Investing Insights: A Growing Dividend and Cheap Utilities

Editor’s note: We are presenting Morningstar’s Investing Insights podcast here. You can subscribe for free on iTunes.

This week on the podcast, R.J. Hottovy gives his take on Restaurant Brands International; Mark Miller discusses the long-term care industry; Russ Kinnel tells us that a high yield can sometimes be a red flag; we think Expedia is undervalued; and we share three attractively priced utilities with good total return prospects.

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R.J. Hottovy: Restaurant Brands International, the parent company of Burger King, Tim Hortons, and Popeyes Louisiana Kitchen, has quietly become one of the more intriguing dividend stories in the restaurant space today. On its most recent quarterly update, the company effectively doubled its dividend payout ratio, now paying $1.80 annually, representing a 3% dividend yield. This puts the company in the upper echelon of dividend yields in the restaurants space today, even after Restaurant Brands and a number of its competitors have sold off company-owned locations of franchisees, taken on additional debt, and used those proceeds to return cash to shareholders. We expect the payout ratio to remain comfortably above 60% for the foreseeable future and grow at a high-single-digit clip.

Our confidence is backed by the company's unique master franchisee joint venture structure, where it assigns franchising rights in a given region to a well-established, well-capitalized player. With the company making some brand acquisitions the past couple of years, including Tim Hortons and Popeyes, we believe these master franchisee joint venture partners will have a lot of brands at their disposal to grow over the next several years, and in fact, expect the company to grow its top-line at a healthy mid-single-digit clip, thus giving us confidence in the company's ability to pay out a dividend.

Because of the annuity-like structure, restaurant franchisers have typically been a very reliable source of dividend payout and dividend growth over the past. However, we do see two potential risks to our projections on dividend growth for Restaurant Brands International. The first is a threat of a large acquisition. The company has been acquisitive the past couple of years, but there's rumors circulating that the company may be looking for a larger brand, like Domino's Pizza, Yum! Brands, or another large QSR chain. While the company has historically been able to balance acquisitions with dividend payouts, something this large may disrupt the company's potential to make a payout.

The second is the threat of a recession. While we're not anticipating anything like the Great Recession that we saw in 2008 and 2009, restaurants have generally had a pretty strong track record the past decade and could be due for a cyclical downturn. This could potentially impact sales at Restaurant Brands International's locations, which would impede the royalties they receive from franchisees and in turn could disrupt the company's ability to pay out a dividend. However, looking across this space, this is one of the most globally diversified and well-run companies in the restaurant industry. We think that they would have one of the best chances to maintain a dividend payout even under these circumstances.

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Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Long-term care costs are the biggest wild card in many retirees' plans. Joining me to provide an overview of the current long-term care landscape is Morningstar contributor Mark Miller.

Mark, thank you so much for being here.

Mark Miller: Hi, Christine.

Benz: Mark, this is a hot topic. Whenever I'm speaking to groups of retirees, the room goes crazy when long-term care comes up. I'd like to discuss the state of the state of long-term care. Let's start with the costs of long-term care. What sort of rate of inflation have we been seeing in long-term care expenses?

Miller: They've generally been going up anywhere from 4% to 5% a year depending on which segment of care you are looking at, if it's home-based or institutional, private nursing rooms, semiprivate. But that's the general ballpark.

Benz: Much higher than the general inflation rate?

Miller: Definitely.

Benz: Let's talk about how retirees and pre-retirees especially can handicap the odds that they will actually be on the hook for some of theses costs. How should they approach that decision-making?

Miller: RAND Corporation did a study that came out last year that's interesting. In general, you will find numbers out there that there's a 35% chance that you will need to be in a nursing home sometime in your life, maybe for a very short period of time. RAND broke it down much more specifically looking at numbers for different age groups. Looking at people in their late 50s to early 60s, the numbers are telling them that 56% of us will spend at least one night in a nursing home during our lifetime. There's a 10% chance that you will spend three years-plus. There is a 5% that you will spend four years plus. I think those are the really interesting numbers because that's where the costs really come in if there's a very extended need for care. Think about that three-year number.

At the same time, the national average rate per month for a private nursing home is $8,000. It's higher in more expensive states--$9,500, $9,600 in California, for example. You think about how those numbers can start to mount and that's where people start going crazy when they are talking to you.

Benz: Right. What I always like to point out is that if you are part of a married couple, sometimes you you are not incurring those costs simultaneously. You might have those costs incurring for both partners at various points in time.

Miller: It could, but there's two sides to that coin, because in many cases, and for married couple, one spouse who is healthy takes care of the other at least in part. Hard to say exactly how that washes out.

