Investing Insights: Top Small-Caps and Stock With 30% Upside

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

***

Susan Dziubinski: Hi, I'm Susan Dziubinski for Morningstar. Last month, we introduced the Morningstar Awards for Investing Excellence. We nominated several topnotch professionals for the Outstanding Portfolio Manager award. Here is a look at some of the nominees and their funds. All of these funds are currently open to new investors.

Robby Greengold: Joel Tillinghast has managed Fidelity Low-Priced Stock for nearly 30 years. Since the fund's 1989 inception, Tillinghast has steadily built one of the finest track records of any fund in the mid- or small-cap Morningstar Categories. He has achieved that by reliably preserving shareholder capital while participating healthily on the upside. And that pattern derives from Tillinghast's extraordinarily methodical approach, his ability to spot high-quality companies, and his refusal to chase short-term fads. This portfolio is broadly diversified across hundreds of companies, and for each of those positions, Tillinghast focuses on the long run. Tillinghast is really looking for resilient businesses that have staying power. What that means in practice is that he is avoiding, or he is trying to avoid, companies that lack an enduring competitive advantage. He steers clear of companies that are loaded up on too much debt. And he looks for honest, capable management that he feels like he can invest with for the long run. Almost without fail, this strategy has offered equity investors refuge during periods of market volatility. And with Tillinghast's steady hand at the wheel, we continue to have high confidence in this Silver-rated fund.

Sarah Bush: In his nearly three decades with Loomis Sayles Bond, Dan Fuss has followed an often contrarian and deep-value approach to bond investing. Today he is joined by a team that includes comanagers Elaine Stokes, Matt Eagan, and Brian Kennedy, and the portfolio managers have a wide investment mandate that includes all types of bonds, including junk bonds, nondollar U.S. currencies, and even the occasional common stock. This makes for an aggressive strategy with the potential for big drawdowns. But over the years, the team's deep research and willingness to go against the crowd has resulted in big wins for the fund and for shareholders. These wins include investing in troubled Irish sovereign debt, investing in financials in Europe at the height of that area's difficulties, and more recently buying high-yield in 2014 and 2015 when that sector ran into trouble. For those who stuck with the fund over the long haul, the returns have been impressive. This remains a strong choice for those with the requisite patience and risk tolerance.

Alaina Bompiedi: Baird Aggregate Bond is stewarded by Outstanding Portfolio Manager nominee Mary Ellen Stanek and a tenured staff of five comanagers. It has achieved one of the best long-term records in its category with a straightforward and circumspect approach. On the surface, Stanek and team ply a deceptively simple process, but the devil is in the details. Each bond in the portfolio represents a strategic over- or underweight versus its size in the Bloomberg Barclays Aggregate Bond Index. This practice is complemented by a valuation-sensitive sector rotation, while the fund's duration is kept neutral to the benchmark's so as to inhibit volatility from interest rates. The fund's returns thus don't veer too far away from its index but have nonetheless been additive over time. Stanek's contributions extend outside this portfolio, too. As Baird chief investment officer, Stanek has aligned staff incentives with portfolio performance, encouraged employees' career development, and was an early advocate for low fees across Baird's fund complex. The fund's retail share class has had an expense ratio of 55 basis points since its launch in 2000. That fee was low then and continues to be low today relative to its competitors. This thoughtfully designed, predictable portfolio has served investors well and continues to instill confidence.

***

Christine Benz: Hi, I'm Christine Benz for Morningstar. I'm here at the Morningstar Investment Conference, and I'm delighted to be joined today by Carolyn McClanahan. She is cofounder of Whealthcare Planning and she is going to be talking to us today about cognitive decline and how individual investors and potentially financial advisors who are assisting them can help assist their clients in protecting against cognitive decline affecting their financial plans.

Carolyn, thank you so much for being here.

Carolyn McClanahan: It's a pleasure to be here. Thanks for having me.

Benz: Carolyn, let's talk about what percentage of the population aged 65 and older is experiencing some type of cognitive decline.

