Investing Insights: Facebook Risks and Values in MLPs

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

***

News surrounding the security of Facebook users' personal data has dragged the stock down 7% on Monday. The controversy may further justify Europe’s General Data Protection Regulation campaign, the enforcement of which will begin in May, and increase the probability of similar demands in the U.S. We've accounted for such risk, to a certain extent, in our model, which has much lower than consensus projections over the next five years, but the news is concerning, and we continue to analyze possible impacts from it on our valuation of Facebook and its peers.

In the meantime, even with the recent pullback in Facebook shares, they remain in 3-star territory, and we are maintaining our $198 per share fair value estimate for this wide-moat name. We continue to recommend investors wait for a wider margin of safety before investing in Facebook.

***

Jim Sinegal: The Federal Reserve announced that it will be continuing along the path to slow interest rate normalization today. The Federal Reserve Open Market Committee decided to raise the target federal funds rate by 25 basis points. That's not surprising, given the economic progress that's occurred over the last year. We've had significant job gains, the unemployment rate is low, consumer spending is up, as is business investment.

The one sticking point is still inflation, which remains below the Federal Reserve's 2% target. The Fed believes that this momentum in the economy will eventually raise inflation up over 2%. We've seen some small hints in the data, nothing yet to be concerned about, but the Fed is trying to get ahead of the puck here, so to speak.

In terms of what it means for the banks, regional banks are very sensitive to interest rates. Banks like M&T and Regions Financial are asset-sensitive. That means they'll continue to benefit as rates go up. On the other hand, we're going to start to see signs of increasing deposit beta going forward. Basically, that means the banks are going to be paying out more of these benefits from rising rates to customers. So, it's good for savers, not as much for bank investors.

We also think that higher rates will lead to growing advantages for banks with large bases of sticky, low-cost retail deposits. If you're not paying anything on your deposits at all, you have an even bigger advantage as rates continue to go up. Unfortunately, banks like Regions and M&T are 25% overvalued right now. Where we're seeing opportunity is actually in the less rate-sensitive credit card names. Capital One is undervalued right now, as is American Express. We like American Express' plans to reinvigorate their reward offerings and think that company is poised to do very well under new management.

***

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. As Berkshire Hathaway has grown in size, some analysts, including Morningstar's Gregg Warren, have raised concerns that the firm may have trouble growing as rapidly as it did in the past. While Warren Buffett is the world's greatest living investor, it's possible to find mutual funds that employ a similar patient, quality-conscious strategy and do so in a more nimble package. We reached out to our analyst team to identify three such funds.

Alec Lucas: FMI Large Cap's long-time manager, Patrick English, helped install the firm's now committee-based, value-oriented approach that has produced fantastic results over full market cycles. Their approach is very value-oriented in that they look for a meaningful discount to a company's intrinsic value. Their top holding is Berkshire Hathaway, but what makes them like Warren Buffett is not that they hold this company, but it is in how they invest in terms of looking for good businesses, trading at reasonable if not great prices. They are more prone than Buffett, perhaps, to take advantage of Mr. Market's 1:00 highs and lows and are willing to sell based on valuation. They also pay heed to Buffett's dictum that size is an anchor to investment performance. They pay close attention to the fund's capacity and are willing to close it to new investors to protect current shareholders. It's currently open, and it is worth investors' notice.

David Kathman: BBH Core Select is a Silver-rated fund that has a lot of Buffett-esque features. Managers Tim Harch and Michael Keller are big fans of Warren Buffett. In fact, Berkshire Hathaway is the fund's top holding as of Jan. 31 with about 7.5% of assets. On the whole, the managers pick stocks in a way very much like Warren Buffett. They prefer to own companies that dominate their market niches and which generate a lot of cash flow without having too much debt on their balance sheets. They also prefer to own stocks that are trading at least 25% below their estimated intrinsic value, which the managers estimate using a discounted cash flow model based on future cash flows. On the whole, they look for high high-quality companies trading at a discount, very much like Warren Buffett, and this fund is a great option for value investors.

