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By Morningstar.com | 10-20-2017 02:00 PM

Investing Insights: Netflix, Microsoft, 401(k) Loans, & More

This week's news from Investing Insights, including Netflix's earnings, Microsoft's dividend, the economic outlook in China, and more.

Editor's note: We are presenting Morningstar's Investing Insights podcast here. You can subscribe on iTunes.

This week on the podcast, Neil Macker says Netflix looks pricey, Rodney Nelson highlights Microsoft’s dividend, Russ Kinnel shares 4 high-cost fund duds, Michael Kitces discusses the pros and cons of 401(k) loans, Dan Rohr sees a continued slowdown for China’s GDP growth, and Mark Miller tells us what we need to know before shopping for Medigap.

Neil Macker: Netflix reported better than expected subscriber numbers for the third quarter as the company continues to outperform on both the U.S. and international segments. The company's paid streaming base hit 104 million in the quarter, up from 83 million just a year ago.

Netflix continues to burn cash, with free cashflow loss reaching $1.5 billion for the first three quarters of the year, up from $1 billion over the same period last year. Management reiterated its guidance of a loss of $2 billion to $2.5 billion for full 2017, implying a loss of up to $1 billion in the fourth quarter alone.

Netflix also revealed on the call that the content spend for 2018 will reach $8 billion, up from $6 billion in 2017. As we've noticed recently, this increased content spend will weigh not only on operating margins, but free cashflow as well over the near term. The firm also recently announced price increases for its most popular packages, the two-stream HD package, which will now be $10.99 a month, and the 4K four-stream package, which will now reach $13.99 a month. The price increases will roll out to subscribers over the next few months. We expect subscribers will continue to pay, but churn will spike and may deter potential subscribers from joining given lower prices at alternatives.

Despite the beat on subscribers, our long-term thesis for the stock remains in place, thus we are retaining our narrow moat rating, but we are raising our fair value to $80 from $73 to account for the recent price increase. Even with the recent price increase, the stock is still trading within 1-star territory.

Rodney Nelson: Although share repurchases have been the dominant method of capital returns in technology, Microsoft has been one of the most consistent dividend payers in the sector. Microsoft's wide-moat business--anchored by flagship cloud properties such as Azure and Office 365 and legacy franchises such as Windows--is a cash-generating machine, supporting consistent annual growth in its dividend. In the last 10 years, Microsoft has more than doubled its annual dividend payment, and the firm recently announced a 7.6% hike payable this December, which would imply a yield of roughly 2.2% at current market valuation.

While Microsoft's dividend yield is certainly not extraordinary, the firm has remained committed to its capital return program, which encompasses both a healthy dividend and frequent share repurchases. These channels have resulted in nearly $200 billion in capital returns to shareholders over the last 10 years. We model consistent 7% annual growth in dividend payments over the next 10 years, which would yield roughly $165 billion in capital returns by itself and imply an annual payout ratio consistently between 40% and 50%.

Further, we believe the market is undervaluing Microsoft's core business. The stock trades at a roughly 10% discount to our $83 fair value estimate. We think the market does not fully appreciate the upside opportunity in Microsoft's cloud business. Azure, Microsoft's public cloud offering, represents a massive growth opportunity for the company, which gives Microsoft access to what we believe will be a $200 billion market within the next five years. We believe Microsoft has succeeded in establishing itself as one of two strategic long-term cloud vendors for the world's largest enterprises alongside Amazon Web Services, and these firms should continue to attract the bulk of business in this burgeoning market.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. When Morningstar's analysts rate funds, high costs are usually a nonstarter. Joining me to discuss some high-cost funds that are duds is Russ Kinnel. He is director of manager research for Morningstar.

Russ, thank you so much for being here.

Russ Kinnel: Happy to be here.

Benz: Russ, you brought a short list of funds that have high costs and have either Neutral or Negative ratings, but before we get into the specifics, let's discuss why you and certainly, the whole research team, believes that investors should really pay attention to expenses when they are selecting funds.

