Jason Stipp: I am Jason Stipp for Morningstar. 2012 offered investors some bumps along the road, a few surprises, and yes, even a cliffhanger at the end. So, what's at stake for 2013 and beyond? We were lucky enough to sit down with four of Morningstar's top strategists to get their take on the current environment and also some of their top picks today.
Up first is Paul Larson, the editor of Morningstar StockInvestor. He looks for wide-moat stocks, selling at attractive valuations. We're going to hear his take on the current market valuation as well as some of his best ideas for 2013.
Paul, before we get to your picks, let's talk a little bit about the broad market and where you're seeing valuations right now. You like to look for high-quality companies, wide-moat companies that are selling at a good valuation, at an undervaluation, a margin of safety. What does your hunting ground look like right now? Are there more opportunities or less opportunities?
Paul Larson: Well, right now, we're in the middle of a bull market. In 2012 we had yet another year of positive returns and strongly positive at that, and for better or worse, that has evaporated a lot of the bargains that we've seen in the market. So, the opportunity set of wide-moat, 5-star stocks or even deep 4-star stocks, that's a very thin cohort right now. You can measure it using one hand.
Stipp: So, that said, you do have a few picks that are on your list right now. The first one, interestingly enough, National Oilwell Varco is led by Morningstar's just-named CEO of the Year, Pete Miller.
Oil and gas is an industry that can be very unforgiving. It's interesting that this firm has a wide moat. I think it says something about the way it operates. What's behind the wide-moat rating on this particular firm in that tough industry?
Larson: I think you have to take a step back and see what the company actually does, and they provide equipment that is used by other E&P firms. So, they are not directly involved in producing the commodities. Instead they're selling the picks and shovels, so to speak, that other oil companies are using to drill their wells.
But what has given this company a wide economic moat is a combination of a few things. One, they have a very large market share among drilling equipment, and this drilling equipment has a fairly high amount of intellectual property in it. And they also turn around and use this scale to get a lower cost and to provide this high-IP equipment to the providers.
Also there's a little bit of a switching costs involved here in that a lot of rigs are standardized around National Oilwell equipment. So, once you're standardized on that equipment, it's fairly difficult to go to a different provider. Also, there's a razor-razorblade component here in that they are providing a lot of the consumables that are actually being used on the rig. So, it's a combination of a couple of different things, but the proof is really in the pudding when you look at the returns on invested capital. They are well in excess of the company's cost of capital, and that's the situation we expect to continue for quite a number of years.Read Full Transcript
Stipp: This isn't necessarily a source of a moat, but the capital-allocation skills of their CEO and the kind of acquisitions they've made have paid off for the company, which is a rare thing to see any acquisition pay off really well for a company. This company has a good track record of that.
Larson: Yes, they have a very good track record of acquisitions and actually buying ahead of industry trends. This is a company that was basically cobbled together via acquisition over the past decade plus, and this process started back when oil was much cheaper than it is today and when drilling rigs was a very unpopular industry. There was not a lot of capital being thrown at that industry, and National Oilwell Varco basically claimed a lot of the space in that industry for itself. And now that large market share that they have is proving to be much more valuable.
Stipp: I said at the outset that the energy industry can be a difficult one to operate in, and in fact in 2012 it was a lagging industry. The sector was up, but it wasn't up nearly as much as the other sectors. What was going on with energy? Why has it lagged recently, and what do you think are the broad fundamentals for energy going forward?
Larson: Energy when you look at what the drivers are, I think the thing that was driving energy was a lot of macroeconomic uncertainty. Here in the U.S., we had positive GDP growth, but when you look at worldwide, areas such as Europe, we had a number of countries around the globe that were in recession. And usually when the world is in recession, demand for energy is muted, and we saw some of that play out. I mean we didn't have a worldwide recession, but we had pockets of the world where we had recession.
Another major thing that was coming into play was relatively low natural gas prices, and this has been a theme over the last couple of years where we've seen just a flood of supply come on from new sources of natural gas. And so natural gas prices are low. That has impacted earnings for natural gas providers and has also flowed somewhat to the service providers that have been pinched a little bit by lower demand from gas drillers.
Stipp: Let's talk about the individual company now in that framework. So, the stock last year, National Oilwell Varco, actually performed a little bit less than the sector average. It has some, obviously, maybe some company-specific headwinds or concerns about it. This is probably a good reason why it's one of your picks, that maybe the market's valuation is a little bit less than what you think it's worth. What do you think some of those reasons are that account for the difference between the market price right now of that stock and what you think it's worth?
Larson: Yes, when you look at the opportunity that NOV provides today, I think you have a very interesting combination of a company that has just a dominant position within its industry. I mean the joke is that NOV stands for "No Other Vendor," and that, very succinctly describes the competitive position that the company has. When you combine that with the valuation on the shares where you are only looking at a stock that's trading barely over 10 times earnings, roughly 6 times enterprise value/ EBITDA, very low valuation combined with that strong competitive position, it does look like a very interesting opportunity.
There have been some headwinds specific to National Oilwell Varco. You have a situation in Brazil, where the Brazilians are trying to foster their own oil equipment industry to service the large increase in demand that is going on there. The Brazilians are failing, but I don't think the market has come to appreciate that just yet. But at the end of the day, we've done our level best to put in reasonable projections in our discounted cash flow model for the company, and we are showing the company would be worth somewhere just south of $100 a share, which is fairly significantly higher than where the stock trades, near $70.
Stipp: Your second pick Paul is in a sector that maybe shares some of the dynamics with your first pick, and that's Exelon. It's in the utilities industry. Before we get to some of the specifics on Exelon, let's just talk first at the sector level. The utilities really trounced the S&P 5-- in 2011, but they brought up the rear in sectors in 2012. What are some of the broad dynamics that are affecting utilities companies and that reversal of fortune that we saw over the last two years?
