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Chris Higgins: The large-cap aerospace and defense names we cover have been consistent dividend-payers over the past decade, and we think this past history will continue over the next several years as the commercial aerospace cycle goes on strong and U.S. defense budgets increase.
Investors hungry for high dividend yields piled into defense stocks from 2010 to 2013. However, increasing share prices across the defense industry pushed yields down, and this trend was particularly pronounced in 2017 and 2018. The recent underperformance for defense names has meant dividend yields look a bit more attractive now, and while we don’t think we’ll return to the days when yields were pushing 4%, we do believe some names offer secure dividends, decent yields, and the potential for some growth.
Across our defense coverage space, Lockheed, Raytheon, General Dynamics, and Northrop Grumman all pay dividends, and they are all planning to increase their 2019 dividends relative to 2018. Lockheed and General Dynamics are currently offering the highest dividend yields in our coverage universe for defense. And we’d note that General Dynamics is a dividend aristocrat, having increased its dividend every year for more than 25 years. Lockheed has hiked its dividend for 17 years straight. We do think General Dynamics has a bit more breathing room with its dividend due to Lockheed’s relatively high payout ratio.
Turning to the commercial aerospace sector, Boeing is top of mind for many investors following the MAX groundings and the potential financial impact this could have on Boeing. Even with the recent pullback in Boeing’s share price, the stock is only offering a yield that hovers around the S&P 500’s. That said, we think Boeing should continue to generate prodigious amounts of cash flow over the next several years, and we believe that the dividend should grow at a double-digit rate on average over the next four years even after having increased 23% per year on average over the past four years. Unless an aviation regulator discovers a critical design flaw on the 737 MAX (something that we think is possible but very unlikely), Boeing’s dividend growth story is secure in our view.
Stefan Sayre: Vanguard’s patented approach of straightforward and robust portfolio design, combined with lower fees, gives its Gold-rated LifeStrategy target-risk series an edge.
There are four separate Vanguard LifeStrategy funds in this series. They maintain static equity allocations, which range between 80% and 20%, and hold the balance in bonds. Four highly rated Vanguard index funds underlie each offering. These provide exposure to U.S. and international equity and fixed-income markets. The fixed-income sleeve does have a higher quality and longer duration than most peers, and this may lead the portfolio to lag in credit rallies and in times of rising interest rates. However, we believe it should provide ample protection during periods of market stress.
The funds are capably overseen by Vanguard’s Strategic Asset Allocation Committee and Investment Strategy Group, who also manage Vanguard’s excellent target-date series. This target-risk series’ performance has been strong over long periods. Each fund ranks in the second quartile of its category over 10- and 15-year trailing periods through the end of February 2019. Future performance should continue to be bolstered by the funds’ lower fees, which are around 70 basis points lower than those of their average peers.***
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Are you better off buying an actively managed foreign-stock fund or sticking with an index product? Joining me to share some research on that topic is Dan Sotiroff. He is an analyst in Morningstar's passive strategies research group.
Dan, thank you so much for being here.
Dan Sotiroff: Glad to be here.
Benz: Dan, you and the team work on something called the Active/Passive Barometer. I think it's such interesting research where you go category by category and look at the performance of actively managed funds relative to their index fund counterparts. And I want to focus specifically on the foreign-stock piece of this because we've seen investors actually seeming to prefer passively managed products here quite recently. So, let's start with the foreign large-cap funds, where most of the foreign-stock dollars are. When you look at actively managed funds versus index funds, which have looked better?
Sotiroff: Well, it's interesting because it's kind of evolved over time. So, I think if you go back maybe 15-20 years, U.S. large-blend category active success rates are probably around 15% to 20%. If you went into the foreign large-blend category, which as you said that's where a lot of people have most of their money parked, the success rate has been notably higher, more like in the 30%-40% range. What you've seen over time is that has come down, and I think that's really just a byproduct of fees really coming into play. You have a lot more passively managed dollars out there. People are more aware than ever that fees are a big part of this. So, I think fees are probably the overriding thing. I think the other thing was, historically, active managers had some things they could do because you have so many more options in the foreign market space.
Benz: So, in terms of country weightings, downplay this country.
Sotiroff: Bingo. Exactly. So, you look 20-25 years ago, just underweighting Japan was a great move.
Benz: That was slam dunk, right?
