Equity Funds for Retirement and Dividends in Tobacco

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Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Most investors hold substantial exposure to stocks well into retirement. Joining me to share some favorite stock funds for retirees 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 by talking about why retirees should make room for stocks in their portfolios.

Kinnel: Yeah, it makes sense to dial down your stock exposure a little bit, but not dial it out because obviously, you can be in retirement for a long time. You need to keep up with inflation. Equities are a good way to do that. So, you may want to adjust your equity positioning, but you really need it for just about all retirees.

Benz: Right. Especially when you consider that retirees are retired for maybe 20 or 30 years or even more.

Kinnel: That's right. You need your capital to grow at least in some parts of your portfolio.

Benz: When you think about funds, equity funds that you think are good choices for retirees, what characteristics are you looking for? It sounds like maybe ones that manage risk a little better?

Kinnel: I want funds that have some components that manage risk well. I screen for funds that have low Morningstar risk scores, which means they're less volatile than their peers. But of course, it doesn't mean no risk. If you have a fund that's 80% or 90% equities and you have a bear market, of course, it's going to lose money, depending on--each bear market is different, but they're not risk-free by any stretch. But I think most retirees need to take on some risk to get to their goals.

Benz: Let's take a look at some of the funds that have low risk and that you like overall that have good analyst ratings, starting with T. Rowe Price Dividend Growth PRDGX. Maybe start with what is a dividend growth strategy because the dividend in absolute terms isn't especially impressive on this fund or any other dividend growth fund.

Kinnel: That's right. So, on the one hand, you have equity income, which is a deeper-value, higher-yielding strategy. Dividend growth is about companies that have a dividend but can grow that dividend. And obviously, to do that you have to have pretty healthy balance sheets and some good growth prospects. So, that takes--most of these funds are large blend funds and they have some growth and value characteristics. But it turns out that's also a really good defensive characteristic because those are the sort of companies that generally held up well in a downturn. So, we saw that in '08-'09 a lot of these funds lost less than the overall market.

Benz: This one is Silver-rated. Vanguard also has some good products in this general strategy, its Dividend Growth and Dividend Appreciation fund. Let's talk about a fund that I think of as being a little bit more idiosyncratic. This is AMG Yacktman YACKX. But it's a fund that you think nonetheless is a good fit for retirees' equity portfolios.

Kinnel: That's right. This fund, you think focused equity portfolio. That doesn't sound low risk at all. And to be sure, there is some individual security risk. But the fund tends to hold cash. Also, it's got a valuation and quality bent so that that tends to reduce risk. Again, it's not going to be risk-free. It's going to lose money in a bear market. But I think they've done a really good job of security selection as well as being risk-averse enough to generally lose less in downturns.

Benz: Another fund that you like for retirees' equity exposure is Fidelity Low-Priced Stock FLPSX. This is a familiar name, but let's just go over why you think it is a sensible choice, especially for people who want to make sure that they have small- and mid-cap exposure in their portfolios.

Kinnel: In this case, part of the risk management is that it's a very diffuse portfolio, really covers small- and mid-caps, value and blend, hundreds and hundreds of names. And generally, though, that leads to a fairly modest risk profile. Joel Tillinghast is the longtime manager of this fund, does a kind of amazing job of finding good quality companies trading at fairly modest prices. And if you look over the long history of the fund, it generally holds up pretty well in downturns.

Benz: One thing we always discuss in the context of this fund is, Joel Tillinghast is a veteran manager. He's been on the job for a long time. Anytime you're looking at a fund like that, I think it's worthwhile to think through succession strategy. Has Fidelity given any indication about what the next steps will be on that front?

Kinnel: Well, they have some comanagers listed who run a small sleeve of the funds. So, I think, presumably, they would take that over. And I wouldn't be surprised if--they haven't officially said that, but presumably they would take that over. So, you would probably have a number of people running the fund. Doing what Tillinghast does on his own is just about impossible for a normal person. He's just an extraordinary investor, just a remarkable investor. And so, you really would have to hand it off to a lot of people. So I agree, you want to watch that closely because it will be a different fund when Tillinghast retires, but we hope he doesn't retire soon because he does such a good job.

Benz: Your last idea is a fund that has some overseas exposure. Let's talk about that particular fund, but also how retirees might approach that question of how global their equity portfolio should be.

