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Investing Insights: Retirees and Bonds, Berkshire's Value

Morningstar.com

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Susan Dziubinski: Hi, I'm Susan Dziubinski for Morningstar.com. We award Gold, Silver, and Bronze Morningstar Medalist ratings to those funds we think are most likely to outperform during a full market cycle. However, we may increase or decrease a fund's analyst rating due to changes in a fund's process, expected performance, management, or price. Today, we are taking a look at three former medalist funds that have been downgraded to Neutral during the past few months.

Patricia Oey: We've long had a favorable view of George Cipolloni and Mark Saylor, who together have run Berwyn Income since 2007. They employed a go-anywhere contrarian approach to this conservative-allocation income fund, and they generated strong results with good downside protection, with returns coming from both asset allocation and securities selection.

In February 2019, the managers unexpectedly resigned. Given that this flexible process essentially resided in those two departing managers, it was reasonable for parent Chartwell Investment Partners to start fresh and create a whole new fund. They appointed a team to run this strategy. And while members of the team have long track records running single-asset strategies at Chartwell, they don't have a public track record running a multi-asset fund in a mutual fund vehicle.

The new strategy is a combination of two existing Chartwell strategies, a mid-cap value fund combined with a core-plus fixed-income fund at a roughly 30% equity, 70% fixed income allocation. This is fairly staid considering what the process was before, where the managers had an all-cap mandate and also invested in a broader range of asset classes including high-yield, convertibles, preferred, and even cash, which sometimes hit 20% to 30% of the portfolio.

With a complete revamp of the process, we have lowered Berwyn Income's Morningstar Analyst Rating to Neutral.

Gregg Wolper: In February, Fidelity announced that Sammy Simnegar, who has managed Fidelity Emerging Markets since 2012, will be stepping down on Oct. 1. Now, he has had a very good record with this fund. He uses a quirky style. It's a little unusual, but it's worked very well for him. The new manager will be John Dance. Dance runs the Fidelity Pacific Basin and Fidelity Emerging Asia funds, and he has ability. We think highly of his skills. The Fidelity Emerging Asia fund, which is the only one of the two that we cover, gets a Morningstar Analyst Rating of Bronze. However, Dance has not run a broad emerging-markets fund. And so, for that reason, there's some uncertainty here. He also uses a slightly different style than Simnegar does. It's growth-oriented but not as much, and there are some other differences as well. For that reason, the Morningstar Analyst Rating of Fidelity Emerging Markets has been downgraded to Neutral from Bronze.

Connor Young: Proposed manager changes hurt USAA World Growth's prospects and warranted a downgrade in its Morningstar Analyst Rating to Neutral from Silver. In its current form, a proven team runs this strategy. The team has talented managers, benefits from deep analytical resources, and has delivered solid long-term results here and at MFS Global Equity. However, Victory Capital plans to move a portion of the strategies' assets to its own investment team, RS Investments, when it completes the acquisition of USAA sometime in 2019 second quarter. And this hurts this strategy's prospects for a few reasons.

First, the RS Investments' team is thin, consisting of just two managers and one analyst. And second, that team uses an approach that's highly correlated to the existing strategy, so it provides little diversification benefit and is not complementary. And third, USAA and Victory have not disclosed their plan to allocate the strategy's assets across investment teams. So, it's uncertain how the strategy's portfolio and the risk/reward profile will look going forwards. Investors should consider other options.

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Susan Dziubinski: Hi, I'm Susan Dziubinski for Morningstar.com. Bonds have badly lagged stocks over the past decade. And in 2018, rising yields led to falling bond prices. Joining me to discuss the pros and cons of the main bond alternatives is Christine Benz. She is director of personal finance for Morningstar.

Christine, thank you for joining me today.

Christine Benz: Susan, it's great to be here.

Dziubinski: Now, let's step back and start at the beginning. Let's talk about the basic thesis for holding bonds as a component of a portfolio. Why do it?

Benz: The thesis is that in normal environments you should be able to pick up a higher yield than you can on your cash instruments with just a little bit more volatility. So, unlike true cash instruments, your principal is not guaranteed in bonds. But typically, your losses will be nowhere like the sorts of losses that you can incur in stocks.

