Ivanna Hampton: Here's what's ahead on this week's Investing Insights. Some retail stocks are on sale this holiday season. Morningstar Research Services' chief U.S. market strategist Dave Sekera will reveal a list of stock picks. Plus, despite big losses, many mutual funds will still make capital gains distributions. Morningstar's director of personal finance Christine Benz shares three ways you can manage the payouts. And Tesla has rolled out its new big rig. We'll tell you what the EV maker's semi and upcoming Cybertruck will have in common. This is Investing Insights.
Welcome to Investing Insights. I'm your host, Ivanna Hampton. Let's get started with a look at the Morningstar headlines.
Tesla Delivers on Semitrucks
Electric vehicle maker Tesla began delivering its new semitrucks earlier this month. Morningstar expects Tesla to increase the numbers over the next few years to around 50,000 big rigs per year. We think there will be a strong demand for the semitruck because the cost savings from electricity versus diesel will more than offset the higher upfront cost. The heavy trucks will be limited to short-hauls initially because there are so few charging stations that trucks will need to return to the garage to charge. Tesla plans to build heavy truck charging stations with its new V4 supercharging technology. Tesla says the faster technology will also be used for its consumer model Cybertruck. The company plans to release it next year. The new superchargers will likely allow faster charging times for all Tesla models in the future. We estimate Tesla’s stock is worth 250-dollars and believe it's undervalued.
Kroger Rings Up a Strong Q3
Kroger rang up solid third-quarter earnings despite high inflation that had consumers coping with rising costs at every turn. That same inflation drove Kroger's results but they were also aided by cost vigilance and rising private label sales. Kroger's own-brand portfolio should remain strong as consumers shift away from name brands. The uptick in sales of those private label items should boost profits and in turn, help to offset rising labor costs. Morningstar’s long-term forecast still includes slight revenue growth and adjusted operating margins on average over the next decade. We don't expect to change our $49.50 estimate of what we think Kroger's stock is worth. And we recommend investors hold off on buying.
Ulta Beauty Still Looks Pretty in Q3
Ulta Beauty continued its hot streak in the third quarter. The beauty retailer's results soared past Morningstar's sales and profit expectations. Despite concerns that consumer spending is slowing because of inflation, the company says the holiday season is off to a good start. And it sees no evidence of shoppers trading down to less expensive products. Ulta’s quarterly same-store sales growth was strong. All its categories seem to be performing well. Meanwhile, we do think Ulta has received some benefit from an unusually high number of strong brand additions this year. We anticipate beauty demand will moderate. We expect to slightly raise our $339 estimate of what we think the stock is worth. At the same time, we view its shares as overvalued.
Which Retail Stocks Should You Be Shopping For?
Hampton: Many people are likely gathering to celebrate this holiday season for the first time in a long time. However, the current economic environment could dampen gift giving. Some shoppers might spend less while others will seek more things on sale. Many retail stocks that were expensive last year are also on sale. Morningstar Research Services' chief U-S markets strategist Dave Sekera has more on the holiday outlook.
Dave, total modified retail sales growth was in double digits last year. Can you describe what modified retail sales growth is and what's Morningstar's outlook for this year?
Dave Sekera: Of course. Total modified retail sales is essentially our proxy trying to gauge what we think holiday sales are going to be in the fourth quarter of this year. Essentially, we take all retail sales as reported by the government, and then we strip out a couple of different categories such as automobile sales, fuel sales, food sales, and so forth, and really try and just concentrate on those type of goods that would be sold at shopping malls, for example. So, this year we're really looking for what I would consider to be relatively sluggish growth, only an increase of 3.2% this year. Well below the 14% that we saw last year. And there's really two main assumptions behind that.
First, as we've talked about a couple of other times this year, just that normalization of consumer behavior. As the pandemic gets further and further in the rearview mirror, people are going out a lot more, and we're seeing that shift in spending. During the pandemic, people were either unwilling or unable to go out, and so therefore a lot of spending shifted out of services and into goods. So, we've been seeing that normalize, that spending going back into services. I think that's a headwind for gift-giving this year. More people will be traveling, holiday travel and so forth. The other part is going to be inflation. Again, inflation's running still over 7%, and as people have to spend more of their money and more of their household paycheck on nondiscretionary items, that just leaves less money overall to be able to spend on gifts this year.