Alec Lucas: Akre Focus' manager, Chuck Akre, and comanagers Tom Saberhagen and John Neff run a focused portfolio of few stocks. One of them is Berkshire Hathaway, but what makes them like Warren Buffett is not that they hold his company but it's rather in how they invest. They like to liken their process to a three-legged stool in terms of the kinds of companies they look for. The first leg of that stool is the business model that produces high free cash flow. The second leg is shareholder-oriented management. And the third leg is the ability to invest that high free cash flow in areas that will produce attractive rates of return. They have built a strong track record in managing money this way. They hold on to their companies for the long haul and it is worth a look.

***

Jeremy Glaser: Good morning. I'm Jeremy Glaser. Midstream energy companies took a beating last week after some regulatory changes. I'm here with Travis Miller. He's an equity strategist, to talk about what these changes are, and if he sees any values emerging.

Travis, thanks for joining me.

Travis Miller: Sure. Thank you.

Glaser: Let's talk a little bit about what happened last week. FERC is probably not an agency that a lot of people are familiar with, but it's a big deal when it comes to these pipelines.

Miller: Yeah, it's huge, and pipelines have had a terrible 2018 so far, and this just piled on. What regulators did, was essentially said, "OK, MLPs, you don't pay taxes. Those are all passed down to individual investors, so you shouldn't be able to charge your customers for taxes," and essentially said "We're changing the policy, you're going to have to cut rates so that you charge your customers, and no longer collect those tax rebates."

Glaser: If they can't collect these tax rebates anymore, does this fundamentally make that MLP model unattractive? Is this really an existential threat?

Miller: Yeah, it does. It does for several of the MLPs. The ones that are going to be most affected are the ones that have to cut their tariffs. If they have to cut their tariffs because they are not collecting the tax allowance, then it makes a lot of sense for them to turn into C-Corps, as we've seen a couple of them do.

Glaser: When you look at ones that maybe are going to be a little bit better off, or this isn't going to be a big deal for them, who do you think fits into that category?

Miller: Some of the C-Corps that own pipelines. Kinder Morgan, they turned into a C-Corp a couple of years ago. They're unscathed from this, and TransCanada also is one that's a C-Corp, has a lot of pipelines, and should be unscathed from any rate changes.

Glaser: Were any of the firms that do decide to stay as MLPs well positioned? Does the sell-off create any opportunities?

Miller: Yeah, we think the sector has several good values. We look at the MLPs that don't have material exposure to the potential impact from the tax allowance going away, and those are typically MLPs that have negotiated rates or rates that are already below market. Among those, we like Energy Transfer Partners family, Energy Transfer Equity among those. Also, Plains All American. All traded 20% or more discount star fair value.

Glaser: Overall definitely a big deal, a big change but still some values there?

Miller: Yeah, and we'd encourage people to watch out for the Enbridge family. Of any of them, we think those are the most affected. This would be Enbridge Energy Partners being the most affected, and Spectra Energy Partners.

Glaser: Travis, thanks for sharing your thoughts on these changes today.

Miller: Absolutely.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

***

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Morningstar analysts expect that their medalist funds will outperform over long periods of time, but they sometimes look underwhelming on a short-term basis. Joining me to discuss some funds that recently have disappointed on the performance front, but that we still think are great long-term picks, is Russ Kinnel. He is director of manager research for Morningstar.

Russ, thank you so much for being here.

Russ Kinnel: Glad to be here.

Benz: Russ, you and I were recently talking about Royce Special Equity. You said you get questions a lot from readers about why we still really like the fund despite the fact that when you look at its performance, it hasn't looked particularly spectacular recently. Let's talk about that. It's conservative-minded, that's part of it, right?

Kinnel: That's right. Even its longer-term record, if you look out 10 years, it's not very impressive. But there's still a lot to like. What I like is that it is a really conservative fund. It's a different fund. It's got some nice diversification qualities. Charlie Dreifus is looking for companies with really good accounting, clean balance sheets, and really is very picky about what he buys. The fund has consistently gained on its competition in down markets by losing less, but in really strong bull markets it's actually typically lagged. Given that we are about eight years into this bull market, the current trailing return periods don't look so good. But I still have faith because he is doing what he has always done, and I think there is a lot of value in that.

