Retiree Traps, a Wide-Moat Stock Pick, and Indexing Risks

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Susan Dziubinski: Hi, I'm Susan Dziubinski for Morningstar.com. The market has been experiencing some turbulence, and a widely used recessionary indicator is flashing red. Joining me to share some counsel for retirees managing their portfolios, and specifically some mistakes to avoid when the market gets rough, is Christine Benz. Christine is Morningstar's director of personal finance.

Christine, thank you for being here with us today.

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

Dziubinski: Now, one thing that we investors often hear is that you tune out the noise and don't pay attention to the market turbulence. But you say doing so could be a mistake. What should we be doing? We shouldn't just stand there; we should do some due diligence?

Benz: It really depends on your life stage. So, I love that advice of not peeking or not just doing something but standing there, makes all the sense in the world for people who are accumulating assets for retirement. But in the years just leading up to retirement or when you're actually retired, you need to get serious about adding some risk controls to your portfolio, adding some lower-risk investments. So, I think that people who haven't checked up on their portfolios recently who are at that life stage of drawing down their portfolios or getting close to it, should absolutely use recent market volatility as an impetus to get in there, check up on their allocations to safer securities. Because if they haven't been topping them up along the way, their portfolios could be getting too equity-heavy and aggressive.

Dziubinski: Now, sort of, on the flip side, another thing, another mistake some of us make is, we start to overdo the safe securities in our portfolios. Let's talk a little bit about that.

Benz: It's absolutely a balance. So, certainly, there is some appeal in investing in something that you don't think will go down, especially when equities are showing some volatility. You don't want to overdo it. That's the key point. Because starting yields on bonds, say, you're looking at a bond fund with a 2%, 3% yield. Well, that's about what you can expect to earn in terms of your total return from that investment over the next decade. So, that's a low rate of return, may not keep up with the inflation rate. So, you want to be careful about the allocation to safe securities. I typically recommend that people who are in drawdown mode, so already pulling from their portfolios, build themselves a runway of roughly 10 years' worth of portfolio withdrawals in cash--maybe two years' worth of portfolio withdrawals in cash, and another five to eight years' worth of portfolio withdrawals in bonds. Any more than that, I think, you are staking too much in very safe securities with low long-term return potential.

Dziubinski: Another thing you advise against is getting too tactical, practicing tactical strategies in this type of market. And that does sound appealing on the surface, especially when you have volatility present.

Benz: That's right. So, just to quickly outline what a tactical strategy means, it kind of means that you jump around a little bit based on your expectation of how various asset classes would perform. So, right now, you might say, "Aha, you know, we've been through this long-running bull market for equities, recession fears are coming up, maybe it's time to get out of stocks, go into cash and bonds, and then at a later date I'll increase my equity allocation again." Sounds great. In practice, that can be super difficult to pull off. We often look at professional tactical asset allocators, and they've had a difficult time executing tactical strategies consistently. So, I would be really careful about market-timing or employing tactical strategies. If you do invest in a fund that employs a tactical strategy, and there are some decent ones out there, I think even there, you want to be judicious about your allocation to it. You probably don't want to put your whole portfolio into it, because it will inevitably have some fallow periods. You probably want to just stick with a strategic long-term asset-allocation framework for the bulk of your portfolio.

Dziubinski: Another trap that we fall into might involve overdoing it with alternative investments when we have market volatility, because it's certainly appealing to want to dedicate some money toward an alternative investment that's maybe going to stay flat or go up a little bit as the market is going down.

Benz: Right. The idea is that you'll have something that is not correlated to either the stock or the bond market. That's the idea behind an alternative strategy. In practice, we haven't seen a lot of environments that have truly stress-tested alternatives. But in the recent past, when we have had difficult markets--I would go back to the fourth quarter of 2018, for example--alternatives haven't overwhelmed with great performance. So, I wouldn't stake too much, if anything, in alternative investments. They haven't necessarily made a great case for themselves and then they also have the headwind of very high costs in some cases. So, you're looking at an asset class that if it performs well should probably deliver a return somewhere between stocks and bonds. But when you're paying 1%, or even 2%, for the privilege of owning that investment that might give you 4% or 5%, I don't like the trade-off there. So, I don't think investors should overdo their allocation to alternative investment types.

