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This week on the podcast, Brian Colello breaks down Apple's earnings; Russ Kinnel shares his favorite funds for retirement; Christine Benz looks at how rising rates affect retirees; Erin Lash says P&G's attractive dividend should continue to grow; Jon Hale talks about investing for impact; and our equity analysts give their takes on the Chinese economy and Amazon's healthcare partnership.
Brian Colello: Apple reported strong results for the December quarter. They gave weak guidance for the March quarter. This was a bit expected because there were some reports about iPhone X production cuts. Probably the biggest news from Apple's earnings, is that they intend to be net cash-neutral, after the U.S. tax reform, and their ability to bring [back] all of their cash overseas. Apple is holding onto $163 billion of net cash at this point, and they intend to spend almost all of it on dividends and buybacks over the next few years. They haven't given a time frame, but they'll update it in April after the March quarter. This is a move that surprised us. We thought that Apple would be a bit more conservative with its ability to access cash, as they have had a historically conservative capital structure. This one really caught us by surprise. That's why the stock moved to up 3% after hours. It was flat before that.
Looking at the actual results, Q1 revenue for the December quarter was quite strong. iPhone revenue was strong. iPhone units were slightly light, but not too bad. The bigger factor was the mix toward the iPhone X. These are higher priced phones, ASPs of $796 were exceptional, up 15% year over year. Flatish sort of sales, but higher prices on those phones, really led to a strong quarter for Apple. The other nice part was the other products business, wearables. Apple Watch and AirPods in particular, surprised us.
Apple's second-quarter forecast for the March quarter was weak, but it wasn't overly surprising, and it certainly could have been worse. We've seen reports that Apple is cutting production of the iPhone X. A couple of chipmakers that supply into Apple gave weak guidance for the March quarter, citing softness in smartphone demand. This isn't a total surprise to us. You have the iPhone X, the highest priced phone. These usually sell very early on in the process, and then inventory wanes, particularly when you get into the spring and summer months, so Apple does adjust inventory around this time. Not a total surprise that Apple is cutting production.
Certainly, it's a negative, and the guidance is weaker than expected, but it certainly could have been a lot worse. The gross margin guidance is good. It looks like there will still be decent sales of the iPhone 8 and 8 plus. And with the good news about the cash distributions coming out in the future, investors are still relatively happy with Apple's report.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. What makes a fund a top pick for a retirement portfolio? Joining me to share some of his favorite retirement picks is Russ Kinnel. He is director of manager research for Morningstar.
Russ, thank you so much for being here.
Russ Kinnel: I'm glad to be here.
Benz: Russ, let's talk about retirement holdings. Say, someone is in retirement, do you think their holdings should necessarily look different than the holdings that someone who is still in accumulation mode should hold, apart from the asset allocation decisions?
Kinnel: Maybe a little bit, maybe a little more caution. Obviously, even when you are in retirement, you still probably have a long-term time horizon. I don't think it should be a drastic difference. When you look at it, you may want to adjust risk down a little bit, but also think about if you've, as you mentioned, changed the asset allocation, so you've got a lot more in fixed income, then you may also want to be aware of some of those specific fixed-income risks, which if it was 20% of your portfolio, it didn't matter. But now, if it's, let's say, 50%, 60%, 70%, now you want to think about things like interest-rate risk and inflation risk as well.
Benz: Diversify within that bond portfolio. You might build out positions that you didn't really have room for before?
Benz: Should costs play a greater role in the equation when you are retired, or should they be a huge consideration all the way through?
Kinnel: I would say costs are always crucial for sure. But certainly, in retirement, I think, the expenses are subtracted from income. The lower your fees, the more income is going to be flowing through to you.
Benz: In your newsletter, Morningstar FundInvestor, you have a lot of funds that you talk about that you like. I asked you to bring some of your favorite ideas for retiree portfolios, and you brought a grab bag of different categories. One that you brought is a core intermediate-term bond fund. Let's talk about that one.
Kinnel: I think intermediate makes sense just because there's a little less interest-rate risk. Intermediate is a really diverse category. There's some very aggressive funds in there. I brought one on the conservative end. Fidelity Intermediate Term Bond is a fund that has interest-rate risk below the peer group average. It has credit risk below the peer group average. It's very mild-mannered. But if you've also got high-yield or some other riskier funds out in your portfolio, this is kind of a nice core anchor for you. Because it's so low risk, it's actually hasn't had great performance lately, but again, I think that's OKif you understand what you are getting. It's got low costs, it's run well, and I think a really nice dependable yet boring fund.