Kinnel: Foreign sounds risky, and it can be, but not as risky as our perception is. I think for most people it makes sense to have some exposure. Tweedy, Browne Value hedges a lot of their foreign currency exposure, so at least you don't have as much currency risk and therefore less volatility. They've got a mix of U.S. and foreign equities, and it's very much a value-driven strategy, which mutes risk a bit. It's a fairly diversified portfolio, that also mutes risk a bit. And they're just good stock-pickers. We're working on the second generation at Tweedy, but they really do a good job of building up their analysts and manager staff so that the transition's been a pretty smooth one.

Benz: Russ, thank you so much for being here to discuss these picks with us.

Kinnel: You're welcome.

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

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Philip Gorham: Love them or hate them, tobacco companies pay big dividends, but it's been a rough ride this year, with the stocks more volatile than they have been in the past. And with the industry facing some disruption, now's perhaps a good time to review the sustainability of those dividends.

Disruption is coming from the emergence of new products, particularly vaping devices. In the U.S., the FDA is clamping down on the marketing of vaping products. And if the vaping category is impaired as a result of that, we would generally see that as a positive for most of the tobacco industry. It may be attracting a new consumer, but vaping is highly competitive, economic moats are almost nonexistent, and margins are much lower than those of cigarettes as a result.

So if the category goes away, the consumer that switched to vaping, and perhaps dual-users of both products, may go back to smoking cigarettes, which remains a highly profitable, multi-cash-generative business that should be able to support dividend growth. Cigarette consumption is, of course, in decline in most markets. So growth is dependent on the company's being able to offset volume declines with price increases. Most markets, we think still have headroom for multiyear price hikes, and we expect that, that pricing power to drive earnings growth in the low single-digit range for the next few years.

However, economic road bumps, tax increases, or marketing restrictions can all have a usually temporary impact on price elasticity. So we recommend one of the globally diverse manufacturers in order to mitigate that risk. Those global players are yielding roughly between 5.5% to 7% yields currently. Philip Morris International is probably the highest-quality business. It has the leading position in higher-margin heated tobacco, and it's yielding over 5%. British American Tobacco is similar in size. It's a bit more skewed to vaping than heated tobacco, but with a 7% yield, it also looks pretty good value.

The company with the highest dividend yield is the UK's Imperial Brands, which is yielding 11%, and that's on the back of recent double-digit dividend growth and a pullback in the stock. We think this is probably the lowest-quality business of the group--it generally has weaker market positions. But while dividend growth will slow significantly to the low single digits in the near term, that 11% yield can't be ignored and the stock looks significantly undervalued.

So, while the headlines have certainly not been pretty, and there will be substitute product in some form going forward, the core cigarette businesses are chugging along reasonably well, and that should drive cash flow and growth for several years to come.

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Christine Benz: Hi, I'm Christine Benz for Morningstar. Assets in passive equity strategies recently surpassed active equity fund assets in the U.S., but bond index fund adoption has lagged that of stock funds. Joining me to discuss the pace of bond index fund adoption is Rich Powers. He's head of ETF product management in Vanguard's portfolio review department.

Rich, thank you so much for being here.

Rich Powers: Great to be here.

Benz: Rich, let's discuss trends that you at Vanguard observe in the realm of bond indexing, or maybe bond indexing beyond Vanguard. Historically, it has lagged a little bit behind; maybe there's been a perception among some investors that this is a place where you want to use an active product. Let's talk about trends that you've seen, and it sounds like maybe you're seeing a little bit of a shift in terms of investors not using bond index products.

Powers: Well, the facts are that many investors have gotten comfortable with equity indexing, be it in a fund or an ETF. They are a little slower to come up the curve in terms of fixed-income indexing. There's a variety of reasons for that. If you just looked at mutual funds as an example, and we'll use our lineup as a good case study, we launched our first index equity ETF in 1976. Our first bond index mutual fund wasn't launched until 1987. Now, it was the first bond index mutual fund in the industry. But there's a 10-year head start for equities. Very similar experience on the ETF side of things. The first equity ETF was launched in 1993. The first fixed-income ETF was launched 10 years later. And so, there's this natural head start that I think investors gain in comfort with equity indexing as a concept more so than fixed-income indexing as a concept. But there are other considerations there as well.

