As part of this process, we scour the quarterly (in some cases, the monthly) holdings of 26 different investment managers
, 22 of which manage mutual funds that Morningstar's manager research group covers, and four of which manage the investment portfolios of large insurance companies. As they become available, we attempt to identify trends and outliers among their holdings as well as any meaningful purchases and sales that took place during the period under examination.
In our last article
, we walked through some of the buying activity we were seeing from our Ultimate Stock-Pickers during the third quarter (and the beginning part of the fourth quarter) of this year. The piece itself was an early read on the purchases—focused on high-conviction and new-money buys—that were made during the period, based on the holdings of over 90% of our top managers.
With all our top managers having reported their holdings for third-quarter 2017, we now have a much more complete picture of what they were up to during the period. Following what had been a recurring trend over the previous six quarterly periods, our Ultimate Stock-Pickers were once again net sellers during the most recent period, albeit at a declining pace as buying activity nearly reached parity with selling activity. Overall activity levels also declined to the lowest levels we've seen in seven periods.
This decline in transaction activity comes as no surprise to us, as these figures continue to match the tone of the most recent quarterly commentaries we've surveyed, which still express concern over stretched valuations amidst a nine-year bull-market run. Our own evaluation of our aggregate coverage universe finds some agreement with this assessment. Currently, our aggregate price to fair value estimate stands at 106%, matching a 52-week high, which suggests some overvaluation.
The trend of more and more capital flowing into passive products has only compounded these stock-picking difficulties as it results in all equities appreciating, regardless of valuation. That said, our Ultimate Stock-Pickers still found some names that piqued their interest, and we believe these are worth highlighting from a valuation perspective.
The conviction buying that took place during the third quarter (and the beginning part of the fourth quarter) was once again focused on high-quality names with defensible economic moats, exemplified by a high number of wide- and narrow-moat companies on our list of top 10 (and top 25) high-conviction purchases. As for the selling activity during the period, most of it seemed to revolve around paring stakes that closely approached our top managers' own internal estimates of fair value, as was the case for positions in narrow-moat rated Apple
as well as wide-moat rated Alphabet
/. Some positions, like narrow-moat rated IBM
and wide-moat rated Medtronic
were trimmed by some of our top managers because of diminished confidence in their prospects. Earlier in the year, Warren Buffett, CEO of Ultimate Stock-Picker Berkshire Hathaway
/, specifically mentioned the effects of competition as underpinning his firm's sales of IBM's shares. He has continued to aggressively sell off shares in the name.
As was the case last period, wide-moat rated Microsoft was once again the most widely sold security during the third quarter (and the beginning part of the fourth quarter). Shares of the technology firm were sold by 11 of the 18 managers that held it coming into the third quarter, with two of our Ultimate Stock-Pickers, AMG Managers Montag & Caldwell
and Sound Shore Investor
selling with conviction. That said, three of our top managers did add shares of Microsoft
to each of their respective portfolios during the period, albeit in small quantities. Even so, Microsoft, along with wide-moat rated Alphabet, Oracle
, Wells Fargo
, Berkshire Hathaway, Comcast
, and Johnson & Johnson
as well as narrow-moat rated Apple, remained top holdings despite seeing a fair amount of selling during the period, with many of our top managers who were selling already having large exposures to each stock. We should also note that an overwhelming majority of the names on our list of top 10 stock sales this period are currently trading nearly at or above our fair value estimates. The only exception at over a 10% discount is wide-moat rated Medtronic, which currently trades at a 16% discount to our analyst's fair value estimate.
The most notable conviction sales to us during the period were once again no-moat rated Tesla
and narrow-moat rated PayPal—with Tesla rising over 40% and PayPal rising over 85%, since the start of 2017. Both stocks are currently trading well above our analysts' fair value estimates. Tesla, in particular, trades at a whopping 50% premium to Morningstar analyst Dave Whiston's fair value estimate of $204 per share. With the stock continuing to defy conventional valuation metrics, it was no surprise to us to see some of our top managers taking some money off the table.
Ultimate Stock-Pickers' Top 10 Stock Holdings (by Investment Conviction)
- source: Morningstar Analysts
As for sector allocation, our top managers remained underweight in energy and utilities relative to the weightings of the S&P 500 Index at the end of October. Our Ultimate Stock-Pickers also continue to hold meaningfully overweight positions in the basic materials, financial services, and industrials sectors (with their exposure to communication services, consumer cyclical, consumer defensive, real estate, and technology being less than 100 basis points off the benchmark index). Compared with last period, our top managers saw their aggregate holdings shift more into basic materials and consumer defensive names, whereas their financial services and technology exposure continued to diminish somewhat.
