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This week on the podcast, we dig into TripAdvisor and Chipotle earnings; Michael Kitces talks about clumping charitable donations; Jason Kephart looks at how liquid alts funds performed during the sell-off; Alex Bryan says passive investing isn't hurting competition; Russ Kinnel shares fund winners and losers during recent volatility; and Vishnu Lekraj says Walgreens has an uphill battle with their acquisition plans.
Dan Wasiolek: We see two key takeaways for investors from TripAdvisor's positive fourth-quarter results. The first is marketing efficiency and the second is a stabilization in revenue growth. During the quarter, TripAdvisor saw over 400 basis points of marketing leverage driven by improved data analytics that allowed the company to identify and eliminate unprofitable marketing channels. We think this can continue to be a driver through 2018.
Despite the lower marketing costs, TripAdvisor saw stabilization in its sales growth, with revenue growing 2% in the quarter above our forecast calling for 2% decline, aided by a new user interface and TV campaign, both of which launched last summer. These initiatives, along with the company's intact network effect, should position the company, in our opinion, to reaccelerate revenue growth to a low-double-digit level starting in 2019.
Although the share price has moved up in response to the report, shares still trade at a discount to our fair value, leaving an opportunity for investors to own a high quality name at a discount.
We're hard-pressed to find a better fit for Chipotle's CEO position than Brian Niccol, the former CEO of Yum Brands' Taco Bell division who will join the company on March 5. Under Niccol's leadership, Taco Bell has been one of the bright spots in U.S. quick-service restaurants. We believe his appointment confirms our thoughts about Chipotle being open to more aggressive measures to drive sales and improve operations, and expect Niccol's influence to lead to new approaches to menu innovation, marketing, mobile technologies, and restaurant experience while elevating the Chipotle brand-intangible asset.
In fact, we believe many components of Taco Bell's U.S. strategies can be dropped into the Chipotle turnaround playbook. These include adding new products; increasing mobile ordering and one-to-one marketing efforts; expanding ways to reach consumers outside restaurants, including delivery; and upgraded restaurant aesthetics.
There is no change to our fair value estimate, narrow-moat rating, or standard stewardship rating until we have greater visibility regarding Niccol's strategic priorities. We do acknowledge upside to our longer term comparable sales outlook of 3% is possible if he can translate aspects of Taco Bell's recent operational success to Chipotle.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. The recently enacted tax legislation makes it much less likely that many taxpayers will itemize their deductions. Joining me to discuss what's going on with deductions as well as some strategies for taxpayers to consider is Michael Kitces; he's joining me via Skype.
Michael, thank you so much for being here.
Michael Kitces: My pleasure. Thanks for having me.
Benz: Many of these tweaks mean that for many taxpayers the standard deduction will be larger than their itemized deductions, but when you talk to clients and kind of think about strategizing, do you believe that there are some opportunities to potentially cluster your itemized deductions together in certain years and potentially get more bang for those itemized deductions and actually find some years where your itemized deductions exceed the standard deductions? Can you talk a little bit more about that strategy?
Kitces: I think we're going to see a lot more focus on this; lower SALT caps, lower mortgage deductions, the giant category of miscellaneous itemized deductions subject to 2% floor are all gone--that had everything from tax preparer fees, investment advisory fees, unreimbursed employee business expenses--most of these have gone away. Because of that a lot of people may not be over the standard deduction every year, but they might get there if they bunch some of their expenses together. We call this a deduction lumping and charitable clumping. Trying to take various deductions we have and mash them all together in single years to see if at least in one year we can jump over the line.
Now unfortunately because we lost miscellaneous itemized deductions and the other categories are more curtailed, it will be hard for us to do this because we are going to keep bumping into some of these caps. But for anybody that is not all ready at the $10,000 cap for SALT deductions this means you are going to just focus more on the timing of your state estimated tax payments. The timing of your property tax payments if you are in a county that actually allows you to prepay your property taxes. You might, say, prepay your 2019 property taxes and pay your 2020 property taxes all in 2019, so that you can try to get over the line in that particular year or at least make sure you are using all of the $10,000 cap.
For a lot of folks the primary way they'll do this actually is with what we call charitable clumping. So taking charitable contributions, if you give regularly to a charity, saying, instead of giving our regular annual gift we're actually going to do several years worth of gifting upfront into a donor advised fund, where we can get the deduction all at once in one year try to get over the standard deduction line. Then if we only want to gift certain dollars out every year, we will give the money out incrementally over time from the donor advised fund to the charity we're trying to give it to. And so it gives us an opportunity to bunch the deductions together but then still spread out the charitable giving over whatever timing we otherwise want to do it.