Benz: Let's talk about the trends in terms of long-term care insurance premiums. We have seen a lot of people who thought they were doing the right thing purchasing the insurance end with these terrible premium hikes that they have had to contend with. Have we seen any stabilization in terms of premiums?

Miller: Well, some. The problem is the headlines continue to be unstable, because a lot of these policies that were sold in the early going days of long-term care insurance were not priced properly. The insurance companies didn't do a good job of pricing out the risk in a number of different ways. The benefits were very generous. You will run into people, I still talk to people who say, boy, I bought my policy long time ago and have these great unlimited lifetime benefits. Those policies were poorly designed and poorly priced. We've seen this history of companies putting through double-digit rate hikes. They have averaged 20%, sometimes higher. Very scary numbers. The industry has gotten a black eye from that. A lot of comp carriers have stopped writing new business.

Benz: Well, that's the question. Fewer companies in that business altogether. That's usually not a great scene for consumers, right?

Miller: A lot of the experts who study this market think that things are stabilizing in the sense that the players who are left have better experience, track records, know how to price the policies properly. They are more expensive at the get go now, but perhaps less likely to see the big increases. There's no way to guarantee that. A lot of smart people who study the business think that we may be through the worst of that.

Benz: That's the pure long-term care insurance policies. Another trend that has been coming on strong is the uptake of hybrid long-term care policies. Let's talk about what those are first and then talk about the trend that we've seen in that marketplace.

Miller: It's a universal life insurance policy that has a long-term care insurance tacked on to it or inside of it, either it's a rider option or right inside. One option, for example, is the ability to convert a death benefit to a long-term care benefit. There are two or three flavors. They come with different levels of benefit protection. The thing that's been striking over the last few years is that sales of these policies have overtaken sales of traditional policies. Now, in one sense, this is not saying much because sales of traditional policies are down 60% since 2012.

Benz: In part because of these premium increases?

Miller: Yeah, it's cratering. Part of it is fear of the product from the rate hike standpoint. I think part of it is just human nature. People don't want to think about this, they don't want to plan for it and they don't want to pay for it. And the policies are not cheap. On the one hand, the traditional market is way down, it's selling about 90,000 policies a year. These new hybrids, at the same time, are growing. They are now selling roughly a quarter-million policies a year. That's kind of a striking change.

On the other hand, if you add it all up, it's still not a real lot of activity considering the need out there in terms of the potential population that might want a policy. That RAND study I mentioned concluded that maybe 12% of the eligible buyers or people who should be thinking of having coverage, have it. We are looking at still a sea change in a segment of the market that overall is kind of small.

Benz: One thing I know you've looked at Mark is, long-term care expenses with the exception of people who might be eligible for Medicaid-covered long-term care late in life just continues to be this big unfunded wild card for many older folks in this country. Any thought about whether there might be any movement of foot in Washington to address this gaping hole for so many retirees.

Miller: Medicaid does remain the big player. It funds two-thirds of long-term care need. Now, a couple of years ago, several bipartisan organizations brought together some of the smartest experts in the room to think about what would be an approach to solving this and getting a less patchwork approach to the way we protect against this risk. The consensus seemed to be that a smart approach would be kind of a hybrid public insurance, social insurance, if you will, and private commercial hybrid approach. You would have something like the Medicare program, for example, providing a base level of coverage. We would all contribute to that to some incremental change in the payroll tax. And then you'd have the ability to tack on higher levels of coverage privately. Almost the way you think about the Medicare market now, where you have the base level of coverage for hospitalization and providers. But then you can pull off the shelf other things ...

Benz: The supplemental type policies?

Miller: Supplemental coverage and the drug coverage and the like. It's a successful approach. It's worked very well so far in Medicare. If you did that it would allow you to provide cheaper private coverage because you'd be talking some of the demand for services out of those private policies. I think that's the approach we should be taking. Unfortunately, given the state of play politically, there's no sign of movement on it at all right now. But at some point, I think that's where we need to still get back to as a discussion about a new framework for providing long-term care because it's kind of the unsolved part of the puzzle, I think, in terms of the overall retirement safety now.

Benz: Mark, always great to get your insights. Thank you so much for being here.

Miller: My pleasure, Christine.

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

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Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Everyone loves income, but sometimes a high yield can be a harbinger that a fund is taking a lot of risks in its portfolio. Joining me to discuss that topic is Russ Kinnel. He is director of manger research for Morningstar, and he is also editor of Morningstar FundInvestor.

Russ, thank you so much for being here.

Russ Kinnel: Glad to be here.

Benz: In the March issue of Morningstar FundInvestor you wrote about yield and the connection between yield and risks in a portfolio. You wrote that sometimes yield can signal that there are problem spots lurking in a portfolio. I thought it was really timely. Let's talk first about, you advise investors to do a little bit of math to look for the expense ratio, look for the current yield, add them together. Why is that?

