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Investing Insights: Hear From the Fund Managers of the Year

Morningstar.com

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

This week on the podcast, we break down Netflix's earnings; Mike Lillard says the Fed will be aggressive in raising rates; Sarah Ketterer sees value in Japan; Steve Wymer says a stock market pullback is possible this year; Michael Kitces says a backdoor Roth strategy is still an option; and Eric Compton highlights trust banks.

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Netflix posted a very strong quarter in terms of subscriber growth as the firm handily beat its guidance, but we still shares as overvalued today.

The better than expected increase in international subscribers meant that both revenue and segment contribution came in above our projections. However, the firm continues to burn cash at a faster pace with a free cash flow loss of over $2 billion in 2017 versus a loss of over $1.7 billion last year. Management expects the free cash flow burn for 2018 to increase to $3 billion to $4 billion. 

Despite the beat on subscribers, our long-term thesis for the stock remains largely in place as we expect management to have to continue to invest heavily in content to keep users happy. We're retaining our narrow moat rating and raising our fair value estimate to $90 from $80 to account for slightly faster subscriber growth, a lower tax rate, and the time value of money.

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Eric Jacobson: Hi, this is Eric Jacobson from Morningstar. We're here today with our manager of the year award winners for Prudential Total Return Bond. We've got Mike Collins and Mike Lillard. 

Gentlemen, thank you so much for joining us today. We appreciate having you.

Collins: Thank you.

Lillard: Thanks for having us.

Jacobson: Let's talk a little bit about the macro environment that you've seen in 2017 and where it's leading you right now.

Lillard: The global economy's really strong, it continues to do really well. All the data comes in strong. Corporate earnings are really strong, so it really looks like a very strong global economic environment, very broad-based, strong strength everywhere around the globe. What that leads us to think, given the strength of this economy, is that the Fed is actually going to be pretty aggressive here in hiking rates. We've been thinking three to four times. I might be more on four times this year. Mike might be more on three times. But we think the Fed is going to continue to be pretty aggressive here in moving short-term rates up. 

That said, we don't think long-term rates are going to move up much at all. Right now, you've got the 10-year at 2.65. I would tell you by the end of the year I think it could be 2.25. So the Fed's going to raise up the front end. I don't think long-term rates go up all that much. Rates are so low in Japan, Germany, and elsewhere in the world, that the U.S. rates just stand out as being really cheap as you move further out the curve.

Jacobson: On the one hand we've got this situation where the global economy looks very good, the Fed responding, as you had said, expectations for some rate hikes and so forth. 

On the other hand, we've got this market with valuations grinding tighter and tighter. A little bit of indication that we might be at the start of weakening underwriting for corporate credit and things like that. I think it's fair to worry, maybe a little bit early, but fair to worry--what do those things mean in terms of the market and risk and so forth?

Lillard: Looking for those opportunities as you point out to decrease risk within the portfolios. Really, you don't see anything on the horizon at all in terms of recession. But on the other hand, valuations have done really well here as spreads have been coming in. Looking at upside, downside, thinking about the probability distribution of where spreads could go, so our base case is that spreads will just continue to grind tighter as people reach for yield and the economies continue to do really well and earnings continue to do well. 

It's not just about the base case. You have to think about the tails of the distribution, too. There's not that much more tightening to come. There's risks that spreads widen materially. We're looking selectively at those spots. How do you decrease risk? How do you get to more emphasizing high-quality core positions with respect to credit risks on a portfolio?

Jacobson: That's the perfect segue. Let's talk a little bit about what you have been buying or avoiding even, but what you really have been focusing on and why, maybe from valuation and fundamental perspective, that's giving you the confidence to get what you need, but also avoid taking on too much of that tail risk.

Collins: As a portfolio manger, you really want to do well or manage for that base case, but really holding well in those tail risks. Right now we're focused a lot on the tail risk because you're not getting paid a lot for the upside. We've developed more of these higher quality, what we call core, long-term positions, which should do well through the cycle. Some of these are the big U.S. money center banks, which have de-levered significantly and are really in great fundamental shape. The structured products, the AAA commercial mortgage-backed securities, AAA collateralized loan obligations, some other secured structured products that have tremendous credit enhancement, where the underwriting has actually been better than it was last cycle. Those are our long term high-quality defensive strategies.

