Wed, 18 Jul 2012
A panel of Morningstar equity, mutual fund, and ETF experts detail several individual investment opportunities and sensible investing strategies for income and growth in today's tough market.
Jason Stipp: Hello and welcome back. I'm Jason Stipp, site editor for Morningstar.com. We're here at the last session of our Midyear Financial Checkup. I can just feel the brainpower up here on our panel discussion. We've got some experts from different research areas. They are going to take your questions. So this is entirely a Q&A session. We've already gotten a lot of great questions, but we want to hear more from you, what questions you have about your individual investments, about your portfolio positioning. So definitely please do input those questions and send them over to us. We're going to monitor them all throughout this Q&A panel.
I'd like to introduce my panelists here, Christine Benz. She just gave the presentation on your midyear portfolio check-up. She is our director of personal finance. Next to Christine, we have Shannon Zimmerman. He is associate director of fund analysis for Morningstar. He covers Oakmark, John Hancock, and some other fund firms. He is also a regular contributor to Morningstar.com. He talks about funds performance trends. Next to Shannon, we have Heather Brilliant. She is the vice president of global equity and credit research for Morningstar. By the way, Heather, I do believe that you live up to your last name. She has covered a lot of different sectors in her long career. She has been in the industry for about 15 years. In financials, she has covered pharma, biotech, and some other industries, and heads up, again, our global equity and credit research group.
Finally, we have Paul Justice. He is director of exchange-traded fund research for North America, and he has also served as the editor of Morningstar ETFInvestor. Paul has more than 10 years of experience in financial analysis, and before he went into ETFs, he covered utilities on Morningstar's equity team. So it's great to have all you folks up here. Thanks for joining me today and taking questions from our readers.
Shannon Zimmerman: Paul, lives up to his last name, as well.
Stipp: We have justice and brilliance. We have a German car up here. So it's a really topnotch group of folks here. So I want to kick it off and talk about broadly there's a lot of focus on macroeconomics, global recession concerns, a slowdown. We had a reader, who is especially concerned, and the question was, would you suggest keeping a hoard of cash because of the economic uncertainties that are out there? I think there's a few different ways we can slice this. I'd like to start, Christine, from the portfolio-planning perspective. What are the implications of keeping a bigger cash stake than you normally would because you're worried about what the economy is going to do and what that might do to the markets?
Benz: It sounds like market timing to me, Jason. I like the idea of if you are an accumulator and you like the idea of putting money to work at depressed valuations and you think stocks could fall further still, I like that strategy. I don't like the strategy of sidelining some money where there is going to be a big opportunity cost because cash is earning nothing simply because you think you will know when to get back in. But you won't necessarily know. So, I don't think it's a great strategy.
Zimmerman: I would echo that. Lurching into and out of the market is almost always a recipe for disaster. And over time, inflation, even though it's low right now, will just erode your purchasing power.
Stipp: So, one thing though I know that fund managers will do, and we also might say on the equity research side is, it does help to have some dry powder on the sidelines, right, because some opportunities may come along. Do you think it's worth having a stake just because when the markets do come down, you might want to put some of that money to work if we do see crisis?
Zimmerman: Sure, absolutely. When the markets are especially overvalued and a manager wants to keep the powder dry--sometimes sell-offs affect all companies equally irrespective of the quality of the companies. So, some of the managers I admire wait for the companies that they like or maybe even are owning in their portfolios to be hit by you know “baby with a bathwater” kind of sell-off, and then they incrementally add to their positions.
Stipp: But it certainly takes a lot of intestinal fortitude I think to be able to execute when everyone is running for the exit.
Zimmerman: You mean guts, right?
Stipp: Exactly. Heather, when you look at valuations and you think about whether it might be good to have some dry powder, what's your take? Do you think that having a cash stake is a smart move right now for the market?
Brilliant: I think it does seem like a smart move, but like Christine said, I wouldn't necessarily advocate sitting on the sidelines altogether. I think it's a good opportunity though to really compile a watchlist of great businesses that you'd like own. We like to look at companies with wide economic moats and really come up with the companies there that you think might look only modestly undervalued, maybe you're interested in taking a small position, but you save some dry powder in the case they do get a lot cheaper.
Stipp: Paul, I know that on the ETFInvestor side you run some different kinds of portfolios. You have more strategic portfolios. You have more tactical portfolios. Do you have more cash maybe than you would in some of those strategies because you expect that things to be either fairly valued or a little overvalued now and they might come down?
Paul Justice: Not nearly as much as we used to have. We believe that fear can be more crippling than greed at times, and I don't think that this is one of those times that people should be completely on the sidelines. You should have a lot of cash if you have short-term needs for cash. Otherwise, you should participate in these markets and recognize that some of the valuations across the globe right are actually quite attractive.