Benz: So, more recently, it sounds like you have been seeing a fair amount of enthusiasm for bond indexing. Let's talk about what the data show and why you think that is.

Powers: Yeah. If you look at industry ETF AUM as a proxy for this, about 18% to 19% of all industry AUM is in fixed-income index ETFs. In contrast, the cash flows over the last couple of years would be more like 30% to 40% of the cash flows are going to fixed-income ETFs. And so, investors, by and large, are adopting in a greater degree than what they currently hold today suggesting they're getting comfort with fixed-income ETFs as a vehicle for them to achieve whatever objectives they are trying to deliver to their clients.

Benz: So, I think there's a lot to like about sort of a core total bond market index ETF as sort of a diversifier for an equity portfolio. But let's talk about what we hear from some active managers of bond funds, which is that, "Well, the index product really isn't representative of what we are doing." So, let's talk about some of the emphases in the bond index versus what we see in, say, the core intermediate-term bond products.

Powers: I mean, there's a couple key differences that you see in the active manager side of things relative to, say, a Barclays Bloomberg Aggregate, which our BND product tracks. First, an obvious one would be active funds tend to have a greater tilt towards corporate bonds than that broad market index offers. Secondly, the active manager will usually move duration depending upon their view of where rates are headed relative to that proxy benchmark. And then, thirdly, would be their active managers usually will dabble in non-investment-grade bonds. So, it will be high yield or non-U.S. fixed income, while the BND or the Barclays Bloomberg Index will focus exclusively on U.S. dollar investment-grade bonds.

Benz: So, the net effect of that would be that in some big equity market shock, the total bond market index, because it has very high credit quality overall, might tend to be pretty good ballast, but then in other environments, it might not perform as well because yield isn't as high.

Powers: Right. In an environment where yield spreads are tightening for credit and the active manager is overweight that, that's certainly a tailwind to the active strategy relative to a broad market fund like a broad market index like our BND tracks, given that about a third of that is in corporates and the active fund is probably going to have much greater exposure.

Benz: So, I think investors when they look at bonds today, whether a total bond market index fund or, even, say, an active intermediate-term fund or a short-term funds, certainly, yields are really low. And so, I talk to a lot of investors who might say, "Why do I need bonds at all in my portfolio when I can pick up a cash yield that's competitive and get away from all that interest-rate risk?" What do you say to that?

Powers: Sure. I think you have to remember why fixed income or bond portfolios are held in a diversified portfolio. And it's really to be a ballast or the shock absorber during very volatile market environments on the equity side of things. Likewise, if the investor is considering "I'll use a cash option instead," I think that investor needs to be cognizant of when is the right time to move to cash and when will be the next right time to move back into fixed income. As we know, through all the different academic studies that have been undertaken, the ability to call future market environments, to call interest rates, is very challenging for professional investors, let alone a retail investor or an advisor. And so, the strategic asset allocation is the key here, and if fixed income is meant to be part of that portfolio, keeping that relatively static over time is probably the right answer.

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

Powers: Thanks, Christine.

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

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Jon Hale: Hi everyone, I'm Jon Hale, head of sustainable investing research at Morningstar. Starting this month, we've made some enhancements to the Morningstar Sustainability Rating for funds.

The enhanced version differs from its predecessor in three ways: First, it is focused on material ESG risk, rather than on a broader array of ESG issues, some of which may not be financially material to investors. Second, company ESG risks can now be compared across industries, rather than only within industry peer groups. And third--the new rating is simple and transparent, no longer requiring a complicated calculation.

Let's take a deeper look at each of these enhancements. First of all, the enhanced rating is based on the concept of material ESG Risk. The original rating reflected more generally how well-prepared a company was to handle a broad range of ESG issues--without a clear focus on materiality. The new rating reflects how much material ESG Risk remains after evaluating the actions a company has taken to mitigate those risks. By materiality, we mean ESG issues that can be reasonably expected to have a financial impact on a company. One important study found that firms that performed better on material ESG issues outperformed those that performed worse on material ESG issues and also outperformed those that focused on material issues more broadly without any emphasis on the more material ESG issues. For an oil and gas company, for example, carbon emissions are, obviously, a major material ESG Risk factor. For an Internet company, data privacy and security issues are big material ESG Risk factors. So different industries have a different mix of material ESG issues, and that's reflected in the enhanced ratings. Secondly--we can now compare companies across industries rather than only within industries. The original approach was based on how well companies managed ESG issues relative to their industry peer group only.