Kinnel: It's one of the things we've studied up and down in all sorts of ways, and we know that costs are the most dependable predictor of future performance--not past performance, not anything else--costs. It sometimes seems a little counterintuitive because people see those past returns and say, well, this fund did really well even despite having high costs in the past, so why should I worry about it in the future. But of course, the catch is, returns vary a lot and those costs are consistent. Things can change at the fund, the markets change, but a fund's current expense ratio is actually a very good predictor of its future expenses.

Even when you look at funds with good performance but high costs, their future performance is really dismal. It's just a high-risk bet. Of course, it could still work out, sometimes it does. It's just not a good idea, because investing is about putting the odds in your favor. Going with low-cost funds is making it a lot easier for you to pick a good fund.

Benz: One of the funds that you think illustrates well why investors should pay attention to costs is LoCorr Macro Strategies. This is a fund that has had some changes behind the scenes recently. It sounds like the analyst thinks that it might be better in the future, but you think that the high costs are just a huge headwind for it.

Kinnel: That's right. The good news is, costs have come down. The bad news is, they are still 2.3%, which is a pretty high fee. It's a little complicated like a lot of alts funds. What this fund does is it invests in other firms that invest in future strategies. In the past, it did total return swaps which meant the other firm would guarantee they would get the return that they would have generated after fees. And so, because it was done in a swap form that fee that the subadvisor was charging wasn't showing up in the expense ratio.

Since then, they have switched around so that the managers are just charging a straight fee and that's now reflected in the expense ratio. So, it's more open. It's easier to see what you're really paying and that actually has brought fees down. At the end of the day, 2.3% is a very high hurdle to overcome and that's a real challenge, especially given that a lot of investments today are pretty low-returning.

Benz: Well, that's the thing--and this area of alternative type investments has historically and continues to be a space where managers charge more for these types of strategies. Is that justified in your view?

Kinnel: Not really, because generally they are lower-returning strategies and then you put on all of those fees. You end up with a kind of disappointing return. To be sure, there's a lot of specialization. Sometimes there's limitations on how big the strategy can be run. And of course, there's lots of quantitative tools often put to work. There are some reasons for the fees to be where they are, but generally, it doesn't make sense to actually invest in those funds.

Benz: That's a Neutral-rated fund. Another Neutral-rated fund that has the headwind of high costs is Gotham Enhanced Return. The ticker is GENIX, 2.15% expense ratio. Let's talk about that one.

Kinnel: Right. This is a 170-70 fund.

Benz: What does that mean?

Kinnel: It means it's 170% long, 70% short. So, essentially, what it means is, your leveraged. You've got a lot of leverage. It's going to still give you essentially 100% exposure, but it's got a lot of leverage. At a 2.15% expense ratio, even though we like some of the components at the fund, run by a good manager with an understandable strategy, but again, that's just a high hurdle and it doesn't seem like a good bet at the current price.

Benz: Now, turning over to a couple of Negative-rated funds, let's start with Federated Prudent Bear. Let's discuss first what strategy is in play here, what it's trying to do and then get into why you think that people should avoid it.

Kinnel: The idea is to bet against stocks and have an investment that's going to make you money in a down market. In a way, that's not a bad idea. I can see where a person might want a small position in that as a hedge. It's difficult because bear markets are so hard to predict and of course, it means you are losing money and compounding those losses most years. It's been a long time since the last one. It's kind of hard to use therefore. Then on top of that the fund charges a 1.78% expense ratio. You figure most years you're losing money from the market and then you got 1.78% additional taking money out of your pocket. It's an awfully hard game to win at.

Benz: I guess, a follow-up question for you Russ is, should people mess around with these types of bear funds, or is my high-quality fixed-income exposure may be enough to protect me against some sort of downturn in equities? I guess, it depends on how large my high-quality fixed-income exposure is.