McClanahan: Well, the numbers are very high. Once 65, it's about 10% of people have Alzheimer's, so true dementia. And then, an even higher number have mild cognitive impairment, which means you can still function well, but you just don't think as well as you used to. The older you get; the numbers get scarier. So, it's important for people to plan for this.

Benz: Let's talk about the risk factors that tend to make us more vulnerable to experiencing cognitive decline.

McClanahan: Well, of course, the No. 1 risk factor is aging. The older you get--and those are obvious, but women are at higher risk. People who have chronic medical illnesses such as hypertension, diabetes are at higher risk. People who smoke are at higher risk. So, anything that kind of affects the blood flow to the brain puts you at a higher risk.

Benz: Okay. So, obviously, the results and the effects of cognitive decline can be devastating in many different ways. But one area that I want to focus on is the financial piece. So, people who are experiencing cognitive decline are susceptible to making financial mistakes and they are also susceptible to financial fraud. So, let's start with the first piece. If I'm an individual investor, and I know a lot of our audience would consist of dedicated individual investors, how can I kind of build a fireproof wall into my plan to ensure that I can't make too many mistakes to really ruin everything?

McClanahan: Yeah. The most important thing as an individual investor ages is to start to simplify things. Because as we age, we lose the flexibility in our brains to make complex decisions, especially if we need to make them quickly. And so, by buying more simple investments, staying away from complicated private placements and things like that is really smart. The other thing is, it's really important to police yourself. Now there are tools out there, like one of the tools we developed through Whealthcare Planning, so that investors can test themselves to see if they are having issues with finance decision-making.

Benz: Okay. Let's talk about the financial fraud piece. It seems like maybe the gold standard of protecting yourself against financial fraud would be to align yourself with a financial advisor who you've worked with for many years. But say we are talking about people who have really constructed their financial plans on their own and have been managing on their own. What can they do to protect themselves against financial fraud?

McClanahan: So, as we age, we tend to become more concrete in our thinking and it's important for you to understand, What is it that puts you at risk of fraud? And if you rely on your gut decisions for making financial decisions, that's a bad thing. If you tend to go on what other people say and trust what people say instead of doing your own research, that puts you at risk. So, there are a number of factors that put you at risk. So, to learn about your factors is really important, so you can guard against those. What we lose in flexibility in our brains as we age, ideally, we have replaced with wisdom. So, people need to understand themselves early, start policing themselves in their 50s or early 60s before they develop problems, understand how the brain works so that when they age and they are becoming more concrete, ideally, they've had--they've put those building blocks in place to reduce the risk of fraud and abuse.

Benz: Are there other ways to build in safeguards, like maybe bringing a trusted adult child onboard your financial matters?

McClanahan: Absolutely. It's very important. Ninety percent of fraud is actually done by people who are close to us.

Benz: Within the family.

McClanahan: Within the family or our close friends. They don't steal as much money, though, as the other 10%. The other 10% are like Nigerian prince scams and all those crazy things that people still fall for. And so, the ideal way to prevent fraud and abuse is to create transparency within your financial situation. So, for example, a lot of older people don't want to share their business with their children. It's important to share it with multiple people, so that as you age, people can start looking in. And when I say share your business, you don't have to give them access to accounts. You can use things like a financial portal, like Mint.com or eMoney, where they can monitor you and see what you are doing without actually having access to your accounts.

Benz: Okay. Carolyn, I'm thrilled to have you here. This is such an important topic.

McClanahan: Yes. Thank you.

Benz: Thank you so much for being here.

McClanahan: It's been a pleasure.

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

***

Linda Abu Mushrefova: For investors seeking deep-value large cap exposure, LSV Value Equity is an excellent option. The fund earns a Morningstar Analyst Rating of Silver for its seasoned team and proven approach.

