Investing Insights: Upbeat Earnings and Kinnel’s Picks

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

***

Strength in Google's advertising, cloud, and hardware offerings helped accelerate overall revenue growth from a year ago, leading to better than expected results for parent Alphabet.

While the better than expected first-quarter revenue helped beat expectations on the bottom line, we note that the growing traffic acquisition costs, plus further investments in data centers and content acquisition, continue to push gross margin lower, as we expected.

Alphabet's network effect and data economic moat sources continue to drive growth in the size and overall usage of Google's ecosystem which help the firm remain the behemoth in online advertising and gain further traction in enterprise cloud.

Our fair value estimate of $1,200 is intact as our higher revenue forecast was offset by a slightly lower margin assumption for 2018 and beyond. Alphabet shares are currently trading in 3-star territory, but we would recommend investing in this wide-moat and high uncertainty rated name on any pullback.

***

Sonia Vora: Coca Cola's first-quarter results tracked in line with our expectation for the year, with our organic sales up 5%, including a 1% contribution from price and mix. We plan to maintain our longer term forecast, which calls for mid-single-digit sales growth, and average gross margin above 65% over our forecast period.

Concentrate volumes were especially strong in the Europe, Middle East, and Africa and Asia Pacific segments, with volumes up 9% and 5% respectively. Trademarked Coca-Cola was the largest contributor to unit case volume growth, which was up 4% during the quarter.

We were particularly impressed by strong performance in the diet soda category, with Coca Cola Zero Sugar growing volume at a double-digit clip. However, new product innovation and distribution growth also helped the firm's top line. During the quarter, the retail value of Topo Chico, a sparkling mineral water brand, grew retail value by over 30%, and Fuze tea was launched in 37 countries in Europe.

Shares are trading at a low double-digit discount to our valuation and have more than a 3% dividend yield, which we view as an attractive entry point for this wide-moat name.

***

Facebook shares rose this morning after the firm reported better than expected first-quarter results, while posting growth in daily and monthly active users, which we think is indicative that the firm's all-important network effect, a key source of its wide economic moat, is intact.

The results also provide some support for our view that the firm can regain user trust and weather the Cambridge Analytica and overall data privacy issues it is currently facing. We don't expect a significant long-term headwind to Facebook's platform, operations, or wide-moat rating.

Based on Facebook's first-quarter results and management guidance, we slightly adjusted our revenue growth assumption upward, but this did not move the needle on our $198 per share fair value estimate for the firm.

Despite the rise in shares today, we still see the firm as undervalued and believe investors have been presented with an attractive margin of safety.

***

Karen Wallace: Rising interest rates have held back returns in most domestic bond categories in 2018, but the bank-loan category is in the black for the year to date. Here to discuss some of the performance drivers and some of our analysts' picks in the category is Brian Moriarty. He is an analyst in our fixed income manager research group.

Brian, thanks so much for being here.

Brian Moriarty: Happy to be here. Thank you.

Wallace: First off, let's discuss what bank-loan funds are and how they work.

Moriarty: A bank loan is a debt instrument that pays a floating coupon. This coupon is pegged to three-month LIBOR. So, as LIBOR rises so will the coupon paid by the bank loan. Now, this also works in reverse. As LIBOR falls so will the coupon paid by the bank loan. But this means that bank loans are one of the few fixed-income instruments that is protected from rising interest rates.

Wallace: They don't take on a lot of interest-rate risk, but they are subject to other types of risk.

Moriarty: Correct. There are two primary risks associated with bank loans. First is credit risk and liquidity risk. On the credit side, bank loans are issued by below investment-grade-rated companies which means bankruptcy is a very real concern. On the liquidity side, bank loans are still technically private securities, which means they can take seven to 20 days to trade and settle. Now, this is a significantly long time, longer than high-yield bonds or other securities. Taken together, this increases the risk of the securities and they can fall significantly in scenarios like 2008 when the bank-loan category lost 30%.

Wallace: With some of those risks in mind, does it make sense for every investor to have a bank-loan allocation? Or how should people think about using bank-loan funds in their portfolio?

Moriarty: Investors should really look at bank loans as comparable to high-yield bonds. If they already have an allocation to high-yield bonds in their portfolio, then they might want to consider bank loans. One thing to keep in mind is that bank loans are actually senior to high-yield bonds in the capital structure, which means that they will hold up better during a sell-off than a high-yield bond and in bankruptcy, they actually have a higher recovery rate. Think of them as a more defensive form of credit risk. But unless an investor is already willing to take that credit risk, bank loans are not for them.

Wallace: Finally, what are some bank-loan funds that you and the team recommend?

Moriarty: On the conservative side of the category is a fund like Pioneer Floating Rate or Voya Floating Rate. These are the very defensive higher-quality funds for a conservative investor. Moving out into the middle of the risk spectrum is a fund like Credit Suisse Floating Rate High Income which plays a little bit more tactically based on valuations. At the most aggressive end is a fund like Eaton Vance Floating-Rate Advantage, which actually uses leverage to boost its returns.

Wallace: Thanks so much for being here to discuss this.