Benz: You mentioned donor advised funds Michael, let's just quickly recap what those are for people who aren’t familiar with them and how they can be such a nice fit for people who want to do this charitable clumping that you are talking about.
Kitces: The basic idea of a donor advised fund is, you can think of it like a holding tank for your charitable contributions. When you put money into the funds, you get a charitable deduction as though you were giving to charity, but the money doesn't actually leave the fund and go to a charity until you direct the funds to make the distribution. It gives me a way to put lots of money in now if I want to get all my deductions at once, but then have the donor advised fund dole the money out to my actual end charities--my church, my synagogue, my arts organization, whatever it is--over time. If you know you make regular gifting anyway and you have plans to keep doing it, rather than giving $500 a year or $1,000 a year or $10,000 a year or whatever you are giving number is, try to do more of it all at once in a single year so you can get over the line and get more of a deduction, and then make the distributions out of the donor advised funds whenever you actually want the charity to get the money.
Benz: In the meantime as long as the money stays within the donor advised fund it can earn at least some return that will not be taxable to you because it doesn't belong to you anymore nor will it be taxable to the charity.
Kitces: Right. If you have some money that you are setting aside and earmarking toward charity anyway as long as it's yours it's taxable. When it grows inside of a donor advised fund, it actually grows tax-free because it is all earmarked for charity at this point. You can get a little bit more leverage out of the dollars as well as you are building them up to donate in the future.
Obviously with the caveat for any of these strategies, you have to have the cash available to do it in the first place. We see people taking more of a focus on just timing of cash flows, can they afford to do things like prepay taxes and even when we are looking at strategies like charitable clumping--well maybe I don’t have the cash flow to do several years of charitable giving upfront, but I could donate an appreciated stock into my donor advised fund, get a tax deduction, and then repurchase the stock with the money I would have given to charity over the next few years. Eventually I end up at the same place, but I lump the deduction into one year in order to get the deduction through.
Benz: Lots of moving parts, obviously, Michael. Thank you so much for being here to provide some guidance on these issues. It sounds like this is also a spot where a financial advisor or a tax advisor could probably give you a lot of good insights about your next steps.
Kitces: Absolutely. I think we're going to see a lot more effort in looking at multiyear tax planning going forward as we try to plan out, when are the cash flows coming and which years can we get over the standard deduction line and which years can we not, particularly for married couples. Because that lower SALT cap is a pretty big gap to where married couple standard deductions are, especially married couples that don't own a home.
Benz: Great point. Thank you so much for being here, Michael.
Kitces: Absolutely, my pleasure.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. How did defensive liquid alternatives funds fare amid the recent market correction? Joining me to discuss that topic is Jason Kephart, he's a senior analyst in Morningstar's Manager Research Group.
Jason, thank you so much for being here.
Jason Kephart: Thanks for having me.
Benz: Jason, let's start by talking about the universe of liquid alternatives mutual funds. It's a broad basket, right? Not all of these funds are set up to be defensive.
Kephart: It's a very diverse category, and you definitely have different degrees of defense being played across categories. Long-short equity are going to have some net equity exposure, so when markets are down pretty reliably they're going to be down too, in general. Except for maybe some exceptions, but the two categories I think people think of as most defensive are managed futures and market neutral.
Benz: Let's talk about those categories. First, what they do, because I think they may not be so familiar to many investors. Then let's talk about this window that we had recently into equity market volatility, bonds not performing so well, either. Let's start with market neutral and talk about that category; what it does and how it fared recently.
Kephart: Market neutral funds are basically long- and short-stocks in equal amounts. What you're doing is basically eliminating any equity market exposure. They shouldn't really be driven by directions in the broad market. If the S&P is up or down, that shouldn't really drive the performance of the market neutral fund. What's going to drive it is the stock-picking skills of the manager. If their longs are outperforming their shorts, when markets are going up or down, then they're going to be profitable and vice versa.
Benz: During this period of equity market volatility, the very recent period, how did the funds do?
Kephart: They held up pretty well. The category average was down about 1%. There's two distinct substrategies within market neutral. You have the equity market neutral, where managers are picking stocks based on fundamental characteristics or risk premia. Then you also have merger arbitrage strategies, which are basically betting on announced mergers and acquisitions. The merger funds held up very well, because even though there was a lot of volatility in the stock market, deal spreads didn't really widen that much.
