Our Ultimate Stock-Pickers' Top 10 High-Conviction and New-Money Purchases

For the past decade, our primary goal with the Ultimate Stock-Pickers concept has been to uncover investment ideas that not only reflect the most recent transactions of our grouping of top investment managers but are also timely enough for investors to get some value from them. In cross-checking the most current valuation work and opinions of Morningstar's own cadre of stock analysts against the actions (or inactions) of some of the best equity managers in the business, we hope to uncover a few good ideas each quarter that investors can dig into a bit deeper to see if they warrant an investment.

With all but two (24 out of 26) of our Ultimate Stock-Pickers having reported their holdings for the second quarter of 2019, we now have a good sense of which stocks garnered attention during the period.

Recall that when we look at the buying activity of our Ultimate Stock-Pickers, we focus on high-conviction purchases and new-money buys. We think of high-conviction purchases as instances when managers have made meaningful additions to their portfolios, as defined by the size of the purchase in relation to the size of the portfolio. We define a new-money buy strictly as an instance where a manager purchases a stock that did not exist in the portfolio in the prior period. New-money buys may be done either with or without conviction, depending on the size of the purchase, and a conviction buy can be a new-money purchase if the holding is new to the portfolio.

We also recognize that the decision to purchase any of the securities highlighted in this article could have been made as early as the start of April, with the prices paid by our managers being much different from today’s trading levels. Therefore, we believe it is always important for investors to assess for themselves the current attractiveness of any security mentioned here based on myriad factors, including our valuation estimates as well as our moat, stewardship, and uncertainty ratings.

Looking more closely at the top 10 high-conviction purchases during the second quarter of 2019, we see a list of stocks that are broadly undervalued. The buying activity was somewhat concentrated within the industrials, energy, and technology sectors. Each of these sectors contributed at least two stocks to the top 10 high-conviction purchases list this quarter. We were interested to see that the energy sector received attention this quarter, as this sector has been spurned by our Ultimate Stock-Pickers for the past several years. All of the stocks on the top 10 list of high-conviction purchases have been granted an economic moat by Morningstar analysts, which is indicative that each of these companies has a sustainable competitive advantage. Booking Holdings remained the top conviction purchase for the second consecutive quarter and was highlighted extensively in the previous New Money Purchases article. The three names that stuck out to us from this list based on valuation were Best Idea and narrow-moat rated Diamondback Energy FANG, wide-moat rated 3M MMM, and narrow-moat rated Cognizant Technology Solutions CTSH, all of which are covered below.

Once again, there was a moderate amount of crossover between our two top-10 lists this period, with five names appearing on both lists. Many of our Ultimate Stock-Pickers bought into the same names this period, with eight stocks receiving conviction purchases and four stocks receiving new-money purchases from at least two Ultimate Stock-Pickers. In addition to the names already mentioned, no-moat rated Macy's M stuck out to us as a valuation play within the troubled brick-and-mortar department store retail space.

From a valuation perspective, narrow-moat rated Diamondback Energy was one of the most attractive to make our top 10 high-conviction purchases list. The Oakmark Equity and Income fund OAKBX and the Oakmark Investor fund OAKMX made conviction new-money purchases into the name this quarter. The Oakmark Equity and Income fund provided the following commentary on its purchase:

Our second purchase was Diamondback Energy, an oil and gas producer with a high-quality acreage position located entirely in the Permian Basin. The Permian Basin is the largest and lowest cost basin within the U.S., positioning Diamondback at the bottom of the global cost curve. CEO Travis Stice and his management team have produced industry-leading returns at Diamondback by focusing on low-cost operations and best execution. We like management's focus on per share value, and we believe the market doesn't appreciate Diamondback's acreage quality and drilling inventory following its acquisition of Energen. Diamondback is growing production 15% per year with a mid-single-digit free cash flow yield and trades at a significant discount to net asset value and historical per acre multiples.

This thesis is in line with Morningstar Analyst Dave Meats' research on the name, and Meats has added the stock to the Best Ideas list.