Hampton: Let's talk about online shopping. Some big e-commerce names have seen their stock prices drop this year. Where should investors look for opportunities?
Sekera: Well, we expect e-commerce sales this year to do OK; still less than what it was last year, but an 8.5% percent increase this year. Now, as far as a lot of the e-commerce names, you can't talk e-commerce of course, without talking about Amazon AMZN. And Amazon has had a lot of negative sentiment in the market thus far this year, and we think investors are over extrapolating some of that negative sentiment. When you think about Amazon, they had just skyrocketed the amount of growth they had for the two years during the pandemic. At this point that growth has really been slowing down, and I think people are over extrapolating that slow year-over-year growth this year too far into the future. And I think some people are also missing some of the other key characteristics that we look at in the evaluation of that company. One, their AWS, Amazon Web Services, that's still growing very quickly at this point in time, although also at a slightly slower growth rate. And then their advertising business, which we see as a very valuable part of their business. So, when we look at Amazon, it is a wide-moat-rated stock, trades at 4 stars, and trades at about a 40% discount to what we think the intrinsic value of that company is worth.
Hampton: How does the brick-and-mortar retailer story from last year compare to this year?
Sekera: With the brick-and-mortar story this year, and thinking about that consumer behavior normalization, we are looking for more consumers to return to in-store shopping. That is a big part of the holiday experience, going back out to the stores. And who's going to benefit from that? While we're looking at some of the mall REITs, so specifically looking at Macerich MAC and Simon Property Group SPG, we do think that both of those are undervalued. The one that would be probably our more undervalued pick there would be Macerich. It's a no-moat-rated stock, but it trades it under half of what we think the company is worth.
Hampton: If we are walking around the mall, and we see some names on some stores, where should investors look?
Sekera: We think that a lot of the retailers, their stocks just gotten pushed down too far, too fast thus far this year. But a little bit of the backstory before we get into a couple of picks there, is I think that the holiday season this year, from the retailer's point of view, especially for the clothing retailers, it's shaping up to be the opposite of what we saw last year. If you remember last year, inventory levels were really pretty low across most of the retailers. And again, there was some shipping bottlenecks, which kept things from getting delivered in time to be able to make it to the store shelves for the holiday season. So, the retailers, because there was less inventory for people to choose from, were actually able to sell a lot of their merchandise at full value, which of course also helped boost their margins.
Well, this year what's happened is a lot of those bottlenecks have eased, so they've gotten that inventory in and in some cases probably have overordered more inventory than what they necessarily need this holiday season. So, we're expecting to see a lot of discounting this year. A lot of sales, which of course will be good for consumers but will certainly impair near-term margins for a lot of these retailers. Now, I don't necessarily expect really great holiday sales this year. But again, when I look at where that stock is trading and thinking about the value of those companies over a longer time period, thinking about next year and the year thereafter, when inventory levels normalize, margins go back to more normalized levels because they'll be able to manage their sales better, two that I would highlight here are Nordstrom JWN and Gap GPS. Nordstrom, we do rate that one with a narrow economic moat. It's a 5-star-rated stock, it also trades at less than half of what we think the intrinsic value of that company is worth. And then Gap is another interesting name. It trades over a 40% discount to our fair value, and that's a 4-star-rated stock.
Hampton: Toys fill a lot of those shopping carts. What are your stock ideas there?
Sekera: Toys this year has actually been, I think, a difficult sector for a lot of analysts to get their arms wrapped around. And it goes back to some of those issues with the shipping bottlenecks that we've had in the past. So, again, the toy manufacturers have to make sure that they had their inventory ready for the holiday season. So, I think that they oftentimes ordered especially early this holiday season. A lot of the inventory they typically get in the third quarter actually came in the second quarter. That's thrown off some of the financial metrics that people look at. Now having said that, we do think both Hasbro HAS and Mattel MAT are undervalued, and our pick there is going to be Hasbro. Part of the story there is that we do expect over time to see more mix shift. And what I mean by that is seeing an increase in the percentage of their sales in their digital toys and products which have higher margins. And so over time we're looking for margin growth there. Hasbro is a 5-star-rated stock. We rate that company with a narrow economic moat. That one trades almost half of what we think the company is worth.