Dziubinski: And the last mistake to avoid in markets like this involves time management. What do you mean by that?

Benz: Well, in retirement, you do have typically--although I know a lot of busy retirees--sometimes you have some extra time. And that can mean extra time to watch CNBC or watch other financial programs, to spend too much time on financial websites as much as we love to have retirees on Morningstar.com, it can make you too consumed with what's going on in your portfolio. If you get out and about do things unrelated to your portfolio, that gives you context for what's going on in the market. And I think it also is a little bit of a distraction. It can keep you from making changes that you might in hindsight regret that you made. So, my advice is to do maybe quarterly, twice yearly, even once yearly portfolio checkup, but any more than that, I think, is overkill. Try to stay away from your portfolio. Try to stay away from the news flow even though it can be tempting to plug in.

Dziubinski: Christine, as always, great guidance to keep us focused on the long term and our goals. Thanks for being here today.

Benz: Thank you, Susan.

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

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Jake Strole: Within our healthcare coverage, CVS Health trades at one of the steepest discounts to our estimate of intrinsic value. With the stock near $60 per share versus our fair value estimate of $92, we think this narrow-moat name represents compelling value for long-term investors.

CVS Health transformed its business with its acquisition of Aetna in late 2018. The addition of a managed-care franchise to CVS' leading presence in retail pharmacy and pharmacy benefits management underpins our positive trend rating on the name, along with our optimistic outlook regarding valuation. The combination sets the stage for CVS to improve its cost position relative to less-integrated peers, while developing a stronger network effect as management looks to better leverage its retail footprint. Management's strategy to develop more clinically relevant stores, or so-called "health hubs," within its network puts the firm in a position to better manage its members' healthcare needs and potentially bend the medical benefits cost curve at Aetna over time. We think management's vision is very much akin to the integrated strategy pursued by UnitedHealth that forms the basis for its wide economic moat, leaving us similarly bullish on the future prospects for CVS. That said, execution over the next several years will remain paramount to generating shareholder value from the transaction and validating our thesis on the future competitive position of the organization.

Shares trade cheaply as investors remain concerned about the political environment for healthcare businesses more generally, management's less-than-perfect track record of capital deployment, and lingering regulatory scrutiny regarding the transaction. As a result, shares are marked at a steep discount to peers, trading at roughly 9 times our 2020 earnings estimate compared with 14 times for the broader managed-care index. We think many of these fears are overblown and think today's valuation sets the stage for CVS to outperform over a multiyear investment horizon.

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Christine Benz: Hi, I'm Christine Benz, director of personal finance for Morningstar. As assets flow into passively managed products, concerns have cropped up about some unintended consequences. Joining me to discuss the legitimacy of these concerns is Alex Bryan. He's Morningstar's director of passive strategies research for North America.

Alex, thank you so much for being here.

Alex Bryan: Happy to be here.

Benz: It's good to have you in person, too, for a change. Let's talk about some of the things that we've seen swirling around ETFs and index funds. As they've grown, some market watchers have voiced concerns that there could be these unintended consequences. So, a biggie that we often hear is that somehow the flow of assets into indexes will cause the markets to be less efficient. It'll cause these, sort of like, market dislocations. Let's talk about just the thesis of why things might work that way.

Bryan: Sure. So, one of the concerns is that as more and more people invest in index funds, and more and more active managers kind of drop out of the market, there's fewer people that are dedicated to doing fundamental analysis on individual securities, and more and more people kind of buying and selling the entire market. In that case, if everybody pulls money out of the market, they may throw out the good stocks, the bad, and that could potentially cause more mispricing in the market than if you have more fundamental stock-pickers doing research and figuring out what each of these stocks are worth. So, that's the concern.

Benz: And the mispricing would be a problem if I'm an index fund investor, because I could end up in some massively overvalued stocks, or ...?

Bryan: That's a concern. Yeah. So, if the market is not efficiently priced, then you could end up owning big stakes and stocks that are overvalued. This was a concern back in the late 1990s when tech stocks were close to 40% of the S&P 500 and those stocks were pretty overvalued. And so, there's that risk that if the markets aren't efficiently priced, you could end up owning a lot of things that are quite a bit expensive.

