Investing Insights: Dividend Leaders and Stock Picks

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

***

Andrew Bischof: Utilities are rich, with the median utility trading about 10% above our fair value estimates. Low interest rates, an uncertain political environment, and a bevy of other factors have pushed utility valuations higher. Utility fundamentals remain strong, with good growth prospects, secure dividends, and sound balance sheets. However, with utility valuations, investors' long-term capital gains are at risk, even if utilities execute on their 5%-7% earnings and dividend growth. However, when compared to Treasuries, utilities remain an attractive source of yield income for investors. Even with elevated valuations, the spread between utilities' dividend yields and the 10-year U.S. Treasury remain above historical parity, with the spread widening to over 170 basis points. We almost reached parity late last year.

For dividend investors, we think NextEra Energy, Sempra Energy, and American Water Works have the highest dividend-growth potential. NextEra Energy's growth is driven by both regulated and contracted renewable opportunities, leading to nearly 14% dividend growth and 9% earnings growth. Sempra Energy's LNG opportunities and regulated infrastructure projects support our 11% dividend growth. Low payout ratios and continued consolidation among municipal utilities support American Water Works' attractive dividend growth. We forecast Southern Co. and Dominion Energy will be dividend-growth laggards, constrained by high payout ratios and capital investment needs. Finally, PPL's struggles in the United Kingdom will probably result in no dividend growth and could lead to a dividend cut after the next regulatory outcome.

***

Christine Benz: Hi, I'm Christine Benz for Morningstar. Investors in target-date funds tend to have good outcomes based on dollar-weighted returns. Joining me to discuss how investors can use target-date concepts to improve their take-home results is Josh Charlson. He's director of manager selection for Morningstar.

Josh, thank you so much for being here.

Josh Charlson: Great to be here.

Benz: Josh, let's just start with a really basic question. What is a target-date fund, and how are they different from funds that might focus on just a single asset class?

Charlson: Sure. So, target-date funds are professionally managed funds using a fund-of-funds structure, usually, that are essentially asset-allocation funds investing in different asset classes, very diversified, but they roll down the allocation over time. So, they're adjusting it as the investor ages to sort of accommodate the different risk profiles--and typically found in retirement plans.

Benz: Our colleague, Russ Kinnel, every year does this study where he looks at dollar-weighted returns, which measure the funds' returns married with cash flows, when investors bought and sold, with an eye toward determining: Where do investors do well in terms of capturing most or all of a fund's return? And where do they do not so well? And one finding that has been pretty consistent in Russ' research is that all-in-one investment types tend to look pretty good from the standpoint of investors being able to capture a lot of the fund's returns; target-date funds look especially good. Can you talk about why you think that is? And of course, there are a lot of different factors in the mix. But what are your leading assumptions?

Charlson: As you mentioned, target-date funds look very good. They tend to have positive investor returns. A lot of asset classes have negative investor returns. So, they encourage good ownership. Reasons for that, I think, one has to do with the level of diversification, both equity and fixed income, and then weaving in other asset classes, just tends out to smooth out the region profile over time. And so, investors don't tend to react as much to the ups and downs in the market. A second factor is--investors are typically dollar-cost averaging into them in their retirement plans, which helps smooth out their cash flows over time in a positive effect. And I think they just tend to sort of "set it and forget it." That's the way these investments are designed. So, they tend to see that they've got an allocation investment and leave it in there.

Benz: So, one thing we know, with 401(k) participants is that they oftentimes are sort of naturally inert. They might make their initial selections, or maybe they're even opted into a target-date fund. Sounds like they don't really do anything and that turns out to be a good thing for target-date.

Charlson: Absolutely.

Benz: So, let's talk about, say, I'm an investor who isn't investing in target-date funds, maybe I want to customize my own asset-allocation mix and pick my own funds. You say that there are still some takeaways that I can gain from looking at the success of target-date investors. One is simply to maintain adequate equity exposure--that that's been a key to target-date funds' long-term success.

Charlson: You'll see that almost all of the target-date series have very high allocation to equities early in the investor's lifetime. So, that early compounding of value is really important. So, not being afraid to take equity risk early in your career, I think, is one of the big lessons you get from looking at the way professional allocation experts design these target-date funds.

Benz: So, oftentimes for people who are, say, in their 20s and 30s, they might have upward of, what, 90% in equities…

Charlson: Typically, the average is around 90%. There are some series that go as high as 100%. Historically, there have been a few that are more conservative and have lower allocations, but more and more of those tend to be in the minority.