The fund benefits from a deep and stable bench. Josef Lakonishok co-founded LSV in 1994 and is supported by 10 additional investment professionals and three academic advisors. Comanager Menno Vermeulen, who created the firm’s proprietary quantitative model in the 1990s, is still responsible for data management and ongoing model enhancements. Together, the team boasts 20-plus years of industry experience, on average, and more than 13 years with the firm. Retention here has been exceptional. They have not seen any departures since 2008, when firm co-founder Robert Vishny retired.

The team has consistently applied its proprietary quant model to identify attractively valued large-cap stocks. It looks for companies with strong earnings, cash flows, and dividends. The fund’s deep value bias pushes it into cheaper and smaller-cap stocks than its typical large value Morningstar Category peer, and these stocks tend to be more volatile and have more downside risk. So while long-term results have been attractive, the ride has not always been smooth. Historically, it has captured more of its Russell 1000 Value Index benchmark’s upside but has not protected on the downside. Nevertheless, its risk-adjusted results over the long haul have justified this added volatility.

Despite short-term swings in performance, its disciplined approach should continue to reward patient investors over a full market cycle.

***

Preston Caldwell: Over the past month, share prices for oilfield-service companies have plummeted again, approaching lows set late last December. Share prices for many names are hovering around 15-plus-year lows.

Our views on the sector have remained largely unchanged despite this drop in sentiment, and so much of our coverage list looks undervalued. We still think the market is implying expectations for oil and gas capex that are much too low. We estimate that the market-implied expectation is flat international capex growth through 2023. This manifests in several international-levered oilfield-service firms being undervalued. In particular, we highlight Schlumberger, NOV, and TechnipFMC.

First, Schlumberger has peer-leading international exposure and therefore is highly affected by the market's pessimistic view on international capex. Schlumberger is poised to gain market share and boost its profitability as a result of its integrated businesses (such as Schlumberger Production Management), which are driving cost savings in oil and gas development. We think Schlumberger's advantage here is missed by the market.

Next, NOV is also being underrated by the market. NOV’s core rig equipment business will benefit from a rebound in drillers’ maintenance capex. NOV’s non-rig businesses will continue to benefit from the rebound in coming years in the overall oil and gas activity.

Finally, TechnipFMC also looks attractively priced. We think the market concerns with industry headwinds are overblown, and investors aren't fully appreciating TechnipFMC's advantage in subsea integration.

***

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Small-cap stocks can add some oomph to a portfolio, but they also have the potential to add some volatility. Joining me to share some favorite small-cap actively managed stock funds is Russ Kinnel. He's Morningstar's director of manager research. Russ, thank you so much for being here.

Russ Kinnel: Happy to be here.

Benz: Russ, let's talk about small-cap stocks--how investors should approach this because there's some academic data that points to small-cap stocks outperforming the broad market over time, but probably don't want to go crazy with them. You want to right-size your allocation. What's kind of an approximate weighting within my equity portfolio that I might dedicate to small-cap stocks?

Kinnel: Well, small caps represent a little less than 10% of the market, so I think anywhere between 5% and 15% would be a reasonable weight. Obviously, you could go above or below that, but I think that's generally a ballpark figure that works for most people.

Benz: So let's get into some of these funds. They're actively managed. Before we get into them, let's just talk about indexing this space. That's a viable idea as well, right?

Kinnel: That's right. It is a viable idea. Active small-cap funds have done better versus the benchmarks than in large-cap space. So some people who will do large cap passive will go with small caps, but I think both are legitimate ways of investing in the small-cap area.

Benz: We're going to look at some of your favorites. Let's start with Mairs & Powers Small Cap. People might be familiar with Mairs & Power Growth, which is a large cap-oriented fund. This one lands in the small-cap blend category, and it's Silver-rated. Let's talk about what you like about it.

Kinnel: It reopened in the fall of last year. So I always like to get funds after they reopen. It's a bit of a contrarian signal.

Benz: Why is that?

Kinnel: Well, because generally you're reopening because investors have gone out of the fund a little bit, which is often a signal that it may be time to get in. And this fund actually closed at a very low level anyway, so I think actually they're very prudent about managing that asset base. It's a fund that looks for companies with sustainable competitive advantages, and it has a bit of a defensive characteristic to it, so that in most down markets, it loses less, which I like a lot.