The overall makeup of the top 10 stock holdings by investment conviction barely changed during the most recent period. The most significant change saw narrow-moat rated Bank of America
displace wide-moat rated Pepsi
, mostly attributable to Berkshire's conversion of warrants into shares of common stock in Bank of America. Narrow-moat rated Apple and wide-moat rated Comcast saw their order of appearance on the list swap, mostly due to Apple being both widely sold and sold with conviction during the period. That said, both stocks were sold with conviction and widely sold during the period. In terms of valuation, Wells Fargo was once again the most undervalued stock on the list.
Taking a closer look at the high-conviction buying that we uncovered during the most recent period, of the names that showed up on our list of top 10 high-conviction purchases, only Starbucks
appeared on our list of top 10 high-conviction purchases last period
. This indicates to us that our top managers had to continue to turn over more rocks in search of attractive bargains. It should be noted that we are looking at all transactions in aggregate here, whereas in the previous article we were focused on individual instances of high-conviction and new-money purchases.
Ultimate Stock-Pickers' Top 10 Stock Purchases (by Investment Conviction)
- source: Morningstar Analysts
As for where are top managers were focusing their attention, the list of top 10 conviction stock purchases this time around was far more concentrated than the last time we looked at our Ultimate Stock-Pickers' top 10 buys and sells. While still somewhat diversified, much of the buying activity was concentrated in the financial services sector this period. Wide-moat rated Alphabet, which ironically also made our list of top 10 sales, was the period's most notable high-conviction purchase, with seven of our Ultimate-Stock Pickers buying the shares during the period. Oakmark Equity And Income
initiated a position in the name during the name, and both Oakmark Equity & Income and Sequoia
meaningfully added to their position in the name during the quarter. From a valuation perspective, wide-moat Wells Fargo was the most attractive name on our list. Also of interest to us were wide-moat United Technologies
and wide-moat Starbucks, which we extensively profiled in our previous issues.
Turning to the cheapest name on our list according to our analysts' fair value estimates, Wells Fargo continues to be battered down as news around its fake accounts scandal continues to hamper the stock's performance. The shares have been relatively flat year to date compared with the S&P 500's year-to-date total return of about 20%. Sequoia, which recently increased its fund's position in the name during the third quarter, highlighted this fact when it made its additional purchases, even as the stock continues to perform in line with its expectations. Shares currently trade at an attractive 16% discount to our analyst's fair value estimate. The bank stock continues to be Berkshire Hathaway's largest holding, at a position size of just under 15% to its overall equity portfolio. In a recent CNBC interview, Buffett noted that while there were some things that went very wrong at Wells Fargo, nothing about the scandal has changed his view on the firm as a long-term investment. That said, Buffett has gone as far as suggesting a five-year clawback of director fees for the board's lapses of oversight during the events that ultimately led to the scandal.
Morningstar analyst Jim Sinegal has also been critical of Wells Fargo's management recently. In June, he downgraded the firm's stewardship rating to standard from exemplary in light of facts that emerged after Wells' submission of a second faulty failure resolution plan to the Federal Reserve. While Sinegal sees earlier news of abusive sales practices and the resulting retirement of John Stumpf as manageable issues related to ill-conceived incentive programs, he sees these unrelated issues as a second strike against the firm. He also believes it's fair to place at least some responsibility for the bank's living will deficiencies on CEO Tim Sloan, formerly the bank's COO. Sinegal believes that until current issues are resolved, management will be unlikely to have full freedom in capital allocation--the primary factor leading to his decision to downgrade the firm's stewardship rating. Sinegal points out that the Federal Reserve's sanctions already limit growth of certain businesses, and he believes that the bank's 2017 Comprehensive Capital Analysis and Review is likely to receive heightened scrutiny. Under these circumstances, Sinegal thinks management will be unable to optimally deploy shareholder capital.