Benz: For investors who are looking at their portfolios and seeing that their equity holdings have gotten enlarged and perhaps want to add a little to the bond piece. It sounds like this is a good core pick?
Benz: That Fidelity fund is a taxable bond fund. You'd want to be sure to hold it inside some sort of tax-sheltered retirement account. How about a fund for retired investors' taxable accounts? You have a pick there?
Kinnel: I like T. Rowe Price Summit Muni Intermediate Fund because it doesn't have really big interest-rate risk. It does have a little bit of credit risk. And so, they take some risks at the margins. Charlie Hill has done a really nice job guiding this fund through thick and thin, and I think it's a kind of steady performer that again is a really nice fund. Obviously, not all retirees need munies. It depends on what your tax situation is. You might want to talk to your accountant and see what kind of tax bracket you can anticipate being in. I think it's a really nice, steady fund. Again, munies behave a little differently from taxable funds. You're getting a little more diversified, you're getting some tax breaks. Obviously, the tax issues are influx these days, but I would talk to your accountant. I think this is a nice steady fund.
Benz: Those are core funds, the Fidelity fund and the T. Rowe Price fund. Now, let's talk about a fund that's a little more of a niche holding, you'd maybe want to hold a smaller position in it. That's Fidelity Floating Rate High Income.
Kinnel: That's right. What you get with bank loan funds like this one is, essentially no interest-rate risk because the coupons adjust with changes in interest rates. You are covered if there's a spike in interest rates, but you do get some credit risk because these are bank loans to companies and so there is some risk there. There's some liquidity challenges, and so, this fund in particular holds a meaningful amount in cash so that it's easier to manage inflows and outflows. That makes it on the more conservative end of bank loan funds. But again, I think, that's a reasonable way to go is, take on a little less credit risk, especially, this long into an economic expansion, I think it's good to be a little more cautious. We haven't had much interest-rate risk in a long time. Presumably there is still some scenario in which interest rates spike and this is a good fund to hold in that time.
Benz: The first three were all fixed-income picks. Now, let's take a look at an equity pick. First, let's talk about why investors in retirement want to be thinking about making room for international equity exposure as a part of their portfolios.
Kinnel: There's a common misperception that international equity is higher risk. And in fact, people across the world all think that the other markets are higher risk which doesn't really add up. I think it's a useful diversifier. Don't avoid foreign equities just because it sounds higher risk. I think it's still a worthwhile place to invest. By a lot of measures, foreign equities are cheaper than the U.S. right now. I would still pay attention to foreign equities and still have some money in there even in retirement.
Benz: The fund you are highlighting today is Causeway International Value. Its managers won our International Stock Manager of the Year award honors for 2017.
Kinnel: That's right. And it's rated Gold. So, needless to say, we really like this fund. It's run by Sarah Ketterer and Harry Hartford. They have been running it for about 15 years, since leaving Hotchkis and Wiley. Just a very good, solid value fund. I chose value just because value has been a little more out of favor than growth these days. It's contrarian in a couple of ways. Very solid, consistent value fund. A nice offset if you've got a lot of growth exposure these days.
Benz: Where does it stand in relation to the emerging versus developed markets question?
Kinnel: That's a great question, because it has no emerging-markets exposure. It's unusual in that way, too. If you want emerging-markets exposure, you'll have to get an additional fund. But they draw the line very clearly here. It's just a developed market fund.
Benz: Good to know. Russ, thank you so much for being here to share these picks today.
Kinnel: You're welcome.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.
Jeremy Glaser: For Morningstar I'm Jeremy Glaser. Interest rates have been on the rise in 2018 after being placid for quite some time. I'm here with Christine Benz, she's our director of personal finance, to see what this means for retirees.
Christine, thanks for joining me.
Christine Benz: Jeremy, great to be here.
Glaser: Let's start by thinking about kind of the most obvious impact of rising rates which is on bond prices. Can you tell us why rising rates mean that bond prices fall?
