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Investing Insights: Large-Caps, 529s, and a Wide-Moat Pick

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Susan Dziubinski: Hi, I'm Susan Dziubinski for Morningstar. We talk a lot about building a portfolio of sensible core funds that can help you reach your goals, but sometimes you may want to take a bit of a gamble on a particular sector at the outskirts of your portfolio. Here are three funds that may not be good core holdings, but they are among the best sector funds around.

Thomas Lancereau: Gold-rated Vanguard Health Care is one of the best in its category. Its subadvisor, Wellington Asset Management, has a stable and experienced team dedicated to this sector including lead manager Jean Hynes, who has worked with the team for almost three decades. The portfolio is broadly diversified across the different healthcare industries such as pharma, biotech, and medical-devices companies. Exposure to foreign stocks is higher than the normal with around 25% of assets in non-U.S. stocks. This fund is the biggest one in the Morningstar health category. It has more than $40 billion in assets under management, but it's not a challenge as it mostly invests in large caps. The fund has delivered for investors. It's outperforming index benchmark over multiple time periods as well as peers on a risk-adjusted basis. Volatility is lower than peers as the category includes biotech-only firms. Plus, fees are amongst the lowest in the category, which makes this strategy even more appealing.

Alec Lucas: For investors looking for a sector fund in the financials arena, Davis Financial is an excellent choice. It brings to bear intergenerational expertise in financials. Longtime manager Chris Davis' grandfather was an early investor in Berkshire Hathaway, for example, and the fund has continued to do very well amidst a very trying time for financial stocks over the past 10 to 15 years. The fund also brings new talent to the equation in the form of Pierce Crosbie, who was named a manager at year-end 2018. It's a portfolio that's proved repeatedly resilient in times of stress period and 2018 was the latest example of that.

Nick Watson: Silver-rated Vanguard Energy's consistent bottom-up approach has served investors well. Many energy funds use macroeconomic forecasting as a central part of their approach. But by contrast, Vanguard Energy's portfolio is largely the result of traditional fundamental analysis at the individual company level. They do keep large-scale energy market trends in mind, but, rather than trying to position the portfolio based on a precise forecast and where they think oil prices are headed, throughout the energy market cycle they look for firms with strong management, quality balance sheets, and promising project pipelines that don't require a particular economic scenario to play out in order to be successful. 2018 was a rough year for energy funds, but this strategy's bottom-up approach helped it preserve capital better than its peers as oil prices plummeted in the fourth quarter of 2018. The fund's sound approach, deep team, and low fees continue to make it a compelling option.

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Christine Benz: Hi, I'm Christine Benz for Morningstar.com. The qualified charitable distribution is a great way to be charitable and get a tax benefit. But not everyone who wanted to take advantage of the QCD in 2018 was able to. Joining me to share some perspective on this issue is retirement expert, Ed Slott.

Ed, thank you so much for being here.

Ed Slott: Great to be here live in Chicago at Morningstar.

Benz: It's always a treat to have you here. Let's talk about the QCD in 2018. You said some people who wanted to take advantage of it were not able to do so. Let's talk first about what the QCD is and then get into what tripped some people up for 2018.

Slott: Right. It's basically a rollover where you move money from your IRA directly to a charity and it's excluded from income. The only negative about it is that many people don't qualify. The only people that qualify--first of all, it's only for IRAs, not for plans. People got mixed up with that.

Benz: No 401(k) assets.

Slott: No 401(k), right. And you actually have to be 70.5. Not the day before you are 70.5. You actually have to be 70.5, and it's only for IRAs. So, that's a limited audience. But even among that audience, you can exclude that income, the amount you give to charity from income, and that lowers what's called your adjusted gross income, which is a key item on your tax return that many other tax benefits, deductions, and credits are based on. Now, this was a fabulous benefit in light of the new tax law as many people saw it from their returns in '18, because they got the extra standard deduction, the higher standard deduction. But if you take the standard deduction, you don't get to deduct your charity. But with the QCD, many people got the extra--when I say "the extra," the larger standard deduction--and an extra standard deduction. That why I said "extra," because there's a special extra deduction for people 65 and over. And obviously, if you are over 70.5, you are over 65. That wasn't a trick question. So, they got their deduction, plus the QCD additional on that. And the QCD is better than a deduction because it's an exclusion from income.

