Call me nosy, but I love looking at top ten holdings. I recently looked at the biggest holdings of Morningstar Gold Medalist rated funds, hunting for shares that also command a four or five-star Morningstar rating.

Criteria 1: Gold medalist funds

Morningstar’s Medalist ratings indicate which funds and ETFs Morningstar believes are likely to outperform a relevant index or peer group on a risk-adjusted basis over time.

Funds and ETFS are evaluated on three key pillars (People, Parent, and Process). These are coupled with a fee assessment before being ranked against other funds in the same Morningstar Category, which represents funds and ETFs that follow similar investment strategies.

Criteria 2: Four or five star stocks

A four or five star rating means our analysts think that a stock is trading at an attractive discount to our Fair Value estimate. These shares may represent an opportunity if they align to your investment strategy.

I wanted these stocks to be in the fund’s top ten holdings as per June 30th according to Morningstar's data. These positions may have fallen in value or been sold since then. But it was the best way I could think of to find cheap stocks with the seal of approval from high quality managers.

Unsurprisingly, none of Mark’s latest ASX shares to avoid made the cut. So, what did?

Light & Wonder (LNW) ★★★★ 

  • Fair Value estimate: $160
  • Price on October 29: $145.41
  • Economic moat: None 

The ICE Fund is led by Callum Burns, who founded ICE Investors in 2005. Its quality centric approach focuses on companies with competitive advantages and steady growth prospects, and our manager research team view it as a strong option for small-cap investors.

The fund has an active share (the difference between its exposure and that of its benchmark) of over 90% as of July 31st, and Light & Wonder ranked as the fund's biggest position at that time.

Together with narrow moat Aristocrat Leisure and International Gaming Technology, Light & Wonder is one of the 'big three' that dominate around 80% of the North American market for gaming machine sales.

The industry, however, is highly competitive and maintaining market share requires players like Light & Wonder to invest heavily in research and development to fund new hit game titles and improvements in machine design and user experience.

Light & Wonder spends less of its revenue of R&D than Aristocrat does (around 9% of sales versus 12% for Aristocrat) but more than IGT's roughly 7%. As a result, our Light & Wonder analyst Angus Hewitt expects the firm to defend its current market share rather than meaningfully expand it.

Light & Wonder shares fell sharply in September after a Nevada court temporarily prohibited further US sales of the company's Dragon Train game, as it was alleged that its development included trade secrets from a similar Aristocrat title. However, Hewitt thinks the 20% fall in share price from over $160 to around $125 on the news was overdone.

After all, the game only made up around 5% of earnings and disputes like this are rather common in the industry. He left his $160 Fair Value estimate unchanged, meaning that the shares have now fallen to a price that commands a four-star rating.

Healius (HLS) ★★★★★

  • Fair Value estimate: $2.50
  • Price on October 29: $1.67
  • Economic moat: None

Perpetual's ESG Australian Share fund, which also trades as an ETF, excludes companies that derive over 5% of revenues from several businesses including alcohol, gambling, fossil fuel production, arms and products linked to animal cruelty. 

This fund has historically tilted to mid-cap names, presumably aided by the fact that around 20%-30% of the ASX 300's large-cap names fail the ESG exclusion criteria. In awarding the fund a Gold medal rating, our researchers noted the strong track record of manager Nathan Hughes and Perpetual's solid quality and value based approach.

As of July 31, the ESG Australian Share portfolio featured a 4.85% top-ten holding in Healius, Australia's second largest pathology lab operator behind Sonic Healthcare. This segment is now responsible for all of Healius's earnings after it announced the sale of its imaging business Lumus to a buyout group for just shy of $1 billion.

Our analyst Shane Ponraj thinks the Lumus deal was moderately value destructive for Healius shareholders, as the consideration was below the earnings he expected segment could deliver over the long-term. Nonetheless, he thinks Healius shares remain materially undervalued and underappreciated by the market.

The sale of Lumus is the latest installment in a multi-year turnaround effort at the company, which will also involve debt reduction and much-needed investments in its pathology business. This will take up some of the $800m net proceeds of the Lumus deal, but Ponraj expects that plenty of cash will be left over for a capital return through a dividend or buyback. 

Ponraj thinks Healius can grow its earnings per share at an 8% annual clip over his forecast period. This stems partly from his expectation that Australia's growing and aging population will support higher revenue. But it mainly rests on his call that Healius can improve its operating profit margins from current levels of around 5% to a mid-cycle level of 12%. 

Scale matters in the pathology business, and Ponraj thinks that more sales can be kept as profit as revenues grow. Investments in improving the company's efficiency and a higher proportion of sales coming from more complex and profitable tests could also help. Ponraj thinks that investors underestimate Healius's ability to pull this off, which potentially explains the gap between his $2.50 Fair Value estimate and current market prices.

Woodside Energy (WDS) ★★★★★

  • Fair Value estimate: $45.00
  • Price on October 29: $24.08
  • Economic moat: None

Lazard's Select Australian Equity Fund takes a concentrated approach, with just over half of its portfolio in its top 10 holdings as of our latest data. Our manager research team has awarded this strategy a Gold medal rating, citing its experienced investment team and disciplined adherence to a value investing philosophy.

The fund's concentration and high active share make it more likely that returns may deviate significantly from its ASX200 benchmark in any given year. The fund's long-term performance record is solid, with returns beating those of its fund category and benchmark over the past 3, 5, 10 and 15 years.

As of September 30, Woodside Energy comprised around 6.6% of Lazard's Select Australian Equity Fund versus a weighting of below 2% in the ASX200 index.

Woodside is Australia’s premier oil and gas company with operations across liquid natural gas, natural gas, condensate and crude oil. LNG interests in the North West Shelf Joint Venture, or NWS/JV, and Pluto offshore Western Australia are the firm’s mainstay, and the low-cost advantage of these assets form the foundation for Woodside.

A big chunk of Mark Taylor’s intrinsic value estimate for Woodside comes from future project development. This is both a complicated and expensive endeavor, but it is one that Woodside has excelled in for over 25 years and has unparalleled experience domestically.

Woodside also benefits from 20-year off-take agreements several blue-chip Asian energy utilities including Tokyo Electric, Kansai Electric, Chubu Electric, and Osaka Gas. These help ensure sufficient project financing during development and should also add stability to cash flows after completion.

Woodside's deep development pipeline is backed up by what Taylor views as an attractive medium-term demand picture for gas, which is a far cleaner energy source than coal and therefore should play an important role in reducing global emissions.

Adding to Woodside's attraction is that its strong cashflow and a healthy balance sheet should support the continued payment of fully-franked dividends. At a recent share price of around $24, Woodside offers a trailing dividend yield of over 8% and trades far below Taylor's $45 per share Fair Value estimate.

Terms used in this article

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn about finding different sources of moat, read this article by Mark LaMonica.

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Uncertainty Rating: Morningstar’s Uncertainty Rating is designed to capture the range of potential outcomes for a company. An investor can think of this as the underlying risk of the business. For higher risk businesses with wider ranges of potential outcomes an investor should consider a larger margin of safety or difference between the estimate of what a share is worth and how much an investor pays. This rating is used to assign the margin of safety required before investing, which in turn explicitly drives our stock star rating system. The Uncertainty Rating is aimed at identifying the confidence we should have in assigning a fair value estimate for a stock. Read more about business risk and margin of safety here.

Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.

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