Benz: Jason, I think that's an important point; the role of valuations in all of this. I see valuations as a better trigger for holding cash because long term when you look at what has driven market performance, it's low valuations; it's not gross domestic product growth or anything like that. If you're looking for a way to stack the deck in your favor, look to add to stocks when they're cheap and maybe scale back when they're expensive rather than focus on some of the economic headwinds that are confronting the economy right now.
Stipp: One of the biggest questions we've been getting on Morningstar.com--and so this is probably a question for many, many of our readers--has to do with income. It says, "I'm 70, looking for income, not growth. Dividend stocks seem to be a bit overvalued, but to get a good return on fixed income I've got to go way out on the duration curve and get, obviously, beyond 10 years for Treasuries given the recent rates that we've seen. What are my options for income right now?" It just seems like nothing is looking attractively valued. Heather, you mentioned dividend-paying stocks before in this panel, and what the valuations look like there. Are they overbought?
Brilliant: Generally speaking, I don't think that you could say that you would buy dividend stocks as a basket, but I do think there are some opportunities within companies that pay high dividends. One topic we were talking about earlier is the master limited partnership space. We actually think MLPs are pretty fairly valued, but if what you are really looking for is that dividend yield, some of them pay very attractive yields in the neighborhood of 5%-6%.
We think those dividends are pretty secure. So that does leave you in a reasonable position. But our ideal situation would be the companies that we think are undervalued and have the potential to grow their dividend yield, and I would put some of the Big Pharma companies in this category, specifically, I know it sounds scary, but the European Big Pharma names like Sanofi and Novartis both look at least moderately undervalued. They are paying in the neighborhood of 4% dividend yields, and they have wide economic moats. And we think the headwinds facing that industry are actually abating a little bit as opposed to getting worse like they have been for the last five years.
Stipp: And a lot of those pharmas, they might be located in Europe but a lot of them are doing business all across the globe, right?
Brilliant: Absolutely, in fact, their revenues are no more concentrated for a company like that in Europe than they are for a Pfizer or a company based right here in the U.S. And Sanofi we think looks particularly interesting because it has a lot of exposure to emerging markets, and so as the emerging markets start to use more and more pharmaceutical products, companies like Sanofi are even better-positioned than any company you can pick based really anywhere in the world.
Stipp: Paul, when you are thinking about ETFs, do you see any areas where you might have better opportunity for income? Are there any places that investors are going that you think could give them a little bit of an income stream, or is it really kind of looking a bit of revalued at this point?
Justice: So, I see a lot of places that people are going. So we're certainly seeing a lot of money coming into the fund flows for dividend-specific funds, low-volatility funds which sometimes will have pretty high yields on them, as well. But I don't think that necessarily those funds flow are indicative of a bubble. As Heather was saying, when we look at a bubble, what we tend to look for is something that has a valuation ratio that's out of control.
If we look at the S&P 500 yielding 2.1% today that's still a lot better than the 1.5% you're going to get on a 10-year Treasury. So it's kind of a trade-off. I feel his pain. He wants some income, but when interest rates are low, it's just very difficult to come by. You'll have to look at more abstract things, like you can get the 7% yield on MLPs right now, but you still don't want to make that one of the largest holdings within your portfolio. It's just too small of an asset class to really bear that weight. You can still look at REITs and perhaps if you're adventuresome, you could go out and look at emerging-markets bonds or some way to complement that. But I think the way to go about it is to get the diversified approach for income. Don't overweight any one of those sectors. You're just going to have to take some of the yields that the market gives you; you can't alter that state.
Stipp: Christine, a lot of investors would love to just live off an income stream, especially in retirement because they don't want to have to invade that principle, but they may need to consider a broader or a more total-return approach if they're just not finding income without taking on a lot of extra risk, right?
Benz: I think that's a great point, Jason. I think that there has been unfortunately and unhealthy preoccupation with current income. Investors obviously anchor on that idea of income because it is so intuitively appealing, but for most people I sort of say, don't focus so much on the current yield, instead think about what is the long-term total-return prospect for this asset or this fund or whatever it might be. Set your sights there, and if your retirement plan includes sometimes invading your principal, big deal, if your pool of assets can grow more than it could if you were using that income-only approach.
Zimmerman: That's a supper important point right now. With yields so low and the scramble for yields, people need to remember that price erosion of a security that's overvalued, say, takes back with the yields gives. They really are not earning anything.
Stipp: So, also, you folks have mentioned a few of the dividend-paying or income-producing investments that folks have looked at. REITs was mentioned here at one point. Heather, when you look at real estate investment trusts, they've historically kicked off income. What are the valuations looking like in that particular area of the market? Have investors really headed toward REITs because of those income streams?
Brilliant: Absolutely, in fact it is our single-most overvalued sector right now. I would really caution investors, especially when it comes to a sector like REITs, to take the approach that Christine outlined of thinking about the total return, because as she said, if you lose what you gain from the dividend because the value of the asset goes down then you're not any better off.
