Investing Insights: REITs With Nice Yields, Value Investing

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

***

Kevin Brown: Real estate investment trusts are excellent investments for income-oriented investors, so we want to highlight three companies that are paying above-average dividends.

Mall-REIT Macerich combines not only a dividend yield near 7%, but is also trading at a significant discount to our fair value estimate. While 2019 might be a rough year for the company as it deals with store closures and redevelopment expenses, we think Macerich will be a much stronger company once they release these empty spaces to higher-quality tenants. Long-term investors should be rewarded with years of solid growth emanating from turning around these stores, and in the meantime can collect the company's high dividend. However, there are significant risks to Macerich's plan, so risk-averse investors should be cautious.

Park Hotels & Resorts is another REIT that income-oriented investors should consider given the company's current mid-5 yield. Given that Park's portfolio is in many markets with below-average supply growth, and that management is only midway through a years-long process of improving hotel operations, we think that Park should see industry-leading NOI growth over the next few years. However, given hotels' sensitivity to the overall economy, Park is another higher-risk company that could underperform if leading economic indicators turn negative.

Investors looking for a defensive name that has a 5% yield should consider healthcare REIT Ventas. While senior housing is going through a downturn due to high supply, the pace of construction starts suggests that supply should fall off just as demand from baby boomers picks up. Even during the great financial crisis, Ventas maintained and then raised its dividend, so we think they present a safe investment with upward-trending fundamentals.

In summary, there are several REITs that income-oriented investors should keep an eye on for both high dividend payouts and potential capital gains.

***

Karen Wallace: Hi, I'm Karen Wallace for Morningstar. No one wants to run out of money while they are in retirement. Often the logic that goes into determining portfolio withdrawal rates in retirement weights this risk rather heavily. The thinking is that it's prudent to keep spending conservative and think of the upside as the icing on the cake. But are we putting too much emphasis on that downside risk? Here to discuss this is Michael Kitces. He is a financial planning expert.

Michael, thanks so much for being here.

Michael Kitces: Thanks, Karen. Good to be here.

Wallace: So, you've recently wrote a blog post where you discussed the upside of sequence risk.

Kitces: Yes.

Wallace: Can we sort of unpack that term for those who might not be familiar?

Kitces: So, idea of sequence of return risk is that what your wealth accumulates to over the long run as well as kind of what you've got left in retirement or how long it lasts is driven not just by literally the returns you get. Like, obviously, if you get higher returns, there is more money; if you get lower returns, there's less money. But also, the sequence that the returns come. Because once you are taking distributions in retirement, you run this additional risk that you get great long-term returns, but you get there by having a terrible start and a wonderful finish. Which means if you are taking money out, you could run out during the bad period before the good returns ever show up.

And that phenomenon in the research is coalesced around this idea of taking the--I guess, now famous--4% Rule that says, if you want a safe sustainable number in retirement, you draw out 4% of the initial account balance and you adjust your spending each year for inflation and it lasts for 30 years even though there's a lot of bad sequences in there. If you just withdrew based on average returns, you could actually withdraw about 6% to 6.5%. But we haircut from 6% down to 4% to defend against this risk of what happens if I get my long-term returns, but I get there in a bad sequence along the way. We are going to hold back the spending a little early on just to make sure we don't spend too much too quickly in a bad sequence.

Wallace: So, it's bad returns at a bad time?

Kitces: Yeah, bad returns at a bad time and I'm taking money out and then eventually, the good returns come, but there's so little portfolio left because you got bad returns and you took money out on top that you just literally don't have enough powder left for when the explosive upside returns come and the portfolio doesn't make it to the end. That's this phenomenon that we call sequence of return risk, and it drives you to spend more conservatively than you might just based on return expectations alone because it's not just do we get the returns, but do we get them in, at least, a not horrible sequence.

Wallace: You also made a point in your post that I thought was interesting and that's just sort of the way the math works. The way that wealth compounds is that you can get exponentially more on the upside and there's something like a 10% chance that your portfolio will decline in value.