Benz: So, is this something I should be worried about? And let's start with the perspective of if I'm a passive fund investor, but also, how about for active fund investors?

Bryan: So, I think it's a concern that I think gets overblown. It's kind of this theoretical discussion that comes up in academic circles. What if everybody were to index? What happens then? I think it really depends on who's dropping out of the market. That's number one. So, if the people who are dropping out of the active market are managers who are less skilled, and I think that's more likely the case ...

Benz: Probably something we're seeing right now, right?

Bryan: Exactly. If investors are kind of fed up with years and years of underperformance, and those poor managers drop out, the market could arguably become more efficient, because the managers who are left who are doing the research are arguably more skilled. So, that's one thing I would mention.

Bryan: The second thing is, although index funds have a pretty large share of total assets that are invested in managed funds, about 40% in the U.S., their share of trade volume is much lower. And that's because turnover in index funds tends to be a lot lower than the turnover ...

Benz: They're not trading.

Bryan: Exactly, they're not trading quite as much. Price discovery happens on the margin when shares trade hands. So, if index funds are accounting for a much smaller share of the overall trade volume than they are of total asset ownership, then actually active managers are still driving most of the price discovery that's happening. So, I think we're a long way from this being a problem. It's not to say that it couldn't be a problem at some point, but we're not there yet. And if we ever were to get to that point where there did, you know, become more mispricings, well, then active managers should start doing better and I think there will be this equilibrium that the market finds where people might shift back to active and back and forth until we find that equilibrium.

Benz: That's what active managers are definitely helping, I know. Let's talk about another concern. You think this one is a little more legitimate. And this is in the case of indexes where maybe those securities are a little less heavily trafficked, where there is a reconstitution of an index fund that's tracking that space, that there can be higher transaction costs. Let's walk people through how this works, when index fund makes changes how that causes funds to have to play catchup.

Bryan: So, whenever an index fund reconstitutes, so when there's a – let's say, stocks that are removed from an index, well, everybody who tracks that index, like the S&P 500, has to sell those securities at about the same time regardless of the price that they get. Now, what that tends to cause is, it causes the prices of those stocks to drop when they're removed. Similarly, stocks that are added to the index see a price pop when they're added, but oftentimes, the index investors are getting the less favorable prices because they're not able to buy those newly added securities until after the price goes up or sell until after the prices have gone down. So, this can cause the performance of the index to be a bit less attractive than it otherwise would be if it weren't forced to buy and sell on these predefined dates. And that's one of the reasons why a firm like Dimensional Fund Advisors doesn't like to track an index. It follows a broad market ...

Benz: To take advantage of these sorts of issues.

Bryan: Exactly, exactly. So, that's the concern. And it's, as you mentioned, more acute problem with less-liquid assets, like small-cap stocks, like high-yield bonds, that's where these costs tend to be more pronounced.

Benz: So, what's the solution? Assume I want to track, say, a small-cap stock index, or I want that type of exposure in my portfolio, how should I address it to not be disproportionately burned by this problem?

Bryan: So, I think there's one or two solutions. Number one, you could just own a total market index, where you're kind of on both sides of these trades, and it's a wash. So, if I own something like the Vanguard Total Stock Market Index, yes, there might be some stocks that go into and out of the S&P 500 that are negatively impacted by that, but I already own them if I own the Total Market Index. So, I think that's one solution.

Now, if you want specific exposure to an area like small-cap stocks or high-yield bonds, I think it's a good idea to look for funds that are a bit less popular that have fewer assets tied to them, because that means that when there's changes to those indexes, there's less market pressure on the prices of those stocks, because there's less dollars going into or out of them. So, I think that's one thing to look for.

The second thing you want to look for is indexes that are taking steps to mitigate unnecessary turnover, because a lot of times, well, turnover is costly and a lot of times it doesn't add a lot of value. So, if you, let's say, you're a small-cap stock, and you migrate slightly into mid-cap space, well, that stock is probably going to have very similar performance to other small-cap stocks. So, it may not be worthwhile selling that. It may be OK to hold on to that. So, I think a fund like, let's say, Schwab U.S. Small Cap ETF. That's a less popular fund, and it's one that tracks an index that applies wide buffer zones to try to mitigate these types of unnecessary turnover trades.

