Tech Stocks for Dividend Seekers and Choosing Bond Funds

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Brian Colello: There are three investment ideas that we like that pay healthy dividends in the technology sector. This first one is Intel, trading at $50 per share. We think the stock is worth $65 per share. It pays a dividend of 31.5 cents per share per quarter, or $1.26 a year. That's about a 2.5% dividend yield. We have a wide moat rating on Intel. It stems from cost advantages realized in the design and manufacturing of chips. They faced a manufacturing delay, which led to a sell-off. They had issues with the CEO that have since been resolved. Long term, we think they'll overcome these issues. They will likely lose some market share to AMD, and they have been in the near term, but we think that's more than priced into the stock, and we're relatively more optimistic than the Street that they'll stem the share loses. And Intel has a lot of opportunities to grow outside of the PC and the data center, specifically in automotive with Mobileye.

The next stock we like is Broadcom, trading at about $274. We have a $300 fair value estimate on Broadcom. So only slightly undervalued. But the company pays a dividend of $2.65 per quarter, $10.60 per year. And that's a 3.8% dividend yield at recent prices. We think Broadcom's a narrow-moat firm based on design expertise in a variety of areas, mostly in semiconductors. And they continue to acquire cash-rich businesses such as CA and Symantec's enterprise business. We don't see a lot of strategic synergies with these deals, but they're buying cash-rich businesses and should be able to fund this dividend.

The third company we like is Nokia. U.S. shares are trading at $4.90. We think the stock is worth $7.80 per share. So it's significantly undervalued. The last dividend Nokia paid out was 22 cents in U.S. dollar terms per share. That's a 4.4% dividend yield. It's a no-moat name because we think there's cutthroat competition in the wireless equipment industry. But Nokia is one of the leaders. It's a prominent player selling 5G equipment to a host of telecom carriers as they roll out 5G networks over the next decade. And we think there's room for margin expansion at Nokia as they shift to selling more software and services. ***

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar.com. Investors reviewing the bond-fund landscape may be overwhelmed by choices, especially if they're new to bond investing. Joining me to discuss which types of bond funds make sense for most investors is Morningstar's director of personal finance, Christine Benz.

Christine, thank you for joining us today.

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

Dziubinski: Now, let's start with a really basic question. Why should someone consider owning bond funds in the first place?

Benz: Well, the key reason is that you earn some type of income depending on the bond. And that income is quite stable because the bond issuers are held to deliver that income to people who purchase their bonds. So, it's a stable source of income. Income is not really high. So, when you compare long-term bond returns relative to stocks, it's nothing to write home about. The big advantage from a portfolio standpoint is that bonds are really the stabilizers for your portfolio. So, your equities are going to be more volatile. They'll have periods where they will perform really well. They'll have periods where they'll be in a downswing. The bonds tend to just perform steady as she goes. Especially as you get older, and you get closer to needing your money, you want to care more about that stability. And that's what bonds bring to the table.

Dziubinski: Now, if an investor decides, yes, I want to own bonds, and I want to own them through a bond fund, that investor is going to have a lot of choices. What are some of the things you need to be thinking about?

Benz: Well, I would say the key thing is probably to focus on your time horizon--your proximity to needing the money. So, if you have a very short-term time horizon of like a couple of years--so maybe it's like next year's tuition bill or the property tax bill or something like that--you probably want to keep the money very safe. You'd want to keep it in true cash investments. Cash investments mostly are FDIC-insured. Money market mutual funds are a separate category; they're not. But these investments are all but guaranteed if not guaranteed. So, near-term spending, keep that money in cash.

Then, if you have, say, a two- to three-year time horizon, I think that a short-term bond fund, kind of a core short-term fund that might own a gamut of different bond types from government bonds to some high-quality corporate bonds, maybe some mortgage-backed bonds, that can make sense.