Dziubinski: And then as one draws closer to retirement and withdrawing these assets, the standard advice is to add more bonds to a portfolio. Why is that?

Benz: Well, the basic idea is that as you get close to needing to spend from your portfolio, you want to try to secure those assets, so that in some sort of catastrophic period that you might encounter during your retirement years, you wouldn't have to tap your equities while they are at a lower ebb. You have enough ideally in cash as well as in bonds to tide you through those rough equity markets that periodically present themselves.

Dziubinski: Now, we're kind of in an interesting period right now, where bonds, whether they are short- or intermediate-term, really aren't giving you much more than you can get from just being in cash. So, why should an investor bother with taking on--even if it's incremental--risk by investing in bonds rather than just staying in cash?

Benz: I think it's a really good question. I think investors should indeed have cash as a component of their in-retirement portfolios or if they have very near-term cash flow needs. By all means, keep that money in cash. But I think the risk of having too large a cash position is that if perhaps bond yields trend down over the next few years, maybe if we encounter some sort of recessionary environment or a weakening economy, that's oftentimes what happens, then the investor in cash will be stuck having to settle for ever lower cash yields. Whereas the bond investor, even though he or she too has to settle for lower yields, you are able to partake in higher bond prices. So, that's a benefit that you can avail yourself of if you are sticking exclusively with cash.

Dziubinski: You recently wrote a column on Morningstar.com about how dividend-paying stocks are really an imperfect substitute for bonds and you hear a lot from readers about that. Let's talk a little bit about what the pros are investing in dividend-paying stocks.

Benz: Right. Our readers love dividend-paying stocks, and I love them too. There are several things to like about dividend-payers. One is that yields right now on sort of a higher-yielding equity portfolio would be higher than what you can earn on a Bloomberg Barclays Aggregate Index product. So, yields are relatively strong. The other big benefit and the thing that people really like about dividend-paying stocks is the ability to actually experience significant capital growth, which is something that you are not going to typically get in a bond product. Those are some of the big advantages. And then favorable tax treatment is another thing to like. So, right now, dividends are taxed anywhere from 0% for taxpayers in the lowest tax bracket up to 20%, way below the ordinary income tax rates that prevail on bond income. So, that's another thing to like.

Dziubinski: But you have to be aware of the trade-off of the different volatility profiles between bonds and dividend-paying stocks?

Benz: You absolutely do. And there's a saying that a bad day in the stock market is like a bad year in the bond market. Stocks are much, much more volatile than bonds. That's the key reason why in my bucketed portfolios, for example, I hold up to eight years' worth of bond investments and two years' worth of cash flows and cash investments. The idea is that you could encounter an Armageddon of an equity market and still have 10 years' worth of cash flows set aside in relatively safe investments.

Dziubinski: Can you offer investors some ideas how they can maintain a decent stake in dividend-paying stocks and still manage their portfolio's risk levels?

Benz: I do hear from investors who are looking to dividend payers to be their cash flow production engine in retirement. And I would say, if that's your strategy, that's something that you'd want to be sure you are augmenting with at least some cash investments. I would also hold some bond investments--maybe not a full eight years' worth of cash flows and bonds, but at least some bond investments. And the other thing I would keep in mind is, to the extent that you have bond investments alongside that dividend-paying equity portfolio, keep it very high quality. You wouldn't want to mess around with some of the lower-quality bond sectors like high-yield, like emerging-markets bond, because you'll have too much volatility there. It's not the right diversifier for your equity-heavy portfolio.

Dziubinski: That makes sense. So, it sounds like there is a place for bonds in a retiree's portfolio.

Benz: There is.

Dziubinski: Thank you for joining us today, Christine.

Benz: Thank you, Susan.

Dziubinski: Thank you for tuning in. I'm Susan Dziubinski for Morningstar.com.

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Abhinav Davuluri: Semiconductor stocks have been on a wild ride thus far in 2019. Toward the end of 2018, a multitude of challenges arose--including but not limited to: PC chip supply constraints, inventory builds in smartphones and graphics chips, cloud inventory digestion, weaker demand in China, and a tepid memory market.

Micron, TSMC, and Intel have all called for a stronger second half of 2019, particularly with improved cloud spending by the likes of Amazon, Microsoft, and Google. While we concur with this sentiment, we think Intel represents the most compelling investment opportunity.