Meats asserts that Diamondback Energy is among the best-positioned oil producers in the business and can thrive at Morningstar's $55 per barrel West Texas Intermediate midcycle price estimate. Meats expects that Diamondback's multidecade runway of low-cost drilling opportunities will allow the company to continue being an industry cost leader, an advantage that underpins his narrow-moat rating. Meats contends that Diamondback's advantage is largely location based. The company owns some of the most prolific areas within the cheapest place to produce oil--the Permian Basin. Meats notes that it is no coincidence that in 2017, the top three companies in Morningstar's oil and gas coverage, ranked by operating margin, were all Permian Basin pure plays. Diamondback, which ranked number one, has a huge footprint in some of the most prolific areas within the Permian Basin. Meats emphasizes this point because the precise surface location of a horizontal shale well plays a huge role in determining its eventual productivity and influences the oil content of its production stream.

The company posted impressive second-quarter production levels and expects to build more oil wells in 2019 than it originally guided to with essentially no change to the budget. Meats views the current weakness in the stock as a buying opportunity amid a cyclical dip across the sector.

Wide-moat rated 3M also piqued the attention of Ultimate Stock-Pickers. Both the Jensen Quality Growth fund JENSX and the American Funds American Mutual fund AMRMX made conviction purchases into the name this quarter, but the Parnassus Core Equity Investor fund PRBLX made a conviction outright sale of the name this period, which indicates disagreement among the Ultimate Stock-Pickers. Jensen Quality Growth fund's management articulated the bull thesis on the name:

While we believe the underlying business fundamentals at 3M remain solid, investors were less enthusiastic about the most recent quarter which revealed a surprising shortfall in company performance due to weak top-line revenue and earnings growth, corporate restructuring, and additional reserves for environmental and safety litigation. As a short-cycle industrial company, sudden shifts in end markets can cause challenges in the short term. Overall, we believe the company is in sound shape fundamentally and will work its way through near-term challenges and will return to more consistent business performance.

Parnassus Core Equity Investor fund's management made the following commentary regarding its outright sale, which articulates a bearish thesis on the name:

3M's stock fell after the company reported weak quarterly earnings and significantly reduced its financial guidance for the full year due to a slowdown in China and 3M's automotive and electronics businesses. This was the fourth consecutive reduction in annual guidance, and the deepest cut yet, which led us to re-evaluate our investment. We also became concerned that 3M's environmental liabilities stemming from its historical production of per- and polyfluorinated substances (PFAS) could be significant, so we exited our position.

While Morningstar analyst Joshua Aguilar recognizes the considerable headwinds exist for 3M, particularly due to the company's legal liability related to its exposure to per- and polyfluoroalkyl substances (PFAS) that can contaminate water supplies, he does not see anything that is fundamentally wrong with the wide-moat company. Aguilar thinks that if the stock price continues to trade down to his 5-star price (which is currently about $150), then the shares would offer an attractive opportunity for long-term investors. Aguilar thinks of 3M as a GDP-plus business, in which the "plus" is a testament to the value-additive nature of the company's products, churned out by what Aguilar contends is a virtually inimitable research and development platform.

Aguilar sees 3M's commitment to leveraging innovation across its disparate businesses as a major differentiating factor for the firm, which makes it worth more than the sum of its parts. Aguilar points to the firm's abrasive technology affecting industrials, construction, home improvement retail, and automotive aftermarket collision repair, as well as the firm’s adhesives, which can be used in applications ranging from Scotch tape and Post-it notes to Tegaderm medical dressings as examples of the company's ability to benefit in numerous ways from its research and development platform. Quantitatively, the company's commitment to research manifests itself in the allocation of just under 6% of net sales to research and development, though Aguilar anticipates that this figure will increase toward 6% by 2023. Aguilar expects the firm will benefit from this research and development to the tune of just under $9 in gross profit for every dollar spent on R&D.

Quarterly results have been challenging recently, due to the ongoing PFAS legal liability, a slowdown in automotive, semiconductor, and Chinese markets, as well as the effects of customer inventory destocking. Given the available evidence, Aguilar projects about a $3.4 billion settlement, which reduces his fair value estimate by about $4 (approximately 2%) when amortized over the course of his explicit forecast. This charge is not material enough to have an impact on Aguilar's overall investment thesis, but he does recognize that the timing of the settlement could have an impact on cash flows. In spite of these headwinds, the company improved underlying margins and had a relatively flat top-line organic local-currency growth against a difficult comparison in 2018's second quarter, which Aguilar sees as welcome results.