Benz: Small value funds as a group have been pretty disappointing recently, and this fund in particular has not looked great relative to other small value funds. One thing I wanted to touch on is the fact that there was the addition of an assistant portfolio manager recently. Does that clear up, I know there were some succession concerns on the team with this particular fund. We love Charlie Dreifus, but we're a little bit worried about what the next phase of the fund would be.

Kinnel: That's definitely one issue going forward is, Charlie Dreifus is already into retirement age. Certainly, you have to figure in at some point he will retire. But now, we at least see the clear successor, and I think we expect the strategy to continue. Of course, when you have a transition like that, there's always the question of will the new manager execute as well as the previous manager. Obviously, that's hard to know for sure, but he has had a long time to study with Charlie and really understand the strategy.

Benz: And it's a very accounting-intensive process …

Kinnel: Yeah, which is what I love. It's really different from a lot of other funds. Dreifus really digs into accounting and really gets to know all the companies and really avoids any companies with red flags in the accounting. To me, that's something different from what a lot of other funds have done, at least the extreme emphasis on that. Obviously, everyone looks at the books, but I think to a greater degree at this fund.

Benz: Another fund that I think fits the conservative mold well and hasn't looked so great recently is the Bronze-rated Dreyfus Appreciation. That's a large-cap fund, a very large-cap fund. Let's talk about that one and how investors should approach that fund and maybe not spend too much time worrying about near-term underwhelming results?

Kinnel: That's right. This is another one that you look at total return and you think why would make that a medalist, it really doesn't look impressive. There's a couple of reasons. One is, it's got a quality bent, and quality tends to do well in recessions because they are well-capitalized companies with good brand names. They hold up much better in down markets. Again, we haven't had a down market in a long time. Another problem is that the fund does have meaningful energy exposure and obviously, energy in the last few years has been pretty awful. Oil prices have rallied a bit. So, maybe it's not quite so bad today, but still, that's another headwind for the fund.

Benz: This is a fund that has very low turnover, right? It tends to stick with ...

Kinnel: Super patient, single-digit turnover, which again we really like. It's a dependable fund. The fund five years from is probably going to look a lot like it looks today. I think that's really great. But again, it doesn't look all that impressive today.

Benz: It might earn its keep on the downside though. Vanguard Short-Term Tax-Exempt Fund, a municipal bond fund, short-term. When I look across the board at its trailing long-term returns, noting to write home about, certainly, but you say real value there is in the risk controls.

Kinnel: Exactly. This is a fund that's at the shorter end of its peer group. It's got less duration and that means lower interest rate risk. It's almost a money market substitute. It's got a little more risk than money markets for sure, but still much less risk than its peer group and obviously lower fee so it doesn't need to take much risk. But again, that pays off in the down markets, but also you can just use it appropriately. If you've got other muni funds with longer duration, it can offset that. Just a very conservative fund. Again, when interest rates rise, it's going to do better. When interest rates are declining, when the bonds are rallying, it's going to lag. That's just a given.

Benz: Royce, Dreyfus, and the Vanguard Short-Term Tax-Exempt, all conservative versions within their category. That explains their recent underperformance. The last fund is Artisan International Small Cap. It doesn't really fit with that mold of the funds that we've just discussed. Let's talk about what's going on there. It's a fund we like. We've got it with a Silver rating, but its results haven't looked that great recently.

Kinnel: That's right. And we can't blame its conservatism. It's really about as risky as the typical foreign small-cap fund.

Benz: Which is kind of a risky category to begin with?

Kinnel: It is. It is. If you look at the bear market from '08-'09, this is a category and this is a fund that really got smacked--lost about two-thirds of their value. So not low risk. But the reason here is more just quirkiness. It's a fund that's got over 70% in Europe compared to about 30% for the peer group. It's got less in emerging markets, much less in Japan. It's kind of just going to have unusual performance relative to the peer group. It's also got big individual stock positions. Just quirky performance. We still have faith because Yockey's very long-term record is still good, and we don't see where anything has changed. He is very good at closing the fund so that it doesn't get too big …

Benz: And it's currently closed to new investors?

Kinnel: Yes, so that gives us faith that he is still doing what he has always done. It just hasn't worked out. I wouldn't position this as a conservative fund. It just appears to be a good fund that's just had a bad streak.