Kinnel: For sure. I think high-quality fixed income is a good way to go, because it has low correlation with the equity markets. Often it even goes up when equities are selling off. I think for the most part boring old cash or short-term high-quality bonds are a much better hedge. For sure, they are not going to make you a lot of money, but they are easy to understand, they are low cost, and of course, they also serve the purpose of being there for you when you have an emergency or some other need you didn't expect. Obviously, a bear market fund is the last thing you would depend upon for an emergency. So, I think, for the most part, the simplicity of cash or something like cash is a much better deal for most investors.

Benz: Let's take a look at the last fund. It's AIG Flexible Credit. This is a bond fund--and before we get into the specifics of this fund, let's talk about why high costs and bonds is a terrible marriage.

Kinnel: Expenses are subtracted from yield, so, if you have a bond portfolio yielding 3% and a fund charging 1%, now you've cut your yield by a third and probably your return by a third as well, because returns and yields are fairly closely linked in the fixed-income world. The fixed-income world we are in today is a really low-yield environment. A lot of the best fixed-income funds charge between 40 and 70 basis points. You can get index funds for even less. When you see a high-cost bond fund, it's maybe even a bigger red flag than a high-cost equity fund.

Benz: And that yield, if its yield is competitive with its peers despite the high costs, that can be a signal that there's some risk-taking going on behind the scenes.

Kinnel: Right. This is a fund that has a mix of high-yield and bank loans, two higher-yielding areas. You're still going to get some yield. But when you think in that 1.43% expense ratio, that's a really high price. There's some very good high-yield and bank-loan funds for way less. This is one of the highest-cost bond funds we cover. I think, again, it's not necessarily that the manger or the strategy are so bad, it's just they've got such a high bar to overcome, it's really hard to make a case for a fund like that.

Benz: OK, Russ. Great discussion of the importance of keeping an eye on costs. Thanks so much for being here.

Kinnel: You're welcome.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. 401(k) loans are incredibly polarizing. Some investors view them as useful financial tools while others think they should be marked with a skull and crossbones. Joining me discuss this topic is Michael Kitces. He is a financial planning expert.

Michael, thank you so much for being here.

Michael Kitces: Thanks, Christine. Good to be here.

Benz: Let's talk about 401(k) loans. You wrote a great piece on your Nerd's Eye View blog where you looked at 401(k) loans. Let's start with them from the traditional standpoint. If I need some additional funds to fund some goal or maybe even pay off debt, how could a 401(k) loan actually be useful?

Kitces: The core idea of a 401(k) loan is the same. We take retirement dollars; we kind of lock them inside of a plan--limited rules about distributions, tax penalties if we do, because the money is supposed to be earmarked for retirement, that's why we get some tax preferences. But in the real world, sometimes you need the money. You need to be able to use it for a little while.

And so, Congress early on implemented these rules. It said, you can borrow the money for a limited period of time out of your 401(k) plan and then put it back into the plan and we won't treat it as a taxable event and we won't apply the penalties. Now, in order to do that and to keep it from being abused, Congress put some limits in place. We can only borrow up to 50% of the plan balance; we can only borrow up to a maximum of $50,000; we still have to pay ourselves loan interest back into the plan--the plan actually gets to set the rate--but typically, we see things like prime plus 1% or 2%, which is actually pretty reasonable interest rate in today's environment.

It becomes a way to tap at least a limited portion of 401(k) dollars to borrow if--I'm not trying to take the money out, but just I have a near-term need and I need to get some dollars out. The water heater broke and we need to repair it and I don't have some cash lying around for that. Here is some money we can tap into in an emergency.

Benz: So, in contrast to borrowing from a bank or using credit cards or something like that, I'm not paying the interest to the bank. You mentioned that I'm actually paying the interest out of my own coffers. From that standpoint, it's actually better than borrowing from some other entity, right?

Kitces: Well, there is an interesting effect. The bad news is you have to pay interest. The good news is, at least, you receive the interest. You don't make the money, but you don't lose the money. It's a net wash, which makes it a pretty good deal all told.