Intel’s updated guidance for 2019 was reduced by $2.5 billion, but nonetheless we remain positive on major industry trends such as 5G, AI, automotive, and the shift to the cloud, with wide-moat Intel well positioned to capitalize on many of these burgeoning trends with unmatched breadth in its product portfolio.

Rival AMD is set to report on April 30, and while we expect share gains for AMD, we think shares are overvalued and we question sustainability of AMD’s competitiveness against Intel and Nvidia.

Nvidia won’t report until mid-May, but the short-term headwinds related to data center spending will likely have a negative impact on the graphics leader, as nearly a third of sales come from major cloud vendors.

We also look forward to hearing from Qualcomm on May 1. Although shares have had a nice run since the settlement with Apple, we would like to hear from management on the timing and magnitude of its chip and licensing businesses returning to normalcy before adjusting our $72 fair value estimate and thus see shares as currently overvalued.

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Karen Wallace: From Morningstar, I'm Karen Wallace. Investors paid less to own funds in 2018 according to new Morningstar research. Here to discuss it is Ben Johnson. He's global director of ETF research at Morningstar.

Ben, thanks for being here.

Ben Johnson: Thanks for having me, Karen.

Wallace: So we've done this fee study since 2000, which is a while now. What are some of the longer-term trends that we've seen?

Johnson: What we’ve seen over a very long period of time is that fees have been marching lower and marching consistently lower since we started looking at U.S. fund fees in 2000. So, in each of the past 18 years is what we've seen is a decline in the asset-weighted fee that’s been levied among U.S. funds. Now the asset-weighted fee is a reflection of how much investors are paying as opposed to what funds might be charging. So, if you look back all the way to 2000 and fast-forward to the end of last year, at the end of 2018 investors were paying half as much on average to invest in funds than they were in 2000. If you go back just five years, what we've seen is a 26% decline in the asset-weighted expense ratio across all U.S. funds.

Wallace: The decline from 2017 to 2018 was something like the second-largest decline we've ever seen. It was 6%, which works out to something like $5.5 billion in cost savings. How does that break down?

Johnson: Well, if you look at the decline in the asset-weighted fee, you are exactly right--having fallen from 0.51% in 2017 to 0.48% last year reflects a 6% decline. As you mentioned, the second-largest percentage decline in the asset-weighted fee we've seen dating back to 2000, amounting to $5.5 billion worth of fee savings for investors in 2018. If you distill that down, given that this is the asset-weighted average expense ratio, it inherently reflects investors' preferences. And the preference that is abundantly clear and has been clear for some time now is that investors are moving to less-costly funds. So we looked at flows into funds on the basis of their costs. Separating them out into 20% chunks across the fee spectrum. So, the lowest-cost quintile, or the cheapest 20% of funds, amassed all of the net new money last year--just over $600 billion worth of net new flows. So, fees are being driven lower, and investors are the ones who are in the driver's seat, with their hands on the wheel, and they are pointed firmly in the direction of inexpensive funds.

Wallace: That sounds like a good thing. What are some of the things that are driving investors toward lower-cost funds? Is it purely their own choice, or is it just the evolving advisor landscape?

Johnson: There is a variety of different factors that are at play here, that are moving investors toward cheaper options. One of them is just a growing awareness of the importance of fees--that every penny that you can save on investment costs is not just a penny earned, but a penny that can be saved and invested and compounded from here until the time that you want to withdraw that penny, which has become multiple pennies further down the road to fund your long-term goals. So, the importance of costs in the investor success equation, I think, has come into ever-sharper focus with time. The other important trend that's driving investors toward these less-costly options is a shift in the economics of advice, whereby advisors are moving away from being paid on commission to charging fees for their services. And that movement toward a fee-based business model is leading to a shift in preferences as it pertains to the funds that they select and build portfolios with on behalf of their clients. As more and more of the economics of that relationship shift to an advice fee, they are getting squeezed out of the investment products that advisors are recommending to their clients.

So, from an investor's point of view, it may actually be somewhat premature to do a victory lap and celebrate all of the billions upon billions of dollars that we've saved on fund fees over the years and to ask some pointed questions as to understand whether or not there is air being let out of the balloon or simply squeezing one side of the balloon in the form of fund fees and pushing all the air to the other side and it's simply staying within the balloon but just turning into advice costs, explicit fees, hourly fees, you name it. So, investors should be happy, they are paying less, in theory they are pocketing more. But take a step back--take a more holistic view of the total cost of investing--to understand whether or not it's really time to pop the champagne and pull out the party hats.