Benz: So, the buffer zone is there to keep things from slipping back and forth out of the small-cap space?

Bryan: That's right.

Benz: Let's talk about the last potential concern related to the growth of indexing. And that is that it could cause businesses to be less competitive, or it could cause the complexion of industry to be less competitive. Let's talk about how that would happen, why that would happen as a result of the growth of indexing.

Bryan: So, the concern is that index investors, asset managers who manage these, they own all the companies in the market. So, they don't necessarily have the same incentive to pressure managers to maximize the value of any single company. They may not be as concerned about one firm winning at the expense of another because they want to see all the firms in industry win. So, that's the concern is that this could potentially harm consumers, because it might create some anti-competitive behavior in the same way that if you see consolidation in a given industry, there might be less competition. The concern is that that same effect would happen if you have a couple of big institutional investors like BlackRock and Vanguard own all the airlines, for example.

Benz: Right. Right. So, there's been some academic work on this topic, looking at a couple of different industries. You have written about this topic before as have some of our other colleagues. Do you think this holds water? Should people be concerned about this?

Bryan: I think it's a weak argument for a number of reasons. Number one, I think managers of most companies are heavily incentivized to maximize their own shareholder--the value of their own company.

Benz: So regardless of external pressures?

Bryan: Regardless of external pressures, regardless of who owns the firm. I think managers in most companies, because they're paid very heavily in stock of their own companies and their bonuses are tied to their earnings and to their revenue, they're not really concerned about maximizing the industry's profitability, they're concerned about maximizing the results for their own firm. So, I think that's the first thing.

The second thing is that this argument makes this assumption that it's always in the firm's best interest or almost always in the firm's best interest to compete more aggressively. And I think oftentimes, it's just not the case. If GM, for example, were to cut prices on its automobiles, it knows that Ford is likely going to react and both companies will be worse off. So, I think the ownership of a company doesn't affect the optimal competitive strategy.

The other thing to note is that most index managers aren't really talking competitive strategy or pricing when they do engagements with their portfolio companies. They're more concerned about corporate governance, things like making sure that the board has proper experience, that the company is taking adequate steps to manage risk. They're not really talking about what business strategy the firm should pursue.

The other point I would note is that even if asset managers did want to influence corporate strategy, it's not obvious that they would want to maximize profits at the industry level, because they own all companies across all industries. So, higher ticket prices in the airline industry could actually hurt their holdings in the hotel industry. So, they may not necessarily want that. So, it's not obvious that index ownership is going to lead to less competitive behavior. I think at this stage, the argument is interesting, but I think it's a more academic argument and the empirical evidence really isn't persuasive as of yet. So, I think there's more work to be done in this area.

Benz: Put that one on the backburner for now. Alex, it's always great to get your insights. Thank you so much for being here.

Bryan: Thank you for having me.

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

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Krzysztof Smalec: We recently initiated coverage of industrial firm Graco with a wide moat and a $46 fair value estimate.

Graco manufactures equipment used to manage fluids, specializing in abrasive, corrosive, and hard-to-move materials. We believe the firm has established a wide moat primarily based on customer switching costs. Graco’s products often perform a mission-critical function and are integrated into a customer’s manufacturing process but typically account for a small portion of overall costs (for example, a paint system at an auto assembly plant). The company has a large installed base of equipment, and customers tend to replace components like-for-like, given the potential cost of unscheduled downtime or wasted material from switching to a cheaper alternative. This leads to a relatively stable and high-margin recurring revenue stream, as 40% of Graco’s sales come from aftermarket parts.

Graco’s lean manufacturing capabilities allow it to thrive in a high-mix and low-volume environment, as the firm generates roughly half of its sales from nearly 60,000 different products it sells no more than one per day on average. This aspect of the business creates a barrier to entry, as competitors would struggle to replicate Graco’s scale and compete effectively.

The firm has delivered impressive returns on invested capital, averaging roughly 25% over the last 10 years. Given its wide moat and high barriers to entry, we believe that Graco is well-positioned to continue outearning its cost of capital and creating value for shareholders.

