Could Meta Make a Comeback?

Ivanna Hampton: Here’s what’s ahead on this week’s Investing Insights. Meta appears ready to make a comeback. What our analyst thinks about the latest moves from Facebook’s parent company. Plus, we look at three dividend stocks popular with income investors. And a new way to invest rippled through the financial markets 30 years ago. Morningstar’s ETFInvestor newsletter editor will join me to discuss the influence of the world’s largest ETF.

This is Investing Insights.

Welcome to Investing Insights. I’m your host, Ivanna Hampton. Let’s get started with a look at the Morningstar headlines.

Meta’s Earnings Beat Expectations

Facebook parent company Meta Platforms META appears well-positioned for a return to growth. The social media giant reported a better-than-expected fourth quarter despite factors like currency headwinds and macro uncertainty. Both drove down revenue. Meta also appears to have improved ad conversions on its apps. For example, that could include users clicking on an ad, watching a video, or buying something off an ad. That is likely to raise demand from advertisers and lessen the impact of Apple’s privacy policy on revenue. Meta’s network effect remains intact, as it saw daily and monthly user growth. Morningstar is pleased with management’s effort to bring costs under control while accelerating revenue growth. Meta’s aggressive share buyback supports our outlook. Meanwhile, we’ve slightly lowered our growth projections. It appears some advertisers are hesitant about more spending due to fear of a possible economic downturn. Morningstar is maintaining our $260 estimate of what we think the stock is worth. And we think it’s undervalued.

Amazon Tightens Its Belt

Amazon AMZN is tightening its belt while focusing on the long-term. The e-commerce giant’s sales reached almost $150 billion in the fourth quarter of 20-22. That was better than the company’s outlook and Wall Street’s estimates. However, the world’s largest online retailer’s net income fell far short of expectations. Online shoppers and cloud computing service customers reined in their spending. Amazon CEO Andy Jassy says the company will help cost-conscious customers spend less in this uncertain economy. He says Amazon has a robust pipeline of customers for its cloud platform known as Amazon Web Services. Morningstar senior equity analyst Dan Romanoff says he foresees cloud computing services, e-commerce’s rapid increase, and advertising driving healthy long-term growth. However, he says the near term remains a work-in-progress with macro issues weighing on 2023. Romanoff has lowered his estimate of what he thinks Amazon’s stock is worth by $13 to $137. But he considers it undervalued.

Pfizer Posts Record Revenue for 2022

Pfizer PFE posted record revenue for 2022 boosted by sales of its COVID-19 treatments. But it gave a lower-than-expected outlook for 2023 as the world emerges from the pandemic. The company expects to take hits on declining sales of its COVID vaccine and antiviral pill. That’s along with heavy investments into research and development as well as marketing. However, while the magnitude of the investments may be surprising, they should help Pfizer prepare for major patent losses between 2025 and 2028. The list includes big name drugs like Xeljanz and Eliquis. Morningstar expects Pfizer will face some pressure over this period but thinks the company is poised to largely avoid any big earnings declines. We don’t expect to change our $48 estimate of what we think Prizer’s stock is worth. We consider shares undervalued.

McDonald’s Strong Customer Traffic Offsets Margins

McDonald’s MCD return to prepandemic profitability could take longer than expected. The fast-food giant reported its fourth-quarter results and 2023 outlook. Earnings per share of $2.59 aligned closely with Morningstar’s forecast. Strong customer traffic offset softer-than-expected margins. The U.S. and international restaurant margins missed Morningstar’s forecasts. We now project slightly softer earnings growth in 2023, with a full recovery to prepandemic restaurant margins likely stretching out until about 2027. We continue to view McDonald’s as well positioned to navigate current headwinds like inflation, with its value-driven menu appealing to cash-strapped consumers. We’d expect McDonalds to benefit from customers trading down from full-service restaurants. Its growing loyalty program should also prop up traffic. Morningstar thinks McDonald’s long-term road map is intact. However, we lowered our estimate of what we think the stock is worth to $240. We consider shares overvalued.

SPY ETF Celebrates 30th Anniversary

Hampton: The world’s largest ETF is celebrating a milestone this year. SPDR S&P 500 ETF Trust better known as SPY has turned 30 years old. It’s the big 3-0.