Kitces: Yeah, this shift towards the 4% rule of, hey, we got to defend against sequence risk, the origin of that as a study done almost 25 years ago by a financial planner and probably not coincidentally former engineer who dug deep into these numbers and actually looked at all the different historical sequences we'd had through--basically all the market history we had available--about 100 years of data and tried to figure out what was the worst sequence we'd ever had, the one worst sequence we'd ever had. And he said, let's take that as our withdrawal rate. The number was about 4.15%; he rounded it to 4.1%; the industry rounded it to 4% and that's where the number came from. It was literally the withdrawal rate that would work in the one worst sequence we'd ever seen in our U.S. market history.

So, it gives you some reasonable comfort. Like, even if we go through another great depression, if it's anything like the last one, the last one was pretty horrible, you would still make it, so some reasonable security. The problem is, if you even just merely get average returns, you are spending 4%, long-term balanced portfolios on average have done about 7% or 8%, and you are going to compound this for 30 years. And so, what we find is, if you actually draw at a 4% safe withdrawal rate, good news, you've made it through every bad market scenario we've ever had in U.S. history. But the flip side is, on average, you more than double your wealth left over. Like, not only do you not risk your retirement nest egg, if you get merely average returns, you double your nest egg.

Like, take all the retirement savings you've been working on for your whole life, double it, don't touch any of it, leave all of it to your kids. Which is usually not the goal we hear from most retirees. I mean, I know some would like to leave a nice legacy for their family and there's nothing wrong with that. But for most retirees that we talk to, the goal is something in the effect of, I would like to spend my money in retirement and enjoy it, which means not don't touch the principal or double the principal and leave it all left over. It's like I want to enjoy my money in retirement. And so, we get this tension now that if the sequence is bad, I need to take 4% so I don't run out. But if the sequence is anything less than bad, I finish with way, way, way more money that I never actually spend and enjoy that I meant to because that's what happens when I dial down on the most conservative possible level.

Wallace: So, there's a risk that by being too conservative with your spending in retirement, you are not maximizing your portfolio, you are not enjoying your wealth?

Kitces: Well, I think, it's more of just you are not maximizing your enjoyment of your wealth. You'll actually do a great job maximizing your portfolio if you let it grow and don't spend it, it's going to go off to the races and compound. And what we find when we actually run the numbers--the origin of the 4% Rule was like the one worst scenario you were just running out of money at the end of 30 years, that's why you had to take only 4%. But if we compare that to the best scenario, because there's kind of equal likelihood of the worst scenario and the best scenario, the worst scenario was you barely make up 30 years, the equally likely best scenario is you leave 9 times your original wealth left over. So, like, you retire with $0.5 million, you leave your kids $4.5 million having not spent it.

And just when we even look at the distribution further, like, there is a 90% chance out of 4% rule you never touch the principal in 30 years. There's an equally likely possibility that--that's the bad scenario, is you merely leave your principal left over. The equally likely good scenario is you leave 6 times your retirement nest egg left over untouched. And so, we get this effect where ratcheting your spending down to that one worst-case scenario--it's a fine defensive strategy. It's built to weather the worst-case scenario. But even bad returns still leave your nest egg over; average returns leave you 2 or 3 times, and you are as likely to still have all your nest egg left over as you are to have 6 times your nest egg left over. And I think a lot of retirees maybe who have heard and read about the 4% Rule just don't realize quite how ratcheted down that actually is and essentially how much upside potential there actually is in spending at that level.

Wallace: Right. What might be a better alternative to the 4% rule if you wanted to sort of maximize your enjoyment of your wealth?

Kitces: So, I think, ultimately, what you come to in recognizing this is it's sort of two different strategies. The first is essentially what I call a ratcheting tool. So, like a ratchet wrench, it turns one way, but it's locked the other way. You can kind of use your retirement spending with a ratcheting rule that says, look, we are going to start out at this number of 4%. If it goes badly, we'll be really happy we started at 4 because it's about the best information we have that it should last. But if things go better or, frankly, just merely not horrible and we start getting ahead, we lift our spending. Like we can set a rule, you know, if my portfolio is more than 50% ahead of where it started, I'm taking a 10% increase in my lifestyle for the rest of my life. And every three years I'm still up 50%, I'm just going to keep ratcheting my lifestyle 10% higher. So, I'm going to enjoy it as I'm getting the upside.

Wallace: So, you give yourself a raise every year.