Now, the caveat that goes along with that is, if I borrow the money out of the 401(k) plan, it's still not invested into whatever the 401(k) plan was going to be invested in, which means the money is not going to be growing. What really happens when you take loans out of 401(k) plans is, the cost to borrow is basically the opportunity cost of what I'm not going to be able to grow with my investments, because I'm using the money over here, and it's literally not invested for that time period. You really net out the loan interest, but you do have to give away some growth along the way which has a cost. That means the loan isn't a perfect zero, but often not a bad deal compared to a lot of other lending options that have much higher double-digit interest rates.

Benz: Right. So, you would put it higher in the queue. It seems like the gold standard would be I have some sort of an emergency fund; I tap that for my hot water heater that's broken. But barring that if those coffers are depleted, the 401(k) loan might be the next best step if I need additional funding?

Kitces: I mean, emergency fund is often number one, frankly, for most folks that we work with. Number two, if it's available, is a home equity line of credit, particularly, ironically, when we are fixing maybe the water heater in the house. But home equity lines of credit tend to be very reasonable interest rates, they are easy to draw on, they are easy to pay back. I'm not taking money out of the market and out of future growth opportunities. We tend to look at things like home equity loans as number two. But 401(k) loans quickly stack up as number three, and often are much better interest rates, the sort of implied interest-rate potential even when we consider the foregone growth over using things like borrowing on credit cards and borrowing from other sources. It does become a pretty appealing option.

Benz: The idea that prompted your blog post was this idea of fixed-income funds, wherever they maybe in 401(k) plans or anywhere else, are not earning much in terms of interest. You've heard this idea from clients, potential investors. What if I actually borrow from my 401(k), the interest that I'm required to pay back beats the fixed-income funds in my lineup. What do you say to that idea?

Kitces: We've heard this a lot lately. Past couple of years as interest rates are low and you just look at these bond funds that might be paying 3%, 2%, 1% sometimes after expenses and saying, why am I investing for 2% when I can pay myself 5% in 401(k) loan interest. And ultimately, the reality is that strategy doesn't work. And the reason it doesn't work--the good news for your 401(k) plan is, you do effectively get 5% returns on the dollars that go back into the plan. The bad news is, you pay the 5% ...

Benz: It's your own money.

Kitces: It's your money. You are paying your own return. What happens when you get a 5% return and you pay a 5% interest cost? You net zero. If you just kept the good old bond fund paying 1% or 2%, at least you would have earned 1% to 2%. It's actually better than zero.

And as it turns out, when you do this with a sort of a pay-yourself bond interest strategy, it actually gets worse than that because some of the tax dynamics that occur around 401(k) plans. Technically, when you borrow the money out of the 401(k) plan and you pay yourself back this loan interest, the money that goes in on the loan interest is not itself deductible as a contribution in your plan. Your plan will get larger with your own money that you put in. And then when you get it back out, you're going to have to pay taxes on it again because it's part of the value of the plan. And so, even if you have the money available to say, hey, I'd like to put in extra 5% of my account balance into my 401(k) plan, you are better just contributing the money …

Benz: Additionally.

Kitces: … additionally, get your tax deduction--obviously, you still have to deal with the overall 401(k) limits--but just contribute the money you would have paid to yourself on loan interest and let that plus the money that's there get invested in bonds at 1% or 2%. It's still better than earning the interest where you pay the interest along the way. And it also gets you out of the secondary risks of, if it turns out you've done this borrow from yourself and pay yourself back strategy and then you have a change in job circumstances, and suddenly, the 401(k) loan gets called because you don't work there anymore. You have to pay it back and you may not have the dollars available. Now, we get additional problems that go along with this, and we could have adverse tax penalties because now the loan gets treated as a distribution. Things kind of quickly spiral down from there.

Using the 401(k) loan just as an actual loan if you need to borrow money actually is a pretty reasonable place to go as long as you're comfortable you're going to be able to pay it back quickly and not get it called on you in a job change. But as an investment strategy, it just doesn't work, it just doesn't work. It sounds you neat to pay yourself 5% loan interest, but it's not just that you receive 5% loan interest, you're paying the loan interest and you're paying it without deductibility and you're putting money into your plan without deductibility and that actually sets you behind the eight ball compared to just adding more contributions if you've got the money.