Benz: Define deal spreads before we go further.
Kephart: The deal spread is when a company announces they're going to acquire another company, typically the company that's being acquired won't go exactly to the closing price; there will be some kind of a spread between the announced price and where the company trades at. The bigger the risk of the deal not going through, that's going to reflect in the deal.
Benz: So it will be wider.
Kephart: Yeah, the deal spread.
Benz: Those strategies did really well, so funds like Merger Fund, for example, held its ground.
Kephart: Yeah, Merger Fund, Arbitrage Fund, they were both down about, I think, a little bit less than 1%. Compared to the Vanguard Total Bond Market ETF, they held up a little bit better. They did provide that downside protection you're looking for from an alternative strategy.
Benz: Let's take a look at managed futures. First, let's talk about what those funds are set up to do.
Kephart: Managed futures funds are trend followers, and they can go long or short across multiple asset classes, typically equities, interest rates, commodities, currencies, and they're going to follow the trends wherever they lead them. They're not trying to predict, which ways the markets are going to go. So in a period, like we just had, where the correction was a quick reversal of a lot of long-term trends that we had seen in equity markets going up, recently commodities had been on the upswing, particularly, oil. In the correction, you saw all of these trends quickly reverse, and that's kind of the recipe for disaster for these kinds of strategies.
Benz: When you look at performance among this subset of managed futures funds, not so hot during the recent sell-off?
Kephart: They also are very volatile strategies. The average fund, it has a target volatility of about 10%, which is about two thirds of what the equity market's been historically, although it's pretty high compared to recent volatility levels. On average, the managed futures funds lost about 7% or 8%, which, given that stocks were down about 10% over the period, it's not a disastrous scenario, but it definitely wasn't the kind of crisis alpha that managed futures funds, I think, had been known for. In the tech bubble and in the financial crisis, they performed very strongly and were up quite a bit, while everything else was down, but in this period, they got whipsawed along with everyone else.
Benz: If they're trend chasers, or trend followers, it seems like there's a lot of opportunity for them to do very different things, to be following different trends. Did you see a big gulf, in terms of best to worst performers during this recent period?
Kephart: No, it was everyone kind of fell together. Because, I think, most of them were all long-equities because the trend in equities had been so strong.
Benz: For so long.
Kephart: For so long, and, also, we had seen interest rates creeping up, so they were short interest rates too, most likely. When interest rates, even though bonds didn't do that well, interest rates held up pretty well, so that didn't really help them either. And commodities fell, so it was kind of just everyone suffered a lot.
Benz: You referenced that the managed futures funds have actually done alright when stressed tested in previous crises. Can we step back and look at the more defensive liquid alts? When you take the long view and, of course, the funds, on average, have not been around that long, but can you talk about how they've performed in previous periods of equity market weakness?
Kephart: Most liquid alt funds, I think, only half the funds that are around today have even a three-year track record. We've only had really these small little corrections to really judge how they're going to do. Managed futures, in general, though in the hedge fund world, do have a longer track record. They did very well in 2008 and in 2000. The difference between their bear market performance and these short-term corrections is really the speed and how quickly the markets are falling. In 2008, the market peaked in October 2007, and so you had this long downward trend that accelerated in the fall of 2008. The trend was always going the same direction. Then when the magnitude really increased, they benefited from it. What they're not going to do well is these short-term reversals. They're not going to protect against corrections, probably, if they're very sharp in nature.
Benz: I guess, my question is, if someone has a well-diversified portfolio, meaning that they have high-quality bonds, they have stocks, maybe they have a cash allocation for near term needs. Do these funds serve a role in a portfolio at all?
Kephart: They're definitely not right for everyone. They're not a must-have for every portfolio, but I think they are a useful tool to more diversify a portfolio. For the most part, you should be looking at them as an equity substitute, because even though market neutral is not going to be driven by the direction of the equity market, they don't have the safety net of bonds. Even if bonds are doing poorly, they're going to be down 1%, 2%, maybe. Equity market neutral funds could go either way. That's a risk that, I think, you really want to keep in mind. You don't want to add more downside risk to a portfolio.
Benz: With managed futures, should I also be thinking of that as maybe an equity substitute?
Kephart: Absolutely, an equity substitute because it's quite volatile, and you could have very big swings in performance, both for the upside and downside. You want that to take the place of some risk assets.
Benz: Last question for you Jason is, the liquidity, the liquid alts funds, the idea there is that you'll be able to come and go as you want. Is there, potentially, a mismatch with the types of assets that they own, or do funds try to control for that issue?
