A Growing Dividend, and Did Active Make a Case?
We examine Duke Energy and discuss active equity funds' performance during the sell-off and more in this week's Investing Insights podcast.
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This week on the podcast, Andrew Bischof highlights the dividend of Duke Energy; Christine Benz and Jeff Ptak talk actively managed equity funds; Charles Fishman looks at FirstEnergy; Jason Kephart shares two entry points for alternative fund investing; and Alec Lucas highlights a Silver-rated fund worth a look.
Andrew Bischof: One utility we really like for its healthy and growing dividend is Duke Energy. Duke has a 4.6% dividend yield, and we think it will grow 4% annually over the next five years. Utilities are down nearly 14% over the past three months and have underperformed the S&P by 19%. One of the key reasons for utility underperformance is that the 10-year Treasury, to which dividend yields are compared as an income proxy, have risen to near 3% during this time, the highest it's been since January 2014. Duke is one of our most attractive names, trading at a 14% discount to our fair value estimate, and its 4.6% yield 100 basis points greater than the industry average. So we think you get both a solid dividend yield and potential for capital appreciation.
The source of Duke's dividend are high-quality regulated utilities with a stable cash flow generating profile. The company's narrow-moat subsidiaries operate in constructive, regulatory environments where we have high confidence that regulators will provide for an appropriate return on investments. Duke operates in Florida, which is experiencing above average customer growth as more and more residents move to the sunshine state. Florida also allows a 10.5% return on equity, well above the national average. Duke also has a large presence in North and South Carolina, which has provided for supportive regulatory treatment and attractive growth opportunities.
We expect Duke's dividend to grow 4% annually, slightly below our 5.5% projected earnings growth rate, as Duke sits at the high end of its targeted 65%-70% range. Supporting that dividend growth is $37 billion of growth capital to be spent over the next five years. These high-quality organic growth opportunities include the typical nut and bolt utility investments. Duke will invest in new natural gas generation, gas pipelines, renewable generation, and grid modernization. The company has consistently earned returns on invested capital above its weighted cost of capital, the hallmark of a strong narrow-moat business.
Additionally, you have what I think is one of the best management teams in the industry running Duke. They have successfully integrated acquisitions, moved the business away from commodity-sensitive markets, and secured above average returns from regulators all while managing expenses well.
To sum it all up, Duke provides an investor an attractive 4.6% dividend yield, significantly above its peer group, and potential for dividend growth. Duke is, in our opinion, a premium regulated utility trading at an unjustified discount to its peer, with what I think is one of the best management teams at the helm.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Did actively managed equity funds earn their keep during the recent market downturn? Joining me to share some research on that topic is Jeff Ptak. He is head of global manager research for Morningstar.
Jeff, thank you so much for being here.
Jeff Ptak: Thank you, Christine.
Benz: You took a look at how actively managed U.S. equity funds did during the downturn that we had in early February. Let's talk about how they compared to their passively managed counterparts.
Ptak: This was actually, albeit a very short period of time, actually a pretty good period for actively managed U.S. equity funds. Not quite 60% of unique active U.S. equity funds beat their benchmarks during that late-January, early-February period where we saw volatility spike. This came amid what's been a pretty desultory period for actively managed U.S. equity funds. They have really struggled. In a sense, this provided a bit of relief to those funds and investors in them.
Benz: One thing that showed up in your data was that the value-oriented funds, the active funds, actually did a little bit better than their growth counterparts. Let's talk about that.
Ptak: They did, yes. I would say that one of the bugaboos for the indexes recently has been energy. Energy has been an area that's been under pressure for quite some time. Some of those energy names where the index went down quite a bit. In aggregate, I think that we would say of the value funds that had energy exposure, maybe they were a bit light in it or they owned some names that didn't go down quite as much as the constituents in the index. That was an area where value-oriented active funds were able to make a bit of hay versus their value indexes, and that explains why the success rates were higher for those types of funds in this recent period and over the year-to-date period for that matter.
Benz: The question is, whether this outperformance that we saw with active funds during this very short period, whether that's persistent, whether there is any reason to believe that actively managed funds will continuously be able to show their mettle during periods of market weakness? Do you think that assertion really stands?