Benz: Michael, important topic. Thank you so much for being here to clear this up for us.

Kitces: My pleasure. Thanks for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

Dan Rohr: China's economic outlook is perhaps the most important question facing investors globally today. Over the past 10 years, China has been the single largest contributor to global GDP growth. Meanwhile, China has become the world's largest buyer of everything from automobiles to airplanes to oral hygiene products.

In pondering China's long-term trajectory, it's instructive to first consider the underlying sources of the country's slowdown from the last decade's double-digit pace. Why, exactly, has growth slowed? Are the underlying causes of the slowdown likely to persist?

To answer those questions in an empirical way, we can begin by estimating the contributions of capital, labor, and productivity to China's GDP growth. What we see when we do that is that faltering productivity explains much of the economy's deceleration--about three fourths of the total. Why then is China finding productivity gains harder to come by? Largely because four sources of "easy" productivity gains are drying up. Technological progress is decelerating as firms must increasingly innovate rather than imitate. Urbanization is slowing as the rural labor surplus shrinks. Returns on capital are deteriorating as overinvestment makes good projects ever harder to find. Finally, The country's demographic window of opportunity is closing.

Looking ahead, we expect GDP growth will come under further pressure as those four sources of prior productivity gains are fully exhausted. That should cast significant doubt on consensus expectations that China can sustain anything close to the current rate of GDP growth in the medium term.

Since China is now the world's biggest buyer of a host of products, investors in stocks spanning multiple sectors will likely need to set their sights lower, too.

Christine Benz: Hi, I'm Christine Benz for Morningstar. One in four people covered by Medicare has a Medigap policy, but that means that three fourths of people covered by Medicare do not. Joining me to discuss Medigap policies is Mark Miller. He is a Morningstar contributor.

Mark, thank you so much for being here.

Mark Miller: Glad to be here, Christine.

Benz: Mark, let's talk about Medigap policies. What do they cover?

Miller: It's supplemental coverage that people use with traditional Medicare. A good starting point would be, just remember that the landscape of choosing a Medicare plan has two paths. You can be in the traditional Medicare program, which is fee-for-service, where you have Part A and you have Part B, which covers your doctor visits and you probably a couple of things on top of that.

The other path is, Medicare Advantage, which is more of an all-in-one solution. Generally speaking, a managed care solution such as a PPO or HMO where everything is included. Medigap is used on the traditional Medicare side, and it's used to plug gaps in the coverage that traditional Medicare offers.

Benz: Just a little bit of terminology I'd like to clear up: You sometimes hear about supplemental policies …

Miller: It's the same thing.

Benz: Same thing. OK.

Miller: Some people call it MedSup, but they are called Medigap policies normally.

Benz: One statistic jumped out at me in a recent article you wrote for us, that 1 in 4 people has these policies. But that means that a lot of people do not. Are some people covered for these other costs out-of-pocket in some other way?

Miller: As I mentioned, if you are in Medicare Advantage, you don't use Medigap. In fact, it's illegal for an insurance company to sell you Medigap …

Benz: Because it would be redundant.

Miller: Right away, you take out about a third of the enrolled Medicare base, everybody who is in Advantage. Second is, a lot of people get some form of supplemental coverage through an employer, retiree health benefit or through a union. And then about 20% of people on Medicare are what's called dually eligible, meaning that their income is low enough that they get Medicaid as well as Medicare. And those folks get a lot of coverage through Medicaid that doesn't come through Medicare.

While the 1 in 4 number sounds kind of low, there are reasons for that. It's not to say that everybody who is eligible for Medigap and doesn't have one of those other things, buys it, but it's fairly popular thing to do if you have traditional Medicare.

I'd just add that a lot of experts on Medicare feel that kind of the gold standard of coverage for people who can swing it is traditional Medicare plus Medigap plus a Part D prescription drug plan. The reason for that is that even though it may wind up being a little more expensive, particularly short term for younger seniors who tend to be healthier, it gives you the most flexibility and choice of healthcare providers that you can possibly get. Medicare Advantage, as I mentioned, is Managed Care, meaning you have to deal with closed networks of providers from elsewhere.

