The following is a replay from the 2013 Morningstar Individual Investor Conference.
Jeremy Glaser: Hi, I am Morningstar markets editor Jeremy Glaser, and welcome to Top Picks from Morningstar Strategists. We're going to get some great ideas for your portfolio. Just as a reminder, you can ask questions to our strategists in the box to the right of your player.
I'd like to introduce our panelists today. First we have Josh Peters, he is the editor of Morningstar DividendInvestor and also the director of equity income strategies; we have Russ Kinnel, he is our director of mutual fund research and editor of Morningstar FundInvestor; Matt Coffina, editor of Morningstar StockInvestor; and finally Sam Lee, he is editor of Morningstar ETFInvestor. Gentlemen, thanks for joining me today.
So, we've gotten a slew of questions about income, and where you can find income in today's environment. So, I am going to start with you, Josh, obviously, your portfolios are very focused on finding dividend income. What kind of opportunities are you seeing in dividend-paying stocks right now?
Josh Peters: I think the most important thing I want to emphasize right now is quality. We've had a big run-up, a big recovery in the stock markets over the last couple of years, valuations across the board when you are looking kind of on a historic bottom-up type of framework don't really look all that attractive. But I like to go back to what Ben Graham said and many of his pronouncements in editions of The Intelligent Investor. He really warned against the idea that you take second-rate securities to try to juice your return. There is certainly the risk that you could overpay for a high-quality security, but he pointed out the bigger risk is that you buy secondary securities at fair-weather prices, and then you go on to have disappointing results.
So, even though there is not whole lot of out-and-out bargains, which is obviously the kind of environment that I would prefer, a name like Philip Morris International in this environment trading a little bit below our fair value estimate, yielding around 4%, a great wide-moat franchiser, I like that name. A couple of names that are still in buy territory for my purposes, Wells Fargo recently raised its dividend for second time this year showing a great commitment to getting that dividend back up and running after having to cut it a few years ago, a great franchise there. General Electric is another name that the dividend is continuing to recover from the crash; it still yields over 3%. There are names out there, but it isn't the kind of environment where you can say "Well, I like energy across the board," or "I don't want to own any utilities stocks." It's really a matter of bottom-up stock-picking and focusing on quality.
Glaser: Is this a case when individual stocks might make more sense than a basket of stocks? Sam do you see any dividend ETFs that maybe are attractive right now?
Sam Lee: I agree with Josh in that there is really nothing that sector wide is attractive, but if I had to go with a dividend-paying stock ETF it would be either, Vanguard Dividend Appreciation, VIG, and dovetailing with Josh's point, it's really a basket of high-quality dividend-paying stocks that have grown their dividends 10 years straight. So, it weeds out all the junky companies, and you can really be sure that those dividends are going to stay around for a long time.
Glaser: But how about dividend growth? What are your expectations for the prospect of seeing these kind of high-quality stocks being able to keep growing out that payout? Or are corporate profits already at a level where they are not going to be able to keep growing them and then grow that distribution?
Peters: Well, I think we're seeing some positive signs on that front, that the payout ratio, the proportion of earnings in the S&P 500 that is paid out as dividends, is starting to creep up. A couple of years ago we actually hit an all-time low of about 29%-30%. We're making some progress there. As we see more companies initiating new dividends, raising small dividends and more meaningful ones, I think that creates more opportunities for income investors. But for me really I want the companies that have already put that great track record out there and a company like, Johnson & Johnson, which has raised its dividend every year for many decades. The growth rate has certainly slowed from where it was a few years ago, but this is not an emerging opportunity. This is a well-established company, capable of maintaining that payout through thick and thin, continuing to raise [the payout] through thick and thin. Those are the names I really want to gravitate to rather than necessarily leaping on the newest company that just started paying a dividend.
Glaser: Russ, on the open-end side, are there any kind of dividend-focused managers, that are doing a good job in this environment. How should investors, who like to invest in those vehicles, think about this?
Russ Kinnel: I think moving up for yield in equities is a little better than in bonds where that's really been squeezed dry. So, I think funds like Vanguard Dividend Growth, one that [Morningstar director of personal finance] Christine Benz recommends all the time, it's got a decent yield, but it's also focused on companies that can grow their dividends. And that means they have to have a pretty clean balance sheet and pretty good business. So, that’s a good discipline. In emerging markets you could move to a fund like Matthews Asia Dividend as a way to get a little yield where maybe you weren't able to get yield before and in that case you are actually dialing down the risk because dividend-paying stocks in Asia are generally going to be a little less risky. So, those are two of the options I like.
Glaser: So, we have a question from Dan, who asks if it's a good time to be adding to MLPs, master limited partnerships, with the time horizon of forever? Do those stocks look attractive?
Matthew Coffina: Well, I think that there is relatively few opportunities among MLPs right now. Two names that I do like, Energy Transfer Equity. It's one that Josh also owns in one of his portfolios. It’s actually our largest position in the Hare Portfolio [in Morningstar StockInvestor], and they are really at an inflection point I think, where it's been very difficult for them to grow their distribution over the last several years, but they've really simplified their business model and reoriented around some new areas where they should be able to reaccelerate the growth going forward. Our analyst is actually looking for double-digit distribution growth over the next five years on top of 4.5% or 5% current yield.