Sotiroff: Yeah exactly, an easy one. And then even over the past 10 years as we've come out of the Great Recession, foreign stocks just haven't performed very well. So, when a market doesn't perform well, index funds tend to not look as good in the category against their actively managed peers, and really that's because active managers can do things like hold cash, maybe hold some more-defensive names, or even just hedge currency or hold U.S. stocks, they don't have that currency exposure. So, there are things that active managers can do to play around the edges that benefit them a little bit. But when foreign markets come back, it's probably going to hurt them in the long run.
Benz: How about a year like 2018 where foreign stocks performed pretty poorly? How did active funds do relative to index funds?
Sotiroff: They did come back a little bit, but I think what you're seeing, though, is those fees are starting to eat more into their returns. So, what you see in the foreign large-blend category, again, is they got knocked--the success rates got knocked, so they are coming down over time. And I think, again, as you see more and more of these foreign index-tracking funds and strategic-beta funds come into the play that are charging very low fees for similar style exposures, it's only going to erode active success rates in those categories.
Benz: Let's talk about some of the more specialized fund types. Starting with foreign small caps. These funds are less widely owned but nonetheless pop up in some investors' portfolios. When you look at the data, the long-term data, what do you see?
Sotiroff: So, the success rate again is much higher in that area because really what I see there is you didn't have as many options 10-20 years ago. So, you maybe had one or two passive funds in the category, and since there wasn't a lot of competition, you probably didn't have to cut your fees a whole lot. But what you are seeing now as time has moved on as more and more competition has moved into that space, you are seeing much lower fees. Again sort of the strategic-beta, simple market-cap index funds are moving into that space, much lower fees, similar style exposure, and they are really taking it to the active funds. And the success rate hasn't come down as much as the U.S. and the foreign large-blend categories, but I expect that it's going to in the years ahead. It's been pretty interesting to see how that space has evolved over time.
Benz: Emerging markets would appear to be an area where maybe if I am trying to decide between some sort of passively managed product or an active fund, it might actually give the edge to the active fund based on the data, what do you see when you look at long-term success rates?
Sotiroff: That's a good point. This is really more of a category-relative ranking. If you look at emerging-markets indexes, they are pretty heavily weighted in China right now. Most indexes are somewhere between 30% and 35%, depending on the actual composition of the index. So, that's a pretty heavy country weighting. It's going to be highly susceptible to the Chinese market, whatever it does. I think you actually saw that play out last year. China didn't do as well as the broader MSCI Emerging Market Index. So, that kind of hurt some of these index trackers. Active managers that underweighted China actually did a little bit better. Again, though, I think in the long run, fees are really going to count more than any of these country weightings. So, it's interesting to see what has happened over the past year in that category. It's indicative of what we would expect, but going forward, low fees, I think, are ultimately going to rule the day.
Benz: A related question: One comment I have heard is that in some of these very volatile categories, whether foreign small caps or emerging markets, that expenses are a less important differentiator than is the case in a category like foreign large blend, where the range of returns might be pretty tight. What do you think of that comment?
Sotiroff: It has been historically, but again, you see the low-cost competitors coming into the space--and it's just the fee differential. If we go back to the foreign small-blend category, the fee differential between a Vanguard fund that's charging 12 or 14 basis points and the average active fund that's over 1%, that's just a huge hurdle they are going to have to overcome, and I just see that as a really, really difficult task ahead for any active manager. I think, in general, if you're going to be in an active fund, you need to be cheap, let's say bottom-quintile at least in order to be competitive in those spaces and really in any of these categories broadly, because low fees are coming in, and it's going to be really, really competitive in the future.
Benz: Okay, Dan, interesting research. Thank you so much for being here to share it with us.
Sotiroff: You're very welcome. Thank you.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.
Susan Dziubinski: Hi, I'm Susan Dziubinski for Morningstar. Last-minute IRA contributions often get a lot of attention around tax time, but you don't hear much about the fact that you can also contribute to a health savings account for 2018 up to the tax-filing deadline. Joining me to discuss why eligible investors should give HSA contributions a look is Christine Benz, director of personal finance for Morningstar.
Christine, thanks for joining us today.
Christine Benz: Susan, it's great to be here.
Dziubinski: Now, how does contributing to an HSA help reduce your tax bill?