Benz: So, generally speaking, if you are a charitably inclined individual who is subject to RMDs on your IRA, you are better off giving to charity through the QCD than you are taking the money out and then sending some funds from your taxable account and then trying to itemize.

Slott: Yes, for a couple of reasons. Because if you do the QCD, as I said, you exclude it from income. And if you do it the other way, the old way, and you write checks, they may not be deductible if you are taking the higher standard deduction.

Benz: So, let's talk about how some people were disappointed in not being able to take advantage of the QCD. You think timing is really key. So, what are the key things to think about if I'm someone who is subject to RMDs and I want to take advantage of the QCD? What should I bear in mind?

Slott: Well, the mistake was: People you said that didn't take advantage of it--they did take advantage of it, but they did it the wrong way, their timing was off, and they didn't get the benefit. The benefit is to exclude it from income and have that count towards your RMD, so you don't have to report that as income. What some people did not know, many people did not know, including lots of tax preparers, there's a rule in there called the first dollars out rule, which means, the first dollars in a year--once you are in a required distribution year from your IRA over 70.5, the first dollars out, however they come out, are deemed to go towards satisfying the RMD. So, some people took their RMDs, their required minimum distribution, and then did the QCD. Well, you can't offset--the big benefit is to offset that RMD income excluded from income. If the first dollars out go to the charity, that's how you get the benefit. But some people didn't know that, so they took their RMDs, say, in March, April, May, anytime during the year, and they did like most people--They saved up their charity till November, December, when most people give to charity. So, they thought they could offset from the RMD, but the RMD came out first, so that had to be included in income. Now, what they sent to the charity still gets excluded from income, but they could have excluded the RMD.

Benz: So, you say that people who are going to take advantage of the QCD, if they are pulling any money out of the IRA and they want to do the QCD, make that the one that is QCD funds?

Slott: That should be the first dollars out until you satisfy the RMD. And another thing people didn't realize--people thought they were limited to the RMD. So, they may have wanted to give larger amounts to charity, but they thought they were limited. For example, if their RMD was $10,000, they felt they could only give $10,000 that way. That's not the case. You can give more than your RMD. You can give up to $100,000 a year.

Benz: That's a good point. Another question that comes into play relates to the first RMD. How does that factor into the QCD? So, once you're 70.5, your first year of RMDs, what should you know?

Slott: Yeah, that's a good point. Because when you turn 70.5, your RMD year is the year you turn 70.5. So, if you turned 70.5 in July, let's say, any money you take that year, even if it's before you turned 70.5, counts towards your RMD. But for the QCD, you have to actually be 70.5. So, what I would say for people who are doing it for their first year, don't take any money out until you are actually 70.5. And if you want to do the QCD to give to charity, make those the first dollars out but after you actually turn 70.5.

Benz: Another thing that comes into play is, some people are complaining that their 1099s were incorrect or confusing. What's going on there in relation to QCDs?

Slott: Yeah. There's no coding on a 1099. Every 1099-R has all kinds of numerical and alpha codes to tell the government what kind of distribution it is. There is no code, there never was for some reason, for a QCD. So, you have to know. So, it might look to your tax preparer even if you are doing your returns yourself, that, hey, they didn't mark this as a QCD. No, you have to do that when you file your return. So, your distribution will look like any taxable distribution. You actually have to go into your return and write "QCD"--not write, nobody does, well, some people do it by hand, but not many anymore. You put in the code "QCD," and it shows correctly, and the amount you gave to charity will be properly excluded from income. But if you just look at that 1099, it looks like you didn't do anything.

Benz: So, presumably, I'd need some supporting documentation from the charity, too, right?

Slott: Right. Just like you would for any charitable gift.

Benz: And you noted also that the QCD can exceed the RMD, so don't be limited to that, but you can only go up to $100,000.

Slott: That's a pretty big limit, and that's per person. But you can't use--we got this question, too--if you have two spouses, they want to give a lot; one spouse gives 100[,000], but the other spouse doesn't give any. Well, the first spouse can't--it's not transferable. The "I" in IRA stands for individual; it's only yours.

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

Slott: Thanks, Christine.

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

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Seth Goldstein: Wide-moat companies rarely trade at a meaningful discount and with near-term valuation catalysts, but Compass Minerals is one such opportunity.

Compass Minerals' wide moat comes from its low-cost Goderich mine in Ontario. The mine's unique geology features 100-foot-thick salt seams, which are 3 to 4 times the size of most other mines. This allows Compass to mine its salt at a lower cost than competitors, an advantage that will persist decades into the future.

