(By The Morningstar Ultimate Stock-Pickers Team)
Brett Horn | Associate Director of Equity Research
As many of you know, the primary aim of the Ultimate Stock-Pickers concept is to scour through the holdings, purchases, and sales of top investors that we admire, mining this data to surface stocks that are drawing the interest of these managers. Given the breadth of our own equity research, we feel we are in a unique position to cross-check the activity of these Ultimate Stock-Pickers with the valuation work and opinions of Morningstar's own cadre of stock analysts, with the end goal being to uncover investment ideas that investors might find useful.
With more than two thirds of our top managers having reported their stock holdings for the most recent period, we're beginning to get a good feel for where our Ultimate Stock Pickers were putting money to work during the second quarter. It should be noted, though, that unlike the first quarter of 2011, which saw more than $25 billion flow into U.S. stock funds (and close to $15 billion flow into international stock funds), investors reversed course during the second quarter, pulling money out of equities at an accelerating rate. With many mangers facing increased redemptions, there was a bit more selling activity during the second quarter than we've seen in past periods. We expect this to be the case during the third quarter as well, given the increased volatility in the global stock markets and the dramatic increase in outflows seen from the U.S. and international stock funds during the month of July alone.
Looking at the purchases that our Ultimate Stock-Pickers make in any given period, we often focus on high-conviction purchases. We define high-conviction purchases as instances where managers make meaningful additions to their existing holdings, or make significant new money purchases in names that were not in the portfolio at the end of the previous quarter. We believe that managers send signals about the level of conviction they have in a position by how much of their portfolio (on a percentage basis) they're willing to commit to a given name at any point in time. For example, we can probably safely assume that the managers at the Yacktman (YACKX) fund, which had 12.3% of their stock portfolio invested in News Corporation (NWSA) at the end of the first quarter, compared to 1.3% in Colgate-Palmolive (CL), have a higher degree of conviction in News Corp than they do in Colgate.
That said, position size can sometimes be influenced by the amount of the portfolio a manager wants committed to a particular sector (especially when there are only a few truly investable ideas in the sector). It can also be influenced by large positions that might be difficult to unwind. For instance, Bruce Berkowitz holds a very large position in St. Joe (JOE) though his Fairholme (FAIRX) fund, which he might find difficult to either increase or decrease in size given that his fund holds about one quarter of all shares outstanding, and he has effectively taken over leadership of the firm by capturing a majority of the company's board seats.
When looking at all of these stock purchases, though, it also pays to remember that these buy decisions were made during a prior period. This means that the prices our top managers were paying for these securities is likely to be different from where they are trading today. As such, the stock that had our managers excited during the second quarter might be not so exciting now, either due to a change in the company's position, or movement in the share price. That said, with the S&P 500 Index (SPX) down more than 10% since the end of the second quarter, many of these stocks might be trading at even more attractive levels, making our current Ultimate Stock-Pickers data even more actionable than it has been in a long time (owing to the rally that has taken place in global stock markets since they bottomed in early March 2009).
| ||Star Rating||Moat Size||Current Price ($)||Price/Fair Value||Fair Value Uncertainty||# Funds Buying|
|Prctr & Gmbl (PG)||5||Wide||61.14||0.79||Low||3|
|Tex Instrmnts (TXN)||4||Narrow||27.18||0.8||Medium||2|
|United Prcl Srvc (UPS)||4||Wide||65.2||0.82||Medium||2|
|Jhnsn & Jhnsn (JNJ)||4||Wide||63.36||0.82||Low||2|
|Can Ntrl Rsrc (CNQ)||5||Narrow||36.67||0.71||Medium||1|
Stock Price and Morningstar Rating data as of 08-12-11.