Benz: You will be able to deduct your contribution to a health savings account. And one key thing to know is that you can deduct that contribution regardless of whether or not you are an itemizer. So, even if you are not itemizing your deductions, you will still be able to deduct that HSA contribution and also, it doesn't depend on your income. In contrast with IRA contributions where, in order to be able to deduct that contribution, you have to be below income thresholds. Anyone of any income level can make an HSA contribution provided they are covered by a high-deductible healthcare plan.
Dziubinski: Now, there are other tax benefits to HSAs, correct?
Benz: You receive that deduction or if you are making it through your payroll you will receive--you will be able to make pretax contributions. But you will also be able to enjoy tax-free compounding as long as the money is inside the health savings account. And then when you pull the money out, provided you use the money for qualified healthcare expenditures, you can take tax-free withdrawals. So, the benefits, the tax benefits, are really the greatest if you are able to use non-HSA dollars to pay your healthcare expenses as you incur them and leave the money in the HSA to benefit from the tax-free compounding for the longest possible period of time.
Dziubinski: Can anyone contribute to an HSA or are there particular requirements?
Benz: The big requirement is that you are covered by a high-deductible healthcare plan, what the IRS considers a high-deductible healthcare plan. So, for 2018, for single people covered by a high-deductible plan, the plan had to have a minimum deductible of $1,350. For families covered by a high-deductible plan, the minimum deductible had to be $2,700. So, that's the big requirement. And importantly, if you wanted to make an HSA contribution for the 2018 tax year, you needed to be covered by that high-deductible plan last year and, of course, you needed to have not fully funded that HSA already.
Dziubinski: If you are making an HSA contribution on your own, what are the things you need to consider?
Benz: Morningstar has been doing some work on HSA plans, attempting to shed some light on what had, I think, up until we began to look at them, had been a pretty opaque area. So, the key thing is to take a step back and think about how you will be using that HSA on an ongoing basis.
So, many people use HSAs as they were originally intended: They use them to spend as they go. So, they pull from them to cover healthcare expenses. If that's your plan, if that's how you are using the HSA, you'd want to look for plans for HSAs with low maintenance fees and also good yielding savings vehicles, right, so you want to be able to earn the highest possible yield. If you are using it as a long-term investment vehicle, if your plan is to maybe leave that money undisturbed and actually get that HSA invested in long-term assets, you'd want to focus on all-in costs as well, but you'd also want to take a look at the investment lineup, and that's something that our team has been working on--evaluating HSAs on that basis.
Some people use a hybrid approach, so they might have the best intentions of leaving the money in the HSA undisturbed but occasionally pull from it. In that case, you'd want to look for both low maintenance fees as well as good savings yields as well as good investment options. And one HSA that our team has found looks good across all of these measures is HSA Authority. That was the top-rated HSA when we last looked at various health savings accounts.
Dziubinski: We've also talked in the past about the role that HSAs can play for people who are concerned about how they are going to cover long-term care expenses someday.
Benz: That's right. And so, I think people who are thinking about purchasing some sort of long-term care insurance policy should bear in mind that the HSA can be usable in this context. And so, I think it might help sort of deal with the psychological aspect of purchasing long-term care insurance--not a fun expenditure--but it's important to know that you can withdraw from your HSA to pay premiums up to the IRS' limits. And so, the limits do depend on your age. So, for people who are between ages 51 and 60, which is often prime time for purchasing long-term care policies, you can steer $1,580 in 2019 to cover long-term care insurance premiums. If you are between ages 61 and 70, that jumps up to $4,220 for premiums. So, that's something to keep in mind. I talk to a lot of retirees and pre-retirees; the long-term care issue is very much on their radar. This is something to think about in that context.
Dziubinski: Christine, thank you so much for joining us today. Lots of great food for thought about a pretty exciting new vehicle for people.
Benz: It is, Susan. Thank you so much.
Dziubinski: Thank you. For Morningstar, I'm Susan Dziubinski. Thanks for watching.
Alec Lucas: Gold-rated American Funds Europacific Growth and Gold-rated FMI International are both great options for exposure to non-U.S. stocks. Understanding their similarities as well as their differences can help investors decide which fund is right for them, and many may want to consider holding both as a complementary pair.
The funds’ similarities begin at the Parent level. Both are backed by advisors who are exemplary stewards. Each has built a robust investing culture characterized by stability, team-based collaboration, and a commitment to superior long-term investment results. Fees are competitive at both shops, and the funds’ managers pay those fees themselves, too, as each invests alongside shareholders in the funds themselves.