Another name that I have in the Hare, it would be Enterprise Products Partners. Again, the yield is only 4% to 5%, but it's very steady grower, really taking advantage of all the drilling activity that's happening here in North America. And our analysts think that the firm can probably grow the distribution 5% to 6% a year. You take a 4% yield growing 6% a year indefinitely, and you get a pretty attractive total return.
Glaser: So there would reasonably be some new structured products that hold MLPs because there are some potential tax issues in holding individual MLPs. Can we talk a bit about what those tax issues might be, and do these new structured exchange-traded products help mitigate any of those problems?
Lee: I don't really like the term structured product because it actually implies more of something that a bank creates. So, there is AMLP which is the ALPS Alerian MLP ETF. And unfortunately, what that does is it uses an open-end company form to buy MLPs, and since more than 25% of its portfolio is in MLPs, it gets taxed as a corporation. So that ETF has suffered some massive tax drag, so it's lagged its index by over 5% annualized. I think in that case, you are way better off just buying the MLPs yourself, or I hate to say this, but you can buy the exchange-traded notes, so there is the JPMorgan Alerian MLP ETN, AMJ.
What JPMorgan has done is they've basically issued a bond that says that they are going to provide the yield of the MLP index and also the price return of the MLP index minus an 85-basis-point fee. So, ETNs get taxed at a very, very favorable rate, so you get kind of stock-like taxation, not on the income, but on the price, and that can really mitigate some of the tax hassles of owning a big basket of MLPs.
Glaser: Just one last MLP question for you. We had a question from a user who was asking, to see what kind of distribution, what would you expect with the units to happen in a rising-interest-rate environment? Would that have any impact on MLPs in terms of financing or anything that could impact your business?
Peters: I think the most important thing you want to look for is growth and that goes for MLPs as well as ordinary stocks and REITs, that if the dividend isn't growing, or in the case of the MLP the distribution isn't growing, then you're kind of left with a junk-bond that's never going to mature and might not be real high-quality if there is not the business to support dividend increases or distribution increases. And you probably are going to have more interest-rate sensitivity even if that income stream remains stable.
So, I look to kind of names that Matt mentioned, Energy Transfer Equity. Enterprise Products is a name I haven't owned in the past, but certainly a partnership I have a great deal of admiration for. As well as my largest holding, which is a little expensive right now trading at $50-$51, but Magellan Midstream Partners is another double-digit-distribution growth story.
As long as they can keep that distribution growing quickly, and I think they've got the business model and the management to do that, then I don't think it's going to just trade like a bond. If interest rates go up, you are not going to see these tumble out of bed like, say, I don't know say an AT&T, with a very low dividend growth rate and a little more exposed. Some regulated utilities are more exposed. REITs I think are very exposed higher interest rates. If you got growth there to compensate, then it's going to behave I think a little bit more like a stock, and if the interest rates are rising because the economy is doing better, then it's a little bit of a tailwind for these companies, too.
Glaser: You mentioned REITs. We've had a quite a few questions about both equity and mortgage REITs as a potential way to get more income. Russ when you look at some of the real estate funds, do see those as being an attractive place for people to look for income right now, or are there some pitfalls that investors need to be aware of?
Kinnel: I think it's an OK place. Like anything else that's got a yield, REITs are not cheap, and so you definitely want to be cautious. If you go with a fund like Third Avenue Real Estate, which will also buy real estate operating companies instead of just REITs, it's going to be more volatile, but at least it's not working an area that's worked over as much as that. I also like the fund PIMCO Inflation Response Multi-Asset, ticker PIRMX or PDRMX, and what I like there is they combine a lot of different inflation strategies. So, it's REITs, Treasury Inflation-Protected Securities, emerging-markets local currency, and commodities, all in one package, which is nice because if inflation does come back you don't know exactly which areas it's going to show up in most.
Glaser: Then Josh, I want to ask about your "favorite topic," mortgage REITs, which I know is an area that investors are enticed by that high yield. Are there any risks associated with that?
Peters: Yes, my tongue is digging through the side of my cheek as you say "favorite topic." These securities obviously are out there providing very high yields, in some cases double-digit yields. You can loop business-development companies, BDCs, with those as well as some other specialty financials. Here's a case, it's just so obvious that you don't get a super-high yield, a double-digit yield on anything in this environment, unless you have taken a lot of risk. And we've been in an era of pretty calm financial markets here over the last couple of years. Financing terms are relatively easy now, interest rates are pretty low, there's been some tailwinds for these sort of financial models, but they don't earn these returns without taking a lot of risk. It might be credit risk, it might be liquidity risk, it might be interest-rate risk, and it might be yield-curve risk. One of the biggest names, Annaly Capital Management, has a pretty good reputation. They managed to get through the crash OK, but it's a play on the shape of the yield curve. And if you don't know what that means and you can't forecast it, then you don't know how the dividend is going to change over time. But you can look back over the last couple years and see that the dividend moves up and down, up and down. It's not going to provide you with that steady level of income over the course of the cycle. I really regard [mortgage REITs] as just too speculative to play a role in a serious income focused long-term portfolio.