Ptak: We do hear that talk quite a bit, especially from active managers, whose interest it serves. There is a kernel of truth to the notion that active funds perform a bit better during downturns. When we have done research over the past two decades, U.S. equity funds in particular, what we have found is over rolling three-year periods they do tend to succeed more often in three-year periods when the indexes are down. They do tend to do a bit better in down market periods.
There's a couple of problems though. One is that we have far more up periods that we do down periods. The second is that we see active funds, they don't persist in their outperformance. If you look at a subsequent three-year period after a fund outperforms, it doesn't maintain that outperformance. It basically decays over time. That's when we look at longer-term measures, five-year success rates, 10-year success rates, the numbers are well below 50%. In fact, in some of the reports that we run like the Active/Passive Barometer, we find that the success rates in many categories are well below 30%.
Benz: That brings me to my next question, which is, if I want a fund or a group of funds in my portfolio that will consistently perform during those periods of market weakness, that I'm kind of looking for that downside protection, are there any characteristics that I should be looking for when I am shopping for holdings?
Ptak: After you kind of go through your progressions and make sure that you've got the right asset allocation that meets your goals--which probably supersedes everything--and you turn your attention to your actively managed funds, I would say that some of the things that we would look at as analysts is how does the manager articulate his or her strategy; are they absolute return-oriented or are they more relative-minded where they are willing to own less overvalued stocks but stocks that are overvalued all the same. Are they sector-concentrated; do they have big positions in individual names; how often do they trade; what sort of forethought does it seem they put into the positions that they put on in the portfolio? Those are all sorts of considerations that our analyst would try to take into account in making an assessment of how robust the risk management process or a particular equity manager has. It probably well serves investors to go through those same sorts of progressions when they are doing their own sort of diagnostics on their actively managed holdings in their portfolios.
Benz: You kind of hinted at this in an answer to a previous question, but when you kind of dial it back, get away from the periods of market weakness and look at the whole mosaic of market performance, you said that actively managed funds as a group don't look particularly compelling. A lot of advisors, certainly, and individual investors are kind of using that as an impetus to say, forget it, I'm just going to own an all-passive portfolio and call it a day. Is that a legitimate way to approach things, do you think?
Ptak: It is, and it isn't, which is a bit of a dodge. It is in a sense that I think that many advisors and investors are maybe recognizing their limitations, or they are recognizing that there are other considerations that take precedence over finding the most skilled active manager out there. Perhaps it's minimizing costs, perhaps it's calibrating their exposures, maybe it's driving higher tax efficiency--all of which can be facilitated more easily through a passive vehicle.
It isn't in the sense that you don't want to throw out the baby with the bathwater. There are some active funds that are out there that are manned by legitimately skilled investors that maybe have some sort of competitive advantage that they can wield over time. Sometimes it's prosaic as a cost advantage; other times it's time arbitrage. They are more patient than other investors for whatever reason; maybe it's because they have a very deep and experienced analyst team. You have to sift through that and do you pick-and-shovel diligence work to identify those managers. With perseverance it can pay off.
As you rightly point out, when we run the numbers, they don't lie. There's relatively few active funds that succeed over longer periods of time. It ranges anywhere from about 10% to 35% over a 10-year period when you take fund deaths into account. The odds are not in an investor's favor. That's why I think that most are probably better off, if they can't put in the work that they don't have to resolve, sticking with passively managed products.
Benz: I want to just poke at this value idea a little bit, backing away from down market periods and looking at active value funds more broadly. When I look at that Active/Passive Barometer, some of the value funds do look a little bit more compelling on a long-term basis, the actively managed funds. What do you think is going on there?
Ptak: It's probably a couple of things. One is, when we back up and think about the discipline with which fund companies introduce funds, they have tended to be a bit more disciplined when it's come to value strategies. And why is that? I mean, value is just not as sexy a story. With growth there tends to be narrative with it. It's a little bit easier to sell. I think the corollary to that is that many fund companies have been a bit less disciplined in bringing products out, and what that's meant is that many of those products, because there wasn't the forethought put into them have failed over time. Whereas with value, you've kind of got to have it steely resolve, the determination, really be committed to the underlying investment discipline. It doesn't mean they all succeed, but I think it gives them a bit more of a fighting chance.