Kephart: Funds tend to control for that. Managed futures are trading only futures contracts, which tend to be very liquid and they're sticking to very major markets. Liquidity is not really an issue in those funds. Equity market neutral funds are going to be trading equities, which, again, tend to be very liquid. They don't go very small down the size ladder. Where you'd be worried is more in the credit area, and we've mainly seen funds steer on the side of caution when it comes to it.
Benz: Overall takeaways though is, keep my position size relatively small if I go at all, and use this to supplant equity market exposure versus some sort of bond exposure that I might otherwise take away from.
Kephart: Yeah, and you really want to judge them over a full market cycle. These corrections are good stress tests to make sure things are within reason, within expectations, but you wouldn't want to extrapolate too much from any short-term period.
Benz: OK, Jason. Thank you so much for being here.
Kephart: Thank you for having me.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Does the uptake of passive strategies reduce competition within industries? Joining me to share his take on that thesis is Alex Bryan. He is director of passive strategies research for North America for Morningstar.
Alex, thank you so much for being here.
Alex Bryan: Thank you for having me.
Benz: Let's discuss how actively managed funds tend to differ from their index fund counterparts in terms of how they assemble portfolios. Your typical active manager might take a position in one or two companies within an industry and might bet more heavily on those companies. Actively managed products tend to differ from index funds in this respect. The index funds would tend to assemble more diffuse portfolios. They would tend to own all of the companies within an industry, right?
Bryan: That's right. Index funds typically will own all the stocks in the index. A lot of times if you look at your broad market-cap-weighted funds, that's going to include most stocks in an industry. That means you are going to own competitors, both Ford and GM. Active managers, in contrast, oftentimes will have more concentrated exposure to the names in a given industry that they think are the most promising. They might have a bigger concentration in Ford than an index manager, for example.
Benz: It's not immediately intuitive why the uptake of index products would lead to less competition in industries. Can you walk us through that thesis, why that assertion might be made?
Bryan: The thinking is that if you own several competitors within the same industry, your incentive is not necessarily to maximize the value of your individual company but rather to maximize the value of the entire industry. You might behave in a way that a more concentrated owner would not by using your influence as an owner in many different competitors to discourage competition to maximize industry profits or to not pressure individual companies to compete as aggressively as a more concentrated shareholder might.
For example, let's say, I invest in both American Airlines and Southwest. On both of those companies I would prefer them to compete less aggressively than they otherwise would if I just invested in one or the other.
Benz: You would prefer them to, kind of, pick their markets and charge as much as they can for them and not compete head to head, for example?
Benz: Let's talk about your thesis, which is that, you don't think that at this point at least this is a big deal and certainly, not something that regulators should be approaching with a heavy hand. You don't necessarily think that the growth in indexing leads to less competition within industries. Let's talk about why that is.
Bryan: That's right. I don't think there's a strong reason to believe that increase in common ownership would lead to less competitive behavior because, number one, most corporate managers are heavily incentivized to act in their own firm's best interest. It's a stretch to imagine that I, as a corporate manager, would adopt less competitive behavior to help out my competitors when my compensation is tied to the value of my stock price and my bonus is tied to my profits and growth metrics and things like that.
Benz: And that's the case for most corporate managers today.
Bryan: Exactly. That's the first point. The second point is that this whole argument that an increase in common ownership leads to less competitor behavior is really the same thing as saying that if you took common owners out of the picture, it would be in firm's best interest to compete more aggressively with one another. And that's not necessarily the case. A lot of times if I were to compete more aggressively, that will elicit a competitive reaction that could actually hurt my profits. For example, let's say I'm American Airlines and I want to take market share away from Southwest and one way I might do that is by cutting prices on a particular route. Well, if I do that, Southwest is likely to respond in kind and we will both be left with lower profitability. Knowing that, it can be in both firms' best interest not to compete more aggressively. I think, most firms have already found the optimal level of competition given their competitive landscape. If you take common shareholders out of the picture, it's not necessarily the case that they would compete any differently than they already are right now.
Then if you take these two bits aside and you assume that this argument or the intuition behind it is right that maybe there is something to this idea that I would want to maximize the value of my portfolio, it isn't necessarily the case that index funds or common owners would stop at the industry level. They would have an incentive to maximize the value of their entire portfolio. It may actually be in my best interest to encourage more competition among airlines because airlines represent a very small part of most index funds' portfolios and most diversified portfolios. Airline prices are input costs for most publicly traded firms. More competition there might actually benefit me as a more diversified investor. I think it's important to look beyond what's going on at the industry level and to look more holistically at the impact of competition on the overall diversified portfolio.