Our fund sustainability rating was thus based on which portfolios held a relatively higher proportion of ESG leaders within their industry and a relatively lower proportion of ESG industry laggards. For example, in the old rating, take two companies--Royal Dutch Shell and Microsoft. Both rated as industry leaders. For funds that held both, Shell and Microsoft would then have had the same impact on a fund’s sustainability rating. But intuitively, most of us probably suspect that, given the industry that it's in, Shell has more material ESG Risk than Microsoft.

The enhanced rating reflects that. Shell’s material ESG Risk is nearly 3 times higher than Microsoft’s, and therefore, Shell now has a much more negative impact on a portfolio. Within-industry comparisons do remain relevant, however. Shell remains one of the better ESG performers within the integrated oil and gas industry; its ESG Risk is about 25% lower than that of Exxon Mobil, so those portfolios with oil and gas exposure would still be better off from an ESG Risk perspective holding Shell rather than Exxon.

Finally, our original rating required a complicated calculation, because the ESG Ratings of the companies in a portfolio had to be normalized and we deducted points when companies were involved in significant ESG-related controversies. In the enhanced version, the use of a single scale of ESG Risk from Low to High means there is no need to normalize scores. And ESG-related controversies are incorporated into the overall company ESG Risk evaluation, so there is no longer a need for a controversy deduction.

That means there is a clear connection between company ESG Risk scores--and the portfolio score, which is an asset-weighted roll-up of the company scores. Globes are assigned the same way they’ve always been: Based the past 12 months of portfolios, a fund’s Sustainability Score--derived from company-level ESG Risk--is compared with its global peer group, and globes are assigned 1 to 5 based on a normal distribution.

Our enhanced sustainability rating provides a way to evaluate any portfolio on ESG Risk. Investors can use it to evaluate how much ESG Risk is embedded in the funds they own and to identify funds with lower levels of ESG Risk as an alternative. While those wanting to invest in, or evaluate, intentional sustainability-focused funds should expect those funds to have relatively low ESG Risk. The rating should just be a first step in a broader evaluation of those funds. Investors may also want to know how funds with a sustainable investing mandate engage with companies, vote their proxies, and, more broadly, seek to provide impact alongside financial return.

For Morningstar, I’m Jon Hale. Thanks for watching.

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Susan Dziubinski: Hi, I'm Susan Dziubinski from Morningstar.com. A strong market environment and year-end mean that it's an opportune time for investors to think about how they can be charitable, while also improving their portfolios, and today after all, is Giving Tuesday, the perfect time to discuss it. Joining me is Christine Benz, Morningstar's director of personal finance.

Christine, thank you for joining us today.

Christine Benz: Susan, it's my pleasure.

Dziubinski: Now, what's the connection between a strong market environment and charitable giving?

Benz: The big one is that many investors have appreciated securities in their portfolios. If they have stocks in their portfolios, chances are they've had some things that have gone up, and so the advantage of tying in portfolio repositioning with charitable giving, is that if you're going to make some changes and make charitable contributions, oftentimes it's more tax-advantageous to give securities directly to charity, rather than liquidating them, raising cash, and then sending cash to the charity.

Dziubinski: Now, we're going to talk about a few different strategies that tie into our investments, but one of the best and most tax-efficient is something that's available exclusively for those investors who are already taking their RMDs, and that's the qualified charitable distribution. Can you talk about that?

Benz: Right, so this is only going to apply, as you said, Susan, to people who are post age 70-and-a-half, so they're subject to those required minimum distributions that have to come out of their portfolios annually. And the way that you can use this qualified charitable distribution is that you can send up to $100,000 in RMDs to the charity or charities of your choice, and the virtue of using this qualified charitable distribution strategy, where you essentially let the financial provider work directly with the charities that you want to give to, is that by doing the QCD, the amount of that RMD that's going into the QCD is not affecting your adjusted gross income, so it's more advantageous to you to give this way.

The other big factor here is that many fewer investors, due to the tax law changes that went into effect in 2018, will be itemizing their deductions in the first place. So this, for a lot of investors, is the best way to make a tax save from their charitable giving. But again, you can only do it if you are subject to required minimum distributions. If you're a younger investor, unfortunately, this is not open to you.