Compass shares remain undervalued, as investors are concerned that the recent operational issues represent a new normal. However, operations are improving at Goderich. We expect production to be fully restored by the end of 2019 and forecast unit costs to decline beginning in 2020.

Further, the most recent winter saw an above-average number of snow days. Historically, Compass Minerals has been able to raise prices following harsh winters, as demand for salt rises while producer inventories are low. As a result, we expect higher salt prices next winter.

Lower unit production costs combined with higher salt prices should drive a rebound in profits as soon as next year. At current prices, we see significant upside for wide-moat Compass Minerals, with shares trading at more than a 30% discount to our $81 per share fair value estimate.

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Christine Benz: Hi, I'm Christine Benz from Morningstar.com. For most U.S. investors, large-cap equity funds take up the lion's share of their equity portfolios. Joining me to share some of his favorite large-cap actively managed equity funds is Russ Kinnel. He's Morningstar's director of manager research.

Russ, thank you so much for being here.

Russ Kinnel: Glad to be here.

Benz: Russ, when we look at fund flows, we see investors are sending the clear signal that the large-cap space is an area where they're saying, "I might as well just buy a cheap index fund and call it a day." That's a reasonable way to go, right?

Kinnel: Absolutely. I think the bar has been raised for all funds. There are some really good low-cost active funds and good low-cost index funds, and you can be picky. Yeah, I think, absolutely: Passive is a fine option here. 

Benz: You could potentially use an active fund to augment an index fund, it doesn't have to be either/or.

Kinnel: That's right. A lot of investors have a mix of active and passive, and I think certainly, you can do that. Large cap as well: You can have a total stock market, and then add in a value or growth fund--however you want. There's a lot of different ways to slice it.

Benz: So you hinted that cheap is the name of the game. So if I'm looking at actively managed products and I want to make good selections, what's kind of the upper limit I should put on expense ratios if I'm looking at large-cap funds?

Kinnel: Well, I suppose 1% is a simple rule of thumb. But you could also drive it down more if you want, 90 or 80 basis points. There are good active funds below all of those price points.

Benz: You brought a short list of funds that you and the team like quite a bit. One is T. Rowe Price Dividend Growth. This one kind of lands toward the mild side. Let's talk about Tom Huber, who's been running the fund for quite a long time, and why you like this strategy and some other factors in place here.

Kinnel: Sure. Tom Huber, as you said, has been running the fund since 2000. I always like it when you've got a manager with that kind of track record because you can go back and look at all of the calendar years, know that the manager owns all of that. It'll help you to set expectations for both the upside and the downside. The dividend-growth strategies are kind of a good idea because in order to find dividend growers, you've got to look for companies with good balance sheets, good growth prospect, as opposed to if you're looking just for yield, you might go for companies with not such great prospects but have really high yields. I think this is actually good, kind of defensive discipline, so it's a good strategy, as you say. Leads to mild-mannered results, kind of higher-quality companies, so that generally, in downturns, this kind of strategy is going to lose less than the market, as a whole.

Benz: And as you hinted, Russ, this fund is not set up to deliver current income. So if you're someone who wants a 3% yield, or something like that, you're not going to get it here. It has a dividend growth strategy, so it's looking for companies with a history of increasing those dividends.

Kinnel: Yeah, much more modest yield, something closer to the S&P. But, all in all, it's a really strong package, and we rate it Silver. 

Benz: OK, and expenses are pretty cheap, too. Let's talk about Primecap Odyssey Growth. First, when I think of the highest-conviction management teams among you and the analyst team, it seems like this Primecap team is one you really like. Let's just talk about what attributes are in place that you find so appealing.

Benz: Yeah, I actually own three Primecap funds. 

Benz: I own one.

Kinnel: I'm a big fan, and I think they just are outstanding fundamental investors. You've raised the idea of passive and active at the top. I think I would hate to have to give up investing with Primecap because they just go really deep into their fundamental analysis with a really experienced team. So you've got very experienced analysts and managers who are just outstanding stock-pickers. This fund is large-growth. Nearly all of Primecap's funds are large-growth. One concern is they are running a very large sum of money if you put all of their funds together. But they just do an outstanding job and at a reasonable fee.

Benz: These funds do run, though, to the more aggressive edges of the fund universe. They definitely have risk controls, but they will be volatile at various points in time.