Benz: Right. Another thing about it, like all of the Mairs & Power funds, it focuses on companies that are based kind of in its general environs, so in the Midwest. What's going on there, and what's the thesis there?

Kinnel: Yeah. It's a little quirky. They're based in Minnesota, and they invest in a lot of companies that are not far from Minnesota, which is a little odd, but at the same time, they do a great job with it. As I mentioned, the portfolio is fairly defensive, so it's not like you're being exposed to extreme risks. Again, we talked at the beginning about how this--Say your total small-cap exposure is 5% to 15%, and let's say this is one of two, then that means a fairly small part of your portfolio. So, I don't think it is that big a deal that they have this unusual regional focus. They're not exclusively dedicated to the Midwest, but it's mostly in Midwest.

Benz: So you mentioned that that one tends to be kind of a mild-mannered fund, a good performer on the downside. Loomis Sayles Small Cap Growth definitely runs toward the more aggressive side of the spectrum within the small-cap space. Let's talk about it and why you and the team like its strategy.

Kinnel: It's also recently reopened, also Silver-rated. Managers Mark Burns and John Slavik have run the fund since 2005, so really nice track record, really kind of a classic growth strategy. And, again, as the fact that they were closed and then reopened indicates they are mindful of their capacity, which is a huge thing, especially in small growth because small growth is also another word for momentum, really. Small-cap companies are growing well. All of a sudden, momentum trade piles in and it can push it up and down very quickly, and so capacity is really important here.

Benz: Finally, let's discuss LSV Small Cap Value. This one, too, is Silver-rated. This is a quantitatively managed fund, and I guess the question is: There have been so many new factor-based ETFs that in some ways kind of replicate quant strategies, at least in my mind. How does this fund, do you think, add value within this increasingly crowded space?

Kinnel: That's right. There're a lot of ETFs, a lot of strategic-beta variations that you can find out there and that I think raise the bar for any kind of quantitative strategy, but this one isn't simply one or two screens. This is a firm that employs a lot of Ph.D.s, who do a reasonable job of building models, and they keep updating things, but they also don't seem to be the kind who chase every last factor down. So, I think you got a nice well-built portfolio from this process. It cost a little more, but if you look at the long-term performance record, it would seem to justify it.

Benz: Russ, I know our viewers always love to get your picks. Thank you so much for being here.

Kinnel: You're welcome.

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

***

Michael Wong: Narrow-moat Goldman Sachs is currently trading at around tangible book value, and it has over 30% upside to our fair value estimate. Many investment banks have had a relatively slow start to the year, but Goldman Sachs still had an annualized 11.7% return on tangible equity during the first quarter, which generally would justify the company trading at a premium to its tangible book value. Our fair value estimate correlates to a price/tangible book value of about 1.3 times and a normalized return on tangible common equity of 13% to 14%.

The most interesting part of the Goldman Sachs story right now is the market not giving the company credit for all of the initiatives that the company has in the pipeline. This reminds us a lot of the period right after Morgan Stanley did its JV with Smith Barney, where it was fairly clear to us that Morgan Stanley was increasing its proportion of capital light and relatively steady earnings that would improve return on equity, and the path to increase those earnings was fairly clear. Goldman Sachs is doing something similar but about a decade later.

Among Goldman's newer initiatives include a push into more consumer finance, such as deposit taking and consumer loans with its Marcus digital bank; corporate cash management; asset and wealth management; and optimizing some of its traditional businesses such as its fixed income, currency, and commodities trading operations. While it might be difficult to see the bottom-line effects of these new initiatives during the next two years--as the company is in an investment stage to build out these businesses, so costs will be a bit elevated and there remains the overhang of a potential legal settlement--we believe the company is pursuing a reasonable strategy that should improve the company's long-run return on equity and earnings quality. With a higher ROE, a more transparent business, and more steady earnings, we believe the market will eventually value the company like us at a material premium to tangible book value.