And then, if you have a slightly longer time horizon, like a time horizon of three to five years, or maybe even a little bit longer than that, I think there you can safely use intermediate-term bonds. Here, again, I would focus on the core intermediate-term bond categories. Morningstar has two--core and core-plus. Either of them, I think, makes sense for spending horizons of three to five years. The core-plus funds generally have a little bit more sort of other exposure. So, their yields are higher, but they might invest in foreign bonds or in higher-yielding corporate bonds. So, they entail a little bit more risk. But those are sort of the core building blocks that I would focus on. I think for many--most--investors, they can be kind of one and done with these bond types; they probably don't need to venture much beyond them.

Dziubinski: Now, one thing you didn't address there were long-term bond funds. Why not?

Benz: Well, certainly, when you look at yields, sometimes they can be more attractive than short- and intermediate-term bond funds. And long-term bonds also look great, especially long-term government bonds, from the standpoint of diversifying equity exposure in a portfolio. So, if you're looking for a single category that looks really good from that perspective, long-term government bonds are excellent. The reason we don't typically recommend them at Morningstar is that they're just really volatile. So, as stand-alone investments, they act kind of equitylike in terms of their behavior. And that's not what most investors own bonds for. Most investors own them for that stabilizer role that we talked about.

Dziubinski: Right. Now, if I'm an investor, I see that I can invest either in taxable-bond funds or municipal-bond funds. What are some things to take into consideration to decide which one would be right for me?

Benz: Well, the key thing to think about is to think about your tax rate, because the thing that's going on with municipal bonds is that their income is free of federal tax typically, and it may also be free of state and local tax if you buy a bond from your home municipality. So, there are tax advantages that come along with municipal bonds. That's why people buy them. But those tax advantages are most beneficial to folks who are in the higher tax brackets. So, here, I think it makes sense to put some math behind your decision about what to do. A key point I would make is if you're talking about investing inside of a tax-deferred rapper, like an IRA, don't worry about municipal bonds. They're not for you. They are for your taxable account. But check your tax rate; use a bond calculator to determine whether you're better off in the municipal bond or in the taxable bond.

Dziubinski: And lastly, when we talk about diversifying our equity exposure in our equity portfolios, we often talk about using international funds as a part of that. What about international-bond funds? Should we be thinking about that when it comes to fixed income?

Benz: I think that they can certainly be a diversifier for a portfolio. From a diversification standpoint, the international-bond funds that provide foreign-currency exposure as well as exposure to bond funds--these are the unhedged foreign bond products--those look really great from a diversification perspective if you're looking to diversify your U.S. bond exposure. The trouble is, similar to long-term bonds, they're really volatile. And that's not what most people want when they're thinking about their bond holdings. If you're looking at adding international exposure to your bond portfolio, my bias would be toward the hedged foreign-bond funds. Sort of a very low-cost hedged product, I think, can make sense to help diversify your U.S. bond exposure. I don't see the category as an essential ingredient. I think for most U.S. investors, building out their short- and intermediate-term bond exposure is probably the key priority.

Dziubinski: Great. Thank you so much for the insights today, Christine. We appreciate it.

Benz: Thank you, Susan.

Dziubinski: I'm Susan Dziubinski for Morningstar.com. Thanks for tuning in. ***

Christine Benz: Hi. I'm Christine Benz for Morningstar.com. As we move into the fourth quarter, many mutual fund investors begin thinking about mutual fund capital gains distributions. Joining me to provide a preview of what investors should keep an eye out for is Russ Kinnel. He is Morningstar's director of manager research.

Russ, thank you so much for being here.

Russ Kinnel: Glad to be here.

Benz: Russ, let's just start with a question about why this happens--why mutual funds make these distributions--and then also let's talk about how they can affect investors who own these funds in their taxable accounts.

Kinnel: Tax laws require that mutual funds net out their capital gains, so they subtract their realized capital gains from the realized losses and distribute the difference evenly to all fundholders. Typically they do that at the end of the year. Usually it's based on the gains realized through the end of October. So, it's kind of an annual thing and in a long-running bull market it means just about every equity fund out there is distributing some capital gains most years.