Benz: Let's take a a look at the specific industries that you referenced were examined in the study, banking and airline industries. Are there any particular things going on in these industries or things that were going on in these industries over the time periods examined that maybe make them somewhat anomalous and not necessarily representative of corporate America as a whole?
Bryan: The time period that both of these studies were looking at, trying to tease out the impact of an increase in common ownerships on competitive behavior, they were looking at data from the early 2000s on through about 2014. During that time period, in both industries, there is a tremendous amount of consolidation, where lots of airlines were merging and many of them went through bankruptcy and emerged from bankruptcy which more rational pricing strategies. The same thing happened in the banking industry.
It's really hard to disentangle that effect from the impact of an increase in common ownership. Obviously, index investing has become more popular over that time period but also there has been an increase in concentration in those industries. It is very difficult to isolate the impact of common ownership on competitive behavior. In order to be convinced that this is something you should be worried about, I really do think there needs to be more empirical evidence of this in other industries and in other markets. I think it's really too early to act on this preliminary research because there is no really good theoretical underpinning for the argument.
Benz: Interesting research. Thank you so much for being here to discuss it with us.
Bryan: Thank you for having me.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.
Karen Wallace: Volatility returned to the market in a big way last week, taking many investors by surprise after the recent tranquility. Here to discuss which fund categories held up the best, and performed the worst, is Russ Kinnel. He's director of manager research, and he's also editor of Morningstar FundInvestor.
Russ, thanks for being here.
Russ Kinnel: Good to be here.
Wallace: Let's start off by talking about some of the suspected causes of the volatility. What was going on in the market last week?
Kinnel: I think we're still trying to figure out what was going on. We know that worries of inflation were growing, and interest rates were rising in response to that. The rest of it is anyone's guess, it's really hard to tell at this point.
Wallace: Which fund categories were the hardest hit last week?
Kinnel: Interest-rate-sensitive ones were among the hardest hit--long-term bonds, real estate and utilities, both of which are yield-driven, were really hard hit.
Wallace: On the flip side, which categories did pretty well last week?
Kinnel: Large growth did well, at a relative basis, as it lost less than small value. Bank loan funds do well because they reset their interest rates as interest rates rise, so they're better protected. Foreign equity funds did better because they're exposed to foreign currencies, and when the dollar falls they will lose less in a market like this.
Wallace: If we're going to put this in sort of a larger context, how should investors think about a one week performance of a fund?
Kinnel: I think it tells you something about where their exposures are. Obviously you can't read anything about manager skill. It's just kind of a blip, but it still gives you some sense of where their bets were, if nothing else.
Wallace: For example, we downgraded a fund from Neutral to Negative, the LJM Capital and Preservation Fund, because it became clear that they did not have proper risk controls for their options-writing strategy. Can you talk about that a little bit?
Kinnel: This is a really unusual case, this is a fund that lost 80% of its value in one week. What they're doing was shorting volatility, and that really blew up on them, obviously they were taking a tremendous amount of risk. And then on top of that it appears that they had margin calls, had to sell at very fire sale kind of prices, and took another hit on top of that. It's really been a mess. They're also posting their net asset values late; we still haven't seen a new one since Feb. 7, so we've missed a couple days of net asset values. It's really unclear exactly what's going on, but it's kind of shocking for really just a modest downturn, and a modest spike in volatility.
Wallace: Russ, thanks so much for the update, and thanks for being here.
Kinnel: You're welcome.
Wallace: For Morningstar, I'm Karen Wallace. Thanks for watching.
Vishnu Lekraj: On Monday it was reported that Walgreens has approached AmerisourceBergen about a merger. While this may be a surprise to some analysts, we've expected this for a while, as Walgreens has purchased about 26% of AmerisourceBergen equity and has integrated a good deal of its operations with the drug distributor.
However, we are uncertain that this deal makes a lot sense from the point of view of AmerisourceBergen. We've assigned the company a wide moat and believe it has deep competitive advantages moving forward. Walgreens, on the other hand, we believe has a no-moat business, and it will struggle over the long term. Thus, we believe a premium above $106 fair value estimate for AmerisourceBergen will be needed in order for this deal to be consummated.
Additionally, we believe this deal is going to be very complex and very hard to pull through as far as operations integrations go. Thus, we believe it will be very hard for Walgreens to convince AmerisourceBergen's management team and their shareholders to go ahead with this deal.