Benz: And then it stays pretty high throughout the investor's lifecycle. But as you said, Josh, when you were talking about how target-date funds are constructed, they do begin to take risk off the table later on. And you say that's another takeaway. I would say, that's probably top of mind for a lot of people approaching retirement today, de-risking at the appropriate date or around the appropriate date is really important.

Charlson: You tend to see a curve, it's called the glide path in the target-date lingo, where it remains pretty level at that high equity level for 15 to 20 years. But then they'll start to bring in fixed income to moderate the risk. You'll see the most variance between target-date series as you get closer to retirement 10 years out into retirement where there's more difference in philosophies. But you'll see all of them rolling down that risk. Some of them choose to do it later. Some of them choose to do it earlier. But really, that area around retirement is where there's greater risk if you were to have a sharp drawdown in that period. So, you will see a much lower equity allocation and higher fixed income during those periods.

Benz: Another thing that you say investors can take away from the success of target-date funds has been the importance of diversification. It sounds so basic, but when you look at the better target-date funds, what you see is that the managers kind of keep the faith in asset classes that have underperformed a little bit. How can investors use that intelligence?

Charlson: I would just say that diversification has been a little bit of a tough sell in recent years, because you've seen U.S. stocks really primarily doing better than most foreign markets, equities doing better than fixed income, etc., diversifying asset classes, in general, not adding as much value. But you'll see that most target-date managers have stuck to their very diversified portfolios, you know, emerging-markets bonds, emerging-markets equities, some of the smaller asset classes in smaller allocations. They're not backing away from them. And so, I would say that the long-term story about diversification remains very much in place. So, that's one of the lessons I take: not to run away from diversification, but to stick with it as a long-term investor.

Benz: You say another takeaway that investors can think of when they manage their own portfolios is the fact that target-date funds can seal a lot of their individual holdings' returns into kind of a neat package where you just see that bottom-line gain and so, investors shouldn't focus so much on the performance of their constituent holdings.

Charlson: I think one of the things that happens with target-date funds is, even though there are many funds underneath--it could be 10, it could be 20, it could be 30 with some managers--as an investor, you're not paying attention to what those individual funds are doing. You're looking at what the overall return of the portfolio is, and again, that tends to be smoothed out. So, you're seeing generally a nice steady return from target-date funds over time. The same with our own portfolios. We tend to look at what an individual fund is doing, and we might be encouraged to say, "Ooh, that fund is underperforming. Maybe I should yank it for something else ..."

Benz: "Or this one is really good and I'm going to put all my money into it."

Charlson: Right. Right. Exactly. Either way. So, that idea of just stepping away and thinking about what the portfolio is doing as a whole and not worrying so much about the intermediate parts, you know, month-to-month, quarter-to-quarter, that's another lesson that we can take from target-date series.

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

Charlson: Thanks for having me.

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

***

Gregg Wolper: Choosing or analyzing an international stock fund is really pretty similar to choosing one for U.S. stocks. There's many similarities. You want a fund with a strategy that you understand and that you're comfortable with and that makes sense to you. There should be an experienced manager in charge with a team with long tenures, if possible. Of course, cost is very important. You might have to pay a little bit more for an international stock fund, but you don't have to pay that much more. Cost is still important as with any fund. And performance, of course, you want to see some good long-term performance.

But there are some differences. Currency exposure, that's the main difference. When an international stock fund buys foreign stocks, they do it in foreign currency. So, you'll have exposure to foreign-currency movements. Some funds hedge that currency exposure back into the dollar, most don't, or some do it partially. But that's OK to have exposure to foreign currencies. Probably most of your portfolio, and if you own a house, most of your assets are in U.S. dollars. So, there's nothing wrong with having some exposure to foreign currencies. It's just a good idea to keep that in mind. That it will affect returns positively, sometimes negatively at other times.

Another difference is emerging markets. You'll have to decide: Do you want to own a separate fund that invests in emerging markets, which can have better growth potential but also more volatility? Or do you just want your international stock manager to make that decision him or herself? Buy stocks in emerging markets when they think they're appealing, or to not own them when they're out of favor? You can also own a fund that doesn't have any exposure at all to emerging markets. Again, any of those choices is reasonable. Just decide what your own preference is--and to understand what you own. As always, that's the most important thing.

All in all, it's not that different, remember, from owning a U.S. stock fund, but just make sure you understand some of those differences and find a fund that you're comfortable with.