Benz: The simple reason is that when higher yields come online that depresses the value of already existing bonds, because they have lower yields attached to them. You tend to see this inverse relationship when yields go up, bond prices go down and the opposite also happens. When yields go down bond prices go up, and that’s the great tailwind that bond fund investors have had over the past several decades, where we've seen declining yields and rising bond prices. Right now we are starting to see a little bit of the opposite effect.
Glaser: Not all bonds are created equal. What categories have been hit particularly hard?
Benz: When we look at bond fund category performance so far here in 2018. As you would expect the long-term bonds have been hit particularly hard, long government bonds tend to be especially interest-rate sensitive. Long-term core bond funds have also been hit hard. Even core-type intermediate-term funds have taken a little bit of hit to principal even as higher yields have come online.
Glaser: We're talking about bond funds here. Investors say OK, well if it's going to hurt my bond fund then why don't I just hold individual bonds, holding it to maturity then I don't need to care about what happens with interest rates. Why would that be a good or bad strategy?
Benz: It's great question and one that I get an awful lot. The fact is that if you are buying say Treasury bonds or very high-quality corporate bonds that can be a sensible strategy. Once you move beyond those very high-quality bonds though I think that there are some risks that start to crop up. One is that it can be difficult to research some of the less frequently traded credits, and it might also be difficult to build a well-diversified portfolio of individual credits, especially if you are a smaller investor who is not buying thousands and thousands of dollars in individual bonds. Then another thing to keep in mind is that bid-ask spreads can come into play, and in talking this through with some of our manager research analysts, it seems that the municipal space--so people who are buying and selling individual municipal bonds--would be especially vulnerable to steep bid-ask spreads that can actually take out a chunk out of the yields that they receive. That's another thing to bear in mind.
Glaser: Another area investors might look at to try to get away from interest-rate risk is to take on more credit risks--buy riskier bonds or maybe non-dollar denominated bonds. Those have been holding up better so far this year.
Benz: They have, they have been performing really well. When we look at the top performing bond category so far in 2018 despite this little bit of interest-rate disruption, we've seen emerging-markets local currency-denominated bonds perform very well, emerging-markets bond funds in general have performed really well. High-yield bonds, bank-loan investments, or floating-rate investments--all of these categories have done really well. That's in large part because people are pretty sanguine about the strength of the economy, strength of the global economy for that matter. These bonds have held their ground pretty well, and of course they do have higher yields attached to them to begin with, so that tends to provide a little bit of a cushion even when we see interest rates jump up.
Glaser: If you are worried about losses in bonds, why not just hold cash?
Benz: A couple of key reasons. I would say actually that the opportunity cost of holding cash has never been lower, because when we look at the differential between even say high-quality short-term bond fund and true FDIC-insured cash instruments today, it's really, really low. You can find an online savings account with a 1.5% yield today, a high-quality short-term bond fund might be yielding like 1.7%, 1.8%, if you are lucky, that's a pretty slim margin considering that the cash instrument is FDIC insured. I think investors, if they do have very near-term expenses that they are going to have to meet--and this is certainly case for retirees looking to build cash flow for retirement--you probably do want to hold that money in cash rather than venturing out and taking even a little bit of risk with some sort of a bond fund, even a short-term bond fund.
Glaser: How do you figure out that balance of how much cash you need?
Benz: I always say that investor should use their cash flow needs to dictate how much to hold in cash. As you know I write and talk a lot about this Bucket strategy for retirement portfolio construction. The starting point that I tell investors to use is to think about their portfolio withdrawal needs, and put like six months to two years' worth of those withdrawals in cash. The rest can kind of get staged by withdrawal timeline. Maybe the next three to eight or three to 10 years' worth of withdrawal needs in bonds, and then the remainder can go into higher returning, higher risk assets, namely stocks.
Glaser: You said you could find potentially 1.5% in an online savings account. How do you figure out where that cash should go? I know a lot of sweep accounts and in brokerage accounts are still going to be pretty low, at least in terms of interest.
Benz: That's right. For investors who have gotten complacent about their cash just sort of figuring that this is dead money, why should I bother, it's time to get out there and take a look at what your cash investments are yielding today. Online savings accounts, in my view, offer the best balance of that daily liquidity, check writing in some cases as well as a pretty decent yield today, as you said of about 1.5%. Money market mutual funds have historically been able to offer higher yields in part because you don't get those FDIC protections. Even though money market funds are now governed by tighter strictures than was the case, say a decade ago, you still need to bear in mind that those are not FDIC insured. There is a trade-off even though in some cases you are able to pickup higher yields.