Kinnel: That's right. Growth has done so well lately that, if you just look at the last couple of years, you might not see that risk. But if you look longer-term, you'll see the fund is going to give money back on occasion. It's not a low-risk fund, certainly when value does well or when growth has a sell-off. These funds will get hit. They have a lot of money in tech and healthcare, so certainly not low-risk. To me, it's a long-term investment that could pay off very nicely.

Benz: Primecap Odyssey Growth is open to new investors. A lot of the funds aren't. Let's talk about why that is actually a little bit of a plus--that they are trying to constrain asset flows on some of the funds that they run.

Kinnel: That's right, they do. They have closed some of their funds, which is good, because the sum of all the money they're running is quite large. The only one's that are open are this fund--Odyssey Growth--and Primecap Odyssey Stock. There are three from Vanguard--are all closed. So they take a relatively prudent approach to managing assets. That is a welcome thing because, again, you want their stock picks to shine through.

Benz: So we've got one in large-blend, T. Rowe Price Dividend Growth, one in large-growth, Primecap Odyssey Growth. Your third large-cap pick is in the large-value space. This is American Funds American Mutual. First, before we get into what you like about it, let's just talk about its availability because some investors might see this and say, "Well, I don't have an advisor. I don't want to pay sales charges." Let's talk about the accessibility of American Funds.

Kinnel: That's right. We probably, most of us, know the A shares from American Funds the best, and that is the one with the front load you buy through an advisor. But they also have F1 shares that are available through No Transaction Fee supermarkets without the load. They typically run about 5 to 10 basis points more than the A shares. But the A shares are priced pretty cheaply, so it's still actually a pretty attractive deal. They are now accessible to just about everyone. 

Benz: So let's talk about this fund in particular, American Mutual. It has a focus on dividends, and like all American funds, it employees a multimanager setup, where these managers run a component of the portfolio.

Kinnel: Yeah, the American Funds' way is to have managers who operate independently--each has a sleeve. You might have, say, seven or eight managers with a sleeve. And then another sleeve might be dished out to the analysts, say, 15% or 20% of AUM might be in the analysts' hands. So essentially, a bunch of people building this portfolio together. Some of the managers might be running fairly concentrated funds but, by the time you build out across all those managers and the analysts' portfolio, you get to a fairly diversified portfolio. As you mentioned in this case, yield's important to them. They also want industry leaders, so they're not going to the extreme ends of yield. They want good companies at decent valuations, too.

Benz: And they avoid certain types of stocks, alcohol and tobacco stocks.

Kinnel: That's right, sort of an ESG-lite. They do have some screens. It's not really what you would call a full ESG fund, but it has long had this alcohol/tobacco screen.

Benz: Russ, I know Morningstar viewers and readers really like to get your recommendations. Thank you so much for being here.

Kinnel: You're welcome.

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

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Karen Wallace: Morningstar released a new 529 plan landscape report. It studies the industry in broad strokes and in fine detail. Here to discuss the paper is one of its lead authors, Madeline Hume. She is an analyst in our manager research group, focusing on multi-asset strategies.

Madeline, thanks so much for being here.

Madeline Hume: Absolutely. Thank you for having me.

Wallace: So, in your report, you mentioned that there are $280 billion invested in 529 plans. And plans sold directly to college savers sort of account for a lot of that growth. Have you noticed any other trends in the past 10 years or so that you can speak on?

Hume: Yeah, absolutely. You're totally right about the direct-sold plans. They've seen growth of about 9.9% over the past five years as opposed to plans that are sold through a financial intermediary, which have only grown by about 4.4% over that same time period. We're watching really closely the trends in asset allocation among 529 plans. So, pretty much every 529 plan has at least one option that shifts between stocks and bonds on behalf of investors as they age. But as 529 plans have grown and increased in prominence, they are starting to get a little more sophisticated with how they approach that asset allocation. So, they are doing that in one of two ways. They are either creating portfolios that investors are buying into and selling out of and physically moving into different portfolios as they age, or they are invested in one option statically, but that option de-risks as investor approach college. So, there's no selling out and there's no buying into, which reduces the impact of market risk. And about 40% of portfolios that are currently in an age-based track take a step of equity reduction of 10% or less over the college-savings time horizon as opposed to only about 10% two years ago. So, it's a pretty dramatic change.