Larson: I think a lot of the underperformance in 2012 came from the fiscal cliff debate and the potential for higher taxes on dividends because utilities stocks, those tend to be relatively high-yielding stocks. Dividend names were quite popular in 2010 and 2011, but then in the latter half of 2012, they started to lose some of their popularity as the concerns about the dividend tax came to fruition. And then we also have the situation in natural gas that we mentioned with National Oilwell Varco. A lot of the utility companies don't necessarily have natural gas in their business plans, and Exelon is one of these companies. But they are indirectly influenced to a large degree by natural gas prices, because electricity prices are basically a derivative of natural gas prices. So, when natural gas prices go down, electricity prices also go down, and for the companies that have unregulated businesses like Exelon, that can provide a fairly significant revenue and profit headwind.
Stipp: The utilities sector as a whole lagged other sectors. It was, as a whole, positive in 2012. Exelon, however, shed about 30% over the last year, which is quite a bit. So, obviously there are some concerns about Exelon that the market has that you don't necessarily share. Our fair value did come down a little bit in recent times in the last year, but not nearly as much as we saw the stock drop. Can you talk about, again, that difference between the market price and that pessimism, and the fair value and why you like the stock?
Larson: Right, well it's interesting when you look at how stocks tend to perform. In 2012, a lot of my absolute worst-performing stocks that I had in the Tortoise and the Hare portfolios were actually the best-performing stocks in 2012. The worst shall be first, that whole idea, and I think that that's maybe in play here with Exelon. I clearly made a mistake by buying Exelon when I did a couple of years ago and it was indeed my worst-performing stock in the Tortoise portfolio last year. That said the perspective from this point going forward looks a whole lot brighter. One of the things that was clearly hurting Exelon was the potential for a dividend cut, and it looks like that is more likely than not to happen in the months ahead. That said even if they cut their payout by one third and get that payout ratio down to about 60%, which is where we think that they need to be in order to maintain their investment-grade credit rating, you're still looking at a stock that's going to yield somewhere on the order of 4.5%-5.0% post-dividend-cut, which is still a fairly attractive yield.
Stipp: If you're looking at the total return, which is something that investors obviously should do when they're making an investment given the fact that it's undervalued in our opinion the way it is, it's something you want to keep in mind besides just that absolute yield level, as well?
Larson: Absolutely. Exelon also, though it's not a natural gas company, we think it is actually a great bet for rising natural gas prices. When you look at what the futures markets are pricing in for natural gas, we do see that the futures markets are in contango in that the further you go out on the futures curve the higher the natural gas price. So, the future's markets think that natural gas going to rise. We also think natural gas prices are going to rise because of the relatively high replacement costs. And the market is finally responding to the relatively low prices that we see in that on the supply side, we're seeing drilling being curtailed, far less aggressive drilling. Then on the demand side, we're seeing some fairly significant switching, especially among utility companies going from coal, which has all sorts of regulatory headwinds regarding pollution controls, switching to natural gas which is a much cleaner fuel. So, as those things play out, we think that natural gas prices are going to rise. Therefore, we think electricity prices are going to rise, and that will benefit Exelon.
Stipp: Your third pick, Paul, let's swing over to health care. It's Express Scripts. This is the only wide-moat company among health plans and drug supply chain middlemen or operators. Can you talk a little bit about what this company does and why it has that wide-moat rating?
Larson: Sure. Well, this is a PBM, or a pharmacy benefits manager. What they do is they basically help their clients who are private companies as well as managed-care organizations to more effectively use the money that they are spending on pharmacy benefits. So, they do things like get health-care consumers to get their prescriptions through the mail as opposed to going to the corner drugstore.
They also encourage them to get 90-day prescriptions as opposed to 30-day, to use generics as opposed to branded pharmaceuticals, different ways of trying to lower the overall cost of using prescription drugs. This is a company that gets its wide moat because it is the largest in its industry. It has a market share of just under 40% and more than one in three of the prescription drugs that are consumed in this country flow through Express Scripts. They have a market share that's more than 50% greater than the second-largest company and more than twice as large as the number three. This is an industry where scale is a competitive advantage. So, you take that market share in this particular industry, and you have a wide moat.
Stipp: So, good strong companies with wide moats don't go on sale very often. So, for you to find one of these companies attractive there must be some headwinds against it. I pulled up the stock chart for this company. In the fall of last year, they did take a downturn. What were the market's concerns there? Our fair value estimate did not change, by the way, over that same period. So what's going on?
Larson: After the company reported quarterly results, they said that the earnings estimates for the year ahead were looking a little aggressive, and they did not provide their own forecast for the earnings. And if there's one thing the market hates it's uncertainty. But when you look at the comments that the company had in their conference call, they were blaming macroeconomic things, uncertainty regarding overall employment, continued uncertainty regarding consumers utilizing discretionary health-care spending, which is a headwind that we've seen for a number of years, but these are things that are not really specific to Express Scripts.
I'd be a whole lot more worried if Express Scripts said, "OK, well we're seeing greater competition for clients. We're seeing greater pushback from the pharmaceutical firms," that sort of thing. But [the concerns are] the wholly macroeconomic things that look like they will revert to mean over the long term. So, from our perspective, the moat is overall intact.
Stipp: Last question on this pick. The health-care reform bill had been a cloud over health-care companies for a while. We got some more certainty on it, obviously, when it passed [Congress], and when it passed the Supreme Court, then again. How will reform, if at all, affect this particular company? Did it brighten the prospects, lessen the prospects, or is it essentially a neutral for them?
Larson: It's a mild positive. It's a positive, but not a large one, because a lot of the additional customers that are going to be flowing through the health-care system tend to be those that are uninsured, who tend to be younger and healthier, less veracious consumers of health-care. So, you are going to see a little bit greater volume through the Express Scripts network, but we think it's going to be a relatively mild positive for the overall company.
Stipp: Well, Paul, three moat-worthy companies in a time when moat-worthy companies at good prices are hard to find. Thanks for joining me today with those ideas.
Larson: Glad to be here.
Stipp: Up next we sat down with Russ Kinnel, editor of Morningstar FundInvestor. He gave his take on where fund investors are putting their money now and what expectations they should have for 2013 and beyond. And he offered a pick for investors who are concerned about the downside protection, worried about inflation, and also who want to eke out a little bit of income in some strong-performing stocks.
