Each year, fund investors would like to see the manager of the actively managed funds they own beat the market, but they’ve been left wanting for well over a decade. The lack of consistent outperformance by large-cap active managers (the main contributors to the Ultimate Stock-Pickers concept) has been well documented by Morningstar’s Active/Passive Barometer. It’s a cutthroat world out there for active managers. For the 20 years ending October 2021, just 10.5% of active funds in the large growth category have managed to survive and outperform their average passive peer.
Actively managed U.S. growth funds struggled during the year through June 2021. Success rates among large-, mid-, and small-cap growth managers declined precipitously versus the 12 months through June 2020. The combined success rate among managers of active growth funds was just 27.5%.
In 2020, the coronavirus sell-off and subsequent rebound tested the narrative that active funds are generally better able to navigate market volatility than their passive peers. But the data showed that there’s little merit to this notion. Across all 20 categories we examined, just 49% of the nearly 3,500 active funds included in our analysis survived and outperformed their average passive counterpart.
The cheapest funds succeeded about twice as often as the priciest ones (a 35% success rate versus a 17% success rate) over the 10-year period ended June 30, 2021. This not only reflects cost advantages but also differences in survival, as 66% of the cheapest funds survived, whereas 59% of the most expensive did so.
Over the long haul, actively managed U.S. large-cap equity funds have generally succeeded less often than active U.S. mid- and small-cap funds. That said, they flipped the script in the 12 months through June 2021. Over that span, nearly 40% of active large-cap funds lived and outperformed their average passive peer versus 33% and 36% for active mid-cap and small-cap funds, respectively.
It’s worth noting that we devised the Ultimate Stock-Pickers concept as a stock-picking screen, not as a guide for finding fund managers to add to an investment portfolio. Our primary goal has been to identify a sufficiently broad collection of stock-pickers who have shown an ability to beat the markets over multiple periods (with an emphasis on longer-term periods). We then cross-reference these managers’ top holdings, purchases, and sales against our own stock analysts’ recommendations regularly, allowing us to uncover securities that investors might want to investigate further. There will always be limitations to our process. We try to focus on managers that our fund analysts cover and on companies that our stock analysts cover, which reduces the universe of potential ideas that we can ultimately address in any given period. This emphasis is also the main reason why we focus so much attention on large-cap fund managers, as they tend to be covered more broadly on the fund side of our operations, and their stock holdings overlap more heavily with our active stock coverage. That said, by limiting themselves to the largest and most widely followed companies, our top managers may miss out on some big ideas on small companies that have the potential to generate greater outperformance in the long run.
Overall, 2021 was a challenging year for stocks, given the COVID-19 pandemic. After a sharp drop in the second quarter, the market initially bounced back as increasing vaccination rates seemed to steady a wobbly global economy. But now with the omicron variant surfacing, the conclusion to that recovery seems to be on hold. Certain sectors remain handicapped (travel, indoor dining), and there remains a high degree of uncertainty as we head into the new year. New travel restrictions, government lockdowns, and the anticipated spread of COVID-19 during the winter season will make for a tumultuous 2022.
Our own Morningstar Ultimate Stock-Pickers index has not been immune to the trend of underperformance of active management, as it still trails the S&P 500 index year to date.
Aside from tracking the holdings, purchases, and sales and the ongoing investment performance of our Ultimate Stock-Pickers, we also follow the makeup and results of the Morningstar Ultimate Stock-Pickers TR Index. For those who may not recall, the Ultimate Stock-Pickers index was set up to track the highest-conviction holdings of 26 different managers, a list that includes our 22 top fund managers as well as the investment managers of four insurance companies–Berkshire Hathaway ((BRK.A)/(BRK.B)), Markel ((MKL)), Alleghany ((Y)), and Fairfax Financial ((FRFHF)). It is constructed by taking all the stock holdings of our Ultimate Stock-Pickers that are not only covered by Morningstar stock analysts but have either a low or medium uncertainty rating and ranking them by their Morningstar Conviction Score. The Morningstar Conviction Score is made up of three factors:
- The overall conviction (number and weighting of holdings)
- The relative current optimism (holdings being purchased)
- The relative current pessimism (holdings being sold)
The index contains three sub-portfolios–each containing 20 securities–that are reconstituted quarterly on a staggered schedule. As such, one third of the index is reset every month, with the 20 securities with the highest conviction scores making up each sub-portfolio when they are reconstituted. This structure means that the overall index can hold anywhere between 20 and 60 stocks at any given time (because some stocks may remain as the highest-conviction score holders in any given period, meaning there can be overlaps in the holdings, reducing the total number of different stocks held). In reality, the index is usually composed of 35 to 45 securities, holding 35 stocks in all at the end of November. These stocks should represent some of the best investment opportunities that have been identified by our Ultimate Stock-Pickers in any given period. It can also have more concentrated positions than one might find in a typical mutual fund. The size and concentration of the portfolio do change, though, as this is an actively managed index that tries to tap into our top managers’ movements and conviction levels over time.
