one trading at a discount to our fair value estimate. Morningstar analyst Bridget Weishaar points out that off-price retailers like Ross have increased their customer bases throughout the recession and weak recovery, as consumers have become more price-oriented and willing to trade customer service and an expensive store design for 20%-60% discounts on the same brand-name merchandise. With economic headwinds likely persist over the near term, she thinks that Ross will maintain its market share and continue to benefit from suppliers' excess inventory. Over the next five years, Weishaar views Ross as a fairly compelling idea, given that the firm is likely to generate 7% average annual revenue growth on 2% comparable sales and a 7% increase in stores. She does note, though, that Ross is susceptible to the risk that customers trade back up to full-price stores once the economy improves.
Top 10 New-Money Purchases Made by Our Ultimate Stock-Pickers
Stock Price and Morningstar Rating data as of 08-15-14.
There was no such restraint from Ronald Canakaris, the manager of ASTON/Montag & Caldwell Growth (MCGIX), who was responsible for the new-money purchases of Schlumberger (SLB) and Thermo Fisher Scientific (TMO), noting the following about these transactions in his quarterly commentary to shareholders:
We established three new positions in the Fund during the quarter--Schlumberger, Thermo Fisher Scientific, and W.W. Grainger. Oilfield services company Schlumberger has embraced the shift to more moderate industry capital spending growth, allowing the company to focus on improving margins and returning capital to shareholders. We built the position on better-than-expected U.S. oil activity levels, increasing the chances for upward revisions on top of already solid earnings momentum. Management’s three-year guidance was well ahead of expectations, which prompted an increase in our estimate of fair value.
Thermo Fisher Scientific is a manufacturer of scientific instruments, consumables, and chemicals. The company has a strong merger and acquisition record, and we think the February 2014 acquisition of Life Technologies should enhance the company's depth and scale in genetic sciences and biosciences, and provide a leadership position in proteomics, genomics and cell biology. Earnings are set to accelerate due to the full inclusion of Life’s results and a buildup of operating synergies. We increased the position when the company disappointed on organic revenue growth given our belief that significant synergies from the Life acquisition will increase going into 2015.
We think positive average daily sales along with peaking internal spending on growth initiatives and higher incremental margins should drive acceleration in revenue and earnings growth for W.W. Grainger, a distributor of maintenance, repair, and operating supplies used by businesses and institutions in the U.S. and Canada. We continued to build this position at a more attractive price following a reported May sales number that missed analysts' expectations.
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Disclosure: Greggory Warren has ownership interests in the following securities mentioned above: Citigroup. 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.