I’m going to talk with Bryan Armour about SPY’s impact on the financial markets. Bryan is Morningstar Research Services’ director of passive strategies research for North America, and he’s also the editor of the Morningstar ETFInvestor newsletter.

Hampton: So, SPY launched in 1993. It was the new kid on Wall Street compared to other investments. Bryan, can we start with you describing what an ETF is?

Bryan Armour: An ETF is an exchange-traded fund. So, it’s exactly what the name implies. It’s a fund, like a mutual fund, that trades on an exchange, like stocks. What ETFs do is they pool investor money and then hold return exposure to stocks and bonds and other investments. And ETFs tend to be a little more cost-effective, tax-efficient than mutual funds. It’s just why we’re seeing ETFs grow in popularity.

Hampton: At the time of SPY’s launch, index funds’ popularity was growing. How did that help ETFs?

Armour: Index funds are highly popular now. But not so long ago, it would’ve been laughable to say that an investor would just accept market returns. Jack Bogle was a big trailblazer for index funds. And Vanguard was really starting to roll in the early ‘90s and gained some assets. And actually he made a comment in 1992, the year before SPY launched, that he believed that the Vanguard S&P 500 Index Fund would become the largest fund in the world and overtake Fidelity Magellan by the year 2000, which it did in 2000. Jack Bogle and a lot of the index fund advocates really laid the groundwork for SPY and for ETFs and to benefit from.

Hampton: SPY tracks the S&P 500 Index, and it falls into the passively managed camp. How has the ETF market evolved to include active ETFs?

Armour: Active ETFs have been around for a long time, but because of the way they started, what we were just talking about, ETFs are more synonymous with passive investing. But active ETFs have been more of a niche part of the ETF market. What we’ve seen in recent years is that in the last three years, basically, regulations changed, and we’ve seen a couple of big asset managers of active mutual funds come over to the ETF space and launch their first active ETFs. So, that’s Dimensional Fund Advisors, Capital Group, and T. Rowe Price, for example. They all launched their first ETFs in the last three years, and so we’ve seen active ETFs make a huge push forward. They’re only about 5% of the ETF market today, but they’re growing at a faster rate than the rest of the ETF market.

Hampton: SPY’s influence has spread over the last 30 years. Where does the ETF market stand today?

Armour: The ETF market’s booming. It sits at about $7 trillion of assets under management today. And it’s growing at a fast clip. One of the big offerings that ETFs have is they basically have thousands of strategies in the U.S. alone that cover every asset class, active, passive, anything any investor could ever want. And we’ve seen a big shift from mutual funds to ETFs. That growth in assets is only going to continue. In 2022, mutual funds lost about a trillion dollars in net outflows, and ETFs, on the other hand, took in $550 billion. So, there’s a big shift from mutual funds to ETFs.

Hampton: We’re talking about the big ETF market, but what’s made SPY in particular so successful since its debut?

Armour: SPY has been really successful in three different ways. Number one, attracting assets. And like I said, a lot of that goes back to the burgeoning index fund market and being an extension of that. But it was a novel product at the time as the first ETF launch in the U.S. And so that’s really helped. But also, in terms of performance, like the Vanguard S&P 500 Index Fund, it tracks the S&P 500, and it has a low fee. And that’s all it really took to outperform competitors. And in terms of U.S. stock funds that existed in 1993, when SPY launched, until the end of 2022, SPY was in the sixth percentile overall in terms of performance. And so that’s a huge boon to ETFs and for SPY. And it really set the tone for ETFs and made them a viable investment strategy.

And a large part of that was three quarters of the U.S. stock funds that existed in 1993 are no longer around. But even still, the ones that did survive, SPY beat 71% of them. It’s a testament to SPY’s performance, the novelty, the strategy that’s widely popular, but it’s also been successful in weaving itself into the fabric of financial markets. And by that, I mean SPY is the pinnacle of liquidity, and its options are used for a volatility index that’s similar to VIX. Its options are used for overlay strategies on ETFs and mutual funds. And it’s just the center of the trading world as far as stock exchanges are concerned. For example, the Vanguard S&P 500 ETF, which is ticker VOO, it’s catching up in terms of assets to SPY. It’s pretty close, not quite there, but SPY trades 20 times more per day than VOO.