Wallace: That’s great advice. And it was an interesting report. Thanks so much for being here to discuss it.

Johnson: Thanks for having me.

Wallace: From Morningstar, I'm Karen Wallace.

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Dan Culloton: Morningstar added Davis International to its Morningstar Prospects list in December 2018 for its unique low-turnover, high-conviction process and its promising manager. This fund is essentially the non-U.S. picks from Davis Global, which already receives a Morningstar Analyst Rating of Bronze. Danton Goei manages both funds, and he's been a member of the Davis Advisers team since 1998, so he has more than 20 years of experience there as an analyst and a manager. He essentially uses the same process that many other Davis funds use here, which is to look for stocks that are trading at attractive discounts to their owner earnings, but Danton really steers his own course at this fund. It's a very focused portfolio of 30 to 40 stocks that keeps 50% or more of its assets in its top 10 holdings and has been known to keep up to 58% of its assets in emerging markets, including 40% in China.

And many of those holdings are also Internet companies such as Alibaba or JD.com, and it also has been known to take positions in private companies such as Didi Chuxing and Grab.com. You expect a portfolio like this to be volatile, and it has been, as exemplified by its steep losses in 2018 when many of its Internet names stumbled, but the fund's also capable of posting explosive gains, such as its more than 22% gain through April of 2019. Over the time, though, this fund has been competitive with its benchmark and with its peers, and we think its unique high-conviction, high active share approach is definitely worth watching for the long term.

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Susan Dziubinski: Hi, I'm Susan Dziubinski from Morningstar.com. Berkshire Hathaway's annual meeting is this weekend. I'm here with Gregg Warren, a senior analyst at Morningstar, who covers Berkshire, to talk about whether the stock is attractive today. Gregg, thank you for joining us.

Gregg Warren: Thanks for having me.

Dziubinski: So, let's start out with your take on the operating business today. What's happening there, what's firing on all cylinders, and what maybe isn't working as well?

Warren: The problem right now is we won't know first-quarter earnings until the weekend of the meeting because they don't release the earnings until then, so we're basically forced to fall back on end-of-the-year results, which overall weren't that bad. From an operating perspective, most of the businesses are doing fairly well. There were some headline issues with the Kraft Heinz impairment, plus the fourth-quarter sell-off in the equity markets impacted the equity investment portfolios. So, barring those, when you look at the operating business, it's pretty good. I mean, if we look at the insurance business, which is about 38% of our overall fair value estimate--good, solid results from Geico. They've pulled back from what was an aggressive push for market share, took some pricing, reduced underwriting overall, and their operating profitability's looking better than it has in a long time--again, back to more normalized levels. On the reinsurance front, pricing has been an issue in that business, but they seem to continue to find ways to find business, and overall they're trying to run it just basically flat, keep it in the black. They've had some headwinds the past couple of years just because of catastrophe losses, but overall they're doing a good job there. And then the primary group business continues to outperform, it's really the crown jewel within that portfolio. 

When we look at the railroad business, it's about 22% of our fair value estimate, a good solid year overall. Beat their closest peer, Union Pacific, on a lot of different measures, from volumes to revenue, but they still are trailing them from a profitability perspective, and this is kind of a concern for us. We've seen some moves within the industry to adopt precision railroading, and Union Pacific is the latest one to adopt this one. As we look out over the next five to 10 years, our concern is that if they don't get on board, Union Pacific could start using this as a competitive wedge. But, overall, it was a good year for them. Expectation is we'll continue to see some good results from them. On the energy business, it's usually sort of a beacon of stability, it's about 8% of our fair value estimate, nothing too exciting happens there. The only time we have any sort of major moves is when they do an acquisition, but overall, a good, solid year from that business. 