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Alec Lucas: American Funds' multimanager approach has long served its equity investors well--and should continue to do so, thanks to parent Capital Group's strong, results-oriented investing culture. Indeed, 13 of the 14 American Funds equity offerings with a forward-looking Morningstar Analyst Rating are medalists, including 10 Gold-rated funds.

To maximize their chances of success, investors should understand the options within the American Funds equity lineup. While the 14-fund lineup is nearly comprehensive in scope, it isn’t exhaustive. There is no foreign-large value Morningstar Category offering, for example. Meaningful exposure to small-cap stocks can also be harder to come by, but it isn’t absent: Smallcap World is a growth-leaning, global small-cap and mid-cap stock fund. There are also two multi-cap offerings: AMCAP, which has a domestic focus, and New Economy, which has a nearly global mandate. Both tend to hold ample cash stakes to help moderate the market’s ups and downs and pick up bargains amid volatility. AMCAP has a capital appreciation mandate, but its sector exposures tend to be more diversified than New Economy, which looks for innovative companies and often invests heavily in tech and biotech stocks, including companies domiciled in emerging markets. Unlike its multi-cap siblings, Growth Fund of America is a large- and mega-cap-oriented fund. It can invest up to 25% of its assets overseas and has latitude to own turnaround plays in addition to more-conventional growth stocks.

Investors interested in value as well as core exposure have a pair of options to choose from. American Mutual and Washington Mutual both prioritize financially sound dividend-payers and avoid companies that receive most of their revenue from alcohol or tobacco. Where they differ is that American Mutual has more of a value orientation and tends to hold a double-digit combined cash and bond stake, while Washington Mutual stays fully invested.

Investment Company of America and Fundamental Investors share growth-and-income mandates. Investment Company of America, the more conservative of the two, has a domestic focus, whereas Fundamental Investors can be more aggressive and makes use of its ability to invest up to 35% of its assets in non-U.S. stocks.

Returning to global options, New Perspective is a large-cap, growth-oriented fund focused on multinational blue-chip companies while Capital World Growth and Income, as its name suggests, has a growth-and-income mandate. So, too, does International Growth and Income, but it limits its purview to non-U.S. stocks. Europacific Growth provides exposure to non-U.S. large-cap growth stocks, though it also has an appetite for turnaround plays, too. New World and Developing World Growth Income both target emerging-markets equity exposure while trying to keep volatility to a minimum. New World tilts more toward emerging-markets debt and developed-markets equity exposure--including U.S. companies with significant emerging-markets revenue--as a means of delivering a smoother ride, while Developing World Growth and Income concentrates on dividend-payers, which tend to be less volatile than stocks without payouts. New World is the more proven of the two.

On the whole, investors have excellent options to choose from within American’s 14-fund lineup.

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Dan Kemp: You may have recently heard about the phenomena of yield-curve inversion and be wondering what this means and how it may affect your investments.

The yield curve simply describes the interest rate an investor can obtain by lending money over specific time periods. Investors typically demand a greater interest rate for lending money over longer periods to compensate for the fact that uncertainty increases as we look further into the future. By drawing a line between these varying interest rates on a chart, a “curve” typically appears and hence we talk about the “yield curve.”

Yield-curve inversion is a rare situation where the cost of borrowing money over the long term is lower than the cost of borrowing over the short term. This typically indicates that investors expect significantly lower interest rates and/or lower inflation in the future. For this reason, yield-curve inversion often indicates a future recession and is used by some as a signal for investors to take less risk.

However, investing is not quite that simple. If there was an entirely predictable way of forecasting recessions, the impact of that recession would be almost immediately reflected in asset prices, reducing the benefit of reacting to the signal.

The challenge for investors is that the future is probabilistic rather than deterministic, and we need to consider a range of potential outcomes and their likelihood rather than a single path. This is, of course, difficult to do, not least because as humans we tend to overweight the likelihood of more-vivid outcomes and underweight the probability of less interesting paths. However, by considering a range of possible outcomes and assigning probabilities to each, we have the best chance of understanding the impact of future events on a portfolio.

Finally, we need to remember that the economy is not the same as the capital markets. Making accurate forecasts about the former may not help you create returns from the latter. As long-term valuation-driven investors, we believe that the price you pay for an asset is the most important determiner of future returns, whether or not the bond market can predict the equity market.