Benz: Just to follow up on the closing comment. Royce Special Equity, I know that's another one that's been closed on and off over the years. Where is it now?

Kinnel: It's open today.

Benz: Open to new investors. Russ, always great to hear your insights. Thank you so much for being here.

Kinnel: You're welcome.

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

***

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. So far in 2018 interest-rate worries have been spooking bond investors. Joining me to provide an overview of the bond landscape is Sarah Bush. She is director of fixed-income strategies in Morningstar's Manager Research Group.

Sarah, thank you so much for being here.

Sarah Bush: Thanks for having me today.

Benz: Let's talk about what has really been roiling the bond market so far in 2018. It seems that investors are concerned about interest rates, the pace of Fed tightening. I know you and the team are very much in touch with some of the top fund managers out there. What are you hearing in terms of their expectation about the trajectory and velocity of interest rates?

Bush: First just to start off with the Fed, you are right--the economy has been strong. I think, really importantly, the global economy has been strong. That's been something that's not been the case for several years. I think that people are looking at the Fed and sort of expecting, consensus is kind of three to four hikes during the course of this year. I think a lot of people think that's kind of getting priced into the market.

The next question then is, what happens to longer-term interest rates. If you are in an intermediate-term bond fund, you are not necessarily holding the shortest bonds, but you are a little bit farther out the yield curve in longer maturity bonds. We've seen rates on the 10-year Treasury come up pretty noticeably year to date. I think we're at 2.85 plus or minus today. We've been hovering around that.

As we talk to the managers out there, there's some diversity of opinion. I would say there aren't a lot of managers, with a few exceptions, there aren't a lot who think we are going to go way higher from this point. You hear people talking about 3%, 3.25% as being fair …

Benz: Not 5% or 6%?

Bush: Not 5% or 6% for the most part, there with a few exceptions. TCW MetWest Total Return, which is a fund that's been kind of bearish on interest rates, they have mentioned that they are getting closer to neutral as we're kind of moving toward that 3% number. One other view, PIMCO is a little bit more concerned that rates could go a little bit higher just because inflation is picking up, and I know we are going to talk about that a little bit later on.

One interesting thing though that I've heard is, we think everybody thinks they definitely see this increase. It could go on, but that at a certain that it might start to hurt risk assets and hurt the economy, and then you could actually see that as a reason why the Fed would slow down, and rates would come down eventually. Maybe not this year, but looking out a little bit further--not necessarily that we are kind of on this constantly upward sloping trajectory.

Benz: Right. And just to provide a little bit of perspective, higher interest rates, even though they hurt bond prices in the short term, they are not an unadulterated evil for bond investors, right?

Bush: Right. Exactly. And this is something Dan Fuss always says. He says I want rates to go up, because as a bond investor, yield is basically the bulk of your total return. Higher yields mean you are getting paid more, and you should have better outlook over the long term for your returns.

Benz: Let's talk about credit bonds. One thing we've observed is, certainly as interest rates have trended up a little bit, the credit-sensitive bonds have held their ground better than the high-quality bonds, certainly long-term high-quality bonds. When you talk to managers, what are you hearing about the outlook for credit in terms of how they are positioning their portfolios? Are they feeling a little bit more defensive at this point given the rally that we've seen in some of the noninvestment-grade bonds or the lower quality bonds?

Bush: Corporate bonds, if you look over the long haul, they have done very well since the credit crisis. We had some real weakness in 2014-15, but then post-2016 again they have done really well. It's definitely been a strong performing part of the market. Managers, I think there's a couple of pieces to this. First of all, if you think the economy is good, you should think corporate credit is going to do reasonably well. But, that being said, investors are not getting paid as much for the default risk, and we are getting late in the credit cycle. So, we've had a pretty long period …

Benz: It's been going on for a while.

Bush: … Right, where lower-quality credits are doing well. Even Loomis Sayles, which is always a pretty aggressive manager when it comes to corporate credit, they have been building cash in their portfolios. You look at a PIMCO, TCW MetWest Total Return, pretty conservative on credit. That's not an area where people are finding tons of opportunities today.