Sinegal continued his criticism of the bank in a note published during the month of October after Wells Fargo CEO Tim Sloan appeared in testimony before the Senate. While Sinegal acknowledges that the individual actions Sloan outlined were encouraging, he remains convinced that Sloan and the rest of Wells' management is ultimately missing the big picture. Sinegal points out that after Sloan's testimony, one question remains unanswered--whether management changes to-date have been sufficient to overhaul Wells Fargo’s corporate culture. On this front, Sinegal concludes that Sloan was ineffective. Sinegal argues that several high-profile allegations were not clearly addressed, including the firm’s treatment of whistleblowers, its use of private arbitration, and a court case involving the company’s attempts to maximize overdraft fees. He was particularly surprised that Sloan was not fully familiar with relatively recent negative headlines, particularly given the firm’s need to rehabilitate its reputation. Wells Fargo’s primary goal is now to “help [customers] be financially successful.” Yet, Sinegal argues that it was unclear how management ensures that the company’s financial goals are aligned with its customers’ financial needs. Even more than a simplistic set of sales goals, Sinegal believes this misalignment of incentives was at the root of Wells Fargo’s problems.
That said, like Buffett, Wells' recent problems do not alter Sinegal's long-term view of the firm as an attractive investment. He still believes that the wide-moat rated bank is attractively valued at an appreciable discount to his fair value estimate, coupled with a healthy dividend yield of nearly 3%. A small number of directors and CEO Tim Sloan also bought the stock during the second quarter at prices similar to current levels, which lends credence to undervaluation by the market.
Wide-moat rated United Technologies also caught our eye. The stock currently trades at a 10% discount to Morningstar analyst Barbara Noverini's fair value estimate of $134, which she recently reaffirmed. Noverini believes United Technologies’ market price reflects near-term challenges, discounting the longer-term value-creation potential of the company's two most significant brands, Pratt & Whitney and Otis Elevators. With cost advantages, intangible assets, and switching costs protecting United Technologies’ wide moat in both business segments, Noverini believes investors willing to own shares for the long haul will benefit from the company's proven ability to navigate the challenges of long product cycles.
With Pratt's product portfolio at an inflection point between the aging V2500 engine and the innovative Geared Turbofan, Noverini thinks that the segment's $10 billion investment will weigh on United Technologies' returns on invested capital until aftermarket revenue starts building. However, Noverini points out that Pratt's new engine strays from the conventional turbofan technology used by competitor CFM International, which is a joint venture between Safran
and General Electric
. As such, Noverini believes this will establish limits on spare parts availability, while making it inherently more difficult for third-party maintenance providers to catch on. In her view, this will benefit Pratt, as both third-party maintenance operators and in-house airline mechanics will initially struggle to match the original equipment manufacturer's inherent expertise in servicing the engines. As a result, Noverini believes this will protect the valuable aftermarket revenue stream for a longer period of time. Noverini adds that already 80% of Geared Turbofan orders are under Pratt's rates per flight-hour fixed maintenance plans, which often last for at least 10 years. Noverini views this progress as strong evidence of building customer switching costs, a dynamic that she expects will build another economic moat for Pratt around the Geared Turbofan program. Noverini believes that the market continues to ascribe very little value to the Geared Turbofan program. Noverini posits that the market is applying a standard industry multiple to trough-like, near-term earnings that reflects costs associated with rigorous preparation for an ambitious product ramp, without factoring any of the longer-term benefits of the new program. However, Noverini asserts that once aftermarket services begin to ramp at the end of the decade, margin improvement at Pratt & Whitney will swiftly follow, rewarding patient investors.
Additionally, Noverini highlights Otis Elevators as another recent pain point in the company's portfolio. She points out that intense competition in a weakening Chinese construction market has recently cast a pall over Otis' growth story. The market has called into question whether the unit's presence in a country with hundreds of aggressive competitors even makes sense. While Noverini acknowledges these challenges, she believes United Technologies' wide moat provides Otis with plenty of defense while waiting out what could be a competitive shakeout in a critical housing and commercial building market with significant levels of oversupply. Finally, on Sept. 4, United Technologies announced it had reached an agreement to acquire narrow-moat aerospace supplier Rockwell Collins for $140 per share, with a majority of the purchase price to be paid in cash and the remainder in stock. The proposed price equates to an equity value of $23 billion and enterprise value of $30 billion. Noverini thinks this move makes strategic sense because it broadens United Technologies’ aerospace portfolio, which remains highly dependent on the Geared Turbofan engine.