Glaser: Finally let's talk about debt. Higher rates means higher rates on debt as well. If you are holding debt in retirement, how do you think about that payoff if you do have cash?
Benz: Think about the variability, and this is especially true for people who might hold home equity lines of credit into retirement who are still servicing those debts. I think the combination of the fact that we're seeing yields trend up as well as the new tax laws which effect the deductibility of home equity interest, should really make many retirees take another look at whether they want to be carrying that debt around. I also think its valuable to look at the complexion of your investment portfolio, look at the return prospects of that investment portfolio. If your portfolio's return prospects are muted, to me that accentuates the value of prepaying debt rather than letting it ride.
Glaser: Christine, thanks for your thoughts on rising rates today.
Benz: Thank you Jeremy.
Glaser: For Morningstar I'm Jeremy Glaser. Thanks for watching.
Erin Lash: Wide-moat Procter & Gamble pays one of more attractive dividends across the household and personal care landscape with a dividend that yields north of 3% annually, far in excess of the low single digits it's peers boast. From our vantage point, P&G's commitment to returning excess cash to shareholders is evident in the fact that its paid a growing or stable dividend for nearly 130 years. We anticipate that it will continue to prioritize returning excess cash to shareholders. As we forecast, its dividend will grow at a mid- to high-single-digit clip annually over the course of the next 10 years.
Looking back, P&G has focused more recently on further bolstering its competitive position by shedding more than half of its brands as a means by which to focus on its highest return opportunities, while also also extracting excess costs, the combination of which we think stands to bolster profitability and further free up funds for the firm to allocate to bolster shareholder returns. As such, we forecast that P&G will direct around 70% of its annual earnings toward the payment of dividends for the benefit of shareholders going forward.
Despite its leading competitive edge, we believe that Procter & Gamble is not immune to the intense competitive headwinds that are plaguing its peers. More specifically, Procter & Gamble has chalked up stagnant top-line growth over the recent past. As other global branded players, lower price private label fare, as well as small niche operators work to chip away at Procter & Gamble's leading share position. However, we view the firm's efforts to reinvest behind its brands, both in the form of marketing as well as product innovation, as a means by which to offset these headwinds.
From a valuation perspective, we think Procter and Gamble's stock is attractively valued, trading at around a 10% discount to our valuation. When combined with its attractive dividend yield, we think long-term investors would be wise to stock up on this wide-moat name.
Jeremy Glaser: For Morningstar I'm Jeremy Glaser. The New York City pension funds have announced that they are going to be divesting from fossil fuels. I'm here with Jon Hale, he's our director of sustainable investing research. Let's see what this could mean for investors who are thinking about making an impact with their portfolios.
Jon, thanks for joining me.
Jon Hale: My pleasure.
Glaser: Let's take a quick look at this announcement about this divestment from fossil fuels. Is this the continuation of a trend? We've seen a lot of pension funds take these kind of steps.
Hale: Definitely we're seeing a lot of pension plans doing this, and if not going fully into divestment there are some other areas that they are exploring as well, like best in class investing or just even engaging with the companies that they do own in their portfolios.
Glaser: Let's take a look at some of these options, it could be illuminating for people who are thinking about their own portfolios. The first is full divestment. What is the case that's been made to walk away from these companies?
Hale: First of all it's probably interesting to talk about divestment in terms of the criticism that is made about divestments, which is basically that if you take something out of your portfolio for sort of noninvestment related reasons you risk it's said underperformance. What it really is is tracking error. You risk tracking error, you could underperform, you could outperform over time. It is very interesting I thought that GMO recently came out with a quick study that they did, where they took the S&P 500 and they took it out sector at a time and looked at what the S&P 500 ex-energy looked like, ex-financials, ex-healthcare. Went back 20 years, 50 years, 90 years--what they found was that it really doesn't make a lot of difference in return.
The primary case I think against divestment that you are risking a lot of tracking error, not that big of a deal. I think in addition to that we've seen over the last few years an investment case developed for divestment which is basically that, your large fossil fuel companies, especially the major extractors of coal, oil, and natural gas, are companies that are going to find it much more costly to operate over the not too distant future. Divestment in fossil fuels really is saying we don’t think these are great investments going forward. We have some evidence certainly in the last few years that that's been the case despite the natural gas boom of last few years. The MSCI All Country World Index ex-fossil fuels has outperformed the base index over the last seven years by about a percentage point annually.