Moriarty: Happy to be here. Thank you.

Wallace: For Morningstar, I'm Karen Wallace. Thanks for watching.

***

Andrew Bischof: PPL is a regulated utility trading at a 20% discount to our fair value estimate in an industry we view as currently fairly valued. PPL has two key segments: one in the U.K. and one in the U.S. The international regulated delivery segment operates distribution networks providing electricity service to customers in the U.K. The domestic unit consists of Pennsylvania and Kentucky utilities that are involved in regulated electricity generation, transmission, and distribution.

We believe the market is overly concerned about PPL's exposure to the U.K. The U.K. political environment is increasingly putting pressure on the region's regulatory conditions as concerns around high electricity prices have raised the ire of consumers and politicians.

We believe the bulk of the pressure will remain on the country's electricity suppliers, which account for a majority of the consumer electricity bill. PPL owns transmission and distribution assets only and does not own an electricity supplier. We recently lowered our long-term rates of return for the unit, and we believe the market's assumptions are overly pessimistic about the long-term profitability of the unit. While returns will likely be lower, we expect a regulatory construct that will support investment in the U.K's infrastructure.

PPL has attractive regulated growth opportunities that could produce 5.5% earnings growth in our five-year outlook. The company benefits from operating in constructive domestic regulatory jurisdictions, with nearly 80% of PPL's planned capital expenditures having little or no regulatory lag. During the next five years, PPL plans to invest nearly $16 billion at its regulated utilities, including wide-moat transmissions investments, supporting our earnings growth outlook.

In our view PPL's valuation is attractive, trading at a 20% discount to our $35 per share fair value estimate and yielding 6%, a full 150 basis points above the utility peer average. We forecast the dividend to grow 4% annually. We believe market concerns over the U.K. offer investors an opportunity to pick up a narrow-moat utility with sound regulated utility operations with a very healthy dividend yield.

***

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. T. Rowe Price has been crowded out of the spotlight in recent years as investors have flocked to passively managed products. But Morningstar's director of manager research, Russ Kinnel, still thinks the firm has a lot to offer. He is here with me today to discuss some of his favorite T. Rowe Price funds.

Russ, thanks for being here.

Russ Kinnel: Good to be here.

Benz: Russ, let's talk about T. Rowe Price. As I mentioned, the asset flows haven't been there as many investors have been gravitating to index products. But let's talk about what's been going on behind the scenes at T. Rowe Price. There have been some notable manager departures as well as executive departures as well, correct?

Kinnel: That's right. Brian Rogers, their leader, has retired. As we've discussed before, a number of their managers are near retirement age or not too far from when people at T. Rowe typically retire. We've seen a couple more retire. There is a transition going on. I was visiting them a year ago, and I was really happy to see that they have really developed depth behind those managers. They have really improved their analyst staff. I feel pretty good about T. Rowe today.

Benz: It historically has been a firm that we have felt has a really good culture internally and also a shareholder-friendly culture?

Kinnel: Yeah, very shareholder-friendly. They are straightforward. You get exactly what they tell you they are going to deliver. The costs are pretty reasonable. When there is a manager change, they handle it really well; that is, they typically will have a transition of a couple of years as the new manager learns the ropes. Even when that new manager takes over, they tend to keep the strategy very similar. It's pretty easy to buy one of their funds and hold on.

Benz: Let's talk about any problem spots or areas for concern when you think about T. Rowe as a firm. You mentioned potential succession strategies. They have done a good job historically hanging on to managers, but we may see some more veteran managers depart before it's all over. Any other things that are on your radar?

Kinnel: It's really hard to come up with the weaknesses for T. Rowe. Their international equity is maybe not quite as good as domestic. A lot of their domestic funds we have rated Silver or Gold, whereas their international tend to be more Bronze-rated.

Benz: Let's get into some of your favorite T. Rowe Price funds. This is not an exhaustive, inclusive list. There are other funds you like, but you picked out a few that you think are worthy of investor attention. One is T. Rowe Price QM U.S. Small Growth. Let's talk about what that QM stands for.

Kinnel: It's for quantitative. This is quant strategy. They have three traditional, fundamental actively managed small-cap funds, but those tend to be closed and have a lot of money in them. It makes sense when you have that situation to come up with a quant fund because the quant fund can generate its own research and not crowd the same stocks that the other funds are owning.

Benz: It can generally handle a little more capacity than the actively managed funds can do. Let's talk about why in particular you think this is a good pick.

Kinnel: Some quant funds are kind of black boxes and it's kind of hard to understand. But this one is kind of straightforward fundamentals. It's things like cash flow yields and earnings quality and fairly straightforward things. A little bit of momentum, but it's a pretty small component. They just do a really nice job, very diversified, as you say. That helps them to have a lot of capacity because they have got a lot of names. It's about 300 names with none over 1% of assets, so a very diffuse portfolio. Really steady performer under the manager, Sudhir Nanda. Just kind of consistently performing in that second quartile which is a very T. Rowe Price-like thing to do.