Kitces: Give yourself a raise and have a plan about how to give yourself a raise so that when to do it and we know what to expect.

The alternative is, you just acknowledge that if you are willing to be a little more flexible in the first place, you can actually spend more. A gentleman named Jon Guyton did a fantastic study on this about 15 years ago, still not widely written about, where he said, well, what if we just make guardrails. Like, instead of starting at 4, let's start at 5. But if things go badly, you are willing to cut back down to 4 or maybe even 3.5. But if things go well, your spending could even go up higher. And what happens if we just put some guardrails in place. So, if things get really bad, we'll cut our spending, knowing most of the time they are not horrible, and we can actually spend more in the first place.

And so, I don't think that approach is for everyone. For some of us, if I came to you and said, hey, the market is having the next great catastrophe, there was nothing anybody could do to avoid it, we're in financial crisis 2.0, you might have to trim your restaurant budget a little, could you do that? For a lot of people, the answer is like, well, yeah. And point of fact, I can't go out with my friends because all of their portfolios are going down, nobody wants to go eat out anyway. So, we are going to potluck for the next two years and have some fun low-cost events with our friends.

A lot of people are comfortable dialing it down a little. Not everyone. For some of us, like, this is my lifestyle and you change my lifestyle, it's going to kind of feel like personal catastrophe to me. So, if that's your experience and your spending pattern, ratchet it down to the lowest level and just wait for the upside. But I think we grossly underestimate how much a little bit of flexibility actually helps. And what Guyton's study found is, if you just put a little bit of flexibility in there, like, I'll take 10% cuts when times are bad and make it up later, the 4% Rule quickly becomes a 5% rule and that's literally a 25% increase in your lifetime spending just by being willing to be a little more flexible.

So, I don't want to preach at everyone you have to be more flexible. Not everybody wants to take the risk of the cuts. But at least understand if you are willing to be more dynamic, the spending number is actually much higher. Like, you don't have to only deal with sequence risk by saying, I'm going to spend the thing that works for the absolute worst sequence ever and just wait for better times to come. If you are willing to be more dynamic to markets that are a little bit more dynamic, the flexibility actually goes a long way.

Wallace: That's really great perspective on this interesting topic.

Kitces: My pleasure. I hope it helps.

Wallace: All right. Thanks. For Morningstar, I'm Karen Wallace.

***

Greg Carlson: Franklin Mutual Quest is a world-allocation fund that earns a Bronze Morningstar Analyst Rating due to its deep experienced team, proven process, and below-average fees. The portfolio managers of this fund work as a part of a team of couple of dozen people. They invest in a mix of undervalued equities, distressed debt, and a smattering of merger-arbitrage plays. This fund invests 55% to 75% of its assets in equities typically, but the managers have a lot of flexibility to vary that weighting depending on where they are finding value. They might find the bonds of a company to be more attractive than its equity. The bond side of the portfolio is typically filled with distressed companies that are in some kind of financial trouble where their bonds are trading very cheaply, as cheaply as $0.50 on the $1. This provides a margin of safety for them in case things turn out wrong. Over time, the fund's below-average fees, strong team, and proven process makes this an interesting world-allocation holding.

***

Greg Carlson: Franklin Mutual Quest is a world-allocation fund that earns a Bronze Morningstar Analyst Rating due to its deep experienced team, proven process, and below-average fees. The portfolio managers of this fund work as a part of a team of couple of dozen people. They invest in a mix of undervalued equities, distressed debt, and a smattering of merger-arbitrage plays. This fund invests 55% to 75% of its assets in equities typically, but the managers have a lot of flexibility to vary that weighting depending on where they are finding value. They might find the bonds of a company to be more attractive than its equity. The bond side of the portfolio is typically filled with distressed companies that are in some kind of financial trouble where their bonds are trading very cheaply, as cheaply as $0.50 on the $1. This provides a margin of safety for them in case things turn out wrong. Over time, the fund's below-average fees, strong team, and proven process makes this an interesting world-allocation holding.

***

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Value investing has been out of style for a while now. Joining me to share some picks for investors who'd like to play a resurgence in value investing is Alex Bryan. He is Morningstar's director of passive strategies research in North America.

Alex, thank you so much for being here.

Alex Bryan: Thank you for having me.