Kinnel: A fund's expense ratio is subtracted from its income and therefore, to understand the portfolio's yield, you want to add back the expense ratio. That will tell you what the portfolio is yielding. When you get a really high yield, that's big red flag. Today, we've had such a long-running bond bull market that yields are pretty low, and so, if a fund has got significantly higher yield than its peer or benchmark, that tells you it's taking on significantly more risk and therefore you really want to be sure you understand what those risks are.

Benz: A high expense ratio, high-yielding fund, that can be a particularly scary combination?

Kinnel: Exactly. The higher the expense ratio, the more risks you've got to take on just to get even with the peer group. If you want to do more than that, you got to take on even more risk. We've done studies in the past where we find there is a direct link between expense ratios and risk. The higher the expense ratio, the more risk the fund is going to take on to justify that fee.

Benz: Let's delve into some common sources of yield, ways that managers can bump up the yields from their funds. The most common is simply taking some credit risk, so being willing to delve into junkier bond types. How common is that and what categories should investors be watchful?

Kinnel: It's very common to see junk added to just about any kind of bond fund. Your typical intermediate bond fund might have a 5% or 10% in junk. You really could see it just about anywhere.

Benz: Funds are limited though by their prospectus. So, if I have a core, say, intermediate-term bond fund, it will have limits on how much the manager can put in bonds that are below investment grade, right?

Kinnel: Exactly. There will be limits. They will need to have most of their investments in high-quality bonds. Our categories also have limits. If a fund is mostly in high-yield bonds, we are going to put that fund in the high-yield category.

Benz: Whether it likes it or not?

Kinnel: Whether it likes it or not. There are some limits. You are right. But even so, it's worth understanding that this fund maybe moving into more aggressive areas to boost yield and to a degree certainly we think sometimes that's a fine thing to do. There is nothing wrong with that when it's done well and as a part of a good process with skilled investors.

Benz: Right, and that risk taking certainly over the past even decade has been rewarded. Is it your sense that--and I know it's a big universe of bond funds--but is it your sense that managers are perhaps, in some cases, too comfy taking credit risk right now?

Kinnel: Probably, and I think individual investors are, too, just because it's been so long since we've had significant credit event. 2015, we saw a bit of a correction. But in general, taking more credit risk has paid off. Individual investors can kind of get lulled to sleep because when things are going well, more credit risk actually mutes volatility. It makes returns look more stable. You don't see that risk showing up in volatility the way equity risk just about always shows up as volatility. It's a little more subtle effect, but it's something you want to keep an eye on.

Benz: Let's talk about interest-rate risk. That's the other main lever that core bond funds have to take a little bit more duration risk than some of their competitors. How common is that today, would you say? Are managers nudging out on interest-rate spectrum knowing that the Fed appears to be in this tightening mode?

Kinnel: I would say that some are, but some have gotten more defensive. It's definitely a mixed bag. The good news is, one, that interest-rate risk tends to show up as volatility. It's a little easier to spot, but also the duration measure is a very simple way to understand a fund's interest-rate risk. If you look at their duration relative to their benchmark and their peer group, that will give you a good sense. And the higher the duration number, the greater the interest-rate risk.

Benz: Another source of yield boosting that may be a little less familiar to some investors is taking leverage into a portfolio. Let's talk about, A, how this works and, B, how that can exacerbate risks even as it plumps up yield a little bit.

Kinnel: That's right. Leverage is most common in the closed-end universe where a lot of bond funds use leverage. The typical way to use leverage is you are borrowing and then you got out and invest the proceeds from that loan out into additional bonds. Thus, you are getting more than 100% invested. And of course, that means you are dialing up the risk based on whatever you are investing in.

Benz: It's a bull market strategy really, but if you get caught leaning the wrong way, it can be problematic?

Kinnel: For sure. It can really backfire, and of course, it really means the fund is just more extended. Another more subtle way is there can be financial leverage where officially the fund is only fully invested, but you can own underlying instruments that really bump up your leverage. And so, therefore, de facto, you see a lot of funds that have a little bit of actual financial leverage in there.

Benz: You brought an example of a fund that actually is, you think, a pretty good example of leverage in a portfolio and perhaps some risks lurking in a portfolio. That's Salient Select Income. Let's talk about that one.

Kinnel: That's right. We rated the fund Negative because it really ticks just about all of the risk boxes. It's got liquidity risk because it invests mostly in REIT preferreds as well as REIT high-yields and REIT stocks. But also, with leverage it consistently is about 10% to 15% levered, but sometimes all the way up to 30%. What really gave us pause was the fund sometimes uses that leverage to meet redemptions. That's signaling that it can have some liquidity issues that maybe it owned some non-rated securities which tend to not trade very easily. And so, when we see a fund using leverage to offset flows, that really worries us.

