By Ari Felhandler | Associate Equity Analyst, Verushka Shetty | Associate Equity Analyst, and Eric Compton | Equity Analyst
For the past decade, our primary objective with Ultimate Stock-Pickers has been to uncover investment ideas that both our equity analysts and top investment managers find attractive, in a manner timely enough for investors to gain value. In cross-checking the most current valuation work of Morningstar’s own arsenal of stock analysts against the actions of some of the most recognizable equity managers in the business, we look to uncover good ideas each quarter that will be of interest to investors. With 24 of our Ultimate Stock-Pickers having reported their holdings for the third quarter of 2022, we now have a good sense of the stocks that piqued their interest during the period.
While looking at our Ultimate Stock-Pickers’ buying activity, we concentrate on high-conviction purchases and new-money buys. We think of high-conviction purchases as occasions when managers have made meaningful additions to their portfolios, as defined by the size of the purchase in relation to the portfolio’s size. 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 recognize that our Ultimate Stock-Pickers’ decisions to purchase shares of any of the securities highlighted in this article could have been made as early as the start of July, so the prices paid by our managers could be substantially 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 a multitude of factors, including our valuation estimates along with our moat, stewardship, and uncertainty ratings.
Since 2020, headwinds created by the pandemic hampered the markets and sidelined a multitude of industries as governments across the globe instituted lockdowns and imposed restrictions. And just as the market was looking to slowly recover as pandemic restrictions were lifted, the Russian invasion of Ukraine threw another wrench into the global economy, elevating energy prices and creating inflationary pressures that have impacted food and energy markets. The third quarter of 2022 has been defined by a tumultuous market, including continued selloffs in tech, inflationary pressure, and lingering fears of a potential recession. The Fed enacted another 0.75 of a percentage point interest rate increase in early November, from near-zero levels that were in place since the early days of the pandemic to a benchmark rate of 3.75% to 4%. Despite market headwinds, Ultimate Stock-Pickers still looks to find value in individual stocks during a period of volatility and uncertainty.
In the top 10 high-conviction purchases list, the buying activity was distributed among a multitude of sectors, including consumer cyclical, communication services, technology, energy, industrials, healthcare, and financial services. All 10 companies on the high-conviction purchases list and six of the 10 companies on our new-money purchases list received at least a narrow economic moat rating from Morningstar analysts, keeping in line with trends we have witnessed over the past years. The three names we find most interesting on the high-conviction purchases and new-money lists are wide-moat-rated Alphabet GOOGL, wide-moat-rated Equifax EFX, and no-moat-rated D.R. Horton DHI.
There was very little crossover between our two top 10 lists this period, with just one name appearing on both lists. This quarter, Alphabet received 17 high-conviction purchases from our manager list, with Wells Fargo WFC receiving five. Both companies have wide economic moats and are trading at discounts to their fair value estimates, which indicates that money managers place an emphasis toward blue-chip stocks such as these in a period of uncertainty.
Wide-moat Alphabet stood out for us, as it attracted a whopping 17 high-conviction purchases during the third quarter of 2022. It currently trades at about $97 (down approximately 32% year to date), well below Morningstar analyst Ali Mogharabi’s fair value estimate of $160.
Alphabet is a holding company that derives 99% of its revenue from Google, a wholly owned subsidiary. Online ads account for 85% of Google’s revenue, while the rest flows in from the sale of apps and content on Google Play, YouTube, cloud service and licensing fees, and hardware sales that include Chromebooks, the Pixel smartphone, and smart home products. Alphabet’s moonshot investments are in its other bets segment, where it bets on technology to enhance health (Verily), faster internet access to homes (Google Fiber), self-driving cars (Waymo), and more. Alphabet’s operating margin has been 25%-30%, with Google at 30% and other bets operating at a loss.
According to Mogharabi, Alphabet dominates the online search market with 80%-plus global share for Google, via which it generates strong revenue growth and cash flow. He expects continuing growth in the firm’s cash flow, as he remains confident that Google will maintain its leadership in search. Mogharabi foresees YouTube contributing more to the firm’s top and bottom lines, and he views investments of some of that cash in moonshots as attractive. Whether they will generate positive returns remains to be seen, but they do present significant upside.
Google’s ecosystem strengthens as its products are adopted by more users, making its online advertising services more attractive to advertisers and publishers and resulting in increased online ad revenue, which Mogharabi thinks will continue to grow at double-digit rates after the pandemic and during the next five years. The firm utilizes technological innovation to improve the user experience in nearly all its Google offerings, while making the sale and purchase of ads efficient for publishers and advertisers. Adoption and usage of mobile devices is increasing. The online advertising market has taken notice and is following its target audience onto the mobile platform. We have seen Google partake in this on the back of its Android mobile operating system’s growing market share, helping it drive revenue growth and maintain its leadership in the space.
Among the firm’s investment areas, Mogharabi particularly applauds the efforts to gain a stronger foothold in the fast-growing public cloud market. Google has quickly leveraged the technological expertise it applied to creating and maintaining its private cloud platform to increase its market share in this space, driving additional revenue growth and creating more operating leverage, which he expects will continue. Most of Alphabet’s more futuristic projects are not yet generating revenue, but the upside is attractive if they succeed, as the firm is targeting newer markets. Alphabet’s autonomous car technology business, Waymo, is a good example: Based on various studies, it may tap into a market valued in the tens of billions of dollars within the next 10-15 years.