Turning to the final undervalued name on our list of top 10 conviction purchases, we look to wide-moat rated Starbucks, which we extensively profiled in our most recent issue of new-money purchases. The stock continues to trade at a 13% discount to consumer strategist R.J. Hottovy's fair value estimate. While we spoke at length about the parallels between Hottovy's and Ultimate Stock-Picker Parnassus Core Equity Investor
's theses, we thought it important to highlight two other facets of this stock--its positive moat trend and its exemplary stewardship rating. Hottovy points out that although the attractive economics of a specialty coffee program have attracted a host of substitutes in recent years, he believes the brand intangible asset behind Starbucks' wide moat is strengthening, which drives his positive moat trend assessment. Hottovy thinks this view is validated by seven consecutive years of global comparable-store sales of 5% or greater. Additionally, he still believes that few national or regional restaurants or specialty coffee operators are willing or able to compete with Starbucks' in-store customer experience, outside a handful of smaller independent coffee chains or select fast-casual concepts.
In particular, Hottovy likes that Starbucks now has a retail concept portfolio that offers a solution for any real estate setting, with large-format Roastery locations offering a truly unique retail destination in major urban markets, upscale Starbucks Reserve stores combining many of the experiential aspects of the Roastery stores in a more flexible setting, the incorporation of Princi bakery counters at Roastery and Reserve locations, and aspirations to incorporate a Reserve Bar within 20% of its traditional stores over a longer horizon. Hottovy also sees longer-term opportunities to reinvent Starbucks' traditional store base, including smaller-format express stores, stand-alone drive-thrus, beverage trucks, and kiosks.
While Hottovy views premium stores as an underappreciated growth initiative in the coming years, he thinks investors should also take note of other drivers for Starbucks to improve store productivity metrics at new and existing locations. Hottovy believes these drivers add incremental support to his positive moat trend rating. Beverage platforms like cold beverages and new beverage innovations developed at Roastery locations should remain a key contributor to comparable traffic and transaction size. Additionally, Hottovy points out that a more refined food lineup--including sous vide egg bites, expanded offerings featuring soups, sandwiches, and salads, and the ability to offer Princi fresh-baked products at Reserve stores--should help to drive greater food growth rates. On top of these initiatives, Hottovy also believes Starbucks still has opportunities to remodel many of its traditional stores using design elements from its Roastery and Reserve formats, which offer an additional potential layer of growth in the future.
Turning to other initiatives, Hottovy remains optimistic about Mobile Order & Pay, a platform that Hottovy believes dovetails nicely with the company's existing digital and loyalty platforms. Hottovy thinks that Mobile Order & Pay could be a game changer across high-frequency retailers and restaurant concepts. The program allows customers to place customized beverage and food orders from mobile devices for pickup in a store of their choosing. Hottovy sees many benefits from the platform trickling down to a myriad of marketing metrics. Admittedly, Hottovy thinks it will take a few quarters to resolve Mobile Order & Pay congestion issues that have weighed on recent store transaction trends. Nevertheless, Hottovy would much rather have a situation where demand outpaces capacity, as these tend to be more easily corrected than other issues. Hottovy is confident that management has the expertise to develop solutions in both the interim and the longer term. With plans to integrate voice recognition technology into its mobile app in 2017 as well as the opportunity to further expand Mobile Order & Pay internationally in the years to come, Hottovy sees an opportunity for even greater utilization of existing stores.
Hottovy is also optimistic about Starbucks' loyalty program synergies across its various business lines and through new partnerships including Spotify, New York Times, and Lyft. In Hottovy's view, the high level of engagement among Starbucks Rewards and mobile app users should facilitate the rollout of a general purpose prepaid reloadable debit card as well as more targeted mobile marketing efforts in 2017. In Hottovy's view, Starbucks' strategic move to expand past its traditional retail roots and develop a more substantive consumer packaged goods business will continue to gain traction in the years to come. Hottovy believes this given the firm's well-recognized brand name that commands premium pricing as well as its unique ability to connect with grocery and mass-channel customers through its licensed on-premises stores and digital platforms. Although consumer packaged goods expansion will require incremental investments over the next few years, Hottovy is convinced that having greater control of its own consumer product distribution will ultimately strengthen the company's competitive position, driving excess economic returns over a longer horizon.
