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This week on the podcast, we examine the impact of the president's steel and aluminum tariffs; our new quantitative rating for funds extends our range to more funds; our analysts suggest three funds to hold for the long haul; Mark Miller tackles some Social Security questions; Damien Conover says Eli Lilly and Pfizer are undervalued; and we break down the results from Target and Costco.
Keith Schoonmaker: U.S. President Donald Trump recently shook up global financial markets by announcing plans to enact import tariffs of 25% on steel and 10% on aluminum. The exact form these tariffs will take remains unclear, but we expect some additional information later today. We've updated our forecasts based on the expectation that certain key trade partners such as Canada and Mexico will be exempted. A blanket tariff covering imports from all countries would be far more severe. The consequences for U.S. metal users, while significant in aggregate, are far more diffuse, touching industries from aerospace to aluminum cans. Accordingly, our long-term forecasts and fair value estimates for these companies aren't materially affected. However, harmful second-order effects, including retaliation by U.S. trade partners, are possible, but we have not assumed major moves in our base-case forecasts.
We've raised our fair value estimates for U.S. steelmakers, as the proposed tariffs increase our forecasted spread between U.S. steel prices and world steel prices. Combined with operating leverage from greater production volumes, U.S. steelmakers are likely to generate higher margins than we previously anticipated. Regardless, we continue to forecast materially lower global steel prices (including the U.S.) over the long run as Chinese gross capital formation growth decelerates, global overcapacity remains, and cost support falters as steelmaking raw material prices decline.
Aerospace investors shouldn't panic over cost increases. Not yet, at least. Aluminum, represents less than 10% of the cost of newer aircraft, and when average aluminum prices rose 23% last year, the aerospace industry managed to absorb the increase. Investors should be concerned about a trade war, though, because Boeing delivers around 70% of its aircraft to non-U.S. customers. In particular, retaliation from China is a concern. China accounted for more than 25% of 2017 total deliveries and represents an estimated 20% of Boeing's backlog in unit terms. China could potentially shift aircraft purchases from the U.S. manufacturer toward Airbus. While the existing backlog most likely isn't at risk, new orders most certainly would be. We estimate the Chinese market alone will drive about $1.3 billion of operating profits for Boeing in 2018. That's 10% or 11% of operating profit and our fair value estimate. We're more concerned about Spirit Aerosystems because, as the largest independent aerostructures manufacturer, aluminum is a significant production input. But we're not planning to change our fair value because we believe the tariff can be absorbed and that Spirit's contracts include abnormal-price-increase clauses.
An increase in automotive input costs might have a temporary impact on margins but if the impact were large enough to cause a downturn in auto demand, given the industry's capital intensity, the impact could be much more devastating. The key issue for the auto industry is how long the tariffs last. Automakers use staggered contracts, collars, and long duration contracts to attempt to smooth out changes in steel and aluminum pricing. GM and Ford source about 90%-95% of their U.S. steel needs domestically. We estimate that in a worst-case scenario, the proposed steel and aluminum tariffs would result in approximately a 1% increase in the average price of a light vehicle in the U.S. However, the average transaction price of a U.S. light vehicle has grown at an annualized rate of roughly 2% since 2012, so we believe the impact of tariffs on U.S. light vehicle demand will be minimal absent a trade war.
We estimate that heavy equipment firms like Caterpillar and John Deere will be exposed to rising steel prices, which account for around 10% of their total operating expenses. Moreover, companies on our coverage list operate without hedges and are thus exposed to steel price fluctuations. We view it as unlikely these firms can materially pass along their increased raw material costs to customers because foreign competitors stand ready to take advantage. If we assume two years of tariff impacts and an inability for manufacturers to pass the increased steel prices along to customers, we expect operating margins to decline over 200 basis points, resulting in fair value declines of less than 5%.
