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Food for Thought

Reflections from the 2012 Morningstar Investment Conference.

Michael Herbst, 06/28/2012

Since we wrapped up our Morningstar Investment Conference this past week, I've found it hard to focus on day-to-day duties. Instead, I'm mulling over what questions to explore or what actions to consider for my family's investment plan. Here are a few thoughts, based on hearing from a number of ace managers across multiple asset classes during the conference.

Greece Matters but Will Matter More Later
Templeton's fixed-income czar Michael Hasenstab kicked off the conference with his take on the European drama, as everyone is wondering whether Greece will stay in the eurozone. In his view, a Greek exit would be strong medicine--bitter in the short term, helpful in the longer term--and dangerous only if market panic struck Italy or Spain. Spain, he argues, has more wiggle room than Italy to navigate that environment, but substantial and likely contentious labor reforms would be essential to getting both countries back on track. On a related note, Loomis Sayles' Dan Fuss raised the possibility that the situation could turn into a geopolitical powder keg if Greece leaves the European Union or if competition for the region's energy reserves heats up.

The European Central Bank ostensibly has loads of cash to cushion any blows, but, in hearing from a number of fixed-income experts during the conference, it appears that the European debt crisis will be with us for a decade or more. That means fixed-income investors ought to brace for volatility and embrace bonds with strong fundamentals and relatively attractive valuations. That could include sovereign debt backed by healthy economies and credible governments such as South Korea and Malaysia (featured prominently in Hasenstab's Templeton Global Total Return TGTRX) or corporate debt issued by "rising stars."

That latter bucket, representing corporate-bond issuers poised for a credit-rating upgrade, is favored by Mark Kiesel, lead manager on PIMCO Investment Grade Corporate Bond PBDAX. Sounding like an equity fund manager, Kiesel emphasized the importance of focusing on pockets of growth within a low-growth environment. Asian gaming and energy figured high on his list, energy being one area where investors may find both the equity and the debt attractive. He also believes that companies owning natural resources or "real assets" (such as timber producer Weyerhauser WY) are attractive because of very long-term increasing demand for commodities of all kinds.

While Greece is hogging the headlines, the real trouble brewing is in U.S. Treasuries, where negative real yields are already here and the potential for capital loss is growing. Should various rescue efforts and artificially depressed rates actually prove successful in assuaging markets and nudging investors into riskier assets, a broad shift in investor sentiment or slightly higher rates could deliver an unexpectedly harsh blow. Steve Romick from FPA Crescent FPACX and the University of Michigan's William James Adams both noted the United States' current interest payments account for 6% of gross domestic product. With roughly 40% of U.S. Treasuries set to expire by 2013-2014, even slightly higher rates could push the interest burden to north of 15%-20% of GDP, a threshold that historically has triggered a mix of severe economic consequences, social unrest, or sharp inflation in countries unfortunate enough to cross it. Maybe this time will be different, but I doubt it, and I'm thinking of how to prepare for that chain of events.

Stocks Are Bonds, and Cash Is in the Eye of the Beholder
Presenting alongside Mark Kiesel were Meggan Walsh of Invesco Diversified Dividend LCEAX and Don Yacktman of Yacktman YACKX and Yacktman Focused YAFFX, two equity managers who sounded a lot like bond managers. I had an "aha" moment when I asked Yacktman if we should consider stocks as bonds in light of today's minuscule bond yields, and he responded, "How could you not?" He and Walsh view stocks as claims on future cash flows--that sounds like a bond to me--and take precautions to home in on those most likely to deliver those cash flows.

Specifically, that means they seek companies whose returns on invested capital exceed their cost of capital (a key component of Morningstar's Economic Moat Rating for Stocks) and those who generate more than enough cash to make their debt payments. For both Yacktman and Walsh recently, this has meant big chunks of consumer staples stocks like Procter & Gamble PG and Sysco SYY. Dan Fuss, a driving force behind Loomis Sayles Bond LSBRX and Loomis Sayles Strategic Income NEFZX, is playing a variation on that theme, favoring issuers such as Intel INTC whose superior profitability could give them a leg up should higher borrowing costs down the line put the pinch on lesser rivals.

Fuss and Yacktman are similar in that they have been holding double-digit stakes in cash and cash equivalents as ballast and dry powder to snap up opportunities should the markets lurch downward. Cash was discussed quite a bit during the conference, in the Fuss/Yacktman vein, as a point of reference for liquidity needs, and in the (to me) quixotic search for cashlike assets that yield more than actual cash. My take-away was the notion that raising cash (held in a dirt-cheap money market account) in order to scoop up beaten-down wide-moat stocks and energy companies or others owning "stuff in the ground" is a good idea at this point.‚Äč

Michael Herbst is an associate director of fund analysis with Morningstar.
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