Investing Insights: Facebook, Alphabet, and Top Stock Funds

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Facebook reported slightly mixed second-quarter results with revenue in line with our internal forecast but below consensus. It did beat expectations on the bottom line.

But Facebook’s guidance on margins trending to the mid-30s during the next couple of years as the company will be investing further in innovation, content creation, and data protection, was disappointing.

Total revenue growth was hampered by slower growth in monthly and daily active users due to the implementation of GDPR in Europe, which was partially offset by higher revenue generated per user. While margins remained at impressive levels, they did narrow year over year, as we had expected and noted in our previous reports. In light of the soft profitability guidance, we lowered our Facebook fair value estimate slightly to $186, from $198.

We’re still confident that wide-moat Facebook will successfully roll out new products for users and advertisers and the firm can continue to more effectively monetize its users as it begins to offer more premium video content not only on Facebook Watch but also on Instagram’s IGTV. Plus, we think Facebook will realize return on its investments in content quality management and data security in 2020 and beyond, resulting in longer-term margin expansion.

With the stock down about 20%, we now view shares as slightly undervalued when compared to our new $186 fair value estimate. But we do recommend waiting for a wider margin of safety, likely in the $150-$160 range, before investing in this wide-moat and high uncertainty name.

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Wide-moat Alphabet beat expectations on the top and bottom-line in the second quarter.

Ad revenue continued strong double-digit growth as Google is monetizing its apps and the YouTube viewers more effectively.

We were impressed by the over 40% growth in other revenue, driven mainly by Google cloud and the consumer offerings.

We’re confident Google can leverage its proven technological expertise, including machine learning, to build and maintain public cloud platforms for various businesses. Its new cloud clients included Domino’s Pizza, PricewaterhouseCoopers, and SoundCloud.

On the margin front, gross margin is still being pressured by growth in traffic acquisition cost rates, higher spending on YouTube content, and the lower-margin hardware offerings. With lower gross margin and continuing increase in headcount and investments in R&D, we expect operating margin to be pressured impacting our fair value estimate of Alphabet, which is now $1,300 per share.

Last, the European Commission decided to fine Google $5.1 billion as it alleges Google is forcing smart phone OEMs to pre-install its apps. We think, whether that’s the case or not, consumers will keep downloading those apps. While there are no switching costs for users, the network effects of most of those apps will remain, especially given Google’s continuing improvement in search results. So, we expect demand for the apps to grow, forcing OEMs to place them on their devices as default, whether forced by Google or not.

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Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Investors have been selling equity funds, and this time around active equity funds aren't the only casualties. Joining me to discuss the latest trends in fund flows is senior analyst Kevin McDevitt.

Kevin, thank you so much for being here.

Kevin McDevitt: Thanks for having me, Christine.

Benz: Kevin, let's look at the headline where we have seen fairly dramatic outflows from equity funds. The interesting thing is that we have actually seen some selling among passive funds this time around.

McDevitt: Yeah, that's right. I don't want to overstate it, but you did have outflows of about $3.4 billion last month, and overall U.S. equity outflows were about $21 billion or so. It was notable that you had--and the lion's share of outflows came from active funds, but a portion of that was passive. I think what's really interesting is, through the first half of the year in three out of those six months you had outflows from passive U.S. equity funds. That hasn't happened in years and years. It's been at least five years and perhaps we've never really seen anything quite like that where we've seen pretty significant outflows from passive funds in successive months.

Benz: Among U.S. equity funds would you say the selling was fairly indiscriminate, that investors were selling equity funds of all types?

McDevitt: On the passive side, you saw the greatest selling from core holdings, core S&P 500 index funds, some total market funds, really kind of the stalwarts of the U.S. equity passive group. While you actually did see a fair amount of inflows from smaller, perhaps more satellite-type funds, small-cap funds in particular, small blend, small growth all saw actually net inflows last month. It's more of those, kind of, core large blend funds that saw the outflows at least on the passive side.

On the active side, it's more across the board. Again, with active U.S. equity funds last month, you saw outflows of more than $17 billion, and that was more across the board. Large-growth, we continue to see outflows. Really, large-cap funds of all stripes saw outflows, large value.

Benz: One thing we had been watching, Kevin, was the fact that international equity fund flows had remained pretty robust over the past several years. But it looks like there's even been a little softness there recently?