***

Christine Benz: Hi, I'm Christine Benz from Morningstar.com. Many investors are quite reasonably confused about the tax treatment of their foreign stock fund holdings. Joining me to discuss that issue and to share a couple of tax-friendly favorites is Morningstar analyst Dan Sotiroff.

Dan, thank you so much for being here.

Daniel Sotiroff: Hi Christine.

Benz: Dan, let's talk about how this works. Because if I own a foreign stock and it pays a dividend, I get taxed on that dividend in the country where the company is domiciled.

Sotiroff: Right, that's correct.

Benz: And then if I look at my 1099, I see a tax credit there. So the goal is to prevent me from paying taxes twice, right? Is that basically it?

Sotiroff: That's the whole idea, right. Like you said, when a foreign company pays a dividend, that government is going to withhold part of that dividend, so you're never going to really see the whole dividend actually come through. So, as sort of a service to U.S. investors, Uncle Sam kind of gives you this ability to write off that dividend that you've paid to the foreign government in the form of a tax credit.

Benz: So, the issue though, and this is one reason why people have had questions about asset location, "Where should I put my foreign stocks? If I've got my foreign stock fund, for example, in my IRA, well, that tax credit's not of any use to me, right?"

Sotiroff: Pretty much, yeah, it's kind of a waste. But you got to remember you're not being taxed twice. So, you're not paying taxes to the U.S. government.

Benz: Because it's in the IRA wrapper.

Sotiroff: Because it's in the IRA wrapper, you're already getting that tax deferral and that tax-free gain depending on Roth or non-Roth.

Benz: So, do you have guidance about where people should hold foreign stock funds? Does it matter?

Sotiroff: You know, in my view, it doesn't really matter, because again, you're being taxed somewhere at the end of the day, right? So if you hold that foreign stock fund in a taxable account, you take the tax credit, you're not being taxed by foreign governments, but you're still going to pay taxes to the U.S. government on that income at your normal income rate. And like we were talking about before, if you are going to put that fund in your IRA or a tax-advantaged account, you no longer pay the U.S. government, but you're still on the hook for paying something to these foreign governments. So at the end of the day, it's a very complicated calculation that ends up, you know, in a certain extent, depending on what your future tax rate is going to--you just don't know. So to me, it's kind of a wash, you know, I don't really let that decision or the tax advantage drive my asset-allocation decisions at the end of the day.

Benz: Nonetheless, if I hold a foreign stock fund in my taxable account, I probably do want to keep an eye on taxes because one thing we know is that dividends have been a little higher overseas, certainly in recent years than in the U.S., right?

Sotiroff: That's true. That's made them a little bit disadvantaged from a tax perspective. And that's just--that's been sort of a persistent characteristic of foreign stocks in general. It's caused a lot of people to kind of flock to foreign stocks a little bit because they offer higher yields, but again, none of that is really guaranteed to persist into the future. You don't really know--foreign stocks in general tend to have very volatile dividends. So it's very possible that those yields could come down in the future. We just really don't know. You shouldn't be letting these things sort of drive your long-term investment decisions. They're more of, like, of-the-moment type things.

Benz: Okay. So if I'm looking at my taxable account, and I want to try to reduce the tax drag there, you have a couple of exchange-traded funds, index funds that you like for the job. Couple of them are from Vanguard. Let's talk about those.

Sotiroff: Yeah, so the Vanguard funds are great, just because they sort of have this ETF share class that's bolted on to the mutual fund share class, right? So the ETF share class they have this in-kind redemption mechanism. So, what that dual share class structure at Vanguard allows them to do is sort of purge the capital gains from their mutual fund through the ETF structure. It makes their mutual funds very, very tax-efficient. And you know, as always, ETFs are a great way to go in general because of that mechanism that I was just describing. You know, you can not only add Vanguard but BlackRock, Schwab, State Street, etc. Very tax-efficient in general--the best way to go is with an ETF in general.

Benz: OK, so a shortlist of funds you like Vanguard Developed Markets Index, Vanguard Total International, Schwab International Index.

Sotiroff: And probably another thing that hit on there. Those are all just broad indexed. Very low turnover, very low cost, great advantage overall for a long-term investment.

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

Sotiroff: Thank you.

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

***

Holly Black: Welcome to the Morningstar series, "Market Reaction." I'm Holly Black. With me today is Dan Kemp. He's chief investment officer at Morningstar Investment Management. Hello.

Dan Kemp: Hello, Holly.

Black: You're here because we're all talking about the R word at the moment, "recession." Why are we doing that?