In sum, we view U.S. steelmakers as beneficiaries of the tariffs, and Boeing as perhaps the firm with the greatest risk resulting from this action.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. We're launching the Morningstar Quantitative Rating for funds. I'm joined today by Lee Davidson, he leads our Morningstar quantitative research group, to look at why we've launched this and how investors can use it.
Lee, thanks for joining me.
Lee Davidson: Thanks for having me.
Glaser: I guess the first question is really why we're launching this quantitative rating for funds. How is this different than, say, the star rating which also uses quantitative data?
Davidson: About five years ago, six years ago, we launched the Morningstar Analyst Rating for funds, which is actually probably the most important thing to understand to understand this quantitative rating system. The Morningstar Analyst Rating covers about 1,700 funds in the United States and Canada. It's forward-looking, which is different than the star rating, which tends to be backward-looking, and it really puts our analysts' best foot forward from an analytical perspective about what funds we think are going to perform the best.
The Morningstar Quantitative Rating for funds is a complement, kind of a megaphone or an amplifier on that Morningstar Analyst Rating system, and it covers all of the funds that our Morningstar Analyst Rating system does not cover in a similar forward-looking, philosophically analogous fashion.
Glaser: How does this work? What inputs are going into this model?
Davidson: We've got a whole bunch of inputs going into this model. It's rooted in artificial intelligence, so what we're really trying to do is trying to understand the decision-making processes that our analysts go through. We believe that our analysts have a repeatable process. We train people in that process when they come in the door. It's rooted in data, it's rooted in rigor, and because of that, because it's data-driven, our analyst rating process is, we can look at the data that are about the funds that analysts cover and the decisions that our analysts have made and draw that connection using machine learning techniques, which is what we did with the quantitative rating. What that allows us to do is take a fund we've never covered before, look at the data about that fund, and provide a prediction or an estimate or a guess, a very educated guess, about what an analyst might do if they were to pick up coverage on that fund, and that prediction becomes the quantitative rating.
Glaser: What's some of that data that the machine's looking at?
Davidson: We're looking at fees, manager tenure, performance, firm success, firm fees--we're looking at a whole bunch of different data points that kind of correspond to the five pillars of the Morningstar methodology: Parent, Process, People, Performance, and Price.
Glaser: When this is all said and done, what comes out? What is the output of this model?
Davidson: It's going be a rating on the same scale that we're used to seeing from the analysts: Gold, Silver, Bronze, which are our recommended class of ratings; Neutral, which are the ones we think will probably perform in line with the market or with the category; and negative, those are things that are going to be impaired or potentially have a flaw. Those five ratings will be the same ratings that our quantitative ratings system uses, but they'll have a superscript Q to denote that it was arrived algorithmically.
Glaser: How should investors use this then? You said there's the recommended ones, is this kind of the start of a research process? What's the best way to think about that?
Davidson: I think investors are probably best to use this in the same way they use the analyst rating. It's a summary expression of our conviction and the likelihood that a fund's going to beat its peers on a full market cycle. Certainly, we don't have an analyst looking at these funds. It's an expectation. We definitely advise folks to use this with caution and incorporate other information into their investment decision-making process, but as a starting point, in a lot of tests that we've done, it's been very efficacious.
Glaser: Lee, thanks for being here today.
Davidson: Thank you.
Glaser: For Morningstar, I'm Jeremy Glaser, thanks for watching.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Warren Buffett famously said that his ideal holding period is forever. Those are good words for mutual fund investors to live by, too. Buying and holding investments for a very long time helps keep trading costs to a minimum. It will also help limit the drag of taxes on your taxable account. Trading infrequently also lessens the amount of time that you'll have to spend on your portfolio. Index tracking funds, whether traditional index funds or ETFs, are the ideal set it and forget it options. You won't have to worry about portfolio managers coming and going or the fund strategy changing. One index fund can cover the whole U.S. market.