McDevitt: It's primarily come from emerging markets where last quarter or so emerging-markets equity funds are down about 8% with all the volatility there plus a strong dollar. That finally has resulted in pulling money from those types of funds. You had about $8 billion leave emerging-market equity funds last month and that had an impact on overall international equity flows, too, which were among the lowest you've seen over the past decade. But year to date still international equity flows have been quite strong, over $80 billion or so. That's somewhat curious because overall emerging markets, it's not just because of emerging markets but international markets are down about 3.7% or so depending on which index you are looking at. Inflows have still been strong, especially in the core like foreign large-blend funds, those flows remained strong versus again just contrasting that with the U.S. side, where you've had outflows of more than $20 billion year to date, even when the S&P was up about 2.7% through June. There has been volatility there but nothing like what we've seen in international markets.

Benz: In terms of what investors are doing with their dollars, where they are putting money, funds flows into bonds actually appear quite strong year to date. Let's talk about that. I'd like to hit on the active versus passive divide in fixed income, as well as what types of bond funds investors seem to be choosing, so what categories?

McDevitt: If you look at overall taxable bond funds, you've seen strong flows there year to date over $125 billion or so. In terms of the active/passive divide, it certainly is there just not nearly as pronounced as it is on the equity side. You've seen passive flows of about $70 billion and active flows of about $55 billion. You've seen a bit of an advantage for passive, but again, nothing like what you see on the equity side.

In terms of individual categories, it's very much core, fairly conservative categories. The top category year to date has been intermediate-term bond with a little over $40 billion in inflows. But that's followed by ultrashort-term bond funds which have seen a little over $30 billion in inflows. That's been really curious to see because it really shows, in my mind, does show a shift of investor preferences in terms of risk appetite. That really started about two-and-a-half years ago when you had a sell-off in high-yield bond funds. Ever since then you have seen declined demand for high-yield bond and increasing demand for ultrashort-term bond funds as the Fed has been raising rates. So, for the year to date, you have seen about $30 billion or so in inflows for ultrashort-term bond funds and about $22 billion, $23 billion or so in outflows for high-yield.

Benz: How about the fund flows among fund families? Vanguard and iShares have been huge beneficiaries as we've seen this enormous torrent of assets going into passive products. It seems like they have both experienced a little bit of softness recently?

McDevitt: They have and it's really across the board and I think it's more indicative of just how demand is slowing for long-term assets in general. Certainly, iShares, BlackRock and then Vanguard, as you said, Vanguard is well behind where it was in recent years in terms of first half flows. I believe this past month was its weakest month since August of 2013 in terms of inflows. You can't really point to any one category or any one asset class. Although, with Vanguard, they have seen net outflows from their active funds this year, active equity funds in particular. But really, that hasn't been the engine for them anyway. It just seems slowing demand, I think, really across the board. It's hard to really chalk it up to an individual family or an individual active versus passive. It's really just slowing demand across the board. I think, again, it's a good thing to keep in mind that this first half was the worst first half for long-term flows since 2015 and the third worst over the last decade. Really, it's really been an across-the-board phenomenon.

Benz: One broad last question for you, Kevin, is the fact that when you sort of look at these fund flow trends in aggregate, I think you see that investors appear to be being a little more pre-emptive in terms of some of their trades that they are not necessarily driving with the rear view mirror as we've so often seen in the past. What do you think--and it's hard to summarize what investors might be doing in aggregate--but what do you think is driving investors to be a little bit contrarian in their choices?

McDevitt: It seems like they are being certainly far more, I don't know if the word is proactive but far more active at least with what they are doing with ETFs in particular. We are seeing big shifts month to month in flows in and out of kind of those core ETF funds. Again, I'm imagining like some of the iShares funds, some of the S&P-related ETFs, you are seeing big shifts month to month. It just suggests that whoever is controlling those allocations has been far more active, whether that's advisors or quantitative investors being model-driven or whatever it is, they just seem to be far more proactive, but also far more risk-averse. Again, it's surprising how much money is going out of U.S. equity funds even though it's nothing like, at least so far, what we saw during the 2015-2016 correction or 2011 or even the credit crisis going back to 2009. It just seems like investors are much more aggressive in kind of tweaking and changing their asset allocations month to month.

Benz: Interesting stuff. Kevin, it's always great to get your perspective. Thank you so much for being here.

McDevitt: Great. Thank you, Christine.

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

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Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Interest rates may be rising but retirees are still looking for extra yield to help fund their retirement. I'm here with Christine Benz, she is our director of personal finance, to look at where there could be some risks in seeking high-yields investments.