Russ, before we get to your individual picks, let's talk about the broad market. 2012 had some volatility, a lot of drama at the end. But at the end of the day, at the end of the year stocks had done well; bonds had done pretty well also. What kind of expectations do you think investors should have going into 2013?
Russ Kinnel: Yeah, stocks had a really good year, bonds did pretty well. So, it's a little bit of a surprise. But at this point, I think, bonds are kind of disappointing. I don't expect a lot from bonds. Stocks, I think, the outlook is OK. So, I would say be sober, don't expect big returns for the next year or two.
Stipp: For an investor right now who does want to stay attuned to the market and make smart decisions, are there any areas of risk or opportunity that you think are being overlooked, just given where most fund investors seem to be putting their money to work right now?
Kinnel: Yeah, I would say U.S. equities and European equities are really being neglected by fund investors, yet prices make them more attractive, particularly European. They came up a little last year, but they still are coming off a really low point. So, I think European equities are still worth a look.
Stipp: You have three picks, the interesting ones for us for 2013, and I assume beyond given that you are long-term investor?
Kinnel: That's right. These are long-term.
Stipp: The first one is Vanguard Dividend Growth, the mutual fund. There is a lot of interest in dividends and income right now. This has been one of Vanguard's top-selling funds, in fact. What is it that you like about this fund? It seems like a lot of people like the fund, but what do you like about it?
Kinnel: I like the basic strategy looking for dividends, but with the potential to grow that dividend, that means you've got to find a good balance sheet because you can't grow a dividend if you have a terrible balance sheet. So, you are looking for a little healthier companies. Yes, you are not getting a big yield, but it's still really attractive. It's run by Wellington Management, Donald Kilbride, a very good investment firm. And finally it has very low costs. So, what yield there is, you are actually getting, as opposed to letting it go to expenses.
Stipp: This, as I said, is one of Vanguard's top sellers. Do you think this fund is getting too popular or that investors might be owning it for the wrong reasons. And if so, what do you think are the right reasons to own this fund?
Kinnel: Yeah. It's very popular right now. I'm not worried yet because it's about $11 billion or $12 billion in assets, and its strategy is a really broad one looking for big large-cap companies that pay dividends, so they've got a lot of room to grow. So, I'm not worried yet, but obviously you want to watch it. I think the right reasons are that it's a good fund that's got a good strategy that will work out for long haul. It can build your income over time because if you have appreciation and a good yield, your income can grow.
So, I think that's the right reason. I don't think it's going to work in every market, that it's going to be great every year. So, be realistic. The stock market's probably not going to have great returns the next few years, but it's a good long-term investment.
Stipp: One of the things that the Morningstar analyst on this fund noted is that this is one of the few funds that holds a majority of wide-moat companies, very high-quality companies. Usually, with these bigger high-quality companies it's not a secret that they're high-quality, they don't come cheap very often. Do you think this is a fund that has trouble because of that, buying undervalued plays where they have to kind of pay up for the sorts of companies that they invest in?
Kinnel: I think on occasion, yes, but I don't think too much. I think last year we actually saw dividend stocks and this fund had kind of an off year. So, I think that's kind of corrected, and you can get them at a reasonable price. It's not like a growth fund that's going to pay a huge multiple. So, I think it's still a pretty good strategy. It's really a core fund.
Stipp: You mentioned also that the yield on this fund doesn't blow the doors off by any means, but do you think this is still a fund that income-oriented investors should take a close look at?
Kinnel: Definitely, because you can't just depend on bonds. I think it's got about a 2% yield, which isn't great, but that income can grow over time, and it's good to have diverse sources of income, too. You don't just want to be completely dependent on Treasuries, particularly given how low those yields are. This has actual appreciation potential whereas Treasuries, if anything, are probably going to lose some value if we see interest rates spike.
Stipp: Your next pick, Russ, is an FPA fund. It's managed by Steve Romick, a very well-known manager here, and one that we follow very closely. He described himself once as a free-range chicken with this regard to this fund. It alludes to the go-anywhere nature of the fund. It's FPA Crescent. What is this fund investing in now, and what might we infer about his beliefs of the market based on where he's been putting money to work?
Kinnel: It's mostly in equities and cash, and just about always it is long equities and cash. It will have a little in shorts. What I think is really interesting now is he's added some tech names. So, he's got Microsoft and Cisco, which you can argue are probably kind of the value side of tech, but he's also got Google. And to me that tells me he's flexible and that he's got his investment criteria of looking for really strong companies with limited downside. But he's not saying, "Oh, I can't touch this company because it's tech or it's growth." So, I think that shows the flexibility, and that's really worked for 20 years almost at the fund.
Stipp: This fund, and I think all of FPA's funds to a certain degree are very conscious of downside protection. This fund has a below-average risk rating over the last three and five years. What steps do they take to protect the downside here, and do you feel like in the current environment they are probably a little more cautious or pessimistic? Or does it seem like they're a little more optimistic for the market given that they have that sensitivity?
Kinnel: This is a fund that uses its flexibility to protect on the downside much more so than to grow the upside. It's a fund that really stays about 40%- 70% long equities, but it will have cash. It will have some shorts; it limits its short positions to 10% or less. Some of it is the positioning of the overall composition, but the kind of stocks they buy are strong companies with modest prices. So, there's limited downside, and I think they are really risk-averse. And you can see that if you go through the calendar-year performance: They had a great 2008 and a great 2011. And that's very consistent in that way.
Stipp: Lastly, Russ, if this is much more kind of a go-anywhere fund or they can invest where they are seeing the opportunities, how should investors use this fund? What should you think about, if you're going to buy this fund of what it might do over different kinds of market environments so that you can own it well?
Kinnel: I think you could kind of view it as like a lower-risk equity fund because it's got cash, it's got some shorts. But it's still got almost a full upside of a regular equity fund with less downside. I wouldn't worry so much about whether it's got a little more in energy or tech today. I think it's just a fund that you're going to build in some flexibility for because it is a wide-ranging fund.