Benz: We've seen particularly large distributions from some funds in the past few years. That owes in part to this long-running bull market that you just referenced, Russ. But let's talk about how fund flows can exacerbate this dynamic, where, if funds have been getting redemptions, they will make extra-large payouts in some cases.

Kinnel: That's right. So, because you spread out those capital gains among all the shareholders as of the distribution date in December, if that number of fundholders shrinks, then now you have more capital gains among fewer holders. So, you have a smaller base. If you have inflows, you have a bigger base, but then on top of that, of course, if you have a lot of outflows, you are forced to sell. So, a fund manager may be forced to sell even some of their winning positions and if that's being going on for a while, they may well have gone through their higher cost positions and of course you can't just simply sell the lower cost and let your fund become really lopsided. So, inevitably significant outflows lead to big capital gains in a bull market.

Benz: And we have seen particularly large outflows among many U.S. equity funds where investors appear to be trading into passive options. So, that's been another headwind in the mix, too. So, let's discuss other factors that can influence big payouts. Manager changes are one as well. Can you walk us through how that works from the standpoint of triggering distributions?

Kinnel: Yeah. So sometimes a manager change doesn't result in a really big change in the portfolio, but sometimes it does. The most dramatic is usually when there is a new subadvisor, because the subadvisor may well plug in their existing strategy portfolio, and therefore, they may really change over the portfolio. But even if it's simply a different manager within the same firm, they may have different holdings they like, they may be brought in to create some change--maybe the fund was floundering and the firm wants them to change the strategy. So, either way you can have some significant distributions with a new manager.

Benz: So funds begin making estimates of these distribution, say, start posting it them on their websites typically, but you attempted to kind of get ahead of that and look into fund data to try to figure out, "Well, which funds look like they could potentially be ready to make distributions?" What factors did you look at?

Kinnel: Yeah. It's in an exact science. But if you look at a few things usually you can get a ballpark idea. So outflows is a big one, of course. Returns--obviously you need to have some pretty good positive returns to have gains in the first place. Figures like tax-cost ratio, which is telling you about the past payouts, and similarly, if you have a rising trend of tax distributions. A particular red flag is if you have two a year--that means they are really trying to get ahead of things, they're really under the gun, they have a lot to distribute. So that's another red flag. And then, another one is potential capital gains exposure, which is, again, kind of a ballpark figure of just rough idea of how much gains a fund might have to realize if they sold the whole thing. So, obviously you're not going to see a fund pay out that whole amount, but the more embedded gains, the more likely it is to have at least some distribution.

Benz: So in the category of a fund that has been seeing redemptions and in turn looks like it could be poised to make at least some sort of a distribution this year, Davis New York Venture hit your screen.

Kinnel: Yeah, that's one that has been making two distributions a year. It's been in redemptions for a number of years. And so, I'm not necessarily expecting a massive, but I would expect probably something along the line of recent years, which is a sizable distribution.

Benz: OK. USAA International is another one. This one saw a manager change, and so you think that makes distribution likely.

Kinnel: That's right. USAA sold its fund lineup to Victory, and Victory fired the lead subadvisor on this fund, MFS, to bring it in-house. More profitable for Victory, but it also means a significant portfolio turnover and a likely capital gains payout.

Benz: So, a question here is, What should investors do if they're owning one of these funds in a taxable account? Should they try to sell ahead of the distribution? What sort of thought process should go on?

Kinnel: Yeah, well, it really depends what your cost basis is. Now fund companies are better at reporting that, so it shouldn't be too hard for you to see, "What's my embedded gain? How much have I got left?" Because if they've been distributing a lot already, maybe you've already paid most of your gains. And so selling wouldn't come with a big penalty. On the other hand, it might, and therefore it's kind of a wash. So, look at your own tax position, and you should be able to figure out what the best course is.