Wallace: And we've actually reorganized our categories to better reflect the landscape of 529s available. Can you discuss that a little bit?

Hume: Absolutely, yeah. So, our categories were created in 2010 when the typical 529 plan took an equity step every three to four years. And so, that no longer holds true for most of the plans in the industry. The categories also formerly bracketed between high, medium, and low equity. But since we've seen such a progression towards these narrower age bands, we've decided to modify our existing categories to reflect those two-year increments. We've also launched new target enrollment categories because more and more plans are embracing the target enrollment model. So, we have portfolios all the way from 2039-plus to a 2015 in three-year increments so that we can more closely analyze the performance of those portfolios.

Wallace: One of the areas that Morningstar analysts look at is the quality of the underlying investments. Can you speak a little bit about changes there?

Hume: Absolutely. We've seen a huge pickup in the quality of the investment options in 529 plans, which is a great win for college savers. So, we evaluate the quality of the investments through our Morningstar Analyst Ratings for mutual funds--most 529 investment options are composed of mutual funds, so this is a really great way to analyze whether these funds will deliver for college savers over the long term. About four years ago, 33% of investment options were Morningstar Medalists, and today, it's more than 66%. So, we've seen a huge pickup in quality in these 529 plans over that time horizon.

Wallace: That's great. And fees are another area of good news, is that right?

Hume: Yes, that's true. So, advisor-sold plans, which are typically the more expensive of the two distribution types, have a 0.93% expense ratio on average, which is a 0.06% reduction year-over-year. And direct-sold plans: They fell a little bit slower at 0.03%. But the all-in expense ratio on average is about 0.39%. So, college savers have a lot to look forward to in terms of affordability. That said, however, there are still some areas where 529 plans have room for improvement. There are a lot of underlying fees that limit the ability of 529 plans to reach the fees that would make them comparable to mutual funds. So, we are watching very closely those types of fees and trying to compare them as best we can, but the cost structures vary from plan to plan.

Wallace: And recently, there were some tax law changes that allowed 529s tax benefits to extend to K-12 private school. What kind of changes have you noticed based on that?

Hume: I would say the majority of 529 plans are still kind of absorbing the implications of the legislation, and they've reacted in several different ways. So, some states like Missouri automatically conform to Federal tax law, which meant that there was an equal tax benefit at the state level as compared to the Federal level where the capital gains taxes are waived for 529 savers. So, they are right in lock step with each other. Other states have tried to pass legislation to conform to Federal legislation on the 529 tax benefits but have failed to do so. That would include New York and Colorado. And finally, some states like Massachusetts and Illinois, our home state, have actually come out and said that these plans are exclusively for college savers and are not recognizing any state-level tax benefits to match the Federal tax benefits.

Wallace: So, you'd have to check with your state.

Hume: Absolutely. Yes.

Wallace: All right. This is a great report. It's got a ton of great information. Thanks so much for being here to discuss it.

Hume: Thank you so much for having me.

Wallace: For Morningstar, I'm Karen Wallace.

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Gregg Wolper: Now that emerging markets have become an accepted destination for many investors, some are looking to the next level: frontier markets. Those are countries that are considered a little less developed than emerging markets as far as their stock markets, but not all frontier-markets funds are the same. Most of them do own smaller emerging markets as well as frontier markets, but there are differences.

For instance, Harding Loevner, their frontier-markets fund, that has about 15% to 20% of their assets in the Philippines alone. Their number-two holding, Jollibee Foods, which has about 4%--a fast food chain in the Philippines--that stock you won't find at all in Ashmore's version, which is Ashmore Emerging Markets Frontier Equity. That doesn't own Jollibee, and in fact, it only has about 3% in the Philippines--3% versus 15% to 20%.

What does the Ashmore fund own? The Ashmore fund has 10% of assets, a little more, in fact, than 10%, in National Bank of Kuwait, and it has about 17% total in the country of Kuwait. The Harding Loevner fund has some in Kuwait but not nearly that much. There are other differences in country weightings, in sector weightings, in individual stocks, but that captures how different portfolios can be. 

Now, there is one similarity among the funds, and that's, unfortunately, their cost. Both of these funds have expense ratios of about 1.5%, and that's for the institutional shares. They both have Morningstar Analyst Ratings of Neutral, so they're not ideal. But if you're looking for a frontier-markets fund, the most important thing is to look at what they own and how much they cost.