Stipp: This kind of fund, as you said, they are not necessarily investing to maximize growth. They are trying to protect that downside. So, if we do see another strong market and this fund lags, that would certainly not be a reason to consider cutting it lose?
Kinnel: Right, it's very consistent. Last year it lagged a little. But again, in almost every down market it holds up much better than its peers. I think I would worry more if it either shot the lights out in a good year or got crushed in a bad year.
Stipp: Your last fund pick, Russ, is from PIMCO, it's PIMCO Inflation Response Multi-Asset fund. This is a relatively new fund and interesting pick; it already has a Silver Morningstar Analyst Rating. What does this fund do, and what gives you the confidence behind that Silver rating on this offering?
Kinnel: For starters it's run by Mihir Worah, who we know from the Treasury Inflation-Protected Securities and commodities side of PIMCO, and so he is a very experienced manager. But what I really like here is that this is a kind of a Swiss Army knife of inflation strategies. And the problem with inflation hedging is that there is all sorts of ways to do it, but if you bought all of them in individual funds you might end up with it becoming a core portfolio, and then it's no longer hedged. So this is a fund that combines TIPS, commodities, emerging-markets local currency, REITs, gold, and a little bit of hedging against equity risk. So, it really combines a lot of things that will protect you from inflation.
Stipp: Do you think this is a pertinent time for investors to be thinking about a fund like this? Are there fundamental reasons why you might want to add that kind of inflation protection at this time?
Kinnel: Yes. It's not that we know inflation is about to take off; I don't know that. But we do know that bonds are very vulnerable to an inflation spike given how low the yields are. So, if you've got a bond-heavy portfolio, this is a useful fund.
Stipp: Because this fund is newer, we haven't actually seen how it performs in an environment where inflation does spike. Is that a concern? Is that something that you would normally like to see before you would recommend a fund like this, or do we really have a lot of confidence in this particular management team?
Kinnel: Well, we have confidence in the management team, but we also can look at all those underlying asset classes and see how they've done. So we have records on all of that, and the fund isn't making huge shifts among those asset classes. I think that makes it fairly dependable. Of course you never know how inflation will spike and exactly which of these things will do well and won't, but I think that's why you want them all bundled together like that.
Stipp: And last question for you, Russ, to kind of wrap up these three picks, none of these picks really had a great 2012, but yet you still think these are good bets for 2013 and beyond for the long term. How do you look at their 2012 performance and wrap that up into your recommendation of these offerings?
Kinnel: What I like is funds that have sometimes had a slow period but have a strong long-term record, and the reason that appeals to me is that, markets are cyclical. They rotate. So there's a reason that you often see one year's winners become the next year's losers and vice versa. I think it's a bit of a contrarian bent, but it often will tell you that maybe these assets have gotten a little cheaper. Clearly two of the funds, FPA Crescent and the PIMCO Inflation Response, are kind of cautious funds, and you had a really strong year [for the market] so it makes sense that that they would lag in a year like that, but I like their defensive characteristics going forward.
Stipp: All right, Russ, three very interesting ideas and a good time for investors to consider those ideas. Thanks for joining me today.
Kinnel: You're welcome.
Stipp: Next we check in with Sam Lee, editor of Morningstar ETFInvestor. He is going to tell us a bit about his strategy for investing in exchange-traded funds and also some of his top picks for 2013.
Sam, you are an ETF investor, so unlike some of Morningstar's other strategists that are looking stock-by-stock, you are looking at a somewhat higher level. So when you are thinking about asset classes, when you're investing in different regions and different big chunks of the market, how do you think about valuations? What's your framework?
Samuel Lee: My framework is actually quite simple. It derives from an equation, so you can break down the total return of virtually any asset class into three components. One is yield, the other is change in per share of that yield, and then finally the last one is valuation change. And by valuation change, I mean what is the change in the multiple? So, if the U.S. stock market, say, is trading at a P/E of 10, and its P/E suddenly jumps up to 20, usually that requires a 100% change in price. So, that's what I mean by valuation change.
Now, interestingly enough, when most people talk about investing or think about investing, they're actually trying to figure out what the changes in valuation are going to be over a short time period but over the long run that washes out to zero because valuations tend to be mean reverting, and you can't have the S&P 500 P/E doubling every 10 years. So, the two main drivers of return are going to be, number one, yield; number two, the growth in that yield. And so, a simple way to value, say the U.S. stock market is to look at current yield and add a term for the growth in that yield. And historically, broad, big stock markets have tended to grow their yields by about 1% to 2% annualized real, that's after inflation, so, using that simple framework, you're looking at maybe 1.5% plus 2% yield, so 3.5% real expected return for the U.S. stock market over a long period of time.
Similarly, you have bonds. So bonds, they don't really have a growth in their yields. So, you can just look at the expected return of the bond by just looking at its current yield. This is a very, very simple framework, but it's been very effective. Simplicity doesn't mean that it's less effective than other forms, and if you just look at this framework, yields are low everywhere. You can't really expect abnormally high earnings growth, and you can't expect interest to fall further. So overall, I think that just looking at this framework, the long-run expected returns for asset classes all around the world are fairly low.
Stipp: So, given that framework and some understanding of how you view it broadly. You do have three picks in ETF's for not just the coming year, but maybe for hopefully the long term here. Your first one is a DEM, that's WisdomTree Emerging Markets Equity ETF. This is a passive fund. Some investors may say with emerging markets, the conventional wisdom is an active manager can add a lot of value there. There are tough markets to invest in sometimes and some of the indexes, the traditional indexes in the emerging markets, are cap-weighted very heavily on some of the multinationals. Some would question, you're not getting great exposure to emerging markets if you're investing in the biggest companies in emerging markets, but you like this particular ETF. What you like about it?
Lee: That's a fair point. Interestingly enough, I do agree that in emerging markets, it's probably going to be a less efficient market, so there are not that many institutional investors relative to the U.S. So, in the U.S., the vast majority of stocks are controlled by institutional investors of mutual funds. People do not tend to pick stocks as much as they use to. A lot of it has been outsourced to the pros. In the emerging markets, it's different. Most people still pick their own stocks, and it's a very common thing to do especially in China. That probably leads to some predictable inefficiencies that you can exploit, despite that I think that cost matters.