Benz: You mentioned inflation and anytime we do see the economy strengthening as it has been recently, and the jobs numbers have been pretty good, people get more concerned about inflation, and inflation, of course, is the natural enemy of anything with a fixed rate attached to it. What are you hearing from managers on the inflation front? Are they finding inflation-protected bonds more attractive or has that already been priced into the market? What's going on there?

Bush: Bond managers are always thinking about inflation. That's absolutely right. And we have seen, I think, people see inflation is firming up. But that being said, TIPS have actually, there's something called this breakeven inflation, which is sort of what's priced into the TIPS market, and that's come up a lot since its bottom in early 2016. I think, managers, you certainly hear some that still like the TIPS market, but I think there's a little less enthusiasm for it today just because valuations have caught up in TIPS.

Benz: When you look at non-dollar-denominated bonds, that's one pocket of the bond market that has done really well so far in 2018 as the dollar has declined a little bit, those bonds have done relatively well. Can you talk about how fund managers, like general fund managers of intermediate-term bonds, are they buying these non-dollar-denominated bonds? How are they approaching that in terms of positioning their portfolios?

Bush: That's interesting. If you think about a core fund, say, in Morningstar's intermediate-term bond category, you won't necessarily think that you have any exposure to non-dollar bonds. But some of the big shops have been using that as a tool, say, a PIMCO, or a Western Asset. That tends to be pretty small. You are talking less than 10% exposures in those portfolios or somewhere around there.

There are a few exceptions; Loomis Sayles Investment Grade and other Loomis Sayles funds as well, that's a shop that's used non-dollar quite a bit in their portfolios. They are pulling back a little bit as a part of that kind of overall de-risking. But it's something to pay attention to because it really can add some volatility to portfolios, especially when it gets to be bigger in size. World bond funds obviously are going to see more multisector funds. It's more common.

Benz: Let's talk about how bonds have performed so far in 2018. When equities have gone down, I think, a lot of investors take it as a matter of faith that when their stocks are down, their bonds will go up. We haven't necessarily seen that so far in 2018. What's going on there, and can investors still look to fixed income to be a reliable diversifier for their equity exposure?

Bush: Obviously, part of what's happened this year is somewhat what we have seen in the stock market, is worries about what's going to happen with rising rates. That's an interesting question, because for most of the past 20 years, bonds, and especially Treasuries, really high-quality bonds have done a pretty good job of moving in the opposite direction of equities …

Benz: They've been your best diversifier really.

Bush: Right, they are very, very good diversifiers. But if you look back further--BlackRock has put out some good information about this--if you look back further, sort of pre-2000, you actually see the opposite relationship. You don't know for sure what's going to happen going forward. Certainly, if rising rates are the problem for equities, bonds could be, bonds would be losing money at the same time. But a couple of things to remember. First of all, just because they are moving in the same direction doesn't mean the swings in terms of magnitude are the same. Your stock fund is probably going to be a lot more volatile than your bond fund in that situation.

Benz: There's a big difference between losing 10% and 2%.

Bush: Exactly. So, that's something to remember. Another thing that's interesting and again, this comes from BlackRock, is they were pointing out, which I think is a very important point, that cash is actually starting to yield again. It's been a very long time since that's been the case. My colleague Miriam Sjoblom wrote a Fund Spy a little bit back, earlier this year, talking about low-duration bonds are actually, because you've seen the short end of the yield curve, shorter maturity bonds yielding more, that can be an interesting place to go. Obviously, cash isn't volatile at all, but short-duration bonds, even though they can move around a little bit if rates rise, you're not seeing really big losses on that. That can still provide some diversification if you're worried about where the equity markets are and you're looking for a little bit more ballast in your portfolio.

Benz: Sarah, great guidance. Always terrific to hear your insights. Thanks for being here.

Bush: Thanks very much for having me.

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

***

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Rising interest rates have roiled the bond market so far in 2018. Joining me to discuss the state of the municipal bond landscape is Beth Foos. She is a senior analyst with Morningstar.

Beth, thank you so much for being here.

Beth Foos: Thanks for having me, Christine.

Benz: Let's talk about rising interest rates. It's interesting when you look at the high-quality taxable bond funds, they have actually done a bit worse than muni funds so far in 2018, and of course, it's early days. What do you think is going on there?