Benz: Yes. Another source of yield boosting is investing in illiquid bonds. Let's talk about the connection there. Why less liquid bonds might tend to have higher yields and also what the risks might be of such a strategy.

Kinnel: If you look at Treasuries or equities, most funds have all liquidity they want. They trade tremendously. When you go into some bond areas, munis and especially, lower-quality or nonrateds, they don't trade a lot. And so, therefore, the funds are taking on some liquidity risk. In other words, if they get redeemed a lot, they might not be able to sell enough to meet those redemptions. Or if they can sell, maybe they will have to sell at a really bad price and of course, then you start a spiral of bad feedback where the fund sells at low prices, performance plummets, more people redeem, they sell more. And so, it can be a real mess.

The most dramatic example--and again, this is a real outlier--is Third Avenue Focused Credit which ended up having to prevent investors from leaving because they couldn't meet redemptions. They had a very concentrated portfolio in small, low-quality energy issues mostly. When energy had its problems in 2015, the fund couldn't meet redemptions. It just about worked out all of those problems today, which means essentially, it's taken them three years to liquidate that portfolio which is kind of a crazy thing to have in a 40 Act fund that's supposed to have daily liquidity.

Benz: Right. And so, you mentioned that that's an extreme outlier case. But we actually did see during the financial crisis a lot of the issues we saw in bond portfolios were liquidity related, right?

Kinnel: One of the scary things is, there are some bonds where the market looks liquid and then it's not. What we saw in '08 was that some forms of mortgages were liquid and then they stopped being liquid. Funds had the difficult choice of, they could either stop investors from redeeming or they could sell but at a reduced price. Some funds chose one option, some chose the other. But in many cases, it was really ugly. That is one of the quirks of the bond world, is just liquidity isn't given and you really want to understand how the fund does that. But I think it also illustrates the importance of really good management that you trust, a really good process, because the good managers know this is a risk and they view different buckets of their portfolio. They will say, we are going to have some cash, we're going to have some more liquid holdings and they really stress test their portfolio and they understand that today's liquidity might not apply to tomorrow. Really be careful with your bond funds. Pick good managers, pick good processes. Pick a firm you trust. Good stewards are much less likely to have these problems.

Benz: If you see a yield, you are attracted to that yield, definitely dig in, get to know the process, get to know that's driving that yield up.

Kinnel: Yeah. The higher the yield you go for, the more risk you are taking on, therefore, the more research you have to do just as you have to do that with an individual bond. The higher the yield, the more research you have to do.

Benz: Russ, thank you so much for being here. Always great to get your insights.

Kinnel: You're welcome.

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

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Dan Wasiolek: Most travelers are aware of the online travel brand Expedia, but [investors] should be mindful that the company possesses a powerful network effect and currently trades at a substantial discount to our $175 fair value estimate, offering investors an attractive entry point.

Expedia's share price has underperformed recently, due to the market's ill-advised concern over increasing competition and investment. But in our view, Expedia's market position is unwavering with no signs of cracks, supported by solid trends in its international and vacation rental segments. This reinforces our stance that the firm's incremental spend in these divisions is justified and being done from a position of strength versus weakness.

Despite this spend dampening Expedia's near-term profits, we see it as a strong use of capital, supporting its around 10% average annual bookings growth the next several years versus the roughly 9% rate we expect for the industry. We also believe these investments stand to buoy Expedia's leading network of 600 million monthly visits and nearly 2 million properties, which is the source of the narrow moat we award the company.

The meaningful discount to our valuation implies that the market seems to assume consistent share losses for Expedia, largely writing off any benefit from the current actions to bolster its network advantage. Therefore we recommend long-term investors buckle up and travel with Expedia shares.

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Travis Miller: With the rise in interest rates in the last couple of months, the utilities sector is now open for stock-pickers. There are several utilities trading at 20% discounts, but all of them face challenges. We now think on the high-quality side there are three that offer good value for investors, especially those looking for dividends.

One of those is Dominion Energy. It trades at a 15% discount to our fair value estimate and a 4.5% yield. With good growth we think this is an attractive total return, especially with interest rates still low.

Another high-quality name we think that is trading at a discount is Duke Energy. It trades at a 10% discount and a 4.5% yield. It's going to have slower growth but still a good total return for investors.

And finally, Southern Company. It’s trading at a 5% yield and a 10% discount to our fair value estimate. It faces some uncertainties related to a new nuclear program, but we think it will resolve those and ultimately give investors a solid total return.