Glaser: Let's shift gears a little bit and start talking about fixed income. Bonds were a lot of what we talked about this morning. We had a dedicated bond panel from Ariel Investments. Charlie Bobrinskoy said we had a bond bubble. Does this mean that there aren't any great fixed-income funds out there? For an investor who is maybe worried about rising rates, what kind of bond funds might make sense for that kind of investor?
Kinnel: The one I mentioned kind of plays on that somewhat, the PIMCO Inflation Response Multi-Asset, though it's not a pure bond fund. So, there are no bond funds that have a lot on offer. I think you can go with an emerging-markets fund like PIMCO Emerging Local Bond. You can go with a fund like Loomis Sayles Global Bond, and you'll get some yield. But they are high-risk.
Glaser: So what about on the exchange-traded space? We have a bond ETF now; you have a PIMCO Total Return ETF. Are there other fixed-income ETFs that maybe investors should get better acquainted with?
Lee: So one thing that I do not like about a lot of bond ETFs, especially the ones that are more speculative, thinner slices of the market, is that they allow investors to make tactical or strategic bets themselves that they'd probably be better off outsourcing to a professional investor. So my advice is actually pretty boring, just own PIMCO Total Return ETF, BOND, because most of the investors don't realize that when they're owning X slice of junk bonds and a Y slice of emerging-markets bonds, they're actually playing the role of a strategic bond manager themselves. And it's not really clear whether most investors have an edge in doing that.
So I would say that just simply outsourcing your bond picks to a professional investor is probably the best course for the vast majority of individual investors. I'm not a fan of broad-based indexing because a lot of the indexes are based on market-cap weightings, and market-cap weightings are supposed to represent the average investor. But the average investor in this world is not mom-and-pop. It's insurance companies that are forced by regulations to hedge their liabilities, sovereign wealth funds, and central banks that need to adhere to some kind of a currency-stability mandate. So just owning a big slug of Treasuries that these broad-based index ETFs own is in my opinion not an optimal course of action.
Glaser: So how about on the global bond side? If you wanted access to emerging-markets debt, an area that's been hot in terms of investor flows, what would be some options there, and is it advisable to have a dedicated exposure to emerging-markets debt?
Kinnel: I would say I think you can but you've got to keep it small because it is high-risk. So if you do that, like a fund like PIMCO Emerging Local Bond run by Michael Gomez, it's a decent fund that gives you some currency diversification. But keep it small because those are high-risk. And, like everything else with the yield, it's been chased down, and the risks have grown as the yields have come down.
Glaser: So I guess taking maybe a step back, we have a question from a viewer who is asking, do you feel that investing in stocks is less risky than investing in bonds right now?
Coffina: Personally, I think that's the case. Even if you're looking for income, I think you can find higher yields from some high-quality stocks and those dividends are also going to grow over time versus buying a 10-year Treasury at a 2% yield that's not going to grow over time and you're taking on all that inflation risk or the risk of higher rates down the road. A name that comes to mind would be Paychex, for example. That's a company in which the stock is yielding 4%, the payout ratio is relatively high, but the cash flows are so stable that we think the dividend is quite safe. And even better, it would actually do even better in a rising-interest-rate environment. There is an aspect of the business where they take the payrolls from the employer before they have to actually pay them out to the employee and they invest that money on their own behalf in the meantime. The low-interest-rate environment has really hurt that stream of income for them. So you get the same yield, but you're actually leveraged to higher rates.
Glaser: You mentioned inflation there, how are you thinking about inflation? Do you expect to see more inflation, Sam, and do you think that there is any kind of products, like a TIPS product, that might make sense in this environment?
Lee: I'm not very confident in my macroeconomic forecasting ability as my crystal ball is a little broken there. But I would say historically it's been the case that when countries run up a lot of debt, massive amounts of debt, so people worry about the United States' debt, the rich world's debt, the United Kingdom and the eurozone, we have been through those periods before. Immediately after World War II, the U.S. actually had a higher debt/gross domestic product ratio. Same with the U.K. And what we did wasn't necessarily massive inflationary periods. There was actually a slow chipping away of our debt. So just let inflation run a few percentage points more than whatever interest rates are, the cash yield is, and over a decade or so, you'll go a long way of eliminating those debts.
So just using history as my guide, I don't expect us to enter into some kind of massive inflationary debt spiral. But I think it's reasonable to believe that we are going to be entering in a world of financial repression. And for that there are already mutual funds that do that. But if you wanted to do it yourself, I would say emerging-markets bonds are probably a decent bet to slightly overweight, especially local currency bonds. So, WisdomTree Emerging Markets Local Currency Bond, ELD, might be a reasonable investment. But, again, as I've mentioned before, if you are going to buy these ETFs yourself and you are going to set in a certain allocation, you are playing the role of an active manager. So, if you don't have an edge in forecasting this type of thing, you're better off outsourcing it, and you can get professional investment help for very, very low costs with a mutual fund or actively managed ETF.
Glaser: When you say financial repression you mean the Federal Reserve's policies of keeping rates extremely low, which makes it very challenging for savers to find kind of a good safe investment.