Looking over the top 10 high-conviction buys of our Ultimate Stock-Pickers, one new name stands out in a big way: Google (GOOG). Google not only makes its debut on our Ultimate Stock-Pickers conviction buying list, but does so with a vengeance, coming in at the top. What's even more striking is the very idea of Google being attractive to managers with a bit more of a value bent in their investment discipline. While few investors have disputed the strength of the company's business or its growth prospects, the stock historically has demanded a very high multiple. But four of our Ultimate Stock-Pickers believed the market had opened enough of a window to buy the name at an attractive price during the second quarter. While not completely new to the name, Parnassus Equity Income (PRBLX) nearly trebled its stake during the second quarter, ending the period with Google as its single largest stock holdings (at 5.4% of the fund's equity holdings). Meanwhile, the managers at RS Capital Appreciation (RCAPX) and Oakmark (OAKMX) both established new positions in the name during the second quarter, and Hartford Capital Appreciation (ITHAX) continued to nibble away at Google, almost doubling its stake but still only committing 1.3% of its equity holdings to the stock.
Looking down the rest of this list, there are a number of names that have popped up a couple of times over the last several quarters, such as Cisco Systems (CSCO), Microsoft (MSFT), Procter & Gamble (PG), and Johnson & Johnson (JNJ). Our top managers have been moving into these names with regularity for some time now, with their interest in "old tech" names appearing to be growing. Cisco, in particular, continues to draw substantial interest. The managers at Yacktman started moving into the name during the fourth quarter of 2010, more than doubled their stake during the first quarter of this year, and then nearly tripled it in the second quarter, making it their fifth-largest holding (at 5.0% of its total stock portfolio) at the end of June. Meanwhile, FPA Crescent (FPACX) and Columbia Value & Restructuring (EVRAX) both established new positions in the name during the second quarter, and Fairholme continued to add to its growing stake.
With regards to Microsoft, which was already the most widely held security at the end of the first quarter (with 16 out of our 26 top managers holding the stock), we saw three managers--Dodge & Cox (DODGX), FPA Crescent, and Yacktman--make meaningful additions to the existing stakes; (although it should be noted that the managers at Parnassus Equity Income completely blew out their holdings in the software giant during the period). Another widely held security, Procter & Gamble also saw three of our top managers--Aston/Montag & Caldwell Growth (MCGIX), Parnassus Equity Income, and Yacktman--adding to their existing stake, with the consumer products giant now accounting for at least 4% of the stock holdings of each of these Ultimate Stock-Pickers.
With the market dropping more than 10% since the end of the second quarter, nine of the 10 names on our list of high-conviction purchases are rated 4- or 5-star by our analysts, making it the largest number of stocks we've seen in quite some time that we would consider buyable in the months after our top managers were buying them. Based on the level of conviction that went into the top three purchases--Google, Cisco, and Microsoft--we thought we'd focus more closely on those names (each of which are trading at at least a 20% discount to our analyst's fair value estimate).
Historically, Google has had two strikes against it from a value investor point of view. First, while few would argue against the fundamental attractiveness of the business and the company's growth prospects, the company's impressive growth has led to a rather rich market valuation, and we believe that most of our top managers would have put it in the "good company, bad stock" category on that basis. On average, Google has traded at a P/E multiple of 35 times over the last five years, a level that few investors with a value bent would have found enticing. Secondly, value investors tend to shy away from technology stocks, as the constant innovation and disruption in the sector makes it all that more difficult to determine long-term intrinsic value. That said, we've seen our Ultimate Stock-Pickers get more and more interested in what some have been calling "old tech" in recent quarters. With the market souring on many of these names this year, valuations have reached a point where our managers have begun to feel that they are being compensated more adequately for the risks they believe they are taking with these stalwarts of the technology industry. While it's a stretch to call Google "old tech," the more constructive view of the sector that seems to be taking hold with some of our top managers might be responsible for helping them to warm up to the name.