Adam McCullough: IShares Core S&P Total US Stock Market Index, ITOT, is a great fund to own forever because it's very broadly diversified and very cheap. This fund only costs 3 basis points per year, so that means for every $10,000 invested, iShares only charges you $3 to own this fund. The fact that it owns nearly every stock in the U.S. market means that you don't have to shift between large-, mid- and small-cap stocks; you can own this one fund and own nearly every stock in the U.S. market.
A big advantage of a broadly diversified portfolio that's market-cap-weighted is that it's very efficient to run. The stock weightings are set by their prices, so they adjust automatically as the market ebbs and flows.
Because this fund is always fully invested, that means that there is some downside risk. It will feel the full force of the bear market, but it also means that it won't miss a rally. For instance, during the bear market in October 2007 through March 2008, it lost more than the average fund in the U.S. large blend category, but it recovered more quickly than those funds because it didn't miss the first part of the rally. All said, this fund earns a Morningstar Analyst Rating of Gold and is a cheap, efficient, and quick way to own the entire U.S. stock market.
Benz: Bond investors can also reasonably buy a broad bond market index fund and call it a day, though funds that are focused on the Bloomberg Barclays Aggregate Index do have a big emphasis on government bonds. Actively managed bond funds with sensible strategies and stable management situations can work well as hold-forever funds, too.
Sarah Bush: Dodge & Cox Income makes a great core, long-term bond holding. The funds stands out for a number of strengths. First of all, it has a stable and experienced management team. Because there's a team-based approach here, it makes manager turnover less likely, and when it does happen it's less problematic. Investors don't have to rethink their choices.
Parent here is an exemplary one; managers invest along side shareholders, which is wonderful. The team takes a long-term, value-based approach, tends to favor corporate bonds, and they are willing to take risks, sometimes investing in controversial or downtrodden parts of the market when they think investors are getting paid. That said, they'll also take risk off the table when they think the valuations are not compelling, which is something we really like about them.
The fund has great long-term returns, can take a little bit of patience through riskier credit markets, but overall investors have been served very well here. Low expenses just sweeten the pot.
Benz: All-in-one funds that bundle together stocks and bonds can be ideal options for hands-off investors with long holding periods. The key to selecting such a fund is ensuring that the firm running it is skillful at managing both stock and bond investments.
Alec Lucas: Vanguard Wellington is a balanced fund whose origins predate the Great Depression. It has a mix of 65% equities and roughly 35% bonds. It's got a large cap-oriented portfolio rooted in dividend paying stocks. It's relatively conservative . It's been a very effective fund for the long term. It's beaten in the S&P 500 over the past 20 years through January 2018.
Over its entire lifespan, dating back to 1929, it's turned an original investment of $10,000 into more than $11.5 million. Named for the Duke of Wellington who minimized his own losses in warfare and overcame numerically superior foes, the fund has had a similar approach throughout its long life and has rewarded investors. It's one to keep for the long term.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Morningstar.com contributor Mark Miller focuses on Social Security for us, and he gets lots of questions about the program. He is here with me today to tackle some of the most common ones that he receives.
Mark, thank you so much for being here.
Mark Miller: My pleasure, Christine.
Benz: Mark, you always do receive an avalanche of comments and questions whenever you talk about Social Security. We wanted to talk about some of the ones that you receive the most frequently. Let's start with the question about whether people should follow the wisdom to delay Social Security, filing at least until their full retirement age or maybe even after. A question that I receive a lot, and I know you do, too, is, why not just file early or maybe full retirement age, and then invest the money? Isn't that a better strategy? Let's talk about that.
Miller: That's the good problem to have is if you can actually afford to bank your Social Security and invest that. The reality is, the lion's share of retirees can't do that. Most people live on Social Security. The idea of that as generalized advice just doesn't hold up. I suppose, if you wanted to take it early and invest it and you don't need the money for anything else, you might come out ahead on that. The way I would look at it is, every year of delay is roughly an 8% increase in the amount of benefit you will receive monthly for the rest of your life, 8% a year up until age 70. That's the number to beat.