Glaser: So, we have a question from David who asks that he know has a portfolio that’s 50% in bonds and the rest in dividend stocks. He says he is not going to need the money for over 10 years. Does it make sense to take some of that fixed-income part of his portfolio and move it into dividend stocks, or is that taking on too much risk in a portfolio?
Peters: It's not a great set of choices. I mean you'd love to be able to say dividend-paying stocks across the board are cheap, and the best things since sliced bread. Well, I happen to think that they are the best things since sliced bread because they do play this dual role of providing a lot of current income like fixed income does, but also giving you that hedge against inflation and capital appreciation and real income growth.
In this environment I think you have to characterize it in terms of relative choices. And if you think of the stock market having run up here as [not having an aggregate Morningstar Rating for stocks of] 5 stars or 4 stars but maybe 3 stars or 2 stars, well then you think about bonds, long-term bonds as being 1 star. And you are actually improving the risk and return characteristics I think of a portfolio by shifting more into equities for income at this point and leaving the Treasuries behind. There are certainly other things that you can do with fixed income, but as far as Treasuries go, I mean, it's very hard to find I think a good reason to want to own those for the long haul. Some people will say, well, they tamped down on the volatility a little bit, but if they're going to lose you money or they're not going to generate any real return, you can just use cash as a sandbag.
On a relative basis you've done very, very well probably in bonds here over a very long number of years. Yeah, dividend-paying stocks have come back from the levels of the crash, but I think there is still a good risk/reward trade-off to be had at this point.
Glaser: So you mentioned potentially moving into stocks, and that's a nice transition to our next topic which is about getting back into the market. We've heard from a number of investors that have been on the sidelines either from the financial crisis or from the recent highs. They are sitting on a lot of cash; they don't know what to do. Matt, what would you say to that investor who is sitting on a big cash pile? Should they just throw everything into equities today and kind of hope for the best?
Coffina: I think the big lesson that we should have learned over the last five years is that you can't panic even when the market is down 50%. The guidance that I would give is that we have to have an investment approach that's really grounded in intrinsic value. The truth of the matter is the value of real business is--the Exxon Mobils, Johnson & Johnsons of the world, especially those high-quality companies--the value of those companies didn't fall 50% during the crash, and they didn't double in the last five years either. The reality is that the intrinsic value is much more stable over that time.
If you look back at late 2008, at the peak of the financial crisis, we had more than 800 5-star stocks; the average stock was trading at maybe a 45% discount to our fair value estimate. Looking at the market today, we think that the average stock is more like fairly valued, and it's much harder to come by 5-star stocks. That said, I think that I would still very much prefer to own stocks over the long run to the alternatives of either bonds or cash. There's certainly a lot worse things in a fairly valued market. If all of our forecasts were exactly correct, I would expect a fairly valued market to return about 10% a year over the very long run. Obviously, you're going to have a lot of ups and downs in the meantime, but that still will kick the pants of bonds or cash.
Kinnel: I would add, too, that I think you need to build a plan and maybe take six months or so to get to those target allocations, and maybe that way you'll be able to survive the next crisis. But also think about what led you to sell everything and get into cash. Was it that you're watching business news eight hours a day or something? I think for a lot of people,the cable news really kind of built up their fears; it's a 24-hour news cycle. Then find out what that was and try and correct for that as well so you don't panic the next time. But build a plan and get there.
Lee: Exactly. I was actually going to say something similar. And especially, a good financial advisor, especially one that's low-cost, fee-only, because if you are the type of person who panicked out and sold everything, that is a much bigger risk than any investment out there. It doesn't matter if you own stocks or bonds or whatever, dividend-paying stocks, the biggest threat to your retirement is yourself. And so, the first thing you got to attack is how am I making mistakes, and how can I prevent that from happening again, and a lot of times that's having a financial advisor who's actually grounded in the principles of long-term investing, low-cost investing, diversification, and who also provides reasonable expectations of what you can do in this market. You're not going to produce 15% annualized returns going forward with no risk or low risk. Anyone who tells you that is probably kind of a shady character.
Glaser: So, you mentioned, Russ, that there could be another crisis and that you need to be able to sit through that. But if you are going to see that volatility, are there certain types of stocks, certain categories of stocks you think are going to do better, or does it make sense just to buy the index and kind of hold on to that?
Kinnel: Well, I'll let the stock guys take the stock part, but I will take on the fund part. I think there are some nice more conservative funds that will take you down to a little less risk, but also still have some decent returns. I think the allocation funds like FPA Crescent, FPACX, run by Steve Romick who is a very good capital-preservation-oriented manager. I think of PIMCO All Asset, PASDX, run by Rob Arnott. He's doing a very broad allocation, but again, with some conservative elements to that. And I think, if a regular stock fund is little too volatile for you, maybe some of these allocation funds can take it down a notch so that you have less extremes and you can stay invested.
Glaser: What about on stocks side? I know we talk a lot about moats. Is that something that's relevant here?
Coffina: Yeah, I think definitely focusing on quality and focusing again on intrinsic value. I think having the confidence to stick with your investment strategy through a market where everyone else is panicking, largely revolves around your temperament, the way that you're approaching stocks in general.
