The Morningstar Ultimate Stock-Pickers Team regularly reviews the investment choices of managers we admire in light of the independent research being done by our own equity analysts. Choices of managers we like can sometimes overlap with the views of our equity research department.
For example, we like to watch, and learn from, the investment managers at Berkshire Hathaway. Berkshire's approach to equity investing is closely aligned with Morningstar's own analytical foundations. Leaders in Morningstar's equity research group have been inspired in part by the principles of Warren Buffett, Charles Munger, Lou Simpson, and, in turn, the work of Benjamin Graham and others who influenced the investment leaders at Berkshire.
In Berkshire's latest 13F filing with the Securities and Exchange Commission, which detailed the insurer's common stock holdings at the end of the first quarter of 2010, there continued to be a good deal of overlap between Berkshire's portfolio and our stock analysts' conclusions. Buffett has long stressed the importance of identifying firms with economic moats--durable competitive advantages and other characteristics that can lead companies to produce returns on capital in excess of their own cost of capital. Moat analysis is a central feature of our research here at Morningstar. We rate fewer than 10% of the more than 1,700 stocks that we cover as having wide economic moats. However, among the 36 companies in Berkshire's $51 billion stock portfolio, we rate close to half as wide-moat firms.
It's also interesting to note that our analysts believe that Berkshire's current portfolio is more attractively priced than the market as a whole. The median price/fair value ratio for the more than 1,700 stocks in our coverage universe is 0.94. Within our coverage universe, there remains significant variation between firms we classify as having no moat, and those rated as narrow- and wide-moat firms. We see more value among wide-moat firms, with a median price/fair value ratio of 0.85, whereas narrow-moat (0.92) and no-moat firms (0.99) are closer to being fairly valued. (For those who are interested, Morningstar's Market Valuation Graph allows investors to look at the aggregate price-to-fair value ratio for our entire coverage universe, as well as by moat rating and sector categories.)
Looking at Berkshire's portfolio of 36 stocks, the median price/fair value ratio is 0.80, with only one stock, Washington Post, with a price/fair value ratio above 1.00. Basically, Berkshire's portfolio looks cheap. So, which stocks look the cheapest?
Seven 5-Star Stocks from Berkshire's 03/31/10 Portfolio
Based on last Friday's close, there were seven stocks in Berkshire's portfolio at the end of the first quarter that are currently five-star rated, which means that they are trading below the price where we think investors should consider purchasing them. Believing that these seven stocks warrant further consideration, we collected some commentary from our analysts reflecting their current thinking on these holdings.
Becton, Dickinson & Company
Becton Dickinson's defensible competitive position, unmatched manufacturing scale, technological prowess, and competent management team make this health-care bellwether one of Morningstar analyst Alex Morozov's favourite names in the medical products industry. While not necessarily a high-growth opportunity, Becton offers investors robust and predictable cash flows and consistently strong returns on capital. With three straight quarters of growth, Becton has recovered from a tough 2009. Alex believes the firm should see strong revenue momentum as the year progresses, with hospital spending continuing to improve, and National Institute of Health's (NIH) stimulus spending trickling down to research laboratories. Becton's highly leverageable operating platform and lean infrastructure should translate into a rapid earnings expansion as revenue growth returns. Becton offers a long history of dividend increases, and its dividend yield is among the highest in the industry. Finally, Morozov thinks Becton's squeaky-clean balance sheet and its wise capital allocation policy should make the firm a safe choice for a risk-averse investor. It doesn't surprise us then that Berkshire increased its stake in Becton Dickinson by more than 15% in a period when it was selling other health care names to fund its purchase of Burlington Northern.
ExxonMobil
Our analyst Allen Good feels that ExxonMobil has done an exceptional job of regularly achieving returns on invested capital that exceed those of its peers, mainly due to the global integration of its operations and delivery of mega-projects on time and under budget. While he believes that ExxonMobil is better suited than the other supermajors for the current environment, it does not necessarily mean that production and reserve gains will come easily. Allen does note that ExxonMobil's experience and expertise, particularly with large projects, should allow it to successfully compete for resources. He expects the firm to achieve annual production growth of roughly 2% over the next five years as large projects come on line, but that growth is likely to be uneven given that most of the production gains will be coming from large projects. Allen believes that ExxonMobil's recent purchase of XTO Energy, a broad-based US oil and gas firm that produces roughly 5% of the domestic natural gas supply, could also add upward of 1% growth per year, depending on future investment plans.