Benz: And it's guaranteed by the way, that return is guaranteed.
Miller: That's where I was going. You've got to beat that number with a risk-free investment in my view. Show it to me.
Benz: Right. Yields are going up, but not that high yet.
Miller: If somebody has got that, I would like to know about it, personally.
Benz: Me too. Let's go on to the next question, which is, what is the break-even rate? For example, if you tell me that I should delay filing to age 70, how long do I have to live beyond that to make that the better decision versus claiming early or maybe claiming at my full retirement age?
Miller: I'll answer that question only if you let me first say I hate the question.
Miller: Social Security is social insurance. It's insuring against the risk. The risk is lost income. Especially that risk increases with age. If you think about longevity risk, kind of a hot topic out there right now, even relatively affluent households can exhaust their savings when they live to very advanced ages, especially women. You picture somebody in their 90s, savings are all gone, a maximized Social Security benefit, with inflation protection, by the way, because that's built in, is highly valuable.
Benz: That lifetime benefit.
Miller: Right. So, rather than thinking about it from this break-even standpoint, I prefer to think about it as longevity insurance. That's I think a better approach in many cases. You always have to caveat it and say, if you are in poor health, you really desperately need the money--sure, go ahead and file for your benefits.
Benz: Setting aside that you think it's not such a great question to think about break-even rates, people still want to know what are the break-even rates if they file at, say, full retirement age and then file maybe until age 70.
Miller: Delaying from 62, the earliest age, to 66, your break-even age is roughly 78. Delaying from 66 to 70, the last year that would make any sense to delay, the break-even age is going to be 84 or 85, depending on a lot of factors that we don't have time to get into.
Benz: You want to think a little bit about your own longevity, especially if you are planning to delay until age 70.
Miller: Yes. For couples, we have talked about this many times here, too, you should have a couples' approach to planning. It is a whole set of strategies that can be employed there with, once people do reach full retirement age with a delayed claim for the higher-earning spouse in order to bring up the lifetime earnings of the couple, and particularly, the woman who is likely to outlive the man.
Benz: So, ideally, a couple should harmonize their …
Miller: Yes. I think about that rather than break-even points.
Benz: One question you say get a lot, Mark, relates to how to fix Social Security and some strategies that might be in play down the line to address shortfalls in terms of Social Security's kitty. Let's talk about means testing. You say you get that question a lot.
Miller: Yes. I call it the Warren Buffett question. The question is, Warren Buffett and Bill Gates don't need Social Security. Shouldn't we means test Social Security so that they don't get anything, is the implicit question. There's a few things about this. One is, there aren't that many Warren Buffetts in the world. Even theoretically if you cut Warren Buffett's, I assume he gets a maximum benefit …
Benz: I would think, yes.
Miller: About $2,400 a month. Even if you take back his $2,400 a month, there is not enough there to make a difference in the solvency of Social Security. It's a gigantic system. There's just not enough mega billionaires to make that difference. It's a way of arguing something with an extreme that the math doesn't play out.
More to the point, sure, he doesn't need it. But many people who do have significant assets will need it for the reasons we were discussing--longevity, exhaustion of assets. And then third, a thing that people don't understand is Social Security really already has some means testing built into it. It's done two ways. One is through the taxation formula, which takes back some benefit for higher-income seniors. The other thing is that Social Security, the way it pays benefits out is it uses a bracketed approach. It's almost like an upside-down income tax bracket. The technical term for it is bend points. What it amounts to is, people who are sort of low income or sort of into middle-class levels of benefits, get about a 90% return on their earned credits. Then there is another bracket on the pyramid that reduces for the next tier of your benefit, you get 32% of that back. And then outside of that it's 15%. It's pyramided in this way.