Hampton: So, it’s getting some competition as we sit here in 2023. What do you think the future holds for SPY?

Armour: For that reason, the fact that it’s such an integral part of financial markets, I don’t see it going away for the foreseeable future. But like all new inventions, there are flaws that all the newer competitors might not have to deal with. And so, one of those is that SPY is actually a unit investment trust, which most ETFs are not. What that means is they can’t reinvest dividends or do securities lending to help reduce costs for their investors. So, it does put them at a slight disadvantage. But an even bigger disadvantage is their fee of 9.5 basis points, which is low overall, but there are S&P 500 ETFs for 2 or 3 basis points, like VOO or the iShares Core S&P 500 ETF, which is ticker IVV. VOO and IVV are hot on SPY’s tail, and so I expect one of those two ETFs to be the world’s largest ETF in the next few years.

Hampton: Well, we’ll just have to wait and see. So, SPY holds the title as the world’s largest ETF, but it’s not the world’s first, right?

Armour: No, it’s not the first. And a lot of people, they don’t know this, right? The first ETF was actually launched in Canada in 1990. And so, I just want to give a shoutout to Canada for coming out with the first ETF, which is the TIPS 30 Index ETF. So, it’s the best thing to come out of Canada since Jonathan Toews, for any Blackhawks fans out there.

Hampton: Oh, my goodness. We can have a whole conversation about that. But Bryan, thank you for joining Investing Insights today for your insights on SPY.

Armour: Thanks so much for having me.

3 Dividend Stocks for 2023

Hampton: You may be looking for some ideas to generate investment income. Here’s Morningstar Investment Management’s editorial director David Harrell with this month’s “3 Dividend Stocks.”

David Harrell: Hi, I’m David Harrell with Morningstar Investment Management. In this monthly video series, we take a look at the dividend prospects of three stocks that are popular with income investors.

First up this month is United Parcel Service UPS, a company that is approaching dividend aristocrat status. Dividend aristocrats are the companies that have increased their dividends each year for at least 25 years in a row, and UPS could earn that designation in 2025. However, UPS is also a stock where the rate of dividend growth hasn’t always kept up with the appreciation in its stock price. A little over a year ago, the stock was yielding less than 2%, but in early 2022, UPS raised its dividend by nearly 50%. That increase, along with an 18.9% decline in the share price in 2022, boosted UPS’ yield to more than 3%.

UPS just announced its dividend increase for 2023, which, as expected, was more modest that last year’s—a raise of about 6.5%. Last year’s increase represented a structural change in the company’s dividend approach, bringing the payout ratio higher; it also followed a year of extremely strong earnings growth. I believe ongoing raises will probably more closely track the company’s rate of annual earnings growth.

Next up is defense contractor Lockheed Martin LMT, which has raised its quarterly dividend rate by a consistent amount—$0.20—every year for five years running. However, that also means the increases have gotten smaller on a percentage basis. Still, the most recent raise represented a 7.1% increase, and five-year annualized dividend growth is a healthy 9.4%. But Lockheed is another example of how dividend growth can lag stock price appreciation, resulting in a lower yield. The stock currently yields around 2.6%, down from 3.1% a little over a year ago, thanks to the stock’s strong price return—nearly 37%—in 2022.

Finally, Paramount Global PARA was formed by the reunion of Viacom and CBS and rebranded as Paramount Global in early 2022. Full disclosure: I don’t own this stock, but my spouse does. While Paramount trades at a large discount to fair value and currently provides a yield of more than 4%, future dividend growth could be minimal. Morningstar analysts note that the combined firm will invest more aggressively in creating content and in revitalizing the cable networks and Paramount studio along with paying down the debt load. Management has made no mention of the dividend, or possible increases to it, in the three earnings calls held since the merger. And the current dividend represents more than half of consensus earnings for 2022, which will be released later this month, and a larger percentage for fiscal 2023. To me, this doesn’t seem promising for any near-term dividend increases.

I’m David Harrell with Morningstar Investment Management. Thanks for watching, and we’ll see you next month.

Watch “3 Dividend Stocks for January 2023″ for more in this series.