Looking at the top 10 stock holdings of the Morningstar Ultimate Stock-Pickers index, there is currently only one name trading at approximately a 10% or more discount to our analysts’ fair value estimates. This company is wide-moat rated Gilead Sciences (GILD), which currently trades at an 11% discount to Morningstar analyst Karen Anderson’s fair value estimate of $81 per share. As this company is both undervalued and a top stock holding on our index, we believe it merits further discussion.
Gilead Sciences develops and markets therapies to treat life-threatening infectious diseases, with the core of its portfolio focused on HIV and hepatitis B and C. The acquisitions of Corus Pharma, Myogen, CV Therapeutics, Arresto Biosciences, and Calistoga have broadened this focus to include pulmonary and cardiovascular diseases and cancer. Gilead’s acquisition of Pharmasset brought rights to hepatitis C drug Sovaldi, which is also part of combination drug Harvoni, and the Kite, Forty Seven, and Immunomedics acquisitions boost Gilead’s exposure to cell therapy and noncell therapy in oncology.
According to Anderson, Gilead is building a pipeline outside of HIV and HCV through acquisitions. The acquisition of Kite (CAR-T therapy Yescarta) has brought only slow sales growth, but the 2020 acquisitions of Forty Seven (CD47 antibody magrolimab) and Immunomedics (breast cancer drug Trodelvy) add to the oncology pipeline. Lead NASH program selonsertib failed in a phase 3 trial, but Gilead is exploring combination therapy with other mechanisms in NASH. Gilead’s Veklury is also a leading treatment for SARS-CoV-2; it generated $2.8 billion in sales in 2020 and is poised for $2.7 billion in 2021.
Anderson assigns Gilead a wide economic moat rating, citing patent protection on newer HIV regimens and the firm’s continued dominance in the hepatitis C market. Gilead’s expertise in infectious diseases and single-pill formulations are part of its research and development strategy, which she sees as one of the strongest intangible assets supporting the firm’s wide moat. Anderson thinks the firm does face environmental, social, and governance risks, particularly related to potential U.S. drug price-related policy reform (Gilead sees more than 70% of its sales from the U.S. pharmaceutical market) and ongoing potential for product governance issues (including litigation). While she factors these threats into our analysis, she doesn’t see them as material to our valuation or moat rating.
Looking at the Morningstar Ultimate Stock-Pickers index’s year-over-year performance, we note that none of the top 10 names are undervalued according to Morningstar analysis. The list seems to be diverse by industry, with three names in healthcare, three in financial services, two in industrials, and two in consumer. Today we’ll look at wide-moat General Dynamics (GD), which is one of the more fairly valued names on our list. The stock currently trades at a slight premium to Morningstar analyst Burkett Huey’s $191 fair value estimate.
General Dynamics is a defense contractor and business jet manufacturer. The firm’s segments include aerospace, combat systems, marine, and technologies. The company’s aerospace segment creates Gulfstream business jets. Combat systems mostly produces land-based combat vehicles, such as the M1 Abrams tank. The marine subsegment creates nuclear-powered submarines, among other things. The technologies segment contains two business units–an IT business that primarily serves the government market and a mission systems business that focuses on products that provide command, control, computers, intelligence, surveillance, and reconnaissance capabilities to the military.