The greatest level of income level replacement that goes on in Social Security goes to lower- and middle-class households. The program is designed primarily targeting middle-class and lower middle-class households, working households. That's really what it's designed to protect primarily. There already is means testing in the program.
There are two other things about means testing that concern me. One is, I think, as soon as you start talking about doing more means testing, you are on a slippery slope away from our conception of Social Security as a universal earned benefit program …
Benz: Something that we all get if we work and pay into.
Miller: We all get and we all pay into, and it starts sounding more like welfare. Well, who needs it, as opposed to who earned it? I think it's a really slippery slope. I also don't know practically how you would really do further means testing with Social Security. If you think about programs that are means tested now--food stamps, for example or Supplemental Social Security Income, SSI--there is a means test, and you have to go through a rigorous process of proving need.
How exactly are you going to do that with the Social Security? Are we going to look at seniors' income? Income goes way down in retirement. Are we looking at assets? If you are going to look at assets, what are we going to all do, start submitting our tax returns for somebody at Social Security to review? A program that already is struggling under a decade of budget cuts, staff shortages--it would just be a logistical nightmare.
Benz: Not to mention an incursion into people's privacy.
Miller: If you want to means test Social Security, think about submitting your tax returns when you file for your benefit. Right now, you can go on ssa.gov and file for your benefits. It takes maybe half an hour, and that's all there is to it. I think it's a lot of noise about something that doesn't make a whole lot of policy sense. It's not something that's going to rescue the program. And I think there are all kinds of reasons not to do it.
Benz: And there are a host of other solutions that could be considered to help address the shortfall.
Benz: Mark, always great to hear your insights. Thank you so much for being here.
Miller: Thank you.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.
Damien Conover: In the current market dynamics, we've got a lot of sectors that we think are overvalued, but within this dynamic we also are looking at the healthcare sector, most notably, the pharmaceutical industry, as being undervalued.
We think a lot of reasons are for increased concern about drug pricing reforms around drugs prices in the United States. We think these concerns are overblown. While there could be some new additional regulation around drug prices, we don't think there's going to be a major shift there.
One of the ways the pharmaceutical firms are fighting back against potential pricing reforms is to really fight for new innovation. A couple of firms we like that are really well-positioned in innovation are Pfizer and Eli Lilly. First, with Pfizer. They are really pushing deep into oncology. That should be a good growth engine for them going forward.
Secondly, with Eli Lilly, they are very well-positioned in immunology. Areas like psoriasis, areas where the body is not taking on the disease in the right way, this firm is to bring in the next generation of drugs and they have very strong pricing power and will likely get strong market penetration.
Within this context of drug pricing reforms, we really like firms that have innovation. Eli Lilly and Pfizer are well-positioned, both from valuation and strategically, to bring out these drugs that should have strong pricing power.
No-moat Target issued fourth-quarter results earlier this week that showed its transformation is starting to bear fruit, as transactions growth accelerated from last year. These results far outpaced the nearly flat transaction trends generated over the past decade, which we attribute to the 29% bump in digital sales. The picture remains mixed, however, when considering its operating margins were down and below our estimates. In our view, this narrowing of margins shows the level of competition and investment required to compete in the retail space, supporting our no-moat thesis. Incorporating these mixed results and the time value of money, we plan to increase our $63 fair value estimate by a low-single-digit percentage. Even after the stock has sold off, we still see shares as a bit overvalued.
Also this week, wide-moat Costco reported second-quarter results that show its moat is fully intact, with comparable-store sales up 8.4%. Unlike peers, Costco also boasted 20 basis points of operating margin expansion to 3.0%. Despite the noise resulting from a Thanksgiving date shift, results are tracking mildly better than our full-year estimates. Combining this with a slightly lower tax rate, we intend to raise our $163 fair value estimate by a mid-single-digit percentage. Shares are down slightly, but we don't think the current share price accounts for the competitive pressures that could ensue. As such, we believe prospective investors should await a larger margin of safety before investing.