Benz: And I think a key takeaway is if I'm adding new assets to my taxable accounts ... really want to be deliberate about that process because some of these actively managed funds have not looked great from the standpoint of tax efficiency.

Kinnel: That's right. Asset location is a big deal, and part of that is deciding what should be in a taxable and what should be in a tax-sheltered. So, if you do choose equity funds for your taxable accounts, you want to think about, What are the funds that are less likely to do that? And, obviously, equity funds that are in redemptions are probably the worst ones to do. And then, on the other hand, passive funds or funds that are getting inflows are among the better ones to put in your taxable account.

Benz: Russ, important topic. Thank you so much for being here to discuss it with us.

Kinnel: You're welcome.

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

Neil Macker: We recently completed a deep dive on the video-game space where we looked at a few areas of interest for investors. The first area of interest is the ongoing Netflix-ization of the video-game space in terms of subscription models. The all-you-can-eat model has come to the video-game space in the last five years, as companies like Microsoft, Ubisoft, and EA have all introduced plans over this time period. While these plans may be good on a monthly basis for many gamers, we continue to believe that most gamers will buy games on a one-off basis. This is largely due to the fact that we believe most gamers play one to three titles a month, versus viewers of film content who may be interacting with tens to even hundreds of titles on a monthly basis.

The success of Netflix has also brought on the advent of cloud gaming. In cloud gaming, the rendering and processing of the game is done on a server and then uses a local client to upload the game, versus consoles and PCs, where everything is done in the home itself. Google is launching its Stadia service in November, an attempt to replace the console and gaming PC in the home. In contrast, both Microsoft and Sony, we expect, will be using cloud to extend where gamers can play their games. We believe this method of cloud gaming will see more early adoption over the next three to five years than the console replacement strategy that Google is using.

The third area of interest for investors is the increased governmental scrutiny of microtransactions in the U.S. and the U.K. Randomized microtransactions, also known as loot boxes, loot crates, or card packs, have helped games like FIFA from EA and Overwatch from Activision Blizzard extend their revenue tails. Government officials have focused on these types of microtransactions because of their underlying principles, which are similar to slot machines and other forms of gambling. While we agree with the market consensus that the industry will self-regulate, we do believe that investors should pay attention to this area because this approach may not work in the long term. ***

Alex Bryan: The market has certainly exhibited a lot of volatility over the past year. Stock investors looking for a smoother ride and better downside protection than traditional index funds might consider a low-volatility stock fund. Well-constructed, low-cost funds like Invesco S&P 500 Low Volatility ETF and iShares Edge MSCI Minimum Volatility USA ETF should offer a better risk/reward trade-off than the market over the long term. These funds take very different approaches to reduce volatility, but they are both pretty effective.

The Invesco S&P 500 Low Volatility ETF is the more style pure of the two funds. It targets the least volatile 100 stocks from the S&P 500 and weights them by the inverse of their volatility, so that the least volatile stocks get the biggest weightings in the portfolio. As you might expect, this tends to pull the portfolio toward less volatile stocks like Waste Management and the Hershey Company, which tend to hold up a bit better than most during market downturns. However, this fund does not consider the correlations across stocks within the portfolio and it does not limit its sector weightings, which can lead to pretty big bets on sectors like utilities and REITs.

Now, in contrast, the iShares Edge MSCI Minimum Volatility USA ETF takes a more holistic approach to portfolio construction. It basically strives to construct the least volatile portfolio possible under a set of constraints. To do this, it considers both individual stock volatility as well as the correlations across stocks. So, a stock with high stand-alone volatility might make the cut if it has low correlations with other stocks in the portfolio. Now, this leads to a better diversified portfolio that should mitigate exposure to sources of risk that past volatility alone may not capture. This strategy also limits its sector tilts to within 5 percentage points of the market, which helps it avoid some of the large sector bets that the Invesco fund makes. This holistic approach should make the iShares fund a better core holding than the Invesco fund over the long term.