So, the case for indexing, the most powerful case, I believe, is that if your costs are below-average, your returns are going to be above-average just by the mathematics of indexing. But that's not the only reason why I invest in it because if that were the case, I would be investing in Vanguard's Emerging Markets ETF, which is the cheapest by far and it's a wonderful ETF. And it would probably be the ETF I'd pick, if I didn't have this dividend ETF. But I like dividends because historically dividend stocks have tended to outperform, and this has been found in virtually every single market out there. It's related to something called the value effect. So, if you sort stocks by almost any kind of plausibly value metric, price/book, price/earnings, price/cash flow, price/ revenue, dividend yield, and you do that and you just buy the cheapest by those valuations, you tend to get an earnings boost or a return boost. This has been found everywhere. So, it's commonly accepted, and I think that this ETF is a good way to exploit the value effect in emerging markets.
Stipp: So, you mentioned there that this uses a dividend model when constructing its portfolio. It's not a cap-weighted index then. What exactly are the managers of this fund doing when they are building that portfolio or the index? What does it do to figure out what is the weighting of this ETF?
Lee: WisdomTree has an index of dividend payers in emerging markets. So, what they do is every year, they sort that list, and they look at the top 30% with the highest yields. And of those, they simply wait by the annual cash dividends paid. It's a very simple methodology, and it tends to result in some idiosyncratic tilts. So a lot of Taiwanese stocks pay a lot of dividends, so here is a lot of Taiwanese exposure. But the strategy seems to have helped out quite well because the fund has done very well over the past few years. But I don't think that's a good enough reason to invest in this fund. Most of my conviction is because of this value effect that has been found across many decades and many countries.
Stipp: And this fund focuses on dividends. Usually dividends are a hallmark of a higher-quality company, more stable cash flows, disciplined management. How is the risk of this fund, compared to other emerging markets funds? And at the end of the day, also this is an emerging-markets fund, so we know that emerging markets can be riskier. What risks do investors in general need to keep in mind when they are getting exposure to this area of the world?
Lee: Historically this fund's volatility has been slightly less than the volatility of the broad emerging-markets ETFs or indexes, but I don't think that's a very significant difference because next year it could be higher or it could be lower. So it's not a markedly less volatile ETF. With that in mind, emerging markets are a risky place to have your money in, and one reason is because you suffer from a nontrivial chance of being expropriated.
So, a lot of these big corporations that DEM and lot of the emerging-markets ETFs invest in are partially stated-owned or essentially controlled by the state. So, they could pursue noneconomic goals such as artificially propping up the price of a certain good or artificially keeping a certain price low, and that's what you see in China. In China the price of natural gas is capped at an artificially low rate. In Brazil, you see certain interest rates or loans capped at an artificially low or high rate depending on what type of bank you are talking about.
So, you run the risk that if there's trouble in these economies the leaders are going to turn these corporations into their own personal piggy banks. That's a significant tail risk, and that's actually been the case in past emerging markets.
Stipp: Your second pick, is HYS. This is PIMCO 0-5 Year High Yield Corporate Bond Index. This is in the high-yield bond category. This fund hasn't been around as some other PIMCO offerings. So, folks might not be as familiar with it. Can you talk about what exactly you are getting exposure to if you invest in this ETF?
Lee: So, first of all, high yield can be closely proxied by a 50-50 split between intermediate Treasuries and 50% U.S. equities. So, that's how high yield tends to behave. So, you are actually getting a hybrid vehicle when you invest in high yield.
You also get a little bit of diversification because high-yield bonds tend to be less liquid, so the market tends to give you a little bit of reward for investing in less liquid securities, but overall you are basically getting interest-rate risk from bonds and equity-type risk.
Overall, the high-yield market isn't radically overpriced, but it's not priced to give you a fantastic return, maybe you can expect 2% real annualized return for a typical broad high-yield fund, not this one. But interestingly enough, in the high-yield market the further out you go on the maturity spectrum--so if you buy high-yield bonds that are going to mature in 10 or 20 years--you don't actually get that much more absolute yield, but you take on a lot more risk.
Stipp: Interest-rate risk?
Lee: Interest-rate risk and also credit risk, because…
Stipp: Longer time that they could default potentially?
Lee: Yes. So, you are basically shrinking your interest-rate risk. You are not taking on as much credit risk but you are going to get about the same ballpark yield. Currently, the yield on this fund is about 1 or 2 percentage points lower, but over the long run, interestingly enough, shorter-duration bonds have actually outperformed longer-duration bonds, even though over the past 20 to 30 years, we've been in a declining interest-rate environment. And the reason is because longer-duration bonds tend to suffer from unexpectedly high credit losses during recessions and during bad times with junk bonds, and shorter duration bonds tend to outperform in that regard.
Over the long timeframes you are probably going to get about the junk-bond return, maybe a little bit higher with substantially lower volatility and lower interest-rate risk.
Stipp: A lot of good reasons to shorten up the duration then if you are going to invest in high yield. This fund has a pretty short duration at under two years, according to Morningstar's data. How does that compare with a typical high-yield bond fund? What kind of duration would you get if you invested in a traditional high-yield index?
Lee: It's actually not that much of a difference. The traditional high-yield index's duration is about four years, and this fund is about two years. So you are not getting a big absolute change in duration, but it does help. And the main reason you want to invest in this is mainly the fact that you are probably going to get about the same return maybe a little bit more with lower volatility.
Also another thing to note is that this ETF tracks an index that's zero to five years. This is unusual because most indexes, almost all the major indexes, do not define high-yield bonds as bonds with maturities of less than a year. They kick them out. So, at the one year mark, all these junk-bond indexes and even lot of junk-bond managers just tend to automatically sell their maturing or soon-to-mature bonds. And this ETF is out there picking those bonds up at discounted rates. So, you are getting a little bit of a boost there by taking advantage of a structural inefficiency in the markets.