Christine, thanks for joining me.

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

Glaser: We are going to look at three different types of investments today that might have some risks that investors aren't fully aware of or haven't fully thought through. The first are a high-yielding, foreign dividend-paying stocks or foreign dividend-paying funds. Why is this an area that could potentially have some risks?

Benz: First of all, we'll start with the attraction, which is that, yields can be really attractive relative to U.S. equity dividend yields. Yields are like 4% right now if you buy sort of a basket of high-yielding foreign stocks. That's a big plus. I do think that investors need to be mindful of the risk factors. Not that they should definitely avoid this category, but a couple of things you would want to keep in mind. One is that anytime you are looking at a high dividend-yielding product or a high dividend-yielding stock, you are usually getting a little bit of a value orientation. If you are buying a fund that tracks some high dividend-yielding universe, you are going to end up with a value tilt. That's one thing to keep in mind. You may end up with a little bit more economic sensitivity with that portion of your portfolio as well.

The other thing to keep in mind is that you may be geographically less diversified than would be the case if you bought, say, a total foreign stock market index fund. You probably will get a little less--Japan, for example, because dividend yields oftentimes are lower in Japan than elsewhere in the developed world. That's another thing to keep in mind. Mind the geographic exposures, recognize that you may be making certain bets there by focusing on dividend yield with your foreign stock portfolio.

Another thing to keep in mind is that dividend yields overseas tend to be a little more ephemeral than is the case in the U.S., where if a U.S. company is paying a dividend, it will sort of turn over every cupboard in order to maintain that dividend. Not necessarily the case in foreign markets where dividends might come and go a little more. This will be a particular issue for investors who want to buy an individual company that happens to have a high-yield attached to it. Something to keep in mind and certainly, anytime you are talking about yields, whether from bonds or stocks, you want to bear in mind tax consequences as well. If you are someone who is interested in making a big play in foreign high-yielding stocks, check with your tax advisor to talk about where to hold that particular product or individual security.

Glaser: Currency risk shouldn't be overlooked either?

Benz: Absolutely. Thank you for reminding me. Anytime you have a foreign stock or a foreign fund that is unhedged, you are exposing yourself to foreign currency fluctuations. There's a chance that your gains, when translated back into U.S. dollars, could be diminished if currency fluctuations break against you. On the flip side, you can also gain if foreign currencies gain at the expense of the U.S. dollar over your holding period.

Glaser: Let's turn to business development corporations or BDCs. Can you just describe exactly what these are?

Benz: Technically, they are closed-end funds that trade like equities. But I think a good way to think of them is kind of a private equity product for the masses. They are pools of capital that invest in either the debt or the equity of companies that aren't public typically, oftentimes smaller companies that need some sort of financing. The big advantage to BDCs and one of the reasons why they might have come on yield-focused investors' radar is that the yields can be really tantalizing. Because like REITs, BDCs need to pay out 90% of their income to their shareholders each year. It's not unusual to look at BDCs and see yields of like 9%. Also, there are managed products that focus on BDCs. They too have very tantalizing yields. That's the big attraction. Certainly, there are big risk factors there as well though.

Glaser: And when you hear 9% yield, that could be more terrifying than tantalizing, raises a lot of red flags. When you look at that number, are these businesses sustainable, is that yield sustainable? What are some of the risks that investors need to keep in mind?

Benz: Yes. Such a great point. Anytime you see a yield that high, it's your job to get in there and take a look at some of the risks. In the case of BDCs, these are oftentimes very leveraged companies whose fortunes are leveraged to the strength of the economy. What we saw in 2008, for example, was many of these companies encountered troubles, BDCs underperformed, some of them had losses of upward of 30% during that period or even more. You need to be careful. You need to recognize that these are risky companies that BDCs own, and you need to be prepared for them to experience periodic downdrafts because they are so sensitive to the strength of the economy.

Glaser: Let's dial down the risk a little bit and look at floating rate funds, like bank-loan funds. These have been increasingly popular. What are some of the pros of looking at a product like this?