Stipp: Shannon, we also cover real estate investment trust mutual funds or managed products. This could be a question for you, Paul, as well. If you are looking to at least carve out from an asset-allocation perspective maybe a certain amount of allocation to a REIT fund of some kind, what sorts of things should you go about from a fund analysis perspective? What would you want to look for in a good REIT fund? It might be the same as for a good any kind of fund maybe?
Zimmerman: I was going to say, you want to use the same criteria that you would use for any mutual fund. Look at the expenses. We found that a fund's expense ratio is one of the most predictive attributes of the fund; the lower, the better the returns will be because the expenses come out of returns that would otherwise flow to investors. [Also look at] the tenure of the manager and how the fund has behaved in different kinds of market environments. Now, REITs seem to be quite overvalued. For the funds that you are considering, [look at] how they behaved in overvalued markets. What you want, I think if you're going to be a long-term investor, is consistency. So, if you have a fund whose historical performance patterns you're aware of and during a market where you would anticipate that it would decline and it does, that should give you confidence to stick with the fund because it's behaving the way that you expected it would even if it's not getting a great return.
Stipp: Paul, I know there are some areas of the market where indexing is a great idea and some areas where it's great to have an active manager. I don't know if you have the data on REITs, but do you have any insights on how you might look at the REIT ETF index products?
Justice: The way we look at it, and I don't have the data with me, but as far as I'm concerned with REITs, fees rule the day. There are so many macro factors that are going to affect the performance of the entire sector. You might find a handful of them that are really going to stand out, but the driving theme there is going to be the value of those properties and interest rates. And as interest rates rise, REITs are going to get impacted just like fixed income is going to get impacted. So, that's going to really drag the portfolio.
Benz: One point I would make too, Jason, is that before people go out and seek dedicated real estate exposure, check what's in your portfolio because if you have a small-cap value fund, chances are it's in there. So, just do a little X-ray of your portfolio before adding additional exposure because most small-value funds do typically maintain some exposure, though, Shannon you may know about that, they're probably doing less these days.
Zimmerman: These days they are. I was just thinking if you have a mortgage, you're pretty heavily exposed to the real estate market, as well.
Stipp: But I know that you've done some correlation work as well, and I can't remember if REITs was one of them. But certainly it's good to make sure that you know you are ready on before you go out and get any more dedicated?
Zimmerman: Right, because how can you know what to buy next if you already know what your portfolio looks like?
Benz: Well, the other thing is, even if your small-value fund doesn't own real estate straight up, the correlation with small value in real estate is really high.
Zimmerman: That's right. So, you're really not gaining anything in terms of diversity.
Stipp: So they're going to move together potentially even if that small-value fund isn't owning a real estate investment trust directly.
Brilliant: I was just going to add also to get involved in the real estate market, if you think the housing market is bottoming, which we are starting to see signs of, that doesn't mean that you necessarily want to pile into REITs either because particularly there, you're dealing with a lot of different sectors within the REIT market that are more geared toward commercial real estate, for example. We actually think if you're interested in the individual housing market recovery that there are some interesting kind of peripheral plays that could be really great opportunities.
First American Financial is one example. It is a title insurance company, and as we start to see more closings happen, actual home purchases and sales going on, there will be a lot more demand for title insurance. So this is a company that we think is pretty undervalued. It’s a relative some cap too, so you might find it in some of these small-cap portfolios. It's only about a $1.8 billion market cap, but we think it's kind of under-the-radar way to play this recovery in housing that could be coming.
Stipp: Besides REITs and other areas, we get lots of questions about, and you mentioned them earlier, as well, are MLPs. MLPs have some interesting tax considerations that go along with them. However, there are some managed products that invest in MLPs. With the tax situation, do some of those things go away with the managed products, Paul, with an ETF that invests in MLPs, and what should you keep in mind about looking for MLP exposure, either through individual holdings or through some kind of a fund?
Justice: When I think about, when you put MLPs in a structured product, it's kind of like a gremlin, you just poured some more water on it, and it starts spewing off. So they are different, but there's some problems there. You can't just put it in a wrapper and hope that it becomes this magical tax-avoidance vehicle. So some of the most popular funds out there try to mitigate all the complications that come with owning the MLPs: the K-1 problem, and if you own a lot of those, you might file income taxes in every single state in the U.S. That's a big problem. The upside is that you get to defer all the taxes on your distribution until you eventually sell the MLP, which most people will just decide to buy it and die with it.
The two structures that people favor most are either an exchange-traded note for owning MLPs or a fund, and if you own it in a fund get, it's got some additional problems here. We didn't see any MLP mutual funds for the last 80 years, and there was a good reason. There was a law against it. So now they have skirted that law. They've put these things in what masquerades as a mutual fund or an open-end investment company but it's really a C corporation. So some of the distributions that these funds receive actually get taxed at a corporate level, which is punitive at 35%, then they send a distribution to you and you pay taxes, as well.