If you're thinking like an owner and you have a very long-term perspective and you're worried about what this company is going to be earning 10 and 20 years from now, then you don't need to worry so much about what the market tells you it's worth today. You can just sort of stick to your guns and wait until the markets comes around.
We always use the analogy of the voting machine versus the weighing machine. In the short term, the market is a voting machine, stocks go up or down based on their current popularity and what investors think of them, but in the long run it's still a weighing machine. The value of a company and its ability to generate cash flows is what matters for what the stock is going to do over the long run.
Glaser: We have a user question about a specific wide-moat stock, Western Union. They are asking, is that as good as it looks? Is there anything that they should be thinking about on that name?
Coffina: Sure. So that's always a tough question. We own Western Union in my Hare Portfolio, and it's actually one of only two or so 5-star wide-moat stocks out there right now. My focus is increasingly though on the moat trend rating. So, this is a rating that we have that indicates whether a company's competitive position is strengthening over time, staying the same, or weakening, and in Western Union's case, we think that the economic moat is actually getting narrower over time as various competitive threats, mobile payments, that sort of thing increasingly emerge.
So, the margin of safety looks pretty good in Western Union. It's trading at a low price/fair value ratio, and it does carry our 5-star rating. I'm OK holding it in the Hare, but I'm not really looking to add to it unless I can get comfortable that the economic moat is going to last over the long run and that these competitive threats are under control.
Glaser: Sam, we have a question from Richard who asked, "What do you think about low-volatility ETFs?" That is a strategy if you're looking to maybe reduce some of the ups and downs.
Lee: Yeah. So, I love low-volatility ETFs. I've been a proponent of them since they were first launched. So, basically, low-volatility ETFs, for those who are not familiar with them, basically try to pick stocks with the lowest volatilities, and it turns out that historically if you apply those strategies across time and across various markets--so emerging markets, the U.K., Europe, or whatever--you would've had similar returns to the broad market, but clearly with lower volatility.
So, it seems like the market tends to overpay systematically because of human nature for high-volatility speculative stocks. So once you just excise those stocks out of the market, you'll get something like the market but with tamped-down risks.
So, my favorite low-volatility ETFs for the U.S. are PowerShares S&P 500 Low Volatility SPLV. It yields about 3%, not bad but it shouldn't be bought because it has a high yield. And it also has a 25-basis-point expense ratio.
Internationally, the iShares MSCI Minimum Volatility ETFs are also very compelling. So there is iShares MSCI Emerging Markets Minimum Volatility, EEMV. It only charges about 25 basis points, and that's a very, very low fee for an emerging-markets strategy. It has a slightly higher yield than the broad emerging-markets ETFs. Not right now because there are some weird quirks. When an ETF first launches and it grows large in size, the trailing 12-month cash distributions on the ETF might be a little understated.
So, if you actually drill down and look at the underline holdings, it yields about 3.2%, whereas the broad emerging markets yield about 2.7%. So you're getting a much higher-quality set of a slightly higher-dividend-paying stocks with EEMV.
And then finally to round out our global low-volatility strategy, there's the iShares MSCI EAFE Minimum Volatility, EFAV. This one charges about 20 basis points, and it applies the same strategy to EAFE stocks, that is Japan, Europe, and Australia. And so if you own a portfolio of low-volatility ETFs, what you can do is actually slice down a little bit, not much, of your bond allocation. So you can actually effectively expand your equity allocation without actually increasing your portfolio volatility that much. So, I think it's a very good way to slightly tilt your portfolio to a more equity-oriented stance.
Glaser: We have some questions--there will be a transcript of this session with all of these tickers later, so if you can't quite get them down as fast as we're going into them, don't worry, those will be there.
Now a viewer wants to know if it makes sense to set up a stop-loss order on an investment to say, "Hey, if this falls more than 20%, I just want to get out." Is that feasible in order to maybe make you sleep a little better at night, or is it just going to give you more nightmares?
Peters: I've been getting this question for years. I always go back to the greats, whether it's Ben Graham or in this case, Peter Lynch. I think went up on Wall Street and said, "Show me a portfolio with 5% to 10% downside stop-loss orders, and I'll show you a portfolio that will lose 5% to 10% every year."
I just don't think that that's the right way to go about it. I think that again it gets so much back to temperament, understanding what you have in mind for your portfolio, understanding the risk/reward trade-offs, and focusing on intrinsic value and in my case, focusing on dividends. You've got the opportunity in a rough market to continue holding a stock like a Johnson & Johnson that's not going to cut its dividend. It's going to continue to raise its dividend. It's reminding you and paying you every quarter [that the company is] still in business. The stock price is going down but it will come back.
I'd much prefer to just say, you know what, I'm not going to spend any time or waste any opportunities or waste any capital trying to tamp down on minimal volatility. Instead, I'll say, if the income is what is the priority then I'll focus on the income and the stability of income in my portfolio and I can let the stock market do its thing, up and down, because it's going to happen. I don't think there's any effective way to try to completely hedge that out, and stop-loss orders, I think, you'll lose many more opportunities then you'll save in terms of capital losses.
