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Investing Insights: Jack Bogle and Earnings Results

Morningstar.com

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Christine Benz:  Hi, I'm Christine Benz for Morningstar.com. I'm at Vanguard headquarters to speak with Jack Bogle. He's the founder of the Vanguard Group. 

Jack, thank you so much for being here.

John C. Bogle:  Always great to be with you, Christine.

Benz: Thank you for having me here, and I'm here for the Bogleheads conference. This is an annual event that honors you and your many contributions to the financial services industry. We've been doing these video interviews for several years now. It's kind of a tradition. 

One thing I often ask you to talk about, because I think you have a very intuitive way of approaching it, is what you're expecting in terms of market returns for the equity and bond markets in the next decade?

Bogle: It hasn't changed from what we talked about last year very much. But there's a reality to the stock market--let's take that first. The reality is that the fundamental return, the dividend yield plus the earnings growth of companies, drives the long term return of the stock market. The only thing that gets in the way in the short term is a speculative return; are people going to pay more for stocks? Are people going to pay less for a dollar of earnings, in essence? 

For example, if the price/earnings multiple were to go from 10 to 20 over a decade, that would be a 100% increase and be 7% added to the return each year, so it can be very substantial. And it also can be negative. If the P/E goes from 20 to 10, minus 7% or roughly 7% a year. 

So where are we now?

The dividend yield is about 1.8%, less than 2%. I'm looking for future earnings growth of around 5%. I don't think we can do much better than that; maybe a lot better this year with the tax cut. Maybe a little bit better next year, too. But maybe 5%. So let's call the dividend yield 2, and 5 is 7. By my numbers, that's the investment return, 2% dividend yield, 5% earnings growth. That's a 7% return.

If the price/earnings ratio is to go down a little bit, I think 1.5% off that 7% return, which would be a 5.5% return on stocks over that period. That's a little higher than I've been using--maybe right, maybe wrong. I've usually been using about 4. But that's a ballpark. It doesn't really matter what we guess in these areas. There's no precision in any of this. Let's say in the 4% to 5% range is just for the fun of it, for stocks.

Bonds are a different matter, because there's only one driving factor for bonds in the long run, and that is the current level of interest rates. We use a combination of the 30-year Treasury, which is a little over 3%, and then we use 50% of that and 50% of the corporate rate, which is around 4.25%, and that's going to give you about a 3.8% let's say, but I'd round it to 4 ...

Benz: Blending those two together.

Bogle: ... on the return on bonds. So, 4% from bonds and a slightly higher percentage from stock. The point of this is not accuracy. I would not know how to do that, and anyone tells you they do know how to do it shouldn't be talking to you--you shouldn't be talking to them. 

But rather that instead of the high returns over the last 25 years, or the market during Vanguard's history, the market's gone up 12% a year--I'm talking now stocks alone--if we get 5% in the years ahead ... just think about this for a minute.

At 12% a year, the market doubles in six years. At 5% a year, the market doubles in approximately 15 years. So basically over 15 years, you're going to get 4 times on your money if it's 12%, which it's not going to be. If it's four times a year, I hope all this makes sense, you're going to get the same number but it's going to take twice as many years.

Benz: And that's not even factoring in inflation or taxes or expenses ...

Bogle: Mutual fund costs.

Benz: I knew you would end up there.

Bogle: When you look at a combined market return of, say, stocks and bonds together, let's call it just for the fun of it 4%, I won't be far off--I don't want to do too many decimal points here--and the average mutual fund has expenses that come pretty close to 2%. Not just the expense ratio, which for actively managed mutual funds is now about 0.75, something like that, but you have sales loads for a lot of funds, and the funds that have dropped their sales loads have higher expense ratios. No way around that.

Then internal portfolio transaction charges; you don't see them, but they're there. Fund managers turn their portfolios over with a fury. Active managers, the turnover rate by my measure, is something like 100%; very, very high. I'm talking about purchases plus sales as a percentage of assets. The convention is to take the lower of purchases and sales ...

Benz: When calculating turnover.

Bogle: The cost is both sides of the transaction, not one. You're talking about 2% cost, and now you've taken the return down. Then you take inflation out, and let's assume that we're lucky to get 2% inflation, you've now got 4% off that return, 5% market return. What does this say? We can't do anything about inflation, but we can do something about fund costs, and that is keep them low. Period.

Which means, as you were about to say I'm sure, index funds should be at the top of your list.

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Christine Benz: One question that you and I have talked about over the years is just the growth of indexing and the potential for it to make the market at large start to behave differently because so much money is in index-tracking products. I know you've said in the past you don't think we're there yet, but let's discuss your view on that topic. Has it evolved since we last talked? Or do you still think that indexing would need to get a lot larger?

Bogle: It's amazing to me. I was citing this statistic to the Bogleheads this morning, and that is, I did a study for the board of directors in 1975, and had the previous 35 years of large cap funds--that's what we had in those days, mutual funds compared to the S&P index--and the S&P index outperformed by 1.6% a year. In an article I wrote for the Financial Analyst Journal a couple of years ago, I updated that study and went 35 years up to 2015, the previous 35 years, and the difference was 1.6% in favor of the index fund.

So why is that? Because the cost of mutual fund management is about 1.6%. I'm oversimplifying, it's smaller at large-cap funds and bigger at small, but it's telling us what we should know: that the average manager is averaged before cost. How else can that be? It's a very competitive business, very smart people competing with one another, but it's hard to get an edge. 

I think there's very little evidence that indexing, even at 45% of the fund industry, has changed the nature of the market. I would add this: Supposing the market is less efficient and people will say, "ah ha," then managers can do well.

Benz: Active managers will have their day.