So you lose a lot more money to Uncle Sam through this structure. You gain diversification, you gain simplification in the tax filing process, but you lose some of that total return. So it's not nearly as ideal as owning the MLPs directly. The ETN, what do you get? You get some credit risk because it's just a note from a bank. Also, the distribution is going to be taxed like you had a loan from the bank or you had savings at the bank; it's going to be income. So there are trade-offs there. Diversification, ease of access, and ease of tax filing [are positives], but it comes with fees.
Stipp: So they come hopefully with some Tylenol as well no matter how you're investing with them. It sounds like a bit of a headache there potentially for investors unless they know what they're getting into.
Justice: Yeah, I don't want to say that people should avoid these products wholeheartedly. It does simplify the process, and with the fund structure you still get a 6% distribution. With the ETN structure, you get a 7% distribution. There is a place in the portfolio for it; it's a smaller role.
Stipp: Heather, I can't remember if you had mentioned any MLPs that are looking particularly attractive to your analysts right now. I know that there has been a lot of investor interest in them, but folks seem to say, well, they look like they are holding up pretty well; they still look attractive to them. What is it looking like from an equity perspective on the valuations of MLPs?
Brilliant: We generally think that the MLPs are fairly valued. So, there is not a screening problem with the valuation of them at these levels, but take Kinder Morgan for example. We think that it's worth about $86 a share, and it's trading at $85 a share. Now, as I mentioned, you do get about a 5.7% return with that yield, but still you're taking on the risk that the price appreciation is not going to participate in the total return.
Stipp: Another area that we've touched on a little bit here in some presentations as well is the muni market, and that could be attractive for income for folks who would be in a higher tax bracket. We do some in-house muni research now. It's a new thing for Morningstar that we have just started up. We have also been covering municipal-bond funds for a long time.
Christine, you've been talking about munis a little bit as well recently from a portfolio-planning perspective. What should investors think about munis right now? We've had a couple of headlines here in the last two weeks about some high-profile bankruptcies in Pennsylvania and California. There were concerns a couple of years ago that didn't really pan out to the extent that some folks thought they would, but the bankruptcy problems still seem to be here with us.
Benz: They do, and then the other issue is that munis have had a great run, so we're back to the valuation question again. I do think though that kind of depending on what happens with tax rates here going into 2013, that could provide yet another tailwind for munis that could kind of counterbalance some of the issue-specific risks that have gone on as well as the valuation problem. So, you've got this new Medicare surtax going into effect next year; you've got higher tax rates, especially on higher-income folks going into effect. So there are a couple of different tax, I think, tailwinds for munis going forward that could kind of counterbalance the other stuff.
Stipp: Shannon, you had mentioned, as we spoke before this, that bankruptcy isn't necessarily the only thing you need to think about as a muni-bond investor. What other risks should be on your mind if you're considering delving into the municipal market?
Zimmerman: Well, I would underscore the valuation risk right now. They had been on a tremendous run, and so now it might not be the opportune time to stake out a position in that part of the market. But yes, bankruptcies have historically been quite low in that space, but there is always a risk of downgrades, as well. So that would take a bite out of your returns if you're a muni-bond investor.
Benz: So, one think I would say though, and I think Shannon would agree with me, unless you are a very large investor, my bias, and I don't know about yours Shannon, would be to invest with a fund to get that diversification, to get that professional management. It seems like given some of these risks of downgrades and bankruptcies and so forth that professional management could be well worth the fees especially if you keep those fees nice and low.
Zimmerman: It's a part of the market where being very selective can yield big benefits.
Stipp: The other issue that I think people worry about and they think that going with individual bonds can help them with interest-rate risk, because they think, well, if I have an individual bond and interest rates go up, I can just hold that bond and continue to collect the income that's thrown off from there. But what do you think about the trade-off given the interest-rate risk versus going a the mutual fund where you might see the value decline if interest rates spike up?
Benz: Yes, that's the rationale that a lot of the people use. I think what they might forget is that by buying a bond today you're essentially locking in today's low yield if you plan to hold it to maturity. Rates could go up nicely in the future and you'd be stuck there with your individual bond; whereas with the fund, your manager can swap into higher yields as they become available. I guess another thing that we haven't discussed is the fact that for smaller investors the bid/ask spreads can be quite punitive on individual munis, and that's another thing to think about before venturing into individual munis.
Zimmerman: Just the risk of investing in an individual security versus a basket of them.
Stipp: Heather, your municipal credit research team is starting to dig into a lot of the financials across the country in some of these municipalities. They recently wrote about those bankruptcies. What's their take on the credit risk that you're taking on in munis right now?