The other thing which is a bit more cyclical in nature, we have seen growth over an extended period of time outperform value. What that tends to mean, value managers tend to be a bit less style-pure than their indexes. They might tilt a bit more toward core and towards growth whereas their index is going really stay in that left-hand column in value. That maybe gives them a little bit of an extra kick, a little bit of an extra tailwind, because they haven't loaded as much to value as they typically would. I think that's a bit more unique to the last five or 10 years than if we are talking about decades of market experience. I think that's probably also a factor that explains why value funds have had a bit more success in the last five, 10 years than have active growth funds.
Benz: That could be fleeting though?
Ptak: It could be fleeting, absolutely.
Benz: Jeff, always great to hear your insights. Thank you so much for being here.
Ptak: My pleasure. Thank you.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.
Charles Fishman: Over the past couple of years, the market has not been kind to unregulated power plants, or what is referred to in the industry as "merchant generation." Weak electricity demand, falling natural gas prices, and tremendous growth in wind and solar energy have squeezed margins. Many utilities have reduced or eliminated their exposure to this commodity-sensitive business, and we are confident that FirstEnergy will soon follow this path.
By 2019, we expect FirstEnergy's earnings will come entirely from fully regulated businesses in Ohio, Pennsylvania, West Virginia, New Jersey, and Maryland, many with wide and narrow moats. As such, we upgraded our moat rating from none to narrow.
Before power markets were deregulated, FirstEnergy was a fully regulated integrated utility. However, returning to its regulated past will likely require a big move: allowing FirstEnergy Solutions--or FES, its unregulated merchant unit--to fall into bankruptcy. We estimate this could cost shareholders a total of $1.7 billion for FES' unfunded liabilities plus a potential $1 billion settlement with creditors to avoid years of litigation.
Still, we think the stock is cheap, trading at nearly a 20% discount to our $40 fair value estimate and a 25% discount to fully regulated utilities. We think the market is too concerned about the pending bankruptcy, and, although costly, we are confident FirstEnergy can separate itself from FES. Once the market revalues FirstEnergy as the fully regulated and narrow-moat utility that it is set to become, investors should realize attractive upside.
Jason Kephart: Alternative strategies can be a good option for investors concerned about stock market volatility. For most investors, it may be daunting trying to choose a single alternative strategy or an allocation to alternatives.
Multistrategy funds take some of the guesswork out of the hands of the end investor and offer a more stable ride than many alternative strategies on their own. These funds combine multiple alternative strategies, like long-short equity, managed futures, and merger arbitrage into a single option. They are far less prone to big performance swings, like those seen in managed futures, so they should be easier for investors to stomach while still delivering some diversification benefit to a traditional portfolio of stocks and bonds. The drawback of these strategies is they tend to come at a higher cost than many standalone strategies. The average price tag is close to 1.5%.
Two of our top picks in the category are Principal Global Multi-Strategy and Litman Gregory Masters Alternatives. One thing both managers have in common is they focus on finding strong underlying managers, not trying to time alternative strategies. These funds could be a good entry point into alternatives for investors looking for diversification.
Alec Lucas: Silver-rated John Hancock Disciplined Value benefits from stable management and consistent execution. Veteran investors Mark Donovan and David Pyle have worked together since 2000 and comanaged the fund since 2006. They make good use of Boston Partners' strong bench of quantitative and fundamental analysts in looking for stocks that combine attractive relative valuations, positive momentum—business as well as share price—and financial health.
The comanagers generally invest with a one- to two-year horizon and pay heed but not homage to the Russell 1000 Value Index in building the fund's roughly 70- to 100-stock portfolio. Indeed, they only overweight stocks in the benchmark and make sizable industry and sector bets when warranted via company-level research.
The fund currently favors banking stocks like Bank of America, which has more than tripled the index's return since management added it in early 2016. That's helped the fund outperform over the past year through January 2018, and its record over that year is in keeping with its long-term record. Fees could be more competitive, and the strategy's size limits its market-cap flexibility, but it is worth a look.
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