Four of our money managers made high-conviction new-money purchases of Equifax, a wide-moat company currently trading at over a 30% discount to Morningstar analyst Rajiv Bhatia’s fair value estimate of $315.
Equifax, along with Experian EXPGY and TransUnion TRU, is one of the leading credit bureaus in the United States. Equifax’s credit reports provide credit histories on millions of consumers, and the firm’s services are critical to lenders’ credit decisions. In addition, about one third of the firm’s revenue comes from workforce solutions, which provides income verification and employer human resources services. Equifax generates over 20% of its revenue from outside the United States. Given the fixed costs inherent in a data-intensive business, Equifax has been able to enjoy strong operating leverage from incremental revenue. As the U.S. credit bureau market is relatively mature, the company has been adding new capabilities and expanding its geographic footprint, both organically and through acquisitions.
Bhatia notes that Equifax’s star in recent years has been its workforce solutions segment, which is now its largest segment. Workforce solutions includes income verification (primarily for mortgages), and he doesn’t believe Equifax has meaningful direct competition for this service. Bhatia expects Equifax’s competitive position to persist as the large amount of existing records and the difficulty of convincing employers to share employee information would be too tough for new entrants to overcome. In the years ahead, Bhatia expects Equifax to focus on expanding use cases of income verification beyond mortgage to auto, card, and government services. Workforce solutions also includes employers’ services, which consist of employee onboarding solutions, I-9 management, tax form services, and unemployment claims processing. Growth by acquisition in Workforce Solutions has also been a focus, most notably with its $1.8 billion deal to buy Appriss Insights.
Bhatia argues that Equifax’s data is critical to its customers’ (often banks) underwriting decisions, and the price of its services is negligible relative to the loan amounts at risk, underpinning the firm’s wide moat based on intangible assets. He estimates that North American credit bureaus’ revenue represents about 1-2 basis points of total household debt. Because the accuracy and completeness of data is critical to credit decision-making, lenders often pull from more than one credit bureau, and he does not believe pricing is the primary factor for choosing a credit bureau. Overall, the barriers to entering the credit bureau business are high, as replicating a database of millions of customers would be incredibly difficult. Because the credit bureaus’ data is based on the voluntary reporting of thousands of financial institutions, it’s unlikely that a startup, particularly with heightened data security concerns, could convince banks to share consumer information.
While Equifax’s reputation took a beating after a well-publicized data breach in September 2017, it wasn’t the first time the firm had suffered from a data breach; however, the depth and the breadth of the breach created ire among the public and showed that the company wasn’t prepared to handle customers’ data securely. Following the breach, Equifax has invested heavily in cybersecurity and incurred significant legal and product liability costs. In Bhatia’s view, Equifax has largely put the episode behind it.
Our Ultimate Stock-Pickers also made two new-money purchases in no-moat D.R. Horton, a leading homebuilder in the United States with operations in 98 markets across 31 states. D.R. Horton mainly builds single-family detached homes (over 90% of home sales revenue) and offers products to entry-level, move-up, luxury buyers, and active adults. The company offers homebuyers mortgage financing and title agency services through its financial services segment. D.R. Horton’s headquarters are in Arlington, Texas, and it manages six regional segments across the United States.
D.R. Horton currently trades at a discount to Morningstar analyst Brian Bernard’s fair value estimate of $107. Bernard’s revenue growth projections are based on our U.S. housing demand forecast and market share, as well as average selling price assumptions. He expects D.R. Horton to increase its consolidated revenue at about a 2% annual growth rate through 2032 as annual housing starts decline to 1.3 million units by 2024 and then rebound to 1.55 million units by 2026 and average around 1.45 million units between 2027-31. All in all, Bernard expects D.R. Horton will continue to gain market share due to its strong position in the entry-level market.
Bernard recognizes that D.R. Horton enjoys certain benefits from its large scale; however, it operates in an extremely cyclical, competitive, capital-intensive industry that has prevented the company from earning consistent positive economic profits over the business cycle. The fragmented homebuilding industry features 17 public homebuilders and many more private regional and local homebuilders. All these builders compete for land, materials, labor, and customers. Irrational behavior, such as aggressively pushing incentives to drive better community absorption rates or overbidding on land deals, can mean adverse repercussions for the entire industry. As a result, he assigns D.R. Horton a no-moat rating.
According to Bernard, industry consolidation could improve his moat trend outlook, currently set at stable. Although the industry has seen some noteworthy consolidation over the last decade (for example, Tri Pointe THP/Weyerhaeuser WY in 2013, Toll Brothers TOL/Shapell in 2013, Ryland/Standard Pacific in 2015, and Lennar LEN/CalAtlantic in 2018), time will tell if other major deals materialize. He believes that further industry consolidation would support a more favorable competitive environment and could lead to distinguishable cost advantages and/or efficient scale moat sources.
Disclosure: Ari Felhandler, Verushka Shetty, 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.