Brilliant: I think generally they think those are one-off events. So, overall, I don't know that any of our research to-date would advocate going out and buying a single individual muni. I think the whole diversification idea makes a lot of sense, because you don't always know in advance when you're taking on that credit risk, especially if you're going into a smaller muni. But generally speaking, they think those were more one-off events than a big trend of some wave coming.
Stipp: Paul, speaking of the interest rate risk in the individual bond versus buying a bond fund, there are actually some ETF products that have maturities. How should investors think about those? How could they use those potentially in a portfolio?
Justice: I think these are great tools for financial advisors, especially if they're thinking about doing some liability matching. So, what we're talking about the BulletShares funds from Guggenheim. So they'll have a stated maturity: 2012, 2013. So instead of really targeting a duration, they're targeting that time when it comes due. So if you were doing bond laddering before, it makes sense if you want to have a diversified approach to bond laddering, especially if you're a smaller investor. So, I think those can be really effective for that.
Stipp: I would like to shift the conversation a little bit but still focus on fixed income. We had a question from someone about the kinds of fixed-income investments, specifically fixed-income funds, that they're using. It says, given the tremendous uncertainty in the markets, would it be reasonable to put a significant part of your portfolio in a mutual fund such as PIMCO All Asset All Authority. This is one of those funds that has a lot of latitude to invest in many different areas of the market, depending on what the management sees there, which could be a good thing, but you really need a skilled manager there.
So when you're thinking about these funds, Shannon, I'll kick this off to you first, how do you assess a fund where the manager has such wide latitude? How would you use such a fund given that it could look different a year from now?
Benz: All Authority!
Zimmerman: That fund is an exception to the rule, because typically tactical can just be a synonym for market timing--so people lurching into and out of asset classes based on whatever signals that they are paying attention to. Usually, it doesn't work. There are a handful of exceptions. I would say that that fund is one. The folks at Leuthold also do a nice job of moving into and out of different asset classes, and over time have developed quite a tremendous record in the Leuthold Core Investment Fund in particular, but those are really quite rare.
I think a lot of times folks want to work with advisors who appear to be doing something. So they are tactically shifting into and out of different asset classes, and you have to ask, what value is added over time, when there are transaction costs that are associated with that, and the risk of getting it wrong--which is usually not just a risk, but a reality. I think that folks who are long-term investors should keep that in mind and use time arbitrage; they can wait for a long, long time for their investments to pan out. So if they pick quality funds to begin with, with talented managers, low expenses, all the things that we look for when we analyze mutual funds here at Morningstar, they should just stick with that and make sure that their asset allocation is consistent with their long-term gameplan.
Stipp: Christine, you've talked about in a tough environment it can make sense to outsource to an active manager potentially. How active, though, do you think those managers should be able to be? Do you think that PIMCO Total Return, for example, Bill Gross does make a lot of different bets, but the fund is not going to be dramatically different as far as its duration. It's still going to be one of those core funds, but some of these other funds, they could look dramatically different. How would you even use that in a portfolio if you are trying to stick to a strategic asset allocation?
Benz: I think that's a great question and really underscores Shannon's point. When we look at the data of how truly tactical, open-toolkit managers have done, it's not great.
Benz: Like a quarter of those funds have gone belly up historically. I'm more interested when you're talking about focused exposure to an asset class a truly active manager. I think that can be a great combination. Bill Gross has shown that that has been effective combination for him. But I would underscore, even if you're looking at PIMCO Total Return maybe as a panacea for an uncertain fixed-income environment, which I think we're in, he's not a miracle worker. There is no way in the current interest rate environment that you're likely to be able to squeeze a great long-term return out of the raw-materials…
Stipp: And I think Bill Gross has even said as much.
Zimmerman: And he recommends equities.
Stipp: Which says something when the biggest bond fund manager in the world says you might want to consider equities for a part of your portfolio. That's a pretty big message.
Zimmerman: That part of PIMCO is growing too, I noticed.
Stipp: Yes, it has in fact.
Heather, we have mentioned valuations as being an important thing to consider as far as how you want to put your portfolio to work. We mentioned it early on in this Q&A. When you look at the market, there is a lot of different ways to look at valuations. We have here at Morningstar a price/fair value for the whole market that looks at the median price fair value.
Another [metric] that a lot of our readers look at is the Shiller 10 year P/E, and this uses a normalized earnings ratio. And by that measure, the market looks more expensive than it has historically. When you look at that measure and you look at Morningstar's valuations, what conclusions do you come to about where we are in the market: over, under, or about fairly valued?
Brilliant: So, generally speaking, I do think we're pretty close to what I would call fairly valued. According to our price to fair value ratio, as we look at it, we're about 10% undervalued which is, in the grand scheme of things, a rounding error from being pretty close to fairly valued. Certainly, it creates opportunities because not every stock is exactly 10% undervalued, and we find some that are 40% or 50% undervalued in this environment.
