By Eric Compton | Associate Stock Analyst
For the past seven-plus years, our primary goal with the Ultimate Stock-Pickers concept has been to uncover investment ideas that not only reflect the most recent transactions of a select group of top investment managers but are timely enough for investors to get some value from them. By cross-checking the most current valuation work and opinions of Morningstar's cadre of stock analysts against the actions of some of the best equity managers in the industry, we hope to uncover a few good ideas each quarter. With three fourths of our Ultimate Stock-Pickers having reported their holdings for the first quarter of 2016, we have a fairly good sense of what stocks they've been buying and selling since the start of the year. Given the market volatility at the start of this year, we expected to see a pickup in both the buying and selling activity of our top managers, which is what ended up being the case.
When looking at the purchases of our Ultimate Stock-Pickers, we focus on both high-conviction purchases and new-money buys. We think of high-conviction purchases as instances where managers have made meaningful additions to their existing holdings (or significant new-money purchases), focusing on the impact that these transactions have on their overall portfolios. We do, however, recognize that the decision to purchase any of the securities we are highlighting could have been made as early as the start of January, with the prices paid by our top managers much different from today's trading levels. As such, it is important for investors to assess the current attractiveness of any security mentioned here by checking it against some of the key valuation metrics--like the Morningstar Rating for Stocks and the price/fair value estimate ratio--that are generated regularly by our stock analysts' research.
Our early read on our top managers’ first-quarter buying activity revealed a slight pickup in purchases, with more managers making conviction buys during the quarter and the overall level of conviction buying being somewhat higher than what we saw during the fourth quarter of last year. As there has been a dearth of buying activity for quite some time, with recent quarters setting new lows for our managers, it was encouraging to see the level of purchases picking up. The largest amount of conviction buying took place in the financial-services sector, which saw a considerable amount of pain during the first quarter. Not too surprisingly, most of the buying in the first quarter was focused on high-quality names with defendable economic moats--exemplified by the number of wide- and narrow-moat names in the list of top 10 high-conviction purchases (as well as among the top 25 high-conviction purchases this time around).
While the purchase of more financial-services names did expose our top managers to stocks with higher uncertainty ratings, at least half of the names on the list of top 10 high-conviction purchases, as well as on the list of top 10 new-money buys, were rated either low or medium uncertainty. The increase in purchases of names with higher uncertainty ratings signals to us that some of our top managers found a few opportunities that were compelling enough to overcome a lack of visibility into results over the near to medium term.
With regards to the top 10 high-conviction purchases during the first quarter of 2016, a significant number of our top managers already owned most of the large financial-services companies that were bought, precluding them from being new-money buys. As a result, despite the slight pickup in overall purchases, only three names--wide-moat Medtronic MDT, narrow-moat Apple AAPL, and nonrated Leucadia National LUK-- appeared on both the list of top 10 high-conviction purchases and the list of top 10 new-money buys for the first quarter. As for the makeup of the new-money purchases during the period, the buying activity was somewhat more widely spread out than the high-conviction purchases, with healthcare--narrow-moat Aetna AET, Medtronic, and wide-moat Pfizer PFE--and technology--Apple, wide-moat Microsoft MSFT, and no-moat Hewlett Packard Enterprise HPE--seeing the greatest level of representation.
Microsoft is now tied for the most widely held stock among our top managers, owned by 17 of our 26 Ultimate Stock-Pickers after making the new-money buy list again this quarter. While Ronald Canakaris at Aston/Montag & Caldwell Growth fund MCGIX, the manager behind the new-money purchase this time around, had little to say about the portfolio addition, he did note that better numbers from the XP refresh, as well as the growth in cloud properties, should benefit the firm's near-term growth prospects. Morningstar analyst Rodney Nelson sees nothing to disagree with in this positive outlook for Microsoft's near- to medium-term growth, having recently increased his fair value estimate for the firm to $61 per share based largely on the issues that Canakaris pointed out.