But, most likely, the more important factor in the decision to buy Google has been the change in the market valuation of the company. The company was trading at around 16 times the 2011 consensus EPS estimate before it announced its $12.5 billion purchase of Motorola Mobility Holdings (MMI) this week. While our analyst Rick Summer has mixed emotions about the acquisition, believing that Google may have overpaid for the ability to be in a better position to defend the legal challenges that have crept up more recently against the Android ecosystem, the impact to his $720 per share fair value estimate for the firm is expected to be negligible. His broader concerns about Google center on its capital allocation decisions, noting that while "this deal looks less silly than others that the company has avoided, we would be concerned if large deals like this became a recurring theme. Although we understand the need for a stronger legal strategy related to Android, we are skeptical that the baggage of a no-moat handset business is worthwhile."
Having stated in its most recent quarterly commentary that "we believe that paying less than a market multiple to buy a global leader in an above-average growth industry--especially when that company's free cash flow approximates reported earnings--is usually a very good investment," we'll have to see how the Motorola deal impacts the thinking of the managers at Oakmark (as well as at our other top managers that held the name at the end of the second quarter). As for our analyst, he would still prefer to see a somewhat higher margin of safety attached to Google's shares before recommending the stock, but he does admit, given the strength of some of the firm's growth prospects, that an "average" market multiple appears to be overly pessimistic.
Cisco Systems (CSCO)
Cisco has been a regular visitor to our high-conviction buy list in recent quarters, as market opinion of the company has increasingly soured, and our managers have grown even more interested in the name. That said, a kind of "hold the line" mentality seems to have developed among our top managers, perhaps best characterized by Donald and Stephen Yacktman's straight to the point commentary in their second-quarter letter to shareholders that "the company has a stellar balance sheet with significant excess cash, and we think management is objectively facing the challenges in the business."
We've discussed Cisco in depth in several articles this year--most notably our look at high-conviction purchases in the fourth quarter of 2010 and the first quarter of 2011--and it looks like our managers' patience appears to have been justified, as the company finally got a positive response from the market this past week following the release of its fiscal fourth-quarter results (with the stock up about 15% the day after it reported earnings). In looking at the quarter, our analyst Grady Burkett noted that Cisco's results suggest "the firm's efforts to strengthen its competitive position are starting to pay off. Revenue, gross margin, and operating margin all came in slightly ahead of our expectations, and management's fiscal first-quarter guidance suggests that incremental near-term gross margin deterioration will be more than offset by operating expense reduction. We believe gross margins are beginning to stabilize."
Even after the post-earnings pop, the stock is trading at around $16 (or less than 10 times the fiscal 2012 consensus EPS estimate). Given that our managers were buying in the second quarter when the stock ranged from $15 to $18, and the positive signs that emerged during the firm's most recent quarter, the stock still looks very buyable at these levels. Trading at only a little over 60% of his fair value estimate, our analyst Burkett thinks the margin of safety is still more than sufficient on this name.
Like Cisco, Microsoft is another name that has popped on our list of high-conviction purchases over the past couple of quarters, with the stock's valuation appealing to a fair number of our top managers. It looks like the market's gloomy outlook on the name was somewhat reinforced in May of this year, though, as the company announced its decision to acquire Skype for $8.5 billion. Our analyst Sunit Gogia thinks the acquisition "makes strategic sense, but the price is steep" and that "Microsoft will need flawless strategic and tactical execution over the coming months and years to keep its shareholders from losing money on this transaction." While unimpressed, he held his fair value estimate steady, noting that the purchase price represented only about one quarter's worth of operating cash flow for Microsoft.
The managers at Yacktman discussed the deal in roughly the same terms, noting that "while companies disappoint us from time to time, we think it is important to objectively evaluate information in context of the entire investment thesis. In Microsoft's case, we think the valuation is so compelling that we are able to look beyond a deal of this modest size that we do not especially like." Trading in a range of $25 to $27 per share during the second quarter, and currently trading at around $25, investors should be able to realize a price on Microsoft similar to (if not a little better than) what our Ultimate Stock-Pickers were paying for the stock during the most recent period. With the stock trading at only about a 20% discount to his fair value estimate, our analyst would prefer to see a somewhat higher margin of safety before recommending the name.