The Dodge & Cox Stock fund DODGX, Jensen Quality Growth fund, and the AMG Yacktman fund YACKX all made conviction purchases into Cognizant Technology Solutions Corporation, an IT services provider, during the period. Jensen's team provided the following commentary on the purchase:

Revenue growth at Cognizant Technology Solutions has slowed in recent quarters, and the company's most recent earnings release prompted decline in reaction to a slowdown in sales and earnings. The sell-off was further exacerbated by an unexpected reduction in near-term guidance. Additionally, a new CEO began leading the company on April 1. We expect the company to remediate its short-term challenges, and we are confident that its business model remains fundamentally robust.

Morningstar analyst Andrew Lange has a 4-star rating on the IT company and thinks the firm is an attractive investment opportunity for those seeking exposure to a world-leading IT services provider. Cognizant provides such services as technology consulting, application outsourcing, systems integration, business process services, and cloud services. The company differentiates its offerings by forming critical long-term relationships and intimate knowledge of customer business processes, which Lange believes allows the company to generally retain about 90%-100% of clients. This deep customer knowledge underpins Lange's narrow moat rating on the firm, which is based on switching costs. Although Lange anticipates that the company's revenue growth will slow, he believes that it can outpace the overall IT services industry due to investments in key industries, new geographies, global delivery, and social, mobile, analytics, and cloud technologies.

AMG Yacktman fund also made a conviction new-money purchase into no-moat rated Macy's during the second quarter. Although the retailer's second-quarter outlook severely disappointed investors, who punished the stock with a double-digit percentage decline in share price, Morningstar analyst David Swartz views the shares as attractive, though he intends to reduce his $27.50 fair value estimate by a single-digit percentage. Swartz anticipates that the company will not cut its current annual dividend of $1.51 because he anticipates that Macy’s 2019 free cash flow of more than $1 billion will be more than enough to cover the dividend cost of less than $500 million, and the stock currently offers more than a 9% yield.

While Swartz is positive on the company's ability to maintain its dividend, he does see headwinds from operating too many stores and rising competition from both e-commerce and traditional brick-and-mortar discounters. Swartz notes that the company operates hundreds of stores in weaker malls, which he sees as facing considerable headwinds from vacancies that reduce overall mall traffic. These stores are not generating traffic, which limits the store's revenue-generating potential. Swartz is concerned that the company is too dependent on significant discounting and promotion to move merchandise in these lower-productivity stores, which pressures the company's gross margin.

Swartz also believes that the company's efforts to respond from increasing online and offline competition is inadequate. On the online front, the company has been losing market share to e-commerce, which Swartz notes has reduced the need for the big-box stores that Macy's operates. While Swartz recognizes that the company's e-commerce segment has been a growth area, it appears that the growth in this segment has cannibalized its physical store sales because same-store sales have been weak despite consistent growth in e-commerce sales. Offline, Swartz is concerned that the company is losing share to discounters such as Ross Stores and TJ Maxx, which are able to undercut the company by buying large amounts of apparel. These discounts are enough to undercut Macy's prices at substantially better margins. While Swartz anticipates the company generates sufficient cash flow to pay the dividend, his no-moat rating with a negative moat trend highlight the substantial headwinds the company faces.

No discussion would be complete without looking at what Berkshire Hathaway BRK.B has been up to, and this quarter the insurance company focused on technology and financials stocks. Berkshire utilized the $1.8 billion in proceeds from Knauf's acquisition of its 28% ownership stake in USG Corporation, a building products manufacturer, to fund the purchase of four names--Amazon.com AMZN, Bank of America BAC, US Bancorp USB, and Red Hat--during the period. Berkshire's stake in Amazon.com is now worth more than $1 billion, which puts it more firmly in the Buffett-approved box. The company's additional purchase of Bank of America pushes Berkshire's ownership level above the 10% threshold that Berkshire prefers to keep its ownership holdings under. From a valuation perspective, our analysis best aligns with Berkshire Hathaway's purchase of Amazon.com, which trades at about a 20% discount to Morningstar analyst R.J. Hottovy's fair value estimate.

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Disclosure: Burkett Huey has an ownership interest in Berkshire Hathaway. 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.