Nelson notes that Microsoft, often viewed as being synonymous with clunky and stodgy systems in the past (as the technology landscape was rapidly shifting and the firm was seemingly left behind), has embraced change and reinvented itself under new CEO Satya Nadella. The company has become nimbler and more user-friendly, ensuring that the firm will maintain its status among technology's elite for years to come. One of the key developments for Microsoft has been its cloud platform Azure, which has turned the company into one of the most important cloud computing outfits in the world, emerging as a strong number-two player behind wide-moat Amazon.com AMZN. In Nelson's view, Microsoft's cloud platform should continue to garner significant user growth as the firm leverages Azure-hosted software such as Office 365 and Dynamics. He sees the public cloud ecosystem representing a monumental opportunity for Microsoft as new workloads increasingly shift to the cloud. How the company capitalizes on and monetizes Azure will largely determine the success of the firm.
Apple actually made both of our lists this time, and trading at 68% of our analyst's fair value estimate of $133 per share, it is also one of the more undervalued names on the lists. Jensen Quality Growth JENSX and Morgan Stanley Institutional Growth MSEGX each made high-conviction purchases of Apple during the first quarter, with the former actually making a new-money investment in the technology firm. Unfortunately, neither manager offered much information about the purchases. Morningstar analyst Brian Colello continues to believe that the firm is undervalued. He does, however, note that it remains a controversial name, with bulls arguing that it’s a cash cow that is fundamentally undervalued at current prices even if the storied growth of yesteryear is not likely to return, and bears making the case that the company's best days are behind it as innovation has seemed to slow and competition has increased as Apple's first-mover advantage in smartphones has worn off.
While Colello admits that the firm continues to face near-term macroeconomic and currency headwinds, he still believes that in the longer term, the iPhone business and iOS ecosystem remain structurally sound and that Apple's lack of growth does not point to a weakening competitive position or a loss of customer loyalty. He foresees a rebound in revenue and iPhone unit sales, perhaps as early as this fall with the iPhone 7. Colello notes that the company's shares are priced as though the iPhone has already peaked and is facing a prolonged secular decline (which is exactly what the bears believe is happening). While the iPhone no longer appears to be a high-growth business for Apple, Colello believes that demand will be more resilient than what the firm's current stock price implies, especially with customer switching costs around the iOS ecosystem remaining strong. Because the longer-term outcome for Apple is less obvious than it may have been in the past, Colello assigns the firm a high uncertainty rating.
Perhaps no sector was more controversial globally than the banking sector during the first quarter. Negative interest rates in more than a handful of developed markets overseas, the potential for a prolonged delay in future rate hikes by the U.S. Federal Reserve, and concerns about slower economic growth globally were just a few of the worries that affected stocks in the financial-services sector. Narrow-moat Bank of America BAC and Citigroup C, along with wide-moat Wells Fargo WFC, were on our list of top 10 high-conviction purchases, with our buying managers having plenty to say about these names and the sector in general. FPA Crescent FPACX and Oakmark Equity & Income OAKBX each made high-conviction purchases of Bank of America and Citigroup, among other names in the sector. Steven Romick from FPA Crescent had the following to say about the sector and, more specifically, his fund's purchase of Citigroup:
Our equity exposure to financials has increased to 20.5%, up from a net negative exposure in 2008 and higher than the S&P 500's current weighting of 15.6%. We seek the inexpensive and care not a whit about market weightings. Financials, particularly lenders, meet that hurdle. Citigroup, as an example, traded down to ~60% of tangible equity at one point in the first quarter. We believe tangible equity is pretty solid, even after assuming a higher level of charge-offs. Investors will frequently act as if they are still fighting their last war but the balance sheets of U.S. banks and thrifts are far stronger now than they were in 2008 when many financial institutions were wounded and close to dying. On the eve of the global financial crisis, Citi had just 3% tangible equity propping up its tangible assets whereas today, it has 10.5%, higher by a factor of more than three. Some of Citi's loans will default and it won't get full recovery in all cases. When we stress test its balance sheet and assume an unusually bad outcome for its loan book, its capital ratios remain solid. If half of its China, energy and metals & mining loans were to default this year and Citi recovered just 40 cents on the dollar, and if consensus earnings are correct, then Citi would still earn money this year and end 2016 with more than $60 per share of tangible book value and tangible equity to tangible assets of more than 10%. That would mean book value would actually increase despite the write-offs. We, therefore, thought Citi at a 40% discount to its minimum worth was a great risk/reward. We purchased additional shares in the midst of its Q1 downturn along with shares of other lenders that saw similar declines.