Dziubinski: Now what can some of those younger investors do who don't have to take the RMDs yet? What are some strategies that they can use to tie their portfolios with charitable giving?

Benz: You'd want to look at finding appreciated securities in your taxable account, maybe where the position is just too lofty for whatever reason. So maybe it's company stock, and you don't want to be heavily invested in company stock because so much of your wherewithal is riding on your company's fortunes. So here might be a place where you could donate some of those appreciated securities to a charity of your choice. The trouble is--I mentioned the tax laws that went into effect in 2018--the trouble is, higher standard deductions mean that many fewer taxpayers are itemizing their deductions, and charitable contributions were a type of deduction that got itemized.

So one strategy that has come up in this context, is the idea of bunching charitable contributions and other deductible sorts of events together into a single year, where you can make them count, where you think, "Okay, in this year I think I'll be able to exceed the standard deduction, so I'm going to gang all these things up in a single year." That's where the strategy can be effective, and the other thing to keep in mind in the context of using your taxable holdings to gift to charity, is that by giving those securities to charity, you're effectively getting that tax gain out of your future tax bills, so you won't owe taxes on that appreciation, so that's another advantage.

Dziubinski: Then how does this tie in with portfolio management?

Benz: I think you want to take a step back and look at parts of your portfolio that you might want to reduce otherwise. So it might be that heavily concentrated individual stock position. It might be that you're getting close to retirement and saying, "Well, in my taxable account I have too much equity exposure," maybe too much U.S. equity exposure in particular. So you can maybe make that charitable contribution really count and improve your portfolio by reducing those positions, steering to charity, and doing so thoughtfully or strategically, so that you are exceeding that standard deduction threshold, at least in a few years out of a series of years.

Dziubinski: Right. And how might a donor-advised fund fit in here?

Benz: They might fit in in terms of being part of the strategy that you use with respect to your taxable holdings. So again, the idea is that you are steering money to the donor-advised fund, and in the year in which you make the contribution to the donor-advised fund, that counts as a charitable contribution, so you'd want to use some sort of a bunching strategy here as well. The donor-advised fund has a couple of advantages over making outright donations to charity. The first is that you can be deliberate in terms of making your contributions to charity, so in the year in which the money hits the donor-advised fund, well that counts toward something that you might deduct on your tax return, but then you can take your time getting that money steered into charity. You can even invest the money. So donor-advised funds may invest in long-term assets, stocks and bonds, and I think that can be another valuable strategy as well.

One other thing to keep in mind is donor-advised funds can accept individual securities, so they can take in-kind contributions of appreciated individual stocks, even some of the more-sophisticated donor-advised funds may be able to deal with illiquid securities, so that's another advantage as well. Your typical charity might not know what to do with those contributions, especially of illiquid securities. Donor-advised funds are usually set up, or often are set up to deal with those types of contributions.

Dziubinski: Oh, that's interesting. Christine, thank you so much. A lot of great food for thought during the holiday giving season.

Benz: Thank you, Susan.

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

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Julie Bhusal Sharma: We've increased our fair value estimate for wide-moat Accenture to $187 per share from $148 per share. While this still leaves the company moderately overvalued, we are confident that Accenture will be able to maintain its wide moat rating, which we believe to be founded on its intangible assets and switching costs.

Accenture is one of the world’s largest IT services companies, serving 80% of the top 500 companies globally. As consultants, we think Accenture benefits from the uncertainty that comes with the ambiguous outcomes on which consulting projects seek to deliver. We think that large enterprises have extreme risk aversion, which leads enterprises to rely significantly on reputation when choosing a consultant. In our view, Accenture’s strong reputation is backed by its strategic and technical expertise gained from years of working with extremely large and complex companies. We think that familiarity with this expertise is a significant source of resistance to switching from Accenture’s consulting or outsourcing services. While Accenture does not boast abnormal operating margins for the IT services industry, it achieves significantly greater returns on capital from its scale. After all, there are only so many blueprints and software partners an IT services company needs to solve enterprise problems, which allows Accenture to spread these blueprints across its larger customer base.

All in all, if Accenture stock were to endure a substantial haircut, we think Accenture would be an attractive buy given the strength of its intangible assets and switching costs.