Top Buys and Sells at Oak Value Fund

Although this does not sound too dissimilar from the criteria used by many of the value managers on our list of Ultimate Stock-Pickers, Oak Value has spent a lot of time over the last five years refining its process. Unlike many value investors, who begin with what is most attractive from a valuation standpoint and then go through the process of analyzing those opportunities to identify their potential investment universe, the managers at Oak Value focus on what they consider to be the best businesses out there (regardless of valuation), and then transact in the securities of those firms only when there is a wide enough margin of safety to warrant purchasing them. The "investable universe" for the managers at Oak Value is composed of businesses that have high operating margins, high returns on equity, and high returns on invested capital, as well as some sort of competitive advantage that will allow them to keep competitors at bay for an extended period of time.

This bottom-up approach to investing is much like what our analysts here at Morningstar do when evaluating whether or not a company has an economic moat. It should come as no surprise then to note that of the 29 stocks in the Oak Value Fund at the end of September of this year, 28 had economic moats (with 20 of those 28 firms having wide economic moats). It is also interesting to note that while the fund has tended to hold a concentrated portfolio of 20 to 25 stocks over much of the last five years, these holdings have been drawn from a universe of just 65 securities, with the managers at Oak Value sometimes buying a stock they will later sell only to buy it back again once the valuation warrants a purchase.

Top Purchases by Oak Value over Last Two Quarters

Stock price and Morningstar Rating data as of 10-29-09.

One such security has been  Apollo Group , which the managers at Oak Value stepped back into during the second quarter for the third time in the last three years, noting in their second-quarter review that "investments in Apollo have been among its most rewarding as [they] have taken advantage of Mr. Market's manic depressive tendencies" over the years. While we had recently mentioned that we wouldn't be surprised if the fund took advantage of last month's volatility in for-profit education stocks to buy up more shares of Apollo, when fears over increased government regulation of the industry erupted in the wake of a report from the Government Accountability Office, this turned out not to be the case.

The managers did, however, make a meaningful new money purchase in  ITT Educational Services , one of Apollo's main competitors, noting that while the "education sector is a bit out of favor among investors at this time, owing to fears of the rising student loan default rates that can be expected to accompany rising unemployment," strong demand for postsecondary education (especially during the downturn in the economy) will continue to benefit companies such as Apollo and ITT. This echoes the thoughts of our analyst Todd Young, who believes that what Oak Value refers to as "Mr. Market's manic depressive tendencies" may have provided investors with another opportunity to step into Apollo, after the stock traded off close to 20% this past week on news that the SEC's enforcement division has started an informal inquiry into the company's revenue-recognition practices. While details of the investigation are limited, Todd does not believe that the investigation will have a significant impact on his valuation and, as such, continues to believe that Apollo's shares are undervalued.

"At its core, this is a business of collecting, hauling and disposing of waste. On a stand-alone basis, we find the economics of trash collection and hauling businesses modestly attractive, even when performed under long-term municipal franchise contracts. The landfill business, on the other hand, is a good business on a standalone basis as it has significant barriers to entry. The industry has consolidated and gone through significant route, costs and market rationalization as the businesses of collection, hauling and disposal have become integrated. With this transition, the economics and pricing power have improved significantly and the industry now has the ability to produce advantaged economics over the long term. For the most part, the industry operates as an oligopoly with a limited number of service providers in each market. From an investor standpoint, the most important thing to know about oligopolies is whether the players will act rationally. In the case of the waste industry, we believe they do."

Our analyst Bradley Meeks couldn't agree more with this assessment, but he notes that with both Republic Services and Waste Management trading at prices close to our own fair value estimates for these firms, it is difficult to see investors stepping into either name right now. If he had to choose between the two, though, he'd pick Waste Management over Republic right now, mainly because while both stocks are trading at similar price/fair value multiples Republic has the added risk of integrating its acquisition of Allied Waste to contend with in the near term.

Of the three other new money purchases-- Colgate-Palmolive ,  Automatic Data Processing , and  Monsanto --made by the Oak Value Fund over the last two quarters, only Monsanto remains in 5-star territory. Our analyst Ben Johnson firmly believes that Monsanto is a fierce competitor that continues to dominate a market that it essentially created more than a decade ago. While there have been some near-term head winds--from lower crop prices to weak demand and increased competition within its Roundup herbicide business--Ben thinks that the firm's ongoing commitment to research and development and assertive capital allocation will allow it to continue to reward shareholders in the long run. This view was echoed by Oak Value in its second-quarter review, when the managers noted:

"Monsanto has been and will continue to be an advantaged business. Its global brands command leading market share positions, produce very attractive economics and provide opportunities for meaningful long-term organic growth. After years of research, we are pleased to have been given the opportunity to own this fine business at an attractive valuation."

Top Sales by Oak Value over Last Two Quarters

Stock price and Morningstar Rating data as of 10-29-09.

Even more interesting than these purchases were the outright sales made by the fund during the most recent quarter. While not based on any change in the firm's fundamentals, the managers at Oak Value completely eliminated their position in  Tiffany , another stock they have regularly bought and sold over the years, as the valuation had reached a point where they felt it best to sell the stock. Tiffany had been a big contributor to performance, increasing more than 120% from its lows in early March to the end of September.

The company also took advantage of a similar run in the shares of  eBay to completely sell its position in the global e-commerce powerhouse, noting that the firm's "on-line auction business ended up being less resilient and had more challenges" than they had originally anticipated. This view has been echoed by our analyst Larry Witt, who does, however, note that while the core auction business is being pressured by cyclical and secular head winds, eBay's fixed-price business and PayPal should help the firm maintain its robust cash flow. With the stock currently trading in close proximity to our fair value estimate, it doesn't surprise us all that much that the managers at Oak Value sold the shares in order to redeploy the capital into what they considered to be better investment opportunities.

Disclosure: Greggory Warren own shares in the following securities mentioned above: Colgate-Palmolive.