Benz: You devoted the latest issue of Morningstar ETFInvestor to value investing. Let's just talk about the basic thesis behind value strategies or the value factor.

Bryan: So, basically, value stocks over the very long term have offered attractive performance, and I think there's two reasons for that. One, value stocks are, I think, more likely to be undervalued than their pricier growth counterparts. There's a tendency among a lot of investors to get really excited about fast-growing stocks, and I think some investors may extrapolate past growth too far into the future and overpay for growth stocks, while investors may become overly pessimistic about slow-growing companies or firms that are going through operational difficulties and push their price below their fair value. The fact that the payoff to value investing has historically been the biggest among the smaller stocks suggests that mispricing maybe at work.

But even if there's no mispricing, investors may require value stocks to offer expected returns as compensation for their higher perceived risk. Because a lot of value stocks, you know, they are less desirable businesses and investors may think that they are riskier. So, if you think about a firm like JC Penney, certainly not growing quite as fast as a firm like Netflix, and I think a lot of investors may only want to buy something like JC Penney if they thought it was going to offer a higher expected return. So, I think it's a combination of mispricing coupled with the fact that a lot of investors require compensation for owning these riskier stocks.

Benz: We've been in the midst of a period where growth stocks have dramatically outperformed value names. Can you talk in general about what factors, what forces tend to drive those types of cycles?

Bryan: Sector tilts certainly have been part of the reason why value stocks have underperformed. Traditional value indexes tend to be persistently overweight certain sectors like energy, financial services, underweight others like technology and healthcare. And over the past decade that certainly detracted from their performance. But at the end of the day, ultimately, what matters is growth relative to expectations, and I think a lot of growth stocks have exceeded investors' wildest expectations over the last decade or so. So, even though they were priced for growth, they've done even better than a lot of people expected, while in aggregate, a lot of value stocks have disappointed. So, it's hard to point to just one thing. But I think it's a combination of those sector tilts coupled with growth stocks beating expectations.

Benz: Investors might be looking at this underperformance of value stocks and think, aha, they are really cheap now, maybe I should get out of growth stocks entirely and move everything into value names. Is that sort of either/or mindset a good strategy?

Bryan: You know, it might be tempting to do that, but there isn't a lot of evidence that that actually works. I've done some research on this, and it just doesn't look like there's a good way of timing exposure to value or growth or knowing when it's going to outperform. So, I think it's important to have a long investment horizon if you are going to be a value investor.

Benz: For investors who are looking at their portfolios today and seeing that their portfolios are maybe heavy on the growth side of the style box and light on value stocks, let's talk about just a very cheap plain-vanilla way to play the value factor.

Bryan: I think Vanguard Value ETF is a really good place to start. This is a really simple broad market-cap-weighted value index fund that basically targets large-cap stocks representing the cheaper half of the U.S. large-cap market. It weights its holdings based on market capitalization. So, it effectively diversifies firm-specific risk. It accurately represents the way that a lot of active manages are investing, and it charges a very low 5 basis-points-expense ratio, which gives it a sizable cost advantage against its actively managed peers.

Benz: One risk, though, with a product like this is that you can get these sector biases that crop up. And you mentioned financials being sort of a persistently heavy overweight among many value-oriented funds. You have an ETF that you like that controls for big sector bets. This is iShares Edge MSCI USA Value Factor. The ticker is VLUE. Let's talk about that one.

Bryan: So, that's a mouthful. But what it does is it basically selects stocks that are the cheapest within each sector. So, it's looking for stocks that are cheap relative to their sector peers. And then it anchors its sector weightings to those of the broad market. Now, there's two principal advantages of this sector-relative approach. Number one, you are able to isolate exposure to the value factor without some of the ancillary sector bets that come along with that with a lot of traditional value index funds. And that's a good thing because persistent sector biases typically aren't well rewarded over the long term.

But the second benefit is that by comparing stocks in each sector that leads to better comparability. Because there's more similar balance sheets between firms within the same sector, there's more similar operational risk and profitability. So, I think it lends itself to better comparisons when you are looking at banks and comparing their valuations against other banks rather than taking a bank and comparing it against the tech firm. So, I think there's more informational content that you can glean, and I think that this type of approach will also help you really get clean exposure to the value factor.