However, I think when you're looking at something like the Shiller P/E, you really have to take into consideration what it is. Every valuation method is a tool, and you have to use it in the context of the broader environment. I think that the Shiller P/E, for example, is a historical measure of earnings over the last 10 years. So, when your last 10-year period includes a period like what we've seen from 2008 to now, where I think earnings have been tremendously depressed, and obviously the whole economy has been--especially in the U.S. and now really just kicking off in Europe--starting to be particularly weak, then looking at something like the Shiller P/E gives you an underappreciated amount of earnings that companies can earn.
So, when we are looking at our valuations, we take a more forward-looking approach and I think that's an important differentiator in terms of having actual analysts looking at the stocks and analyzing where we think each company can go on an individual basis versus having to make some broad-based assumptions about the past being what the future is going to look like.
I mean, generally speaking, I think there is a lot of data to support the Shiller P/E ratio. It's a good measure. It's certainly one that should be part of a toolkit, if you ask me, but you have to take it in the perspective of the context of the current environment.
Justice: Totally agree. It's so useful, but limited, in what it can do. So, if we look at the CAPE, we're sitting at about 20-22 right now versus, we'd say, over a longer period of time closer to 15 is fairly valued. But if we look at current forward-looking P/Es it's much lower than that. So it gives a contrasting picture.
Now, go back to the CAPE, the cyclically adjusted P/E, when you evaluate that over a long period of time, Treasuries average 4.5% over that period. When the CAPE was high, yields would be about 3.6%, so the dividend yield on stocks would be under what the Treasury yield is. When the CAPE is low, say 12, which was an undervalued market, dividend yields would be a 5.5% or a point above what Treasury yields were. So today we've got this contrasting picture. Dividend yields are about 50 to 60 basis points higher than Treasury yields on the S&P 500. So, right now, you've got the high valuation but the higher yield. So what do you get out of that data point? It gives me mix signals.
Stipp: Heather, you mentioned our own forecasts and how we think about fair values. We had a question from a reader about, given the current economic growth that we're seeing and some of the other factors we're seeing in the macro economy, do you expect that the stocks that you see are undervalued that might be under pressure, might it take longer for them to reach fair value? How long in your models do you expect it takes for undervalued companies to reach fair value? How patient do you have to be, especially in an environment like we have right now?
Brilliant: That is a really good question. I do think that there is sufficient uncertainty out there right now in the macro environment that you have to be particularly patient. Generally speaking, we try to think of our fair values as the price that we would expect the stock price to converge to within approximately three years, but that's really a rule of thumb.
In fact, historically, when we've looked at that ratio, we see convergence happening in more like 18 months, but that is not scientific. It's just a matter of observation. So, on a go-forward basis, as our analysts are thinking about, what do I think this business can reasonably achieve and how long will it take to get there, we use typically a three-year time horizon.
Justice: Abby Joseph Cohen once said valuation tools are not timing tools. You have to have the patience to see it through. Just because something is cheap, doesn't mean it's going to get expensive right away. You have to be willing to stick with it. Eventually, it will get there, but don't let the fluctuations in the market that are happening right now throw you off of a good deal.
Brilliant: I would say, though, one thing that's really important is that, we obviously value every company we cover from wide moats to narrow moats to no moats. It's a lot easier, I think, to have that long-term conviction in the valuation when you're looking at a wide-moat business, because there is a less variability in what those earnings are going to look like over time. They're a lot easier to forecast. They typically have lower uncertainty ratings, so you need less of a margin of safety to be willing to buy them. So we really see that our valuation work works even better with wide-moat companies. So I would just stress, the longer a time horizon you're taking when it comes to valuation, the more important it is that you're buying a high-quality business that's going to keep compounding returns over time.
Stipp: So, you mentioned there about stability, and it's nice to have that as you ride through rough patches in order to see your investments thesis play out on specific investments. We had a question here I thought was an interesting one. It says, why should I worry about portfolio stability? He mentioned that quality mutual funds after falling in 2009, 2010 are now higher. We mentioned that quality was a great story that we told recently, but those stocks have appreciated. He says that some of those valuations look even higher now. If an investor just ignores market fluctuations, they seem they could get through unstable periods just fine, which seems like a great strategy, right? But it's pretty hard to practice, and our data would so, right?
Benz: Definitely. So we track a data point called Investor Returns that looks at the dollar-weighted returns of a fund in contrast to the total returns that we publish, which simply measures the returns of the basket of securities, regardless of when investors bought and sold.
So, what we see with these Investor Return data points is that investors oftentimes do a poor job of buying and selling. So they inopportunely time their purchases and sales and therefore their returns that they earn are smaller than what the published total returns of a fund would be. And we have found a really strong correlation with high volatility, worse investor return. So the higher volatility the investment, the more likely investors are to do that buying high and selling low.