Benz: You might be constrained in some way. You talked about how a lot of folks are covered in some other fashion, but I sometimes do run into people who say, you know what, I'm going to forgo this, I'm healthy, I don't think I need this sort of supplemental policy. Is that a reasonable approach for people who are in good health?

Miller: It can be. But it's worth remembering this that the best time to sign up for a Medigap policy is when you first sign up for Part B. The reason for that is that by law an insurance company cannot turn you away, the so-called medical underwriting, for a pre-existing condition and they have to offer the policy to you at the lowest possible price. It's the most advantageous time to buy it. You could certainly delay and say, well, I'm in good health and I'm not going to need this and sign up later. But it's a bit of a roll of the dice just to how much more you'll pay for it later.

Benz: Say someone does have maybe a few years or very good health not needing much in terms of out-of-pocket costs but later on encounter some more serious health condition, then pre-existing condition clauses might apply?

Miller: Yeah, the insurer could charge you hundreds or even thousands of dollars more for the policy, with the exception of three states: Massachusetts, New York and Connecticut, which have ongoing guaranteed issue rights. They have the strongest regulatory posture in the country. If you in any of those three states, as I said in the article, you've hit the Medigap jackpot. You could sign up for it anytime with a guaranteed issue right.

Benz: Let's get into some shopping tips for people who are looking to sign up for some type of Medigap policy. What should they know before they go?

Miller: There's kind of an alphabet soup of letters, and we have that described in the column that I did recently. More than half of Medigap buyers buy the most comprehensive policies which are C and F policies. Don't get scared by the alphabet soup of letters. There is a terrific in-depth guide to Medigap policies that we link to in the article that gives you chapter and verse on what all they cover. It's worth knowing that, the things that it cover includes hospitalization deductibles, which can get quite high for lengthy stays; the Part B deductible, which we'll come back and talk about in a minute because that has to do with the phase out of C and F; it covers deductibles for skilled nursing facilities; a range of other things.

The other thing worth knowing is that the prices of these policies can vary quite a bit from state to state. But even more importantly, within a state you get a range of different prices for the very same product. We have a little chart and a story that shows that. It's definitely worth shopping around. A lot of people kind of tend to default to either the name of an insurer that they know and trust or hey, my neighbor has this one and likes it. You might wind up paying hundreds of dollars more for that policy per month than if you shop the market a bit. That is definitely worth knowing.

These policies are really the same. The letters are regulated nationally. A C plan in Illinois has to have the same coverage as the C plan in Ohio or California. They are the same. There is no particular reason to pay a lot more. The only additional thing to say about that is, you want to look for an insurer with strong rating, strong financial stability because it's going to be a partner throughout your retirement, one hopes. But do shop for price because oftentime there is no particular reason to pay hundreds of dollars more for the same product.

Benz: How about switching around? Once I've chosen my initial provider, are there any limitations to how often and when I could make changes?

Miller: If you make changes after that initial enrollment period, you could be subject to much higher prices because you're outside of that guaranteed window. If you move from state to state, if the insurer that you are using has an offering, a similar offering in the state you're moving to, they will move you to their product in that state, but the price could go up. Price can change.

It's also worth mentioning though that price can change, period. Let's say you sign up during your guaranteed issue window at the beginning, there's nothing to say that the price of that policy can't jump down the road. There are several different ways that insurers are allowed to calculate price increases down the road. The price of a policy can go up. One thing I caution about is to look out for sort of a very low come-on rate that could change quickly. The way to know about that is to ask an insurer about what the history is of price increases, for example, to find out, because people could just be trying to get market share with an initial low rate that's going to really jump in the out years.

Benz: An alphabet soup, but one worth paying attention to.

Miller: Yeah, definitely.

Benz: Thanks so much for being here, Mark.

Miller: My pleasure.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

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