Lee: So adding on to that, the market day-to-day tends to be very volatile. So there are whipsaws in a lot of stock prices. So you may remember the Flash Crash, in which a whole bunch of stocks just suddenly plummeted in 15 minutes. And there are little micro flash crashes that happen all the time, not as severe, but there are times when stock prices suddenly go down, really, really quickly because someone just put in a massive order and then they bounce right back up.
So, some of that might actually be due to high-frequency hedge funds that are exploiting stale stop-loss orders. So, I would try not to use a stop-loss strategy. If anything sounds very simple and it sounds like it's going to produce risk-free returns or really high returns, I'm going to get all the returns of the market or most of the returns in the market, but I'm going to hedge it all to the downside with some stop-loss orders, if it sounds too good to be true, it is too good to be true. So there are all kinds of strategies that investors like to do that sound intuitive. One is a dividend-capture strategy. So just buy a stock right before it pays a dividend, it pays a dividend, and then you sell out and collect the dividend. Well, the stock price goes right down to adjust for that dividend. So, a lot of these strategies that sound good that anyone could think of, they don't work.
Peters: And they don't go away either. Dividend capture, I've been asked about this regularly for eight years now at the helm of DividendInvestor, and [I explain] you only get the benefit of receiving that dividend if you've owned the stock long enough for the company to have earned the money to pay it to you. So, you need to back away from that.
Now that I'm thinking about it, I think what I mentioned earlier about the Peter Lynch reference is he may have been talking about put protection, buying puts to insure your portfolio against declines, but it's the same thing. You're spending a lot of money to protect against a risk that if you can manage it, you should just absorb it and save yourself of trouble.
Kinnel: Both of these are really saying "there's no free lunch."
Peters: There is no free lunch. There is no free lunch, not dividend capture, not stop loss, not option protection. I think you make a decision to buy or sell based on the relative opportunities. You have the strength of the company. You don't outsource that to the whims of the market. Whipsawed is the perfect word for it.
Glaser: So, one of our viewers is actually looking to take on more risks. So, unlike some of the investors we were talking about earlier, who maybe we're trying to be more conservative, looking for more core [assets], [these other viewers] are looking for more of that "explore" part of their portfolio. What are some good picks maybe on the fund side of more concentrated portfolios and maybe some riskier equity ideas?
Kinnel: One of the first funds that came to mind is not that concentrated, but I like PRIMECAP Odyssey Aggressive Growth, POAGX. It's just a very good, well-run, fairly aggressive growth fund. PRIMECAP just has outstanding managers who really look at the fundamentals. If you want to get focused, a fund like Oakmark Global, I think, is an outstanding focus portfolio of world stocks where the manager, Clyde McGregor, really has a lot of flexibility to buy just about anything he wants.
Glaser: Matt, is there anything from maybe your Hare portfolio that you think looks interesting right now?
Coffina: Probably the riskiest name in the Hare, but also a name that I think there's a lot of opportunity in would be Baidu, ticker BIDU. It's basically the Google of China. There's an enormous number of risks that come with investing in China ever. Really this is probably the only Chinese company that I would consider for my portfolio. But it's a very high-quality company, $30 billion or so market cap audited by PricewaterhouseCoopers. But most importantly, it's trading at about 16 times this year's earnings, but growing 40% a year. And over the last several years, they’ve been growing 100% a year.
If Google is any indication, I think that it has a very long way to go in terms of the opportunity of online search. There are a lot of secular trends working in its favor. One being the growth of China's economy overall, but also a secular shift in advertising away from traditional media into online media. And then within online, it shifts away from portal-type sites like Yahoo! and toward search sites where you can have the most effective advertising. So, a relatively risky name. It's only a narrow-moat company, but the price/fair value ratio looks very attractive and the long-term growth story looks extremely attractive.
Glaser: Let's take a look at our global investing then. We looked at this Chinese stock and does it make sense to look at other Chinese investments? What part of your portfolio or how much of your stock allocation should be outside of the U.S.?
Coffina: So, in my portfolio Baidu is the only emerging-markets company. We are very U.S.-centric. I still think the U.S. is the greatest wealth creator that's ever been imagined really. U.S. business has been creating value for 200 years. We have one of the more favorable regulatory environments. We have more favorable demographics than most of Europe for example. So, there is less risk in the U.S., and I still like the U.S. for the vast majority of my portfolio.
The best way to gain international exposure, I think, is really through multinational companies that have exposure to all of these regions. So, some names that come to mind a lot of Big Pharma. A lot of those companies aren't necessarily cheap, but we own Pfizer. Novartis is based in Europe, but really just a global pharmaceutical company. Johnson & Johnson. MasterCard is a name that looks fully valued also but gets more than 60% of its revenue from outside the U.S., and that's really my favorite way to play international markets.
One more name I'll give you is Potash Corp of Saskatchewan. This is a good play on international emerging markets without taking all of the risk that come with actually investing in those emerging markets. Assuming China and India continue to grow in the way that they have been, the populations are going to want to eat an increasing percentage of meat, fruits, and vegetables, and those take a lot of fertilizer to grow. So Potash Corp is one good way to get exposure there.