Benz: Yeah, there are a couple of key pros here. One is that yields have become pretty attractive on floating rate or bank-loan or senior-loan products where you don't have to stretch too hard to find a product that is yielding in the neighborhood of 4% today. The other big attraction to floating rate products is that you do tend to have less vulnerability, much less vulnerability to changes in interest rates. Typically, bonds are very vulnerable to interest-rate changes. Floating-rate products are a little bit different in that when rates trend up, when the LIBOR trends up, so will the rate on the loans in the portfolio. They tend to perform pretty well in periods of rising rates. When we looked at what categories performed well in inflationary environments, floating-rate products also look good from that standpoint. Those are the big advantages.

Glaser: But there's some downsides as well?

Benz: Certainly. Some of the same things that we've talked about in the realm of BDCs, although to a perhaps smaller extent, are in play with the floating rate products. Specifically, you get a lot of sensitivity to what's going on in the economy. You get a lot of sensitivity to what's going on in the equity market. In periods of equity market weakness and economic weakness what we typically see is floating-rate portfolios behave in sympathy with the equity markets. Keep that in mind.

I think this is a serious category that serious investors should consider, but I would limit it to a small portion of the portfolio and certainly not think of it as a substitute for high-quality, fixed-income securities.

Glaser: Bottom-line, what should retirees keep in mind who are looking at these higher-risk, higher-yield type of investments?

Benz: I think you hit on it, Jeremy, when you said anytime you see that sort of very high, eye-popping yield, that's your trigger to get in there and take a look at what risks might be lurking in the portfolio. Keep that in mind. I think it's also worthwhile if you are looking at high-yielding securities to the extent that you can diversify across a basket of securities, I think that is a great thing to do for your portfolio. Then also, anytime you are looking at products with yields attached to them, so any sort of managed product, really focus on keeping the costs down on that product.

Glaser: Christine, thank you.

Benz: Jeremy, thank you.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

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Susan Dziubinski: I'm Susan Dziubinski for Morningstar.com. Stocks can play an important role in the portfolios of retirees. After all, if you are going to live off your portfolio for two decades or more, you will likely need stocks to provide some much needed growth during the drawdown phase. Morningstar's director of personal finance Christine Benz includes three stock funds in her model portfolios for retirees. She is here today to discuss them.

Christine, thanks for joining me.

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

Dziubinski: Your retirement portfolios include stock funds in that third and last bucket. The stock fund that takes up the largest percentage of assets is Vanguard Dividend Appreciation. Why did you pick that fund?

Benz: I think of it as sort of a high-quality subset of the total market. It focuses on companies that have increased their dividends in each of the past 10 years, and the net effect of that screen is that it tends to focus on companies with sustainable competitive advantages. When we look at the portfolio, it actually has a much larger share in what we call wide-moat stocks than does the S&P 500. It's also a Vanguard index fund. It's very, very inexpensive. It charges just 8 basis points for the admiral shares. It's a cost-effective way to own what I think of as a very high-quality portfolio. It tends to be less volatile than the broad market. In 2008, it lost 10 percentage points less than the S&P 500.

Dziubinski: You also include another Vanguard index fund, Vanguard Total Stock Market, in the portfolio. How does that come into play with the mix?

Benz: It comes into play because there are sectors of the market that that Vanguard Dividend Appreciation does not encompass. Vanguard Dividend Appreciation tends to be pretty light on the technology sector, for example. Vanguard Total Stock Market, of course, just mimics the total market capitalization of the U.S. stock market. It's not making bets on various sectors. It offers very broad-based market exposure. It's even cheaper than Vanguard Dividend Appreciation; it charges just 4 basis points for the admiral share class and it's also incredibly tax-efficient. For an investor who has a taxable component of his or her retirement portfolio, this can be a one and done choice because it is very tax-efficient. It comes either as an exchange-traded fund or a traditional index fund.

Dziubinski: Harbor International is the third fund. Why that one in particular?

Benz: This is a little more controversial, I suppose. It's certainly more volatile and it has tended to be a little bit streaky when we look at performance. It has some periods of very strong returns, but periods where returns haven't looked as good. But I think it's a great fund, because I believe that its strategy is fundamentally really prudent. Management focuses on companies that it believes have sustainable competitive advantages. It likes to buy them when it thinks they are trading cheaply. Once it buys them, it hangs on and on and on. It has very low turnover, it's a patient approach. I would say, investors who like the idea of that strategy, need to have a similarly patient mindset because it will go through these fallow periods where performance will look out of sync with other foreign stock funds.

Dziubinski: Christine, thanks so much for providing us some perspective on these funds today.

Benz: Thank you, Susan.

Dziubinski: Thanks for watching. I’m Susan Dziubinski for Morningstar.com.