Stipp: Your last pick, Sam, is also a PIMCO fund, one that's certainly more well-known. It's the PIMCO Total Return ETF. This is the ETF version of a Bill Gross famous PIMCO Total Return mutual fund. It technically follows the same strategy as the open-end Total Return mutual fund, but this is its own fund, it's not just a separate share class of that fund. Can you talk about what the differences are between the Total Return ETF and the Total Return open-end mutual fund?
Lee: They do pursue the same strategy, but one major difference is they have different legacy holdings. So, the PIMCO Total Return fund has about 21,000 bonds and other securities in its portfolio, and many of these securities are just leftovers from years ago, and they're expensive to transact so that PIMCO just keeps among its balance sheet and tries to manage its duration and other types of risks via derivatives and other investments. The ETF started off with a clean slate. So, right now, it has 700 holdings. It's not quite a lot. So, PIMCO was able to pick the best securities for it.
That doesn't necessarily explain all of the outperformance that this ETF has had over the mutual fund. Another difference is the ETF was not able to use derivatives for most of its life to date. The SEC has changed that, and is now allowing ETFs to use derivatives, but that was another major difference between the mutual fund and the ETF. PIMCO is a very, very active user of derivative swaps; all kinds of other exposures.
Stipp: This PIMCO ETF is not the first actively managed ETF, but it's arguably the most famous actively managed ETF. Why active management for fixed income? Why did you choose an actively managed fixed-income fund for this pick?
Lee: Number one, it wasn't that much more expensive in the passive exposures. Passive exposure will cost you about 10 basis points; the PIMCO ETF will cost you about 55 basis points. So, 45 basis points is not that much in absolute terms, though it is still something that you have to strongly consider.
One thing that I like about the PIMCO ETF that's not related to any active management at all is the fact that it is more diversified than the passive Barclays Aggregate Bond Index. It can hold municipals; it can hold emerging markets bonds. And just on the basis of diversification, the fact that PIMCO can trade these bonds relatively patiently, relatively low-cost, just on the basis of diversification, you get a return from that. So, the diversification alone could arguably justify the 55-basis-point expense ratio. But in addition to that you have PIMCO's very long track record of success.
Now, people should not think that Bill Gross can work magic. The PIMCO Total Return bond fund has only beaten its benchmark by about 1 percentage point. That's relatively small in absolute terms, but it's enormous in the fixed-income market. So, that is the type of long-run outperformance that you can reasonably expect. People who think that Bill Gross can replicate the 5% excess return that he has tallied up to date versus the benchmark, may be disappointed if they think that Bill Gross is going to continually outperform by 5% or 10%.
Stipp: You seem to imply that you're expecting some headwinds for fixed income if returns in the past are not going to necessarily look like returns in the future. There are certainly some headwinds in general and with fixed income [there are] low current yields and a chance for inflation. What should investors, even if they're investing with one of the world's best fixed-income managers, what kind of realistic expectations should they have for fixed income if they're getting into a fund like BOND in the future?
Lee: They should just look at the yield and subtract out the estimate of inflation. So, the Barclays Aggregate Bond Index, the yield to maturity is about 1.5%, 1.6%. Expected inflation is about 2.5%. So, the expected real return of just the broad bond market as proxied by the Aggregate Bond Index is about negative 1%. That's probably what you should be prepared for, which is, you're going to lose money in bonds over the long run. You might lose a lot of money if interest rates go up.
Stipp: If you think that, that Gross can do a little bit better than, perhaps an index, you're still maybe talking about flat real return. So, would you even consider investing in fixed income right now, if you had your choice among different asset classes?
Lee: Yes. I think everyone should own some fixed income because fixed income is still a valuable insurance hedge. It offers diversification benefits. Say the U.S. or the world economy falls into a deflationary scenario, fixed income will do very well, almost every other asset, will do terribly. So, you don't want to bet too heavily on one scenario playing out in the future. You want to be very modest about what you can predict about the future and insulate yourself from any type of extreme risks.
Stipp: All right Sam, three very interesting picks in the ETF world. Thanks for joining me today.
Lee: Thank you, Jason.
Stipp: Finally, let's check in with Josh Peters, editor of Morningstar DividendInvestor. He always has interesting insights in the ever-popular dividend investing market and some top picks for dividend investors today.
Josh, you have a short list of ideas for 2013 and beyond. But before we get to those, I want to talk to you a bit broadly about valuations in your area and your hunting grounds of the market. There has been a lot of interest in dividend payers and the income producing investments in general in recent times. There have also been some concerns over the last year about taxation on dividends. We got some clarity on that late in the year in 2012.
So, when you're looking out at your hunting grounds, the dividend payers, the income producers, the types of companies that you like, what do valuations look like broadly? Is your hunting ground wider? Is it narrower? Have valuations been demanding? Have they been a little bit looser? What's your feeling on that from a high level?
Josh Peters: Well, I think it's important to put in context what you are looking for in terms of valuations. One is that obviously dividend-paying stocks have attributes that you don't have in either just straight fixed income or straight equity, that you're really getting sort of a hybrid situation that gives you the best of both worlds. You are getting a current income stream that can certainly be competitive with long-term Treasuries or with high-grade corporate debt, but you are also getting that growth of income. So there are some really unique attributes I think that allow these stocks to be purchased at what we might look at as fair valuations and still serve investors pretty well over the long term.
Now, if we look over on the fixed-income side, I don't think there are really many people who would say that bonds still have tremendous room to run on the upside over the long term. Yields are very low. You're not getting that inflation protection. That points you back to dividend-paying equities, and you can say that this is still a compelling area of the market. There's a lot more criticism I think from the equity side. A lot of people, including some pretty prominent investors who are concerned about valuations, they find, say, standard bearers like utilities or telecom stocks, tobacco stocks to be trading at historically high multiples. They find issues with that.