Hampton: In-person celebrations are making a comeback. Where should investors look?
Sekera: Well, the alcoholic beverage industry is an interesting one. Now that's not typically a sector that people look at when they're thinking about holiday sales and thinking about investing in stocks that could leverage off of good holidays. But what happened during the pandemic is that consumption of alcohol stayed relatively stable, but that consumption changed. It went from what's called on-premise, being at sporting events or bars and taverns, to at home. And when that shift occurred, a lot of times people were buying lower price point, lower-branded items which have lower margins. Now as people are going back out again, we're going to see more in-person celebrations, more office parties, more people going back out to restaurants. As that consumption shifts back to on-premise, we also expect to see a shift and higher margins as people when they're in public, you'll tend to get those higher-branded and premium products. Our pick there is going to be Anheuser-Busch InBev BUD. That is a wide-moat-rated stock. That one is rated 5 stars, and it trades at about two thirds of what we think that company is worth, so a 33% discount to its intrinsic value.
Hampton: Thanks Dave, for your stock pick ideas.
Sekera:All right, well thank you Ivanna, and happy holidays.
Hampton: Happy holidays.
3 Ways to Manage Capital Gains Distributions in 2022
Hampton: Mutual fund investors could face a tax bill despite the market's downturn this year. Capital gains season is here. There are ways to manage the payouts. Here's Morningstar Inc's director of personal finance Christine Benz and Morningstar Inc's director of content Susan Dziubinkski with three tips.
Susan Dziubinski: Hi, I'm Susan Dziubinski from Morningstar. Although most stock and bond funds have lost money in 2022, many funds are still expecting to pay out capital gains to their fundholders this year. Joining me to discuss this odd disconnect and how investors can manage those distributions is Christine Benz. Christine is Morningstar's director of personal finance and retirement planning.
Christine, good to see you today.
Christine Benz: Hi, Susan. Good to see you.
Dziubinski: Let's talk about this. It's been a losing year for most funds. So, why are they making capital gains distributions?
Benz: It's incredibly frustrating. Fundholders don't necessarily have the cash on hand to pay the tax bill, and yet they're getting socked with these distributions. The key reason is that we have continued to see this exodus of investors from actively managed funds, they've borne the brunt of these redemptions. So, shareholders are leaving. Managers are having to sell things, in many cases, to raise cash to pay off departing shareholders. That selling triggers capital gains realization, and those capital gains need to be distributed to shareholders of record at the end of the year. And so, that's what we're seeing. Funds are making their distribution estimates available, but it's mainly that vicious cycle that we've seen where investors are going into passively managed funds, in part because of better tax efficiency, and they're forcing even worse tax efficiency at actively managed products.
Dziubinski: Can you generalize a little bit about maybe where we're seeing some of the larger distributions this year?
Benz: In general, it's U.S. equity funds, although we have seen some distributions in international equity as well. Large-growth funds have been seeing fairly significant outflows, in part because that category has performed fairly poorly this year after a long-running series of very strong market environments. And so, U.S. equity, and especially growth-oriented equity, appears to be bearing the brunt of the redemptions, and in turn, these funds are paying out these big capital gains distributions.
Dziubinski: Now, let's say, I owned a fund that has signaled that it's going to make a sizable capital gains payout to me. Let's talk about some of the options that I have. The first is to sell that fund pre-emptively. What should investors keep in mind if they do that?
Benz: The value of selling preemptively is that you could dodge this impending distribution. The key thing to keep your eye on, though, is to remember that you pay taxes on mutual funds in one of two ways. One, if it makes one of these distributions, either an income distribution, or in this case, a capital gains distribution. And the other tax bill could arise if you sell your own positions. So, remember that you could dodge this distribution, but if the position has appreciated since you purchased it, you will still owe taxes on that gain. Bear that in mind. Check your cost basis relative to the current share price.