Zimmerman: It's across all asset classes. We estimate about 1.5% across all asset classes that investors are leaving on the table, because they don't have the patience to stick with the fund when it goes through a volatile period.
There is one example that kind of underscores the point that Christine was just making. I cover a fund called Fidelity Leveraged Company Stock. The mandate of the fund, and the word "leverage," a very scary word, "leverage" is in the name of the fund. Over the last 10 years--and the manager who is on it now owns about nine years of the fund's 10-year track record--it's gained 14% annualized during a really lousy decade for equities. The typical investor, based on our Investor Returns data point, gained about 2% annualized, a massive gap. So, everything that we do here, I think, is to try to close that gap. People have a hard time using a fund like Fidelity Leveraged Company Stock.
Stipp: So that basically means investors were buying that fund after it had run up and they were selling the fund after it hit a rough patch. So, they didn't really get to enjoy in those gains as if they had just bought it at the beginning of the period and held on through?
Zimmerman: Exactly, and as widely volatile as it is, it's wildly consistent. It performs over the last 10 years exactly the way you would expect in the market environment--it succeeds in 2009 and crashes in 2008.
Stipp: So a question, since we're talking about funds and analyzing funds, we're talking about volatility there. We had a question on fees. A reader is wondering, when does it makes sense to pay additional fees that would be associated with active management, for example, versus an ETF product? Fees, we know and we've talked about it again and again and again, are very important determiner of what your investment return is going to be. If you have a lower-cost investment, it gives you a smaller hurdle, but we've also seen some active managers do a great job.
Maybe I'll start with you, Christine. When you're thinking about fees on investments, when does it make sense to pay up a little bit to get a better performance?
Benz: It's the magic question, isn't it? But I would say that, in general, if you are going with an active manager who is charging an active fee, make it at least something reasonable. So that's why Vanguard suite of actively managed funds are so easy to recommend. They charge 45 basis points for their active products, not 1.45% for their active products. So, think realistically about what an asset class is likely to return over time and just think about what sort of hurdle you're creating for that manager.
If it's an expense ratio that's encroaching on 2%, and you think you'd be lucky to earn 10% from that asset class, that is a big bite of your return. So, I think that that's one way to think about how much is too much.
Certainly, with fixed income, when you're looking at the headwinds facing fixed income, how low yields are, anytime I see any sort of bond fund that's getting close to 1%, forget it, because you're lucky to earn 3% or 4% on that asset class over the decade ahead.
Zimmerman: It's important to remember, too, it's not an either/or proposition. You could think of it in terms of strategic diversification. In some markets, indexing works well. We're in one now. In some other markets, active management works better. So you can own both.
Stipp: Paul, to that point, you folks have done some interesting research about where you've seen indexes work really well and certainly when you see indexes working well, that usually means lower fees with ETFs. We're certainly seeing that to be the case, and ETFs have enjoyed a lot of popularity. But there are other areas of the market that you found where, as Shannon was saying, it is better and an active manager can extract more value. What are some of your findings there?
Justice: Well, first, I want to be on record saying I'm anti-fee. I like no fees. So we've got that clear for everybody. But yes, I think when you have a well-established, liquid market an ETF or an index-based product can work really well. Some of the cases we already talked about. Muni bonds, I probably wouldn't want to have a ton of money in an index-based product, especially when there is turmoil unfolding in the market, because liquidity can be fleeting. An on-the-run muni bond can be very liquid today and then three months from now, it might not trade again until the thing expires. And if you've got an index product that has rules that say it has to get in and out of these things, it might lead to a bad investor experience for you.
So, we've certainly seen some bad performance there in smaller/microcap stocks. They have been horrible. Junk bonds, they have been pretty bad. Those are all areas where I would actually reach in my pocket and hand some money over to somebody--nothing over 1.5% certainly; I'd be searching for something lower than that--to go ahead and put that capital to work and make sure my asset class is being managed very well.
Zimmerman: And you pay that money despite being against fees?
Justice: Against my better judgment.
Stipp: We're running up against our time here, but I wanted to get one more question in. This one maybe gets to some of your personal feelings as well. This is a big one I think.
We've heard the term new normal a lot recently, for the last couple of years. I think it was popularized by PIMCO. The reader asked, is this the new normal? If not, how long should the current situation continue in the markets where we're in this risk-on, risk-off environment with all of this attention paid to the macro economy. The person says, looking out over the coming years, will returns in the financial markets revert to long-term trends or have things fundamentally changed in the market, and we just have to get used to lower returns?
Do we feel like it's different this time? It's been dangerous to say, "it's different this time," during certain periods, and it's also been dangerous to pretend like it was just a recession, a mild recession in 2008. It certainly was a different kind of recession.
Christine when you think about the markets, are there fundamental differences now that you need to take into account as an investor--and I think a lot of tactical folks would say yes--or can a strategic asset allocation plan still work for you in a market that is depending on those long-term trends continuing?