And then we look at the MSR segment, which is manufacturing, service, and retailing. That's about 32% of our fair value estimate right now. It's gotten larger because they folded up the finance and finiancial products business into there. At the end of the day, it's a big black box, though. It's really opaque, Berkshire does not give us a lot of details. What we do know is Clayton Homes, ISCAR, Lubrizol, Precision Castparts, and Marmon are the five biggest contributors there. They're about 60% of pretax profits overall. So, we can get a general sense of where things are going directionally, but when we look at how results ended up last year, it's about in line with our expectations, sort of mid-single-digit growth on the revenue line, 8% pretax margins, so overall, it was a pretty good result from them, barring the issues we saw with the equity investment portfolio. And with Kraft Heinz, we do include that as more of the equity investment portfolio than actually a operating company.

Dziubinski: Now, we assign Berkshire a wide moat. Do you see those competitive advantages improving? Do you see any threats to those competitive advantages? How does the moat look today?

Warren: Our moat trend for the firm overall is actually stable. So, we don't really see anything positive or negative on an overall basis. With our trend, it's sort of like our moat and our fair values overall. We're doing a sum of the parts. We're breaking down the different businesses. We're looking at the competitive advantages, sort of the threats and the weaknesses that are impacting the businesses. And we look at insurance, I mean, overall, good, solid advantaged businesses. Geico's in a great spot. Direct sell is growing much, much faster than the rest of the industry, and it's a much better position to be in. On the reinsurance side of the business, pricing is terrible, that's a known-known for that business. Berkshire's unique, though, relative to its peers, because it tells its underwriters, if you can't find a good business that's reasonable for the risk we're taking on, don't underwrite it. So, they can sit on their hands when the pricing isn't appropriate. And then, when we look at the business, overall, you can have situations like Geico did for a couple years there, where they could take advantage of the entire book of business, the larger insurance business, and then the larger business that is Berkshire, to go out and be aggressive, taking some market share, run some losses in order to do that, which they did for almost four or five quarters. Because the offset within the rest of the organization is going to help them to do that. 

With BNSF, which we talked about just a little bit there, everything's good right now, but my concern is longer term. If Union Pacific gets in a point where their spread in operating profitability widens out even further than it is now, they could eventually start taking price and use that as a competitive wedge. And that's where we worry about it because that's its most direct competitor in the western part of the United States. On the utilities business, it's really what Berkshire Energy is, which is sort of an almost private company operating underneath the Berkshire umbrella. The biggest advantage they have relative to public peers is that they don't have to pay out 60% to 70% of their earnings as a dividend every year. So, that's capital they can throw back into the business. In the past 10 years, that's all gone toward wind power and solar power. They've driven down the cost basis on that so dramatically that it's put them at a huge competitive advantage relative to a lot of peers within the areas in which they operate. So, from that perspective, that's a huge advantage, nothing really changing there. 

And then with the MSR segment, again, that's a more difficult one to really sort of peg because there is just not a whole lot of clarity within the business operations themselves. But, again, we know the five major players in there, we know what's going on with those businesses, so directionally things seem to be fairly stable right now. But we do keep an eye on that because, again, there will be times when one or two players, or some of the smaller players, will face competitive pressures, but depending on the size, it may or may not have an impact on the business overall.

Dziubinski: And then, lastly, how about Morningstar's fair value estimate today on Berkshire? Does it look undervalued, overvalued, fairly valued?

Warren: Our fair value is $360,000 on the Class As, it's $240 on the Class Bs. The shares right now are trading about a 10% discount to that, so it's not a huge margin of safety, but in the way in which we look at things, for a medium uncertainty firm, that is enough to start to putting capital to work in the business. Now, that said, I'd wait for prices lower than this. Berkshire's traditionally traded about 1.4 to 1.45 times book value per share. There seems to be a ceiling at about 1.6 times, so it never really gets past that, and I think part of that is because the concerns about Buffett, and will he pass away tomorrow, next week, next year? But then, they also have never really gotten below 1.25 times book value per share. Now, part of that was because Buffett has sort of built a floor under the stock at 1.2 times book value. But since he's taken that threshold off, it's still really not driven down that far. Ideally, I would look for prices between, say, 1.25 and 1.35 times book value, which seems to be the prices that Buffet's looking at because that seemed to be where he was buying stock in the fourth quarter overall.

Dziubinski: Interesting. Gregg, thank you so much for your time today.

Warren: Thanks for having me.

Dziubinski: For Morningstar.com, I'm Susan Dziubinski.