Kemp: Well, it's a very good question. And it's somewhat circular, because when we see evidence of the economy slowing down, people naturally extrapolate that into a recession, which, as we know, is a period of negative growth that's not just a blip that normally lasts for six months or more. And we're all taught as investors and as consumers to fear recessions. And partly, that's conditioned by the big recession that we went through in 2008-2009. But it tends to be a story that plays in our emotions and often drives us to make bad decisions.

Black: And the thing that has sparked this is that last week the bond yield curve inverted. Horrible sentence. What does that mean? Why is it important?

Kemp: Well, I'll explain what it means, and it's a real question whether it's important or not, but we'll come on to that. So, what it means is that the price you pay to borrow money over the longer term if you are government is less than the price you pay the interest rate for borrowing over the short term. So, typically, when you lend money as an investor to a government by buying a bond--buying a promise to pay that money back--then the longer you're prepared to lend the money, the higher the interest rate you'll receive. And that makes sense because, of course, over the longer term, the risks are greater, whether it's the risk of inflation, which will eat away the real value of your money, or whether it's just a risk that something will happen to the government and they won't be able to pay it back. And so, the longer you're prepared to lend, the more you expect to receive back. And that's called the yield curve because, typically, it rises in a curvelike shape.

Now, what we've just seen in the U.S. is that the price of 10-year money--so, lending money to the U.S. government for 10 years--is now less than the two-year. And that's seen as significant by many forecasters because, in the past, it's tended to be associated with recessions. But we think investing is a little bit more subtle than just taking these very broad indicators and assuming that they'll be able to tell you what the future holds every time and, more importantly than that, they'll be able to tell you what will happen to asset prices. In reality, there's much more going on. And also, it only inverted for a very short period of time. I think it was two or three days. And so, when we think about an inverted yield curve, we shouldn't really pay it too much attention. We should just think about the overall opportunities for investors. And we would agree, they don't look great at the moment, but it's nothing to do with the yield curve. It's because prices are very high.

Black: The thing that blows my mind is that people will accept those returns. We had in Europe a couple of years ago, people accepting a negative rate of interest. And that is a sign of just how worried people are presumably.

Kemp: Well, that's right that people are concerned about lending money. That's one thing that's going on in markets. The other thing that's going on is that governments over the last decade have forced the price of borrowing lower. And so, by lowering short-term interest rates and by buying in bonds, which is a form of quantitative easing, QE, which people will remember, they are forcing interest rates low. And so, in some ways, forcing people to get a negative interest rate on their savings, either an actual negative interest rate or just a negative real rate, so negative return after we take into account inflation. Well, if you're getting a negative return in the bank, then it's sensible to go and look for a higher return elsewhere. But what that does, of course, is put pressure on these longer-dated rates or even on equity prices. So, the prices of everything rise, the return that you get as an investor falls, and that's why we think it's not a great time to take a lot of risk.

Black: So, lastly, what does this mean for me, not just me, any investor?

Kemp: Well, what it means for investors is very similar to what these normal economic signals mean, which is that you should ignore them generally. And instead of being too focused on the latest piece of economic news or the latest tweets by the President of the United States or whatever else is going on in a very noisy environment, you should really spend your time looking at the value of the assets that you're investing in or finding a great manager or a great financial advisor to help you do that. But focusing on the long term and the return that you can expect, not just on what the latest signal is. What that does is--if we pay too much attention to the signals, it drives us to make short-term poor decisions. So important to focus on the long term.

Black: Thank you so much for your time. And thanks for joining us.

***

Our quarterly series, Ultimate Stock-Pickers, culls investment ideas from the most-recent transactions of some of our favorite investment managers. With all but two of our Ultimate Stock-Pickers having reported their holdings for the second quarter of 2019, we now have a sense of which stocks piqued their interest.

The buying activity was somewhat concentrated within the industrials, energy, and technology sectors. Several of the stocks these managers added--including Booking Holdings BKNG and John Deere DE--are fairly valued by our metrics. Several, however, are undervalued by our standards.

For instance, three managers bought Cognizant Technology Solutions CTSH. This narrow-moat IT-services company is trading well below our fair value estimate, and we think it’s an attractive investment opportunity today.

Two managers picked up Microsoft MSFT. We think the wide-moat company is firing on all cylinders: Adoption of its cloud services has been strong and margins are improving. It, too, is trading below our fair value estimate.

And two other managers purchased shares of Diamondback Energy FANG. We think Diamondback is among the best-positioned oil producers in the business and can thrive at Morningstar's $55 per barrel West Texas Intermediate midcycle price estimate. Shares are undervalued today.