General Electric
Morningstar industrial analyst Daniel Holland thinks CEO Jeff Immelt finally has the portfolio that he wants, exiting the recession. NBC Universal should move out of the picture by the end of the year, leaving the firm with its core energy, health care, and aviation pieces (which Daniel believes are all wide moat franchises). In a move repeated by many of the diversified manufacturers in Morningstar's universe, GE shifted its growth focus from acquisitions to heavy research and development, giving the company one of the strongest new product portfolios in recent memory. After the recession, GE Capital's contribution to its parent earnings and cash flow should snap back as delinquencies slow and noncore assets are liquidated. Holland is encouraged by Immelt's recent comments that the dividend will increase by 2011, and that share repurchases will be a priority with the stock trading below $22 per share.
GlaxoSmithKline
Morningstar analyst Damien Conover sees GlaxoSmithKline as a market leader. As one of the world's largest pharmaceutical companies, GlaxoSmithKline has used its vast resources to create the next generation of medicines. In his opinion, the company's innovative new product lineup and expansive list of patent-protected drugs create a wide economic moat. Damien also believes that GlaxoSmithKline's diverse operating platform should more than offset patent expirations for its respiratory drug, Advair, and its anti-viral drug, Valtrex. While the near-term patent losses will weigh on the company's growth in 2010, he expects the company's diverse operations to yield steady long-term earnings growth going forward.
Johnson & Johnson
Damien remains impressed with Johnson & Johnson as well, believing that the firm stands alone as a leader across several major health-care industries. He feels that the firm's diverse revenue base, robust research pipeline and exceptional cash flow generation capabilities provide Johnson & Johnson with a wide economic moat around its business. While many of its competitors are approaching a major patent cliff, Johnson & Johnson has successfully surmounted this hurdle, and is on the verge of returning to growth with several new potential blockbusters. This well-positioned company has survived the loss of patent protection on the anti-psychotic drug Risperdal and neuroscience drug Topamax by bringing forward a robust set of replacement drugs. Damien believes that the company will deploy its enormous cash flows to fund small acquisitions that will augment its own internal development efforts. Additionally, J&J's medical devices and consumer health products greatly reduce the company's earnings volatility and offer investors an opportunity to own a health-care conglomerate.
Lowe's Companies
With close to $50 billion in annual revenue, Lowe's is the second-largest home improvement retailer in the world. Lowe's has established itself as a solid operator over the past decade. Morningstar analyst Peter Wahlstrom is impressed with Lowe's scale, which enables consolidated purchasing power and leads to a low-cost position for the retailer. He also like how the firm's highly automated distribution network seamlessly places vendors, distribution centers, and stores on one IT platform, driving operational efficiency. These competitive advantages generate positive economic returns and support the firm's wide economic moat. Despite the impact from macroeconomic headwinds, which have resulted in three years of negative same-store sales, Peter believes that the firm executed well. Over the last three years, Lowe's has maintained a conservative capital structure, generated more than $3.5 billion of cumulative free cash flow, and paid out more than $1.3 billion in dividends. He is currently projecting double-digit earnings growth in 2010 and 2011, believing that Lowe's is well-positioned to benefit from a multi-year recovery in the U.S. home improvement retail market as housing turnover, unemployment, and consumer spending start to improve.
Sanofi-Aventis
Morningstar analyst Damien Conover believes that Sanofi-Aventis's wide lineup of branded drugs and vaccines, along with a robust pipeline of new products, create strong cash flows and a wide economic moat for this global pharmaceutical firm. He thinks that the growth of existing products and new product launches should help to offset patent losses for its cancer treatment drugs, Eloxatin and Taxotere, as well as its anti-clotting agent, Plavix. With close to a third of Sanofi-Aventis's current sales at risk of generic competition by 2013, Damien does note that the firm faces one of the more challenging patent cliffs in the industry. Nevertheless, he still expects the company to meet its 2013 revenue goal (of total sales comparable to 2008 results) largely due to a strategy that involves building out the firm's consumer health care platform, growing its diabetes franchise, developing new drugs for largely unmet medical needs, and expansion into emerging markets.
Our Views Don't Always Line Up Neatly With Berkshire's
Even with these seven 5-Star opportunities, Berkshire was a net seller of common stocks during the first quarter, even liquidating holdings in two health care firms--UnitedHealth and WellPoint--that are trading below our consider-buy prices. Morningstar analyst Matthew Coffina believes that investors continue to approach the managed care sector with caution, concerned about the impact that health-care reform legislation will have on future earnings power. While health reform certainly contained some negatives--such as Medicare Advantage reimbursement cuts and explicit limits on underwriting margins--he thinks that the impact of these provisions will be more modest than current stock prices seem to imply. Matt believes that UnitedHealth and WellPoint are best positioned to capture market share from smaller competitors with uncompetitive cost structures. He also thinks that they will benefit from an influx of new customers as the previously-uninsured either gain access to insurance subsidies or become eligible for Medicaid. Best of all, the companies continue to generate copious amounts of free cash flow, which they are using to repurchase their undervalued shares.
Disclosure: Bill Bergman owns the following securities mentioned above: General Electric and Lowe's Companies.