As for the coffee giant's stewardship, the firm recently saw the transition of longtime CEO Howard Schultz to executive chairman. Taking over the reins in April 2017 was president and COO Kevin Johnson. Hottovy believes investors should take comfort in the fact that Starbucks' management team is more experienced and dynamic than at any point in the company's history. While Hottovy acknowledges that Schultz's vision and attention to customer experience have been key to Starbucks' development, his exemplary stewardship rating--which remains in place after the transition--is based on his view that Starbucks has one of the deepest benches in the consumer sector. As such, he expects that the company's key growth objectives will remain on track in the years to come. While Hottovy agrees that most of the focus is rightfully on Johnson after the announcement of Schultz's departure, Starbucks' December 2016 investor day gave Hottovy greater confidence in Johnson's ability to lead the organization. Hottovy points out that not only does Johnson possess a meaningful consumer technology background from his previous leadership roles at Juniper Networks and Microsoft, but he also demonstrates a solid understanding for Starbucks' other strategic priorities, including a focus on its customer experience efforts. Hottovy concludes that Johnson has the backing of the entire executive team based on his conversations with executives. Furthermore, Schultz will continue his involvement with certain Starbucks' premium initiatives, and for this reason, he doesn't expect a repeat of 2008, where Schultz was forced to return to CEO after the firm faced a number of notable setbacks that received a lot of media scrutiny.
Ultimate Stock-Pickers' Top 10 Stock Sales (by Investment Conviction)
- source: Morningstar Analysts
As for our list of top 10 stock holdings by conviction, wide-moat rated Medtronic was the only firm that looked attractive to us. The stock has been in a near-term slump recently, losing just over of 5% of its market value in the past six months, while total returns for the S&P 500 have risen over 10.5% during the same period. Even so, the wide-moat rated firm continues to trade at a 16% discount to analyst Debbie Wang's fair value estimate. In a recent note, Wang relayed that Medtronic posted second-quarter results that demonstrated the strength of underlying demand for its products and the firm’s ability to roll out innovative products, despite unexpected speed bumps from hurricane damage to manufacturing facilities. That said, the firm remains on track to meet Wang's full-year projections, and she's leaving her fair value estimate unchanged. Wang remains a fan of Medtronic’s wide moat. For support, Wang points to adjusted constant-currency quarterly revenue that grew 4% in the third quarter, fueled by structural heart and neurovascular, but partially offset by softness in pain therapies and spine. As is typical for Medtronic, Wang argues that waxing product cycles tend to compensate for waning products.
Wang further believes that Medtronic’s impending new product introductions and recently approved devices should help the firm sustain growth through the near term and close some of the gaps with competitors. Wang points to a next-generation aortic valve that offers significantly reduced rates of conduction abnormalities following the procedure. Previously, this was an issue that required up to 25%-30% of patients to have a pacemaker implanted as well. While Wang believes that the latest transcatheter valve still does not match Edwards Lifesciences' Sapien on arrhythmia, she does think that the aortic valve named Evolut PRO is now within striking distance of its rival. Furthermore, Wang continues keep an eye on the emergence of competition in MRI-safe implantable defibrillators. While competitive commercialization is still accelerating, Wang had anticipated that Medtronic’s market share would erode on the periphery. In contrast to these expectations, however, Medtronic’s position has held up better than Wang has expected, thus far.
Wang is also pleased to see that supply issues with the continuous glucose monitor sensors have been addressed and that adequate supply is in sight. This gives Wang confidence that diabetes revenue should rise to high-single-digit growth into fiscal 2019. Wang also thinks there is potential for further upside, now that rival Johnson & Johnson has directed its Animas pump users to Medtronic.
Finally, Wang is reassured that the commercialization of Intellis, a spinal cord stimulator for relief of chronic pain, should provide some news around Medtronic’s pain franchise and keep it from falling too far behind competitive products. Wang add that a large amount of meaningful innovation has been taking place in the pain device market. For example, Wang points to Abbott Laboratories' variable stimulator that is intended to quiet breakthrough pain and Nevro’s high-frequency therapy. With these innovations taking place in the industry, Wang believes Medtronic was previously at risk of having its leadership position in spinal cord stimulation for pain management nibbled away. Although Wang is skeptical that Intellis is more efficacious than next-generation rivals, simply launching a next-generation product will still help Medtronic, Wang believes. Thanks to Medtronic’s diversification and expansive reach into the hospitals, Wang argues it isn’t necessary for the company to always launch meaningful innovation in every product category. Wang asserts this is a privilege that comes with the firm's wide economic moat. As long as Medtronic doesn’t fall too far behind peers, Wang believes the medical device supplier can still press on as a formidable competitor.
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Disclosure: Joshua Aguilar has an ownership interest in both Berkshire Hathaway BRK.B and Apple AAPL, while Eric Compton has an ownership interest in Berkshire Hathaway BRK.B. 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.