General Dynamics is about three fourths defense prime contractor and one fourth business jet manufacturer. Defense primes rely on defense spending for revenue, and we favor companies with tangible growth profiles through a steady stream of contract wins, ideally to contracts that are fulfilled over decades. General Dynamic’s crown jewel of long-cycle contracts, the Columbia-class submarine, exemplifies this with planned procurement through 2042. Regulated margins, mature markets, customer-paid research and development, and long-term revenue visibility allow the defense primes to deliver a lot of cash to shareholders, which Huey views positively because we don’t see substantial growth in this industry.
Huey notes that defense primes are implicitly a play on the defense budget, which he thinks is ultimately a function of both a nation’s wealth and a nation’s perception of danger. As the U.S. budget is looking increasingly bloated with pandemic relief, Huey expects a near-term slowdown in defense spending to flat or even negative growth but thinks that contractors will be able to continue growing due to sizable backlogs and think that defense budget growth is likely to return. He recognizes there is substantial political uncertainty in the budget but thinks that it will be difficult to materially decrease the defense budget without sweeping political change. Huey notes that one of the most common budgetary compromises of the previous decade has been more nondefense spending for more defense spending.
General Dynamics’ business jet segment mostly produces long-range wide-cabin business jets. This market is low volume, at roughly 200 global deliveries each year and many repeat customers. New, quality, product drives demand in this segment, so the company must continuously convince customers that it has built a better aircraft. Gulfstream dominates volume in this segment, with roughly 50% market share, which leads to superior margins due to progression along the learning curve. Huey anticipates that the introduction of the G700, G800, and G400 in 2022, 2023, and 2025, respectively, will be major sales drivers.
Huey assigns the firm a wide moat, due to an aggregation of strong moat sources throughout the entirety of General Dynamic’s separate business segments.
While lists of top-performing stocks are often composed of stocks that have already run up, our top detractors’ list can sometimes be a good area to pick through the wreckage. Even though these names might not be performing well, it is possible that there could be some value plays in the long run. From our current list, we will highlight Conagra Brands (CAG), which currently trades at about a 20% discount to Morningstar analyst Rebecca Scheuneman’s $42 fair value estimate.
Conagra Brands is a packaged food company that operates predominantly in the United States (over 90% of revenue and profits). It has a significant presence in the freezer aisle, with brands such as Marie Callender’s, Healthy Choice, Banquet, and Birds Eye. Other popular brands include Duncan Hines, Hunt’s, Slim Jim, Vlasic, Orville Redenbacher’s, Reddi-Wip, Wish-Bone, and Chef Boyardee. While the majority of revenue is sold into the U.S. retail channel, 7% of fiscal 2021 sales were to the food-service channel, down from 11% in fiscal 2019 due to the pandemic.
The introduction of CEO Sean Connolly in 2015 signaled a fundamental shift in overall strategy. The new strategy increased the productivity of marketing investments by shifting spend to the more efficient digital channel and to higher potential brands. In addition, the firm has since significantly reshaped its portfolio inorganically, shedding non-branded or noncore businesses and acquiring brands that enhance the firm’s growth and/or profit margins. As a result, in recent years, sales have inflected from declines to growth and from market share losses to modest gains. Scheuneman thinks the pandemic–which resulted in four and a half years of incremental new buyers and saved the firm hundreds of millions of dollars in customer acquisition costs–will accelerate the benefits Conagra is reaping from these efforts, as many new consumers have been exposed to its new fare. Once the food retail market normalizes after the pandemic, she believes that Conagra can realize 2% annual organic sales growth.
However, despite these improvements, Scheuneman thinks a sustainable competitive advantage via its brand assets or entrenched retail relationships remains elusive. Conagra maintains many market-leading brands, which makes it an important partner to retailers. However, Conagra’s commitment to maintaining below-average investments in marketing (3% of revenue compared with the 4% peer average) and research and development (0.6% of revenue compared with the 0.8% peer average) weakens her conviction that Conagra can maintain its preferred status with retailers over the next 10 years, as required for a narrow moat designation.
Disclosure: Justin Pan, Eden Alemayehu, and Eric Compton have 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.