The funds differ in their mandates, approaches, and the kinds of portfolios that those different approaches give rise to. American Funds Europacific Growth is a growth-leaning fund that often has significant exposure to emerging markets, especially China. In contrast, FMI International is a value-leaning fund that largely steers clear of emerging markets and has opted not to invest in China because of concerns about its accounting and governance standards. Europacific Growth uses American’s signature multimanager approach. The fund’s massive $160 billion portfolio is divided into smaller, separately managed sleeves. Nine managers and two analyst teams in total have charge of the portfolio. Five managers come from equity subsidiary Capital World Investors and four from equity subsidiary Capital Research Global Investors. These two manager teams each draw on their own analyst teams and while they collaborate within their respective portfolio manager and analyst teams, they don’t share investment ideas across teams or across subsidiaries. This tends to enhance diversification in the fund’s 330-stock portfolio. The fund’s size, though, still makes mid-cap exposure a challenge and makes it more of a mega-cap-leaning strategy.
FMI International’s $7 billion asset base makes it much easier to hold mid-cap stocks. FMI International’s 10-person management team does not divide its portfolio into separately managed sleeves but makes decisions together. The managers build a much more concentrated portfolio of roughly 40 stocks. FMI International also distinguishes itself by systematically hedging foreign currency back to the U.S. dollar, whereas American Funds Europacific Growth’s managers have the ability to hedge but tend not to systematically make use of it.
Investors may find themselves gravitating toward one fund or the other because of their individual risk preferences, but many investors should consider holding the two funds as a complementary pair. Indeed, the two funds held together in equal proportions and regularly rebalanced would allow investors to profit from cyclicality in value versus growth stocks, foreign-developed versus emerging-markets stocks, mega-cap versus mid-cap stocks, and even the rise and fall of the U.S. dollar versus other currencies.
David Whiston: Our global automotive team expects mixed results for 2019 auto sales, with flat to negative year-over-year percentage growth for developed and developing markets such as China, the U.S., and the EU versus mid-single-digit to low-double-digit growth in emerging markets such as India, Russia, and Brazil. This growth comes from rebounding off of some softer years in recent times, especially in Russia, where sales took a big hit from sanctions and lower oil prices a few years ago, as well as in Brazil, which has battled inflation and now has more accommodative monetary policy and new labor laws that we expect will spur hiring, and in turn, vehicle demand. We see Japan as the exception among developed markets and actually growing 1% to 3% this year in anticipation of consumers pulling some 2020 demand into 2019 to stay ahead of a consumption tax increase to 10% from 8% in October this year.
For the U.S., we forecast about a 3% drop in 2019 light-vehicle sales to a range between 16.7 million and 16.9 million units. The year has started off not far from those levels with total sales down 2.6% through February. Car models remain out of favor and are down 8.5%, and light trucks have cooled, up just 0.3% in the first two months of 2019. We see continued penetration at the expense of car models because there's still many people out there driving a car over 11 years old, and we think those owners will want a light truck, such as a crossover, SUV, or pickup, when they eventually have to buy another vehicle. Another reason we expect more light-truck penetration is the Detroit Three have nearly exited cars altogether, with a few exceptions such as the Chevy Malibu. We believe fewer car options should lead to more light-truck growth over time, and a buyer doesn't have to sacrifice a lot on fuel economy anymore to buy a bigger vehicle.
Credit remains reasonably healthy, and New York Fed data shows originations to subprime borrowers is not out of control as we continue to see erroneously reported in the press. However, delinquencies over 90 days are rising. Despite a reasonably healthy lending environment, automakers are pulling back on leasing. With off-lease vehicles, per Cox Automotive, expected to peak this year at 4.1 million units versus just 1.5 million back in 2012. OEMs are wisely expecting some consumers to go back to buying used over new vehicles as used supply finally gets back to a more reasonable level following the massive plunge in used supply when new vehicles cratered during the Great Recession.
We don't think it's time to panic about U.S. auto demand, but we think the party is getting late, and Trump's trade policies around tariffs on foreign autos and the fate in Congress of the USMCA trade deal to replace NAFTA are big wild cards. Much of the fleet is old, and vehicles have more tech and safety in them than ever before, which can help bring people to showrooms, but a credit pullback favoring prime borrowers and more used vehicles to choose from says to us that there likely won't be growth in U.S. auto sales this year.