Jason Stipp: I'm Jason Stipp for Morningstar and welcome to the Friday Five. This is our look at five notable themes for investors.
Joining me this week on the Friday Five is Morningstar director of equity research, Pat Dorsey.
Pat, thanks for being here.
Pat Dorsey: Hi, Jason.
Stipp: First question for you, this week we wrote about some fund flow data. We saw some trends continuing there with money moving out of equity funds, especially actively managed equity funds, and moving into bonds and into some passive strategies. It seems like investors are saying, "This is not a stock-pickers market." Do you agree with that?
Dorsey: Typically, whatever investors are saying with regard to fund flows is wrong. Sorry to say, but fund flows are usually a pretty darn good contrarian indicator. We've done the study for years at Morningstar about funds, especially sector funds, that have had large outflows. They typically do pretty well over the subsequent periods. Once large inflow is there, they don't do too bad – but they do pretty badly coming soon. And I think it's going to be especially the case with the bond versus stock point.
Money has been flooding into bond funds, with Treasuries that are 2.8% yield, and I think frankly investors are just stuck in the rearview mirror. They are saying, what do I wish I had done 10 years ago, and they wish they'd put money in bonds, which have returned about 6%-7% annually over the past decade, and they wish they hadn't put money in stocks. But sadly, right now, we are investing for the next 10, not for the last 10.Read Full Transcript
Stipp: One thing that people who are still investing in the stock market will obviously pay close attention to is the upcoming earnings season. Earnings the last few times around have been a little bit better than some folks expected. What are you thinking? What are you going to be closely watching for third-quarter earnings coming out in the next few weeks?
Dorsey: Well, I mean, part of it is going to be revenue growth, right? We've had a fairly weak end market demand mainly in the U.S, and so sales numbers--companies that disappoint on sales, I think, have really gotten whacked much more so than the ones who have disappointed on an earnings basis.
But the other trend that I think is more likely to exceed expectations is on the margin side, because productivity gains in the U.S. have just been absolutely incredible. I mean, we had a lot of U.S. companies tell us over the past year, you know during the downturn, we did five years of restructuring in five months.
And then, of course, the question becomes, how long can that be sustained. Did they cut into the muscle, so now they are going to have to add cost back as end market demand and sales ramp back up?
But generally speaking, margins keep coming in better than we thought they would, even with revenue levels for companies with a lot of operating leverage below peak. So, that's kind of encouraging, but it's definitely something we'll be watching closely, because this trend has been going on for a few quarters now, and when the thing can't go on forever, it'll stop.
Stipp: Sure. Also in corporate news, we have been seeing a trend of M&A, something that you did a video about recently. Of the some of the deals that have come down the pike in the last few weeks, have any of them to you looked like especially smart deals, and have any just made you go, "I don't know... What's going on there?"
Dorsey: The Intel-McAfee deal had us all kind of scratching our head. I mean maybe, they are just crazy like a Fox and there are some reasons for building security into the hardware as opposed to into the software stack, but that one, that was a stretch.
I mean, they didn't pay a crazy amount for it, that's good, but it was definitely from strategic perspective a little, I am not certain, a little strange.
I am always reluctant to give any M&A deals sort of the USDA Grade A stamp of approval right out of the gate. So, there weren't any that sort of had me jumping out of my chair and going, "you go CFO."
Stipp: Well, I think one of the reasons that we might be seeing some deals is because on corporate balance sheets, on some of them, there is a lot of money, and one of the things they can do with money, as you had brought up before, is that they can make acquisitions. They can also pay dividends, and we saw one tech company start to pay a dividend this week, Cisco. What's your take on that move?
Dorsey: I wanted to give John Chambers a big fat smooch. I am not kidding, because I mean I think for a long time, tech companies have had this idea that, you know, tech companies just don't do dividends, right. We're admitting that we're weak, we're admitting that we can't grow anymore; it's some sort of admission of defeat. And it's not. It's actually, it's an admission of victory. It means you won. It means you dominate your market so completely that you basically build up excess cash in the balance sheet, which you should be returning to shareholders.
Microsoft still has not really figured this out. John Chambers, Cisco seem to be figuring it out. But more and more tech companies are.
There is a wonderful chip equipment company I like called KLA-Tencor. I have talked about it a few times, 3.5% yield. When did you think you would see a 3.5% yield from a chip equipment company?
So, I think you know sanity starting to come around, but generally speaking you know the more of dividend payouts I see, the happier I get.
Stipp: Well, certainly something we'd like to see more of, if possible, it could be setting a good tone.
Pat, for number five, you know, I don't know what kind of comments this video will get, I hope it gets some good comments but…
Dorsey: Well, they'll probably comment on my tie, because I think they were angry that I was wearing the same one.
Stipp: I noticed you were wearing a new tie today, and you look very nice.
Dorsey: Don't ever let it be said, I don't respond to the viewers.
Stipp: Well, one thing that we have noticed in the comments is that for some of them there is a really sort of pessimistic tenor, and you know things are – there's still a feel like that things are bad out there for a lot of the individuals out there, but yet we also see as you were saying before earnings are coming in pretty well, better than expectations, corporations have a lot of money on the balance sheet.
But individual investors, they are heading into bonds, they are pessimistic. What's behind that? What's behind that sentiment?
Dorsey: Yeah, I mean, it's actually quite clear what's behind that, which is that the experience, the day-to-day experience of most individuals and small businesses is quite different than what most companies are reporting, and there is some very good reasons for that.
You know, if you are a small business, you're probably borrowing money from banks; and banks aren't really willing to lend right now. If you are an individual, you know your neighbors probably got their home foreclosed upon. Your spouse may have lost their job. I mean, unemployment is still 9.5%. I mean, things are pretty tough out there on that level.
But I think what people often forget is that you know 40% of S&P 500 companies' net income comes from outside the U.S. So there's this huge chunk of earnings coming into American companies that just isn't tied to people's daily experience.
And also the S&P 500 is, big corporations, are typically more levered to business spending than we see in our day-to-day lives. You know the corner dry cleaner that's having a rough time, or the corner deli that closed. They are not public; they are not part of the investable universe.
Whereas you know giant tech companies that sell huge databases, which we don't really buy on a day-to-day basis, they are part of the investable universe. And I think that's why it's hard for a lot of people who see the pain that the economy is going through on a day-to-day basis to understand why businesses are doing so well, and it's simply because the demand is coming from different places.
Stipp: Well, Pat, thanks so much for joining me. Thanks for your insights. And thanks for being on the Friday Five.
Dorsey: Thank you, sir.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.