But I think that is really more of a relative argument. When I look at valuations in an absolute context, I think you can still put together a pretty good portfolio that's reasonably well-diversified. You are going to have some exposure to those areas. You want to look for the best companies and the best bargains, but you also want to look elsewhere into perhaps more cyclical names. There are some better valuations perhaps among a stock even like Intel coming from the tech sector, that you can build a good portfolio with. But you don't have a problem that you have in what you'd call low- or no-yield equity, which is you're really depending on multiple expansion to drive returns from here. The outlook for earnings growth is just not that good. It's probably not going to improve here over the next couple of years. So, if you're looking to the stock market and say, well the stock market looks better than the bond market, you still need a lot to go right if you're going to get a total return that's really going to be consistent and work for you in your portfolio.
So, it really keeps pointing you back to that hybrid area of the market. The stocks that have those 4%, 5% yields, as long as they're safe then you can put that in your pocket over the course of the year. You didn't need the stock market to go up in order to provide it. You do need to the stock market to go up if you're depending purely on capital gains. You do need interest rates to stay pretty low even to preserve a low rate of return on your long-term bonds. With that dividend-paying area of the market, unless we saw some really, really extreme over valuation which we're not seeing at this point across the board, I think that it's still really the most compelling area for most investors, the most practical area for them to concentrate their holdings.
Stipp: Josh, you have a list of companies that are hitting a lot of those marks you'd like to see. They do have a range of current income, but obviously they're all hitting the qualities that you want in a dividend-paying investment. Let's start with the first one; it's in the health-care industry. A bellwether--Johnson & Johnson. The current yield is around 3.4%. Why are you looking at this stock right now?
Peters: To me, this is the classic name that you can really count on the stability of cash flows, the stability of revenues, a great balance sheet, through thick and thin. They've been in the dog house deservedly during the last couple of years because of some of the manufacturing and product-quality issues that they had, some self-inflicted wounds. But you can see this underlying strength of the business and that even though they made some mistakes and they paid a fairly steep price in some of their business lines, they've continued to provide stable earnings, they've continued to have their resources to raise the dividend. The dividend is still less than 50% of earnings. Compared with history, Johnson & Johnson is growing more slowly than it has in the past, but the dividend yield is lot higher than it's been in a decades.
Looking at a yield here in the mid-3% range, I think, it's very easy to take this kind of yielded and just comp it to what you'd get and say five- or 10-year investment-grade corporate bond or a long-term Treasury bond. Here you're getting a larger stream of income up front, but you're also getting what I would expect the long-term dividend growth in, say, the 6% area as kind of a low-end conservative estimate. Now to me that makes for a very, very compelling alternative to the bond market without taking on a whole lot of additional risk.
Stipp: Your second idea in the energy industry is Chevron. Energy can be, in general a difficult industry because of the commodity-price fluctuations that you can see. What gives you the confidence about Chevron that they will be able to pay steady dividend and one that can grow consistently over time?
Peters: Well, you're right in that in the energy sector everybody typically is going to have some reliance on commodity prices, if they are energy producers. Pipelines, the midstream names, are in a different situation, even though they are part of the broader energy industry. What I like is when you get up to the really big guys you move up a little tiny wildcatters and to kind of the midsized E&P guys and then up to the super majors, the super majors tend to generate tremendous cash flow even when energy prices are low, when commodity prices are low. And in those periods then they have the opportunity to cut back on their capital investments. Low energy prices are essentially signaling, the market is signaling, that we don't need as much exploration right now; we don't need as much new supply right now. So they can adjust their balance sheets, they can adjust their cash flows in order to continue to provide for that dividend. But the most important piece with a company like Chevron is, first you got a tremendous margin of safety. At current oil prices, current level of earnings, they are covering the dividend by more than 3 times over. So, even if energy prices come tumbling down, they are still going to, in all likelihood, provide more than enough earnings, more than enough cash flow to continue paying that dividend.
The second question is where is the rest of the money going? And Chevron really stands out from some of the other super majors in having had very good luck. I think their effort certainly had a lot to do with it, but they've done a very good job of creating a path toward faster production growth a couple of years out. They've been investing very heavily in order to expand their production. They've had the benefit of a portfolio of assets that's kind of tilted away from North America natural gas where they don't have much exposure where prices are really low toward crude oil, especially internationally where some of the prices are higher than here in the United States. But as they are retaining those earnings that aren't being paid down as the dividend, it's driving the ability to grow production, reinvesting back into the business, so that you've got that stream of cash flow that's growing out there in the future even if energy prices remain volatile, which I assume they will, that you got that path toward the resources to pay a steadily growing dividend over time.
And third, the commitment of this company to paying a good and growing dividend is really one of the strongest I have ever seen. They understand that there is not going to be some big giant pay-off, and nobody is going to come along and gobble them up to provide an exit for their shareholders. The dividend is how they create value for their shareholders. And so by maintaining that through thick and thin, providing a secure stream of income for many years in the future, decades into the future and growing that dividend to drive total return over time, they understand. They really get it that these are the kinds of actions that they take as a management team to make sure that the value of the business flows back and becomes value for shareholders.
Stipp: Your next idea, Josh, comes from consumer products, it's Kraft. This is a company that now in its current form, after a recent split, could be more attractive to income investors. It has a 4.4% current yield. How did that recent corporate action affect the dividend picture for Kraft, the company now?
Peters: Kraft is kind of an interesting story, because I owned it a few years ago in our Builder portfolio, long before the split. They had grown their dividend every year since they were spun out of Altria Group way back in the day, and then came their acquisition of Cadbury, the big confections company in the United Kingdom. The first thing they did after announcing that acquisition was they stopped growing the dividend. The dividend was fairly generous, but I wondered why is it that the dividend growth takes a back seat to just making the company bigger? Most of these big acquisitions, they don't really create value for shareholders; they create value for executives, who get to run a bigger company and get to make more money. They create lots and lots of value for bankers and lawyers, but do shareholders actually benefit from these kinds of transactions.
So, I sold Kraft at that time. I said, "You know what, the company's priorities are just not lining up with my investment objectives." A few years later it turns out that Kraft kind of came to the conclusion that maybe it didn't make that much sense to have these cookie and candy businesses along with mayonnaise, Cheese Whiz, Oscar Mayer bacon, and things like that. So they decided to separate the two businesses. And I think it's very interesting to look at those two companies now because Mondelez International, which is essentially the continuation of the old Kraft Foods, yeah, they've got some more growth potential, they've got more international exposure, but their emphasizing acquisitions or share repurchases. The dividend yield is very low, they are just not putting that dividend in the position it needs to be in order to have its priorities match that as of me, as an income investor.