Benz: In your research, Alex, one thing that you found was that the value factor was particularly pronounced in the small-cap space. So, for investors who are intrigued by that idea, who want to make sure that they have smaller-cap value exposure in their portfolios, is there any product that you would recommend there?

Bryan: I would keep it really simple and stick with a low-cost option like Vanguard Small-Cap Value ETF, ticker VBR. This is a fund that basically, again, offers very broad exposure to U.S. small-cap value stocks, targeting basically the cheaper half of the U.S. small-cap market. And then, it weights its holdings based on market capitalization. Now, this fund doesn't control for any sector tilts. So, there is a risk. But I think this is a really good option for exposure to small-cap value stocks, and it's one of the cheapest ways to invest in that part of the market.

Benz: Interesting research, Alex. Thank you so much for being here with us to discuss it.

Bryan: Thank you for having me.

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

***

Danny Goode: Among the Mexican airport companies we cover, we believe wide-moat Pacifico is the best positioned and most ready to take advantage of several tailwinds, including a demographic boom in Mexico and an aging U.S. population. A healthy balance between domestic and international passengers and a lack of reliance on a particular airport also puts Pacifico in a unique position compared with its domestic peers.

In the interim, we expect economic headwinds and AMLO's recent referendum to cancel construction at Mexico City's international airport to slow passenger traffic growth through 2021. Denying expansion at Mexico City's primary station will crimp growth at a major artery within Mexico's network and consequently lower air travel’s growth trajectory through lower connectivity. We think AMLO’s administration will refrain from meddling with airport concessions, and we see more uncertainty emanating from potential economic policies.

Pacifico remains our top choice because of the diverse set of airports it operates and the upside we expect from those stations. Guadalajara and Tijuana, good for business travel, and Los Cabos and Puerto Vallarta, good for tourist travel, offer Pacifico access to Mexico’s budding middle class but also ever-growing international markets. Guadalajara and Tijuana are also among the top five busiest airports in the country and unlikely to cede these positions in the coming years thanks to growing urbanization in Mexico’s metropolitan areas. Pacifico’s nonaeronautical revenue represents only about a quarter of overall sales, below about 35% for Sureste, so we expect stronger revenue growth for Pacifico exiting a slowdown in passenger traffic through 2021.

We think Mexican air travel markets sit at the edge of a decade-long demographic tailwind and growth in Mexico's working-age population will drive airport traffic. While air travel remains quite cyclical, a growing Mexican working-age population coupled with this group's higher propensity to travel generates a secular demand driver for domestic and cross-border air travel to the U.S. For international travel, the weakened peso compared with historical levels and a growing retirement population in the U.S. should continue to support tourism flows to Pacifico's Puerto Vallarta and Los Cabos airports.

***

Christine Benz: Hi, I'm Christine Benz from Morningstar.com. A bill wending its way through Congress would fill some holes in the way we plan for retirement in the U.S. Joining me to discuss what's called the Secure Act is Aron Szapiro. He's director of policy research for Morningstar.

Aron, thank you so much for being here.

Aron Szapiro: Thanks so much for having me.

Benz: Aron, let's talk about this bill. How sweeping are the changes that it would introduce?

Szapiro: So, on the one hand, this really is the most significant change to the defined-contribution system from a policy perspective, if it passes, since the Pension Protection Act of 2006. On the other hand, it's a lot less sweeping than the Pension Protection Act of 2006, but it would introduce a number of significant reforms that could really help ordinary people as they try to save for retirement.

In some ways, the bill is almost like a random grab bag of ideas that have bipartisan and bicameral support, but if I'm looking for a through line that gives me some indication of some of the themes around these provisions, I think you see a pivot and shift from Congress to issues of equity and adequacy in the defined-contribution system and away from some of the issues of sustainability, which were much more top of mind, particularly for defined-benefit plans during the last really major retirement reform bill in 2006.

Benz: So, one thing that you've written about before on Morningstar.com is the idea that in a lot of ways, we have kind of this two-tier retirement system in the U.S., where if you work for a large employer, you, chances are, have access to a very good quality plan, whereas if you work for a small employer, you might not have any plan at all or maybe the plan is subpar. Does the bill address that issue and that inequity in any way?