Benz: That's what I was thinking. Right. Let's look at T. Rowe Price Real Estate. This has long been one of our favorite real estate mutual funds. It's Gold-rated. The Small-Cap Growth fund you just talked about is Gold-rated as well. Let's talk about Real Estate. It's got a veteran manager. What else do you like about it?

Kinnel: We don't talk about a lot of sector funds here in part because they are hard use and manager turnover. Here you've got David Lee with 20 years on the fund, consistent investor. Just done a really good job of picking the right real estate names, very straightforward, like we mentioned at the beginning, buys U.S. REITs, not a lot of surprises in that portfolio. Just a consistent performer, and you can really depend on what you are buying is going to be what you are going to get five years from now.

Benz: That's kind of a hallmark of T. Rowe Price in general that if you buy the mid-growth fund, it's going to have most of its assets in that mid-growth square of the style box.

Kinnel: That's right. They really care about style, and they also will try and keep their sector managers around. It's not just a stepping stone. It's a really attractive place to find sector funds.

Benz: Your last idea is a bond fund, the last fund that you like. This is T. Rowe Price Tax-Free High Yield. Let's talk about why you like it. It, too, has a veteran manager. Then I also am hoping you can spend a little bit of time talking about how such a fund can be used in the context of a broader portfolio.

Kinnel: It's a high-yield muni fund, and obviously that means you are taking on some risk. High-yield munis can be kind of treacherous every once in a while, things go south with them and the more aggressive ones have gotten caught up in things like Puerto Rico. This fund has largely avoided those issues. Jim Murphy has been running the fund since 2001. So, again, you've got a really experienced manager. T. Rowe always uses the cautious side, or almost always. I like that. Diversified is always a good thing to do in a bond fund. You like the T. Rowe fund for this kind of strategy because most investors don't really like to lose money in their bond fund. If you've got an aggressive strategy in high-yield munis, it's nice to have one that at least doesn't go too far and is aware of the risks and doesn't take any big risks for you.

Benz: But nonetheless, this is not the type of fund that I would want to own as my whole muni fund? I should have high-quality exposure and maybe use this around the margins?

Kinnel: Exactly. This is a smaller part of a portfolio. Because you do have credit risk munis are kind of a quirky area. I would not want to go whole hog into a high-yield muni. They are naturally sensitive to credit issues. If you go back to '08, you will see there were some significant losses in this fund and pretty much every high-yield muni fund. You don't want to make it a core holding. I think it is more of a role player.

Benz: Russ, thank you so much for being here to discuss your picks today.

Kinnel: You're welcome.

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

***

Seth Goldstein: Wide-moat Compass Minerals shares have fallen roughly 10% since the company issued profit guidance below expectations as a part of its fourth-quarter earnings release. Investors are concerned that the operational issues facing Compass might represent a new normal for the company's earnings power.

We view a sell-off of this magnitude as unwarranted and believe the adverse news flow has created an attractive entry point for a high-quality, wide-moat stock. We continue to see near-term catalysts that will aid Compass' profits, which should drive share prices higher.

First, our thesis that winter weather has historically exhibited mean reversion tendencies remains intact. The 2017-2018 U.S. winter saw increased snowfall relative to the past two winters. Historically, harsher winters have led to increased deicing salt prices as local governments need to replenish inventories. Higher salt prices should drive profit growth for Compass in the second half of 2018 and into 2019.

Second, Compass Minerals is navigating operational issues at its cost-advantaged Goderich rock salt mine, the crown jewel of its asset base. However, we expect the company to fully restore normal operations at the Goderich mine and resume the mining of lower-cost salt in the second half of 2018.

At its current share price, Compass Minerals is trading in 4-star territory, representing attractive risk-adjusted return potential relative to our $82 per share fair value estimate.

***

Kevin Brown: We are lowering our moat rating for the big three healthcare REITs--HCP, Ventas, and Welltower--to no moat from narrow moat. However, we maintain our Exemplary stewardship for Ventas and Welltower and believe there is significant value to be found in these companies' high-quality, well-diversified portfolios. Of these three companies, Welltower is currently our favorite name in the space.

The first baby boomers will turn 75 in three years and the 80-plus population will double over the next decade, increasing demand when they first start to move into these properties. High current supply and a severe flu season are causing senior housing fundamentals to turn negative in 2018. However, construction start data suggests that we are currently at peak supply, the severity of the flu season is a one-time event, and these issues are more than offset by long-term baby boomer demand. We remain confident that these companies are well-positioned to benefit from the increasing healthcare needs of an aging population.

Rising rates have also weighed heavily on these companies' stock price. However, we think that the sell-off from rising rates is an overreaction and misses the long-term value that the healthcare companies have spent years cultivating. The companies are all trading below their net asset values, indicating that the public market is pricing these companies below where the private market values the underlying real estate.

Our fair value estimate for Ventas and Welltower is above our net asset value due to our belief that the Exemplary stewardship that these companies exhibit will create value through leveraging relationships and operational expertise to drive higher internal growth. Finally, all three healthcare companies currently have dividends in the mid-6s that are well covered.

If investors are willing to overlook some short-term supply disruption in the senior housing space, we believe these companies are well-positioned to benefit from long-term demand for their assets.