But on the other side of that, we do have a little bit of a barbell. There are some opportunistic, attractive relative value opportunities around the world. Some of them are favorite names within the BBB space. Some are high-yield, and some are even in emerging markets or some of the European peripheral countries where we've opportunistically added positions.

Jacobson: Thank you guys so much for joining us. Congratulations on a great year, and good luck continuing with that success in 2018 and beyond.

Collins: Thank you, Eric.

Lillard: Thanks again, Eric.

Jacobson: From Morningstar, I'm Eric Jacobson.

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Andrew Daniels: Hello, I'm Andrew Daniels for Morningstar. Today I'm joined by Sarah Ketterer and Harry Hartford, co-founders of Causeway Capital Management. They are both lead managers of Gold-rated Causeway International Value, which won the 2017 International-Stock Fund Manager of the Year. 

Sarah and Harry, thank you for being here today and congratulations on the award.

Ketterer: Thank you.

Hartford: Thank you, we're delighted to be here.

Daniels: As you look ahead to 2018 and beyond that, how are you positioning the portfolio currently, to take advantage of those opportunities?

Ketterer: Andrew, as you well know, markets are at very high levels and undervaluation is scarce. When, given our long history of managing money, our team reacts to this type of environment by lowering portfolio risk, and one of the major ways we do that is through diversification, ensuring that we have stocks that tend not to correlate closely with each other. Furthermore, keep trying to find the low-beta stocks that still have upside potential. Several of those are in Japan, there are a few located in Europe, but keep pushing risk down ensuring that if we can outperform on the way up, we'd like that to outperform on the way down, too. I've yet to meet a market that didn't go both ways.

Hartford: What I would say is that some of the characteristics we're anxious to own from a portfolio perspective are securities with strong capital positions, and--to the degree that the valuation is supportive--also have defensive characteristics. The portfolio's single largest industry exposure today is in pharmaceuticals, and that's very deliberate given the recurring cash stream that pharmaceuticals generate and the low risk characteristics that they historically exhibit.

Daniels: Are there any stocks in particular that you are really excited about now?

Ketterer: Some of the recent additions would include companies like Sompo in Japan, known for their non-life business, half of their non-life revenues come from automotive insurance, which sounds very sleepy, but they've also got a life insurance business, they bought Endurance in the U.S. They're growing their international business. What we like about them is that their valuation is attractive, they're well managed, they're well-positioned in their area of expertise, they've got good dividend yield versus the Japanese market, and we get that low risk characteristic. Right now, in the context of battening down the hatches, they fit the bill.

Hartford: We also have stocks that we would characterize as self-help, going through a process of restructuring. As long as they've got strong balance sheets to support that restructuring, whether it be a consequence of new management in a company like Cobham or whether it be a consequence of acquisitions and ability to integrate those acquisitions and generate higher margins for the overall business. I like Micro Focus. They would be two examples of companies that we would feel will do well regardless of the overall market conditions.

Daniels: Sarah and Harry, thank you for being here today, and congratulations on the award.

Hartford: Thank you very much.

Ketterer: Thank you.

Daniels: For Morningstar, I'm Andrew Daniels. Thank you for watching.

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Katie Reichart: I'm Katie Reichart with Morningstar. I'm here with Steve Wymer of Fidelity Growth Company. He's Morningstar's Domestic Stock Fund Manager of the Year. Steve, congratulations and thanks for being here.

Steve Wymer: Thanks, Katie. Glad to be here.

Katie Reichart: After such a strong run for equities the past few years, and especially in 2017, how are you thinking about the portfolio heading into 2018?