Kinnel: I have a little different take. I would say anywhere from 30% to 70% of your equity stake can be overseas. They have done surveys in every single country. People think that their market is safer than everyone else's, which collectively is complete irrational. And I think really there is not that much difference. As Matt points out, a big multinational here or Europe or Japan, there is not that much difference. But I do think there is some diversification and currency value in going outside the U.S. So, I think you can really have a pretty wide range.
Glaser: What are some of your favorite global stock funds?
Kinnel: I like Dodge & Cox Global. I like Oakmark Global. And then there are some global-allocation funds like I mentioned PIMCO All Asset. So, I do like global-allocation and world-stock funds because the managers have a lot of flexibility to go wherever the best values are.
Glaser: Sam, Russ mentioned that a big global company in Europe is not that different from a big global company in the U.S. I know a lot of ETF providers have tried to then create ETFs that get into smaller-cap names in emerging markets and elsewhere. Can you talk to us a little bit about those ETFs and maybe the advisability of using them these days?
Lee: So, historically, across almost all markets, smaller-cap companies have outperformed larger-cap companies, and there is a name for it, it's called the small-cap premium. And ETFs are a great way to access the small-cap premium because you are doing it with a very low-cost, widely diversified product. So, one of my favorite small-cap international funds right now is WisdomTree Emerging Markets SmallCap Dividend ETF, DGS. And what this does is this looks at the highest-yielding small-cap stocks in emerging markets, and it weights them by their share of dividends to be paid over the next year. And so what you are doing is you are buying a strategy that every year trades against the markets, it applies a mechanical contrarian dividend-oriented strategy on these smaller emerging-markets stocks. I don't recommend a big allocation to this fund because it's fairly volatile, but I think that if you hold a small slice of it to complement your preexisting emerging-markets allocation, it could add a little bit of extra return.
Peters: I'd add to that and say I think dividends are great tool to go and get international exposure, especially in the emerging markets, where the legal protections, the accounting rules, and whatnot, maybe a little dodgier. But I think if you're looking to have a portfolio here as a U.S. investor and generate a lot of dollar income, and you go overseas and you take on some currency risk and you may deal with some withholding taxes, it's one of the reasons I like a Johnson & Johnson, but I'm not as big a fan of Novartis because in Switzerland, there is a pretty large withholding tax against U.S. investors. You can recoup some of it in a taxable account, but not a tax-deferred account like an IRA. So there are some practical constraints.
I tend to be more U.S.-centric, but there are a couple of companies in the U.K., Vodafone and Royal Dutch Shell, both of them are certainly global companies in terms their exposure, but out of the U.K., that I think are some of the more bargain names for yield seekers right now.
Glaser: So, we had a viewer question about the Japanese economy. For a while it was almost a joke that a fund manager can outperform the index by just not holding Japan. Are those days behind us? Have valuations finally become attractive there?
Kinnel: It's interesting. Dennis Stattman of BlackRock says, yes, now is the time to get into Japan. And then you see someone like Longleaf and they are actually backing out of Japan because they got burned by names like Olympus, where you can have some issues, and it's clear that shareholder rights are not as strong there. So, on a valuation basis, a lot of people say, yes. On a shareholder rights basis, people are still a little wary.
Lee: To add on that, Japan has had problems for a long time because their culture does not emphasize shareholder returns. Companies and CEOs see themselves as servants to the greater society, so to the government, to their workers, to the suppliers. Their shareholders are just, you know, one of many, many stakeholders. And so, the return on equity in Japan has historically been fairly low, and not only that, but a lot of Japanese companies for a very long time, over 20 years, had hidden debts that they accumulated.
So, during the Japanese real estate bubble which was truly massive, it completely outstripped the U.S. bubble in terms of the price appreciation in commercial properties, a lot of Japanese companies decided that they are going to turn into a real estate hedge fund, so they borrowed a lot of money and invested in these commercial properties. And when prices collapsed, what these Japanese companies did was they didn't mark down their assets because if they did, virtually every single large-cap Japanese company would've been insolvent and should've gone through bankruptcy and what not.
So, what the regulators and what Japanese companies did was they slowly whittled away at that. So Olympus is actually a case in which they were using dodgy accounting and using their organized crime connections to sort of write down the debts that they had accumulated. So they were writing down debts that they accumulated 20 years ago, so that's why this massive debt overhang that a lot of investors didn't understand, combined with a very shareholder-unfriendly society that didn't emphasize returns, has managed to produce consistently low returns. But now people think finally that the debt loads of a lot of these Japanese companies are finally gone. So a lot of these hidden debts are mostly paid down. So, you can't look at Japanese returns 10-20 years ago and project that into the future.
That said, there is still the case that your return on equity is still probably going to be very low because cultures do not change; 20 years from now Japan will still probably be less shareholder-friendly than the U.S. is right now. But I would say that Japan right now is about fairly valued. So, it's not outstandingly cheap. Full disclosure, I'm actually overweight Japanese equities at this moment.
Glaser: We have a few minutes left, so I thought we'd maybe try to tackle a few different topics. The first being alternatives. We had a question about buying gold and silver and other precious metals in today's market. What's the advisability of that?