The managers at Oakmark Equity & Income echoed similar sentiments on the sector, and in addition to their purchases of Bank of America and Citigroup also made conviction buys of wide-moat State Street STT, narrow-moat Comerica CMA, and nonrated Ally Financial ALLY. Timothy Hartch and Michael Keller at BBH Core Select BBTEX also made some modest movements in financial services, sharing the following insights about the U.S. banking sector in their quarterly letter to shareholders:
Our view is that mainstream investor sentiment on the sector has not only overlooked the attractiveness of bank valuation levels (e.g. low deposit premiums, trough level price-to-tangible book ratios, and price-to-earnings multiples averaging 30% below the market multiple), but has also failed to appreciate that true economic risks for banks are lower than they have been in many years. The latter point is reinforced by the structurally higher capital levels the industry now maintains and the very high bar that banks must pass in the Fed's periodic stress tests. Even if earnings growth is constrained for an extended period, we contend that well-positioned banks can earn solid returns on equity while paying more than half of their earnings back to shareholders via dividends and repurchases, suggesting a potentially attractive proposition vis-à-vis public market valuations that seem to imply an imminent capital crisis. With these considerations in mind, we added modestly to our positions in Wells Fargo and US Bancorp during the first quarter.
Morningstar analyst Jim Sinegal agrees with many of these views, having written in early February (in the midst of what was an ugly rout of financial-services stocks) that despite the fears of energy-related credit losses, global deflation, and potential interbank contagion, the dour outlook the market had for the sector was premature and that the sell-off appeared overdone. Sinegal argued at the time that exposure to the energy sector--both direct and indirect--was more than manageable for most of the large U.S. banks, whose balance sheets remained rock-solid. He noted that underwriting standards, especially with respect to consumer loans, had been unusually conservative since 2008, with securities portfolios more tilted toward short-term liquid assets. While bank stock prices still appear attractive, risks remain--particularly in the short term. Sinegal has long believed that the Fed would be slow to raise rates, with current market data suggesting that further rate increases are unlikely this year. At the same time, credit quality is likely to deteriorate as years of historically low provision rates can't persist indefinitely. Sinegal assigns a fair value estimate of $68 per share to Citigroup, with the share currently trading at a 37% discount to that value, and a $17 per share value to Bank of America, which is currently trading at an 18% discount to his fair value estimate.
Looking more closely at Aetna, it was the only stock to be a new-money purchase from more than one manager during the first quarter. Columbia Dividend Income LBSAX and Diamond Hill Large Cap DHLAX each made new-money purchases in the name, with the activity of the first manager being a bit more subdued, as the holding accounted for less than half a percent of the fund's equity assets at the end of the most recent period. However, Chuck Bath, Chris Welch, and Austin Hawley at Diamond Hill Large Cap bought the name with a fair amount of conviction, with the managers providing the following color about their new holding:
We initiated a position in diversified health insurance company Aetna, Inc., which is in the process of acquiring Humana, Inc. We believe the stock is undervalued for two reasons. First, the market is too pessimistic about the odds of the purchase of Humana closing. We believe market overlap is manageable and the deal should close in mid-summer with modest divestitures. Humana is a best-in-class Medicare Advantage insurer, and should enhance Aetna's clinical capabilities. Second, the market is overly focused on the viability of the public exchanges (Obamacare); however, the exchanges represent only 5% of revenues and can be exited or repriced.
Morningstar analyst Vishnu Lekraj agrees that the Humana acquisition appears increasingly likely and that it should drive profit growth for the managed care organization and boost overall operations over the long run. He disagrees with the overall valuation of the firm, though, believing Aetna to be overvalued right now. Lekraj's main concern is that the long-term secular headwinds facing the MCO sector have not changed, evidenced by the firm's recently reported 140-basis-point increase in its medical loss ratio during the first quarter. He cautions investors to keep this in mind when determining the long-term value of all major MCO sector players. Lekraj expects that greater competition, profit caps mandated by the Affordable Care Act, and available membership growth coming only from lower-profit cohorts will weigh on the sector. Additionally, the sustainability of the individual public exchange market has come into question as this membership cohort remains unprofitable, leading many state-based co-op insurers to close and forcing many major health insurers to curb their growth strategy. While Lekraj believes that the firm is positioned well relative to its peers, as its membership base has been built to a critical level where it can obtain solid provider pricing and benefit from centralized cost scale, he believes that the company's current valuation is a little rich.
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Disclosure: Eric Compton has no ownership interests 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.