Glaser: Another option is just looking at best in class investments. Instead of saying I'm not going to own fossil fuels you own the least polluting or the ones that are the best stewards. Why would people gravitate toward this option?
Hale: Best in class is really saying we're not going to take out everybody. We're going to just focus on those in the sort of transition to a low carbon economy, are handling that better than their peers and are sort of improving their sustainability performance in areas like managing their carbon footprint, energy, efficiency, maybe even investing in renewables. That's definitely a way to go as well.
Glaser: And then finally there is engagement. We hear a lot of this particularly from the passive index providers who have to own everyone. What's the case for owning them but then engaging with management to try to make a change?
Hale: Engagement is having a seat at the table with shareholder. We are seeing quite a lot of action on that front. Recently in the engagement world just last year for example 63% of the shareholders of Exxon, including their largest fund company shareholders like BlackRock and Vanguard and State Street, all voted to encourage the company to release regular reports to investors about the risk they face from climate change. BlackRock just announced they were indeed going to do that, just last month.
In addition, there is a group of investors called the Climate 100 Task Force that have bound together this year and said, we're going to coordinate our engagements with the 100 companies that have the heaviest carbon footprint globally to talk to them about how to reduce that footprint and what their plans are for the future. Certainly, engagement can be effective I think tilting portfolios toward best in class can be effective but so can fossil fuel divestment. They are not as mutually exclusive as they might seem. You can do sort of combinations of all three. I think investors have a choice here of paths they want to take. It's just really not that productive to say, one's good, one's bad-- I think they all can serve a purpose.
Glaser: Jon, thanks for walking us through that today.
Hale: My pleasure.
Glaser: From Morningstar I'm Jeremy Glaser. Thanks for watching.
Dan Rohr: Despite the appearance of steady growth in official GDP and other headline measures, China's economy has likely been cooling for the past several months. Morningstar's power proxy, which sums GDP-weighted sectoral electricity demand to estimate changes in total economic output, has signaled slowing growth since September. Deceleration is also evident in other alternative measures. For example, our raw-materials-based proxy of fixed-asset investment suggests spending growth slipped from about 3% in the third quarter to nearly zero in the fourth quarter.
That's important because fixed-asset investment accounts for 44% of Chinese GDP. We're also seeing some signs of softness in consumer spending, although not nearly to the same extent that we are on the fixed-asset investment side of the economy.
Why is China's economy slowing? Largely because the stimulus that led to the most recent economic upswing is being withdrawn. Historically, credit has led economic activity in China by six to 12 months, so the slowdown we're seeing now is a consequence of waning credit growth from earlier in 2017. With credit growth continuing to slow in the fourth quarter, we expect the economy will decelerate further in the first half of 2018, especially on the more credit-sensitive fixed-asset investment side of the economy.
Despite slower credit growth in 2017, economy-wide leverage continued to rise. We estimate total debt-to-GDP in China reached about 260% at year end. That was largely due to an increase in household mortgage debt. China's once lightly leveraged households now carry one of the heaviest debt burdens among major middle-income countries at nearly 50% of GDP. That's up from only 11% a decade ago.
While we continue to expect consumer spending to perform fairly well in the decade to come, especially relative to fixed-asset investment, the growing household debt burden is becoming a greater concern.
Vishnu Lekraj: With the announcement today of Amazon, JP Morgan, and Berkshire Hathaway forming a potential healthcare behemoth, many of the healthcare services firms have sold off over the course of this morning. However, we believe the sell-off is overdone.
In the past, many major corporations have tried partnerships in order to bring healthcare costs down. However, because their core competency is not healthcare and because this is a very dynamic and a very complex space, they haven't been as successful as what some industry analysts have believed. In addition, we believe the buying power of a combined trio of JP Morgan, Berkshire Hathaway, and Amazon will pale in comparison to what the healthcare services firms have built over the past several decades.
We believe, again, the sell-off here for many of these stocks is overdone. The moats for these companies, the wide moats for the PBMs and the narrow moats for the MCOs are still intact and will continue to allow these companies to produce significant competitive advantages and economic profitability over the next several decades.