I suppose a good news story in this scenario is that thanks to the combination of declining markets as well as the fact that many of these funds that are making distributions this year have been, sort of, serial distributors. This isn't the first year they've made a series of these distributions. If you've been reinvesting those distributions, you're able to increase your cost basis by the amount of that distribution. So, you've effectively prepaid your tax bill in previous years. You may find that the disconnect between the current share price and your cost basis in the security and the fund is not that great. But do your homework on your cost basis and the tax bill and whatever other implications there will be for your total tax picture. And by the way, I should have mentioned, Susan, you would want to not like this position, or you'd want to feel like it couldn't be easily replicated with something else.
Dziubinski: Christine, some people who might be thinking about selling this particular fund because they want to dodge the capital gains distribution might then be interested in repurchasing something else that's somewhat close to that. What are the tax rules around that? And then, secondly, how could someone in that situation perhaps choose an investment that's a little bit more tax-efficient so they don't end up in the same situation a few years down the road perhaps?
Benz: Really good questions. So, the first question is, if you are wanting to supplant that holding that you've just sold with something else that provides similar market exposure, you need to be aware of what's called the wash sale rule, which means that if you purchase something that the IRS considers substantially identical to the thing that you've just sold, and you do that within 30 days of the sale, you essentially disallow the tax loss. So, be careful of that substantially identical wash sale rule. That means that if you're swapping out of an index fund and into an exchange-traded fund that tracks the same market benchmark, probably not a great idea from the standpoint of the wash sale rule.
On the other hand, if you're leaving an active fund, getting into a passively managed product, that's OK. So, just keep that in mind. And then in terms of how to make that portfolio more tax-efficient on a forward-looking basis, passive products on the equity side, broad-market-tracking passive products look really good from the standpoint of tax efficiency. So, that might be traditional index funds; it might be exchange-traded funds. For higher income investors who are in a higher tax bracket, and they want to hold fixed-income securities in their portfolio, municipal bonds will be a good bet.
Dziubinski: So that covers people who want to sell in advance of the distribution. The second route that an investor could take is to just hang on and reinvest that distribution. Who is this a good situation for?
Benz: It's a good situation for the person who likes the holding, right? If you have a holding in your account, even if it's not tax-efficient, it probably makes sense to hang on, reinvest the distribution, and not sweat it so much. And remember you are getting credit for these distributions even though you're having to pay taxes in the current year in which you receive the distribution. If you're reinvesting back into the fund, you're increasing your cost basis. That reduces the taxes that will eventually be due down the line. So, it's not ideal to have a holding that's consistently kicking off a lot of capital gains. But if you like the position, it's probably the best bet to let that fundamental decision-making rather than tax factors, tax implications drive the car here.
Dziubinski: And then, lastly, there seems to be an option that sort of, I don't know, splits the difference almost in that we've covered selling, we've covered hanging on and reinvesting, but there's the third option of hanging on but not reinvesting the distribution. How might that work for someone? And who is that a good idea for?
Benz: Right. Many of us when we open up a mutual fund account, kind of, reflexively check that box saying reinvest all my income and capital gains distributions. But there is that middle ground where you can say just pay me the funds, pay me my capital gain and then you can deploy the funds into some other holding. And I think this might be particularly appropriate for people who want to start gradually moving the funds into another position. That's an easy way to do so. The funds will get deposited usually into a brokerage sweep account that's kind of living alongside your holdings. And then, you can deploy into whatever else you want, maybe some more tax-efficient fund going forward. So, that's a nice option for people who aren't quite sure and maybe aren't quite ready to make that break and pay the full tax bill that might be due upon their sale of the security.
Dziubinski: Well, Christine, thank you for your time today and for sharing these strategies. We appreciate it.
Benz: Thank you so much, Susan.
Dziubinski: I'm Susan Dziubinski with Morningstar. Thanks for tuning in.
Hampton: Thanks Susan and Christine. Subscribe to Morningstar's YouTube channel to see new videos about market news, personal finance, and investment picks. Thanks to podcast producer Jake VanKersen who puts this show together. And thank you for tuning into Investing Insights. I'm Ivanna Hampton, a senior multimedia editor at Morningstar.
Read about topics from this episode. Tesla: Stock of the Week Which Retail Stocks Are Well-Positioned for 2022 Holiday Sales? What You Need to Know About Capital Gains Distributions Which Popular Funds Will Hit Investors With Losses and Capital Gains Distributions This Year?