Kraft Foods Group on the other hand realizes it's a mature business, it's a cash cow business. They do have opportunities to reinvest as they cut costs and reinvigorate some brands that were ignored under previous management, but the emphasis here is all about the dividend. The dividend here is much more generous. As you mentioned stock yield is well over 4%, and their plan from the get-go is "We are going to provide for a mid-single-digit dividend increase every year. This is how we are going to run the business."
Again, it's not just the businesses themselves I am looking at. The Nabisco and Cadbury businesses over at Mondelez, they do have better growth potential, they have more international exposure. There are things to like about those businesses that make them perhaps a little bit more attractive than what Kraft Foods Group now has for its portfolio of brands. But when I look at the capital-allocation priorities, the dividend policies of these two companies, then Kraft Foods Group strikes me as clearly the better option for long-term income investors.
Stipp: Your next idea, Josh, is the first one from a really traditional dividend investor's hunting ground in telecom. This is Vodafone at 5.9% current yield. What's the case for Vodafone?
Peters: Well, Vodafone is an interesting comparison to make with, say, AT&T and Verizon here in the United States because Vodafone doesn't really have any serious landline business. AT&T and Verizon have their wireless businesses; they are growing. But they are also dealing with the secular decline of the traditional landline business. With Vodafone you don't have that. You do have some other issues in that it's a European cellular phone company, predominantly. They've also got very large positions in emerging markets that are growing. But in Europe, the economies are very weak; that has taken something of a toll on near-term results there. But the real kicker here to the story, I think, is that Vodafone owns 45% of Verizon wireless.
Here you have the opportunity with Vodafone to get a substantial stake in what is the best piece of probably the best telecom business in the United States, Verizon Wireless, without getting the drag of Verizon's other assets here or frankly what I think is a pretty overvalued stock price. But you are not taking on with that mix these traditional landline businesses that are in decline. You are getting a mix of wireless businesses, some of which are in mature markets that have some economic difficulties, but some like in Africa or even in India that have still a lot of long-term growth potential ahead.
So, as long as Vodafone continues to receive dividends from Verizon Wireless on its 45% stake, then the path is pretty clear here to see continued growth in the dividend which already yields close to 6%. And there are some investors who worry about whether or not Verizon is going to try to squeeze out Vodafone by withholding dividends on its stake in Verizon Wireless. Verizon needs the money just as much as Vodafone does from Verizon Wireless, and Verizon cannot pay itself from Verizon Wireless without giving Vodafone 45% of the cash.
So, it's a situation that is a little more complicated than some people would like and maybe someday, there would be some kind of transaction that clears it up. But in the meantime for me, it's a pretty straightforward situation. Vodafone is probably the better way, honestly, to play telecom and even in the Verizon Wireless story than Verizon itself.
Stipp: Your last idea, Josh, has the highest current income right now 8.0%, that's obviously very appealing yield level just given what yields are across the board and a lot of other areas of the market. What's behind that yield for this particular company, and why do you have faith in that yield being sustainable and being able to grow in the future.
Peters: AmeriGas Partners. This is a partnership that has treated us very well. We've owned it for over seven years now in our model portfolios. They are the nation's largest propane distributor, which is mostly for home heating, but also for industrial uses and things like those cylinder tanks that you buy for a gas grill. The business has got some fluctuations associated with the weather. And if you have a really warm winter, like we had last year in most of the United States, the demand for home-heating fuel drops. That means fewer gallons sold, and it took a toll on AmeriGas's profitability last year.
However, this is also a partnership that runs with a big margin of safety against its normalized results. In a normal type of scenario, they would be covering their distributions that provide that 8% yield at today's price by more than 1.3 times over. So, you've got about 30% excess coverage for that distribution. That gives them plenty of leeway for any sort of normal weather environment. If you get into an extreme year like we had last year, then you're going to have a shortfall. But weather is mean reverting. I mean, over time perhaps the world is getting warmer, or regions of the world are getting warmer. But you're going to have a mix of cold winters and warm winters; a lot of it is going to even out. And I think what people really miss about the AmeriGas story is it's not just a play on one year of weather. It's about a really good long-term competitive position for this business.
Propane suppliers typically own the tanks that their customers use, and if you own the tank, you can say, well, nobody else can fill this tank, only AmeriGas can fill the tank. In order to switch suppliers it means swapping out the tanks. So, you have a situation that creates switching costs and makes it difficult for customers to just shop around on price. Yet, unlike a regulated utility--where you have a flat-out monopoly on the distribution side of the business, you don't have the opportunity to select a different supplier for somebody to deliver you energy, so therefore prices are regulated--AmeriGas just goes ahead and raises their per-gallon mark-up by the rate of inflation or maybe a little bit more every year like clockwork.
So it's almost like an unregulated utility having a lot of those advantages that a traditional regulated utility would have. I think that even if we are in a longer-term warming trend, that competitive position is still going to drive very good results for AmeriGas. Their target is to raise the distribution 5% a year. They don't really need to make much by way of acquisitions or big deals in order to meet that objective which frankly most other MLPs do need lots of deals, big construction projects, or acquisitions in order to drive mid-single-digit growth. I think it's a very simple story that a lot of people just don't understand that well, and it's something that even if it's going to be somewhat variable based on what's going on with the weather, I'm very happy having owned over the last seven years and see myself owning and collecting those distributions and the distribution growth, many years into the future.
Stipp: Josh, some great picks for dividend investors. Thanks as always for your level-headed and insightful take on income investing.
Peters: Thank you, Jason. Happy New Year.
Stipp: Thanks to Paul, Russ, Sam, and Josh for their ideas and their market insights. If you'd like to watch this again, a replay will be available on Morningstar.com. We hope you found these picks useful and many happy returns to you in 2013.