Lee: Well, gold can be thought of as a currency, a nonyielding currency, and that's how it's being priced in the market today. As a nonyielding currency, you can't really expect to make a lot of money on it. The only reason why you would invest in it is because you can sell it to someone who's more scared later on as Warren Buffett put it. So, long term, gold and silver are not going to do you any good; 20 years from now, I'll [make a large bet] that you would probably be better off in just large-cap high-quality stocks.
That said, gold has diversification properties. So if you buy gold and silver with the expectation that you are going to lose money over the long run, but you're willing to pay up, you are willing to lose that money for perhaps the Mad Max scenario that might unfold making it worthwhile, then yes, gold and silver is a decent bet. And even though I sound dismissive of gold, I do own a little bit of gold in my portfolio. So, I just wanted to get that out.
Coffina: I would just add to that. I think the key point is the difference between investing and speculating, and any investment in gold is really speculation about what people are going to value gold at in the future. People think of it as being the ultimate good with intrinsic value, but I'd really say it's the opposite. It doesn't generate any cash flow. It has no intrinsic value. The only value of gold is what somebody else is willing to accept for it down the road.
Glaser: Matt, we had a question that I think you'd probably be able to tackle about tech stocks, particularly Facebook and LinkedIn and in particular. Do you think those are attractive right now? I know you've just trimmed your position in Facebook a bit in your portfolios.
Coffina: We're overweight tech in general, and I think there are a number of opportunities. I already mentioned Baidu as one. Facebook I think is trading at a decent discount to our fair value estimate, but on the other hand there's a tremendous amount of growth that's baked into that fair value estimate, and the stock is trading at a very rich multiple of earnings. I'm not sure what the latest multiple is but something in the 45 to 50 range, I believe. So, the stock is expecting a lot of growth, and we're expecting a lot of growth, but that kind of story just gets me nervous that something could happen ,and the growth story cannot play out quite as much as we expect.
The difference with Baidu is that you're getting a similar level of growth but you're not paying for it. You're only paying 16 times earnings instead of 45-plus times earnings. Some other names that I like right now in tech, Oracle is a company that was off quite a bit earlier this week. It seems like it's partly a one-quarter issue with their sales staff. There's certainly some concerns out there that they're getting disrupted by cloud computing and cloud-based competitors, but so far our analysts think that the wide-moat is stable, that the competitive threats are under control, and that Oracle's going to be able to navigate its way into the cloud in this new environment.
Glaser: There's another question from Kim who asked that now that the market is at an all-time him, she regrets not selling stocks after the last time we hit the high in 2007. Should she be thinking about trimming positions? How do you know when to trim some of your winners?
Kinnel: Well, I think one simple thing is simply rebalancing. If you've got a plan that says I want to be 60% equity, and the market rallies and now you're at 65%, well, on an annual or twice-a-year or whatever basis, you can you can sell some of that in. I don't think simply hitting the high is enough information to tell you that the market is overpriced. I think you need a little more than that. And I think at a minimum just simply following that rebalancing, sticking to your plan can help you a lot.
Peters: It's not a high in real terms either. The record from the early 2000s is probably going to stand for a while if you adjust it for inflation. And I get the question that came up earlier: Is it time to just throw all my money back in the markets? That is an almost impossible question to answer because nobody has got the operating crystal ball. But stocks I think are much more attractively priced than bonds; cash is being trashed with no return as inflation continues to eat away from it.
So, I think in this kind of environment you have to say, "Yeah, new highs, that's just an interesting little tidbit of news, but there's no reason that the market can't continue to run much farther from here." And even if you wanted to wait for a pullback, there are going to be pullbacks and corrections, I'm sure even some this year, but there's no guarantee the market goes to some point that's lower than where it is at today.
So I think you follow a plan, you stick with a plan. If you want to get back into the market, don't let new highs necessarily put you in or out. Step back and make that decision about what you need your money to do over the long run and the risks you're willing to tolerate while taking it.
Glaser: So it comes back to that discipline. How about the basic materials sector? Any good opportunities there?
Coffina: So that's another sector that we have an outsized exposure to, especially in the Hare. Some names that come to mind would be Compass Minerals; it's a very high-quality company. They mine salt in the Great Lakes region. They've been underperforming as in the last two years, anybody that's in the Chicago area knows, there hasn't been a whole lot of snowfall, which means that inventories of salt have stayed there and municipalities haven't had to buy a lot of new salt. They also have some exposure to potash, which is a similar story that I was talking about with Potash Corp, another name that I like in the basic materials industry.
One more name that comes to mind would be Cloud Peak. This is pretty much one of the lowest-cost coal miners in the world. Right now, coal is not a great place to be as natural gas prices have been very low and utilities have been diverting their generation capacity away from coal and toward natural gas. But we think even at current natural gas prices the prices that Cloud Peak is getting for its coal are unsustainably low because of some inventory overhang. As utilities work through that overhang, and we still can't get by generating enough electricity or all the electricity that we need without burning some coal, no matter how dirty it is, prices should rebound, and that would be reflected in Cloud Peak.
Glaser: That's about all the time we have today, but I want to thank, Sam, Matt, Russ, and Josh for joining me today. Great picks.
Kinnel: You're welcome.
Coffina: Thanks for having us
Peters: Thanks, Jeremy.