Szapiro: Yeah, it certainly tries to, and that's one of the focuses on sort of the equity of the defined-contribution system. It has a provision that would make it much easier for small employers to get together and offer multiple employer plans, and specifically it would set up a system where a pooled provider could go and offer these plans, bring in small employers, and hopefully improve the quality of those plans. We've been a little bit skeptical that this would greatly increase the number of small employers offering plans. We think it's much more likely to enhance the quality of those plans since they'd have a much bigger scale. They'd be centrally managed by one of these new pooled providers, and the Joint Committee on Taxation, which is the professional group that scores these things for Congress, agrees. They don't see this leading to a big increase in coverage, but it's still an important step forward, raising the bar for small plans and making them look a little bit more like big plans, have some of the features that we know really help people save for retirement.

Benz: Getting people to save is another one of the challenges in the retirement planning space. This bill allows employers to enroll their employees at a higher rate, is that correct?

Szapiro: Yeah, that's right.

Benz: To automatically enroll them?

Szapiro: Exactly, so it can automatically enroll people up to 15% of their salary and still be in a safe harbor to avoid getting tangled up in some of those nondiscrimination testing requirements, which is an important thing. Now, the old limits were 10%, which is pretty high, and most employers don't do that, but I think that's an acknowledgement, again if you're looking for sort of a through line through this bill, that maybe some of the existing auto-enrollment practices don't lead to enough adequacy of saving, and we should give employers the tools to ensure that their participants are saving at sufficiently high levels to enjoy a secure retirement.

Benz: Another component here is lifetime income. It will be easier for plans to adopt some sort of a lifetime income provision. Let's talk about that.

Szapiro: Yeah, absolutely. So one of the things this bill would do, and I should say, this is an idea that's been kicked around for quite some time. It's something the Government Accountability Office has opined on. There's a pretty wide consensus that it's important to give employers some comfort if they're going to offer an annuity in their plan that they won't be on the hook if that provider has financial problems 10, 15, 20, 30 years down the road, and so this bill would provide a clear safe harbor where if you check the box, you are not liable for that insurance company's solvency as long as you follow the safe harbor. That I think is necessary, maybe not sufficient, but necessary to give employers some comfort that they can offer annuities inside their plans.

It also has provisions to make sure that when employers do offer annuities inside 401(k)s that those annuities will be portable. I think that's also really important, and we've been talking for a long time about the maturation of the DC system and how we're going to get people to convert all that they put together during the accumulation phase into lifetime income, and I think this removes an important barrier to offering those solutions inside plans.

The last thing it does in terms of lifetime income is it directs the Department of Labor to promulgate regulations that would instruct plan sponsors to show participants what their lifetime incomes could be based on their account balances and contributions, and you'd expect that to look a lot more like the lifetime income you can generate from a single premium immediate annuity than from something like the 4% rule, so we think that's what those regulations will ultimately look like, assuming this all passes.

Benz: Right. So you mentioned annuities, and I think some of our viewers' hackles might go up when they hear the word "annuity." We're talking about very vanilla annuities that would be embedded within defined-contribution plans, right? Not high-cost variable-annuity products.

Szapiro: I think probably that's what we're talking about. I mean, the legislation of course just speaks to all annuities, which as you say, encompasses a lot of different kinds of products, but the bill does not relieve the plan sponsor of their fiduciary obligations for picking products that are for the sole benefit of their participants, so our expectation is that this would pave the road for products that could help people lock in some guaranteed income and would hopefully be high-quality products.

Benz: Final question, Aron, an important one: In today's Congress, how likely is this bill to become law and to come to fruition?

Szapiro: Well, a lot of these provisions have been popular for some time. A number of them were in a bill that passed in 2016 by a unanimous 26-to-nothing vote out of Senate Finance, and so there's been bipartisan, bicameral support for every provision in this bill for a long time. So, given that it's now passed out of Ways and Means, we're really optimistic that this will become law some time this year, so the chances have not looked better for some time for these provisions, and hopefully this is the year Congress gets it done.

Benz: OK, Aron. Always great to get your perspective. Thank you so much for being here.

Szapiro: Thank you.

Benz: Thanks for tuning in. I'm Christine Benz for Morningstar.com.