Foos: It's really difficult to know exactly what's driving the difference in performance between the taxable market and the tax-free market. I will say that Morningstar's long-term category is rather small, and it includes some funds that are very long. They have a lot of sensitivity toward rising rates. With that, the muni market is also long, and I think, honestly, it's been propped up in the last couple of weeks because of promising supply and demand dynamics. That's really what's giving it the edge over the taxable counterparts.

Benz: Let's talk about that, because we did see that giant tax package passed in the late hours of 2017. Let's talk about the interplay there with the muni market. You said there was a big rush to issue new municipal bonds in 2017. First, why was that, and what were the implications for how munies performed or how you expect them to perform in the future?

Foos: The debate over the U.S. tax reform alone was enough to provide a significant amount of activity in munis in the fourth quarter of 2017 as you said. Issuers rushed to the muni market to get their deals passed before the Jan. 1 start date for the new tax bill. That resulted in muni issuance in December of 2017 which was roughly about $70 billion, which was three times what December of 2016 saw.

Benz: Why were they rushing to get the deals done and to get the bonds to market?

Foos: They weren't quite sure exactly what was going to pass, what was going to be included and excluded from that particular bill and how that would impact the market moving forward. Because we saw all of that issuance come forward in December in particular in 2017, there has been a lull in supply in the early parts of 2018 which they expect to continue moving forward. That should bode well for current muni investors if that demand holds up.

Benz: Let's talk about that. From an individual taxpayer standpoint, there might be increased demand for munis, because in high-tax states, for example, people are able to deduct less than they could in the past. Do you think that that will be a tailwind for the muni market going forward?

Foos: That is something that market participants are hoping. There are new limits on tax deductions for certain individuals, and in those high tax states that should make munis more attractive for them as they try to keep their tax bills down.

Benz: There aren't that many tax breaks you can take advantage of anymore; municipal bonds remain one.

Foos: Right. On the other hand, there are some aspects of the tax reform bill that could actually dampen demand moving forward. Participants are looking to track those aspects as well. In particular, with the decrease in the corporate tax rate, that may make muni bonds less attractive for, say, banks and insurance companies that are traditionally large holders of municipal bonds.

Benz: How about from a credit picture standpoint? When you look at the overall health of the municipal market, health of municipal finances, are things kind of holding steady? I know they have been improving with the exception of a few high-profile basket cases like Illinois. Is that still the case?

Foos: That is. For the most part, we would say that the overall credit quality, the credit picture of the muni market is strong, default rates remain pretty low. Most states right now are reporting general fund operating revenues as stable or as growing, which kind of coincides with that stronger U.S. economic picture that we have seen. With that, like you said, there are still some pockets of concern that we will continue to watch. The debt issued by the struggling Puerto Rico and Illinois and New Jersey. But those aren't big new stories in the muni market. They haven't been surprises for anyone.

Benz: The last thing I want to talk about with you, Beth, is the passive funds landscape. In the past, everyone went with active products for their municipal bond exposure, active funds. But we have seen increased number of passive products coming to market. What do you and the team make of those funds today? Have you issued ratings on them, and do you think any of them are any good?

Foos: We have seen an increased number of passive options in the muni market, particularly in the last three years, which has been really interesting. Several of those ETFs have earned strong Morningstar Analyst Ratings. I think a solid option for folks that are looking for that kind of exposure is a Bronze-rated iShares National Muni Bond ETF. MUB was one of the first entrants into this space, I want to say, in 2017, and it's the largest, it's most liquid, and it's offered just at 25 basis points.

Another strong option is Silver-rated Vanguard Tax-Exempt Bond Fund. Vanguard launched that fund in August of 2015 and it features an ETF as a share class and that's offered at a very low 9 basis points.

Benz: That's an index product. Vanguard has a suite of actively managed muni funds as well but that's an index product.

Foos: That's an index product. Both of those funds track very closely to the S&P AMT-Free Muni Index, which is focused on higher-quality bonds. The returns might lag a bit as investors reach for yield as they have over the past couple of years. I still think they are very strong options for folks looking for that indexlike product.

Benz: Beth, always great to get your insights. Thank you so much for being here.

Foos: Thanks for having me.

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