Benz: I guess, Jason, I would still espouse a pretty vanilla plan for most people that doesn't involve a lot of tactical maneuvering. I think it makes sense, as you get closer to needing your money to just gradually tip more and more of it to the safe stuff as time goes by. I don't see the fundamental underpinning for that formula not making sense, and I also would keep those asset classes within the portfolio pretty vanilla, rather than--you know how I feel about alternative-type investments. I'm not a great big fan, even though there has been a lot of hubbub around them. I think that stocks and high-quality bonds have shown that they can be sort of opposing forces to balance a portfolio, and that formula made sense for my grandparents. I think it still probably makes sense for my nieces and nephews, too.
Stipp: So one thing, though, that I think you would advocate is, we likely will see some continued volatility and always you're going to see volatility at some point in the equity markets. So, even though you can have a strategic plan, you still want to make sure that you have an allocation to cash, for example, so that you don't have to worry about the value of that portfolio in equities at any given time?
Benz: Right that emergency fund or we talked about the bucketing system for retirees--that bucket number one, with one to two years worth of living expenses plus some emergency fund. That always makes sense. That's an all-weather prescription for everybody.
Stipp: Shannon, are things different this time as an investor? Can you rely on the same kind of plans that you might have had 10 or 15 or 20 years ago?
Zimmerman: I think you can. We like to think about the market's long-term historical returns and look at that from a high level, the trend line looks quite smooth. It hasn't been smooth. It's been a wild ride over the course of many, many market periods. This is just one of them. I don't know if it will be a blip on the trend line when people are looking at it 100 years from now, because when you're going through it, it feels quite raucous and alarming. But risk comes with the territory when you're investing in equities or even in fixed income these days given the low yields and risk of inflation and interest rates. But I think that the long-term gameplan should remain the same for investors who have the patience to sit through the turbulent times.
Benz: One point I would add, too, is, do count on muted return expectations. I think [moderating your return expectations] is actually a good thing, that there is a fundamental underpinning for that. Plus if it's a catalyst to get you to save more than maybe you thought you did, I don't see how you can go wrong with staying pretty muted on what you expect from various asset classes.
Stipp: Heather, when you're looking at return expectations, do you think that investors will have to get used to muted returns or is there a way that they can maybe get the kinds of returns that they might have been accustomed to in the 1990s or even in some parts of the 2000s?
Brilliant: I do think lower return expectations are reasonable now. There is a whole headwind that we are all going to face for a long time of deleveraging. But importantly, that doesn't always carry through to company balance sheets, for example. And so of all of the areas of the economy, one of the areas where you can find investment opportunities that suffer the least from this potential deleveraging that we really are starting to embark on, are on corporate balance sheets. And I mean high-quality, wide-moat names. Again, I don't mean to beat a dead horse when it comes to wide moat, but if you can buy a business that you believe can compound returns at a better rate than the overall market, and you don't have to take on a lot of leverage on that corporate balance sheet, I think you're in the best possible situation. And also, you know the fees to buy stocks are pretty darn small.
Stipp: Paul, we've been through some exceptional periods over the last five or six years. One of the wildcards that we've seen, not really wildcard, but one of the differences we've seen is dramatic intervention by government policymakers. Do some of the things that we're seeing in the market, the low rates that have been pushed low, do they mean to investors that you have to think differently about investing, or is this a period of time where it will be a bit abnormal because of the intervention that we've seen and because of that dramatic bear market that we've seen, but we'll get back to the fundamentals again at some point?
Justice: We will get back to the fundamentals. I think you have to pay attention to what's happening and alter your perspective. Back when you got 10% returns on stocks, you had 5% Treasury yields. So you had to get some sort of risk premium there. Just readjust your basis here. Have an expectation of Treasuries at 1.5%, I'll still get my 4% to 6% equity premium over a long period of time. But that means 6% returns on my portfolio, and if they stay here, that probably means inflation is really low. If inflation goes up, interest rates will go up, and the returns of stocks will follow. It doesn't make you any richer relative to everyone else, it'll just be a bigger number and everything will cost more. So keep that in mind: With these lower returns, you'll probably be able to live off some of that income, a little bit easier than you used to.
Stipp: Paul Justice, Heather Brilliant, Shannon Zimmerman, and Christine Benz, thanks so much for bringing all your brainpower to our Q&A, answering our readers' questions. I appreciate you being here.
Justice: Thank you.
Benz: Thanks for having us.
Zimmerman: Thank you.
Stipp: Thanks for joining us today, and we hope to see you again soon.
All Investments Mentioned in This Video
First American Financial FAF
Kinder Morgan Management KMR
Leuthold Core Investment LCORX
PIMCO All Asset All Authority PAUAX
PIMCO Total Return PTTRX
Guggenheim Bulletshares ETFs