Steve Wymer: The economy seems to be strong in the U.S. and perhaps picking up some steam. The international economies, for a change, are very strong all around the globe. It looks fundamentally very strong. Stock valuations are a little higher than they used to be, but the fundamentals are strong. Where the market goes, we had a strong market last year. We're very strong year to date. With some of the indexes up high single digits already, we don't expect that to continue. Usually we get some pullbacks along the way, and I'm sure we'll have some this year.

Katie Reichart: Do you expect to see some tailwinds from tax reform?

Steve Wymer: I think tax reform is very positive for our economy. We're going to see probably more investment from the companies that are out there. They're clearly bringing more down to the bottom line and we'll see how they spend it.

Additionally, we're also seeing foreign companies step up their investment in the United States where their tax rates have gone down low and with the weakening dollar things in the United States look a little bit more attractive than they used to for them, too.

Katie Reichart: Biotech's been a big part of the portfolio throughout your career and an area where you've had a lot of success. How are you thinking about that part of the portfolio and any particular names that you're excited about now?

Steve Wymer: We've done well with biotech in the fund and one of the ways that helped us do well is taking a portfolio approach because there's a lot of risk in this area even though these companies are innovating, but there's a lot of clinical risk and there's a lot of regulatory risk, and even how well competition will do in the marketplace or how that stock will do in the marketplace.

What we do is we balance that risk out over time because these stocks can have some ups and downs as they try to move their products forward.

Katie Reichart: And Alnylam I know is a top contributor last year, but that hasn't always had a smooth path while you've owned it.

Steve Wymer: It's not an overnight success, but they're on the brink of launching their first drug in 2018. It's a company we think has a nice pipeline behind it, so Alnylam was a strong contributor last year, and hopefully will be a strong contributor in the years ahead.

Katie Reichart: Great, well Steve, thank you so much for being here.

Steve Wymer: Thank you.

Katie Reichart: I'm Katie Reichart with Morningstar.

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Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Backdoor Roth IRAs are a hot topic. Joining me via Skype to discuss them is Michael Kitces. He is a financial planning expert.

Michael, let's talk about the state of the state of backdoor Roth IRAs--what they are and whether investors can still take advantage of this maneuver.

Michael Kitces: The backdoor Roth contribution is, essentially, we've kind of come up with the workaround for the fact that Roth contributions still have income limits. If once my income is too high, I'm simply not allowed to put money into a Roth, but I'm always allowed to put money into a traditional pretax IRA regardless of income. If my income is high and I'm an active participant in an employer retirement plan, I might not get to deduct my IRA contribution, but I can always put money in as long as I have earned income to contribute.

And because we don't have income limits on Roth conversions, what that essentially means is, no income limits on the contribution, no income limits on the conversion. A contribution plus a conversion means the money ends out in your Roth account. You essentially got the money into a Roth account if you couldn't because your income was too high. We call this the backdoor Roth contribution strategy because we are kind of getting there in two steps around the back door because we couldn't just go on the front door with the contribution if we are over the income limits.

Now, a key part of that backdoor Roth is, there's a contribution and a conversion. You need to be able to do the conversion. The good news is, it means the strategy is still on the table. Because again, we didn't change anything about Roth conversions as a part of the rule changes. We can't recharacterize it. Once you do the conversion part of the backdoor Roth, make sure you are ready to stick with it. But the strategy otherwise is completely unchanged because we can still do the contributions to IRAs and we can still do the conversions. That hasn't been altered.

Benz: Were you surprised that this loophole wasn't closed? This had been on the chopping block on a couple of occasions before, but it didn't appear in the final tax law that we saw.

Kitces: Yeah. I was a little bit surprised that it didn't end out there only because there were so many other so-called loophole closures on the chopping block. This has been proposed for crackdown before. It was in the Treasury green book for several years in a row as a potential change. The change is actually very straightforward from the tax code's perspective. We would simply write a rule that says you cannot convert aftertax dollars to a Roth, and then almost all backdoor Roth and the so-called mega backdoor Roth strategy, all go away. It survived the chopping block here.

Honestly, it's still a provision that we track and expect at some point in the next few years that door will probably get closed. We will get to a point where you are just not allowed to do conversions of aftertax dollars anymore. But for the time being at least, it's still on the table, it's still valid as a strategy, and the limitation on recharacterizations really doesn't curtail it at all.

Benz: There is a major caveat, though, for this for people who are high-income and looking at this idea as a way to get some Roth IRA assets, get some assets over into the Roth column. The key thing is that you need to be careful about other traditional IRA assets that you might have in your account, right?

Kitces: Correct. There are still some tax consequences--anytime we do a Roth conversion, including money that we just contributed, got to pay taxes on the conversion amount, anything that would have been ordinary income when we withdraw it. Now, classically, one of the reasons why backdoor Roths are popular is, if your income is high and you are already active in a 401(k) plan, the money you put in your IRA is all going to be nondeductible, which means it's aftertax money anyway. If it's all after-tax money and I convert it, there is normally no tax bill because it's all aftertax money. I just put it in there. I know that.

The problem though is that anytime you do a Roth conversion, regardless of whether we are in the backdoor context or just any Roth conversion, we always have to calculate the tax consequences of a Roth conversion based on the portion of all of our IRAs in the aggregate that are taxable, not just the one account that I created. And so, the problem that crops up is, if I just put $5,000-plus into a nondeductible IRA and convert it, but off to the side I've also got this $500,000 rollover IRA from the past, as far as the IRS is concerned, you didn't covert a $5,000 after-tax account; you converted 1% of your $505,000 of which only about 1% was after-tax contributions. So, 99% of your Roth conversion is suddenly taxable, even though you only put aftertax money into that account and immediately converted it. The phenomenon of separate accounts does not exist as far as the IRS is concerned. We may do it because it's convenient to keep track of money. But for tax purposes, you only have one giant bucket and you can't only convert the after-tax portion.

It doesn't necessarily make the partial Roth conversion strategy bad. But it means you are not really doing a backdoor Roth anymore; you are just converting 1% of all your IRAs with all the tax consequences that go with it.

Benz: It sounds like checking with a tax advisor or your financial advisor to make sure that this maneuver makes sense for your probably is a good idea before you execute?

Kitces: Yeah, it's definitely important to make sure that you are looking at all the IRAs on the table when evaluating the strategy. There are some options out there of using strategies where you roll the pretax dollars out of IRAs into a 401(k) to try to segment the assets back out, so that you can convert just the after-tax IRAs that are left. But there's definitely more to it than just, I need to put money into a new IRA and immediately convert it and not pay attention to what's happening with the rest of the IRAs in the picture.

Benz: Michael, you are always such a great source of information for us. Thank you so much for being here today.

Kitces: My pleasure. Thank you.

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

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Eric Compton: The trust banks do not operate like your typical bank. For example, trust banks are not primarily focused on deposit gathering in order to fund loan growth. As a result, trust banks typically take on minimal credit risk and have low liquidity and duration risk. 

Rather than viewing trust banks through the lens of your typical bank, we instead think of them more as a service provider. The trust banks provide the infrastructure and technology which allow everyone to connect to and use the financial markets. This includes items such as record-keeping, maintaining custody of assets, calculating NAV values for mutual funds, and much more. The trust banks then charge fees for providing these services, leading to roughly 80% of total revenues coming from fees for these banks. We currently view BNY Mellon and State Street as more or less fairly valued, with both trading at roughly 8% above our fair value estimates. 

We view Northern Trust as overvalued at this point, trading at 30% above our fair value estimate, and this is even after factoring in a boost from tax reform, of which Northern Trust would be the largest beneficiary of the three given its higher concentration in the U.S. Northern Trust is arguably the most conservative of the trust banks, and the bank is loath to lever up or take on excessive risk simply to boost returns. We expect this culture of conservatism will continue, maintaining the bank's excellent reputation among its high net worth clients, and slow but steady cost cuts will help expand margins over time. Right now we think the market is simply expecting too much margin expansion, and we believe returns may be limited in the stock over the next several years.