Bogle: Active managers. There will be a stock-picker's market, as they say. No, because if active manager A beats the market, active manager B will lose to the market. There's no way around the fact that that part of the market that's outside of indexing, if somebody does better relative to the market, somebody does worse relative to the market. 

As for a stock-picker's market, I never saw a phrase that seems to have such acceptance that meant so little when one thinks about it. Sure, there's a stock-picker's market, but every stock that's picked is unpicked by somebody else. Everybody that buys is buying from a seller. It's the simplest thing in the world that people don't seem to get. We're all consigned to average as a group. And when you take costs out, that's where the index advantage comes in.

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Christine Benz: Let's talk about international, and you and I always talk about this. You're kind of a contrarian even within your firm in terms of thinking that investors don't necessarily need international stocks to have a globally diversified portfolio. But yesterday at the conference, you talked about Jason Zweig's good piece on the perhaps relative undervaluation of foreign stocks. Do you think investors ought to look at that, be thinking about the fact that we have not seen foreign stocks perform as well as U.S.?

John C. Bogle: I guess the answer to that is yes and no. Number one, the fact that they're undervalued may mean that they're undervalued because they're riskier, which I think is at least importantly the case, maybe not the entire case. Second, I'm just a great believer in a U.S. portfolio because we're the most entrepreneurial nation, we've got the soundest institutions, financial and otherwise, or have had in the past, governance is pretty solid, in the past at least, and a well-diversified economy. 

For U.S. corporations, about half of their revenues and half of their earnings come from abroad anyway. It's not as if we're America first or America only. The entire world economy is integrated around many, many countries trading with many, many other countries. I do not think you need to add international. 

People have been doing it a long time. The cash flows in the fund business have been much stronger in non-U.S.-

Benz: In international, yeah.

Bogle: -than in the U.S. despite the inferior performance. I don't quite understand where this thing is that you must have a global portfolio. Maybe it's right. Of course, maybe anything is right, but I think the argument favors the domestic U.S. portfolio, and they have to worry about whether the dollar is strong or weak. One more risk.

Many of these foreign nations, particularly emerging markets nations--which are, I think, around 20% of the non-U.S. index--are very risky, very interest-rate sensitive, governmentally not as strong or maybe capable of tipping over rather easily. I do tell people, feel free to disagree with me because I'm not always right, but I have 0% in non-U.S. I say you don't need to have non-U.S., but if you do, limit it to 20%. A lot of portfolios now have 25%, 35%, 45% in non-U.S. securities, and I think that's just too much.

Damien Conover: Johnson & Johnson reported third-quarter earnings that largely surpassed consensus expectations but were largely in line with our expectations and so we're not changing our fair value. We think the stock is slightly overvalued but still very well positioned for growth on a fundamental basis and really believe that the firm has a strong wide economic moat. 

When looking at the quarter, the drug division again helped lead overall results. They've got a lot of new products hitting the market that are really in areas of unmet medical need that allows them to price these drugs very well. The uptake is very strong because there's a lot of unmet medical need. 

Outside of the drug division, the consumer group actually did very well, and we were surprised by that. It's been an area of weakness in the past, so it's nice to see that group finally hitting its stride and really showcasing the brand power of that division. 

Lastly in the medical device division, the scenario where Johnson & Johnson has struggled a little bit with innovation and some pricing headwinds, and this is continuing to be a bit of a laggard for the company. We do expect that to continue for the next couple years; however, longer term with some of the robotics that they're working on looks like an area of nice growth beyond the 2020 time period. 

Overall the results were better than consensus and pretty close to what we are anticipating, and we continue to view the stock with a wide economic moat and just slightly overvalued.

Neil Macker: Netflix posted stronger than expected subscriber guidance in the third quarter as the company beat its own weak guidance by roughly 2 million subscribers. The company now has over 130 million subscribers globally, as it continues to expand its global subscriber base. Growth is still being driven internationally, as the company now has almost over 80 million subscribers outside of the US. 

Despite the subscriber gain, Netflix continues to burn cash, as the loss reached almost $860 million in the quarter. The company continues to expect a $3 billion loss for the full year and expects that level to continue in 2019. While the company expects an inflection point in 2020, we do note that increasing competition from not only Disney but possibly launches by Warner Media, Apple, and Walmart should increase the amount of competition. This increased competition may force the company to continue spending on original content. 

We are retaining our narrow moat for Netflix along with our $120 fair value estimate, as we expect the company to face increasing competition over the next five years, which should necessitate ongoing cash burn and limit international margin expansion.

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Andrew Lange: IBM posted an underwhelming third-quarter result as the company continued to juggle strategic and nonstrategic business lines. The company's legacy revenue and the decline there was apparent. We're particularly surprised by the decline in the cognitive solutions business. The company highlighted things like collaboration as the mainframe middleware as areas of weakness. 

On the positive side though, the global business services and global technology services businesses showed improvement. We're hopeful that digital transformation will drive revenue for the consulting and infrastructure services business lines. 

In terms of strategic imperatives, the business grew 11% on a year over year basis. On a trailing 12-month basis, it constituted $39.5 billion. Strategic comparatives are expected to be a decent midterm growth driver for the business. However, we expect a slow down over time as the compare gets harder and harder. Still strategic comparatives remains one of the only viable options for IBM's top-line growth rate, that's if it is to achieve even modest revenue growth. 

Our fair value estimate is $168 on this narrow-moat name. We believe investor sentiment is low and we think the company is trading at a discount to our fair value estimate. Therefore, we think the company would appeal to risk-seeking technology investors.

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Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar.com. Dividend-paying stocks are attractive to yield-seeking retirees. But a collection of high-quality dividend payers can make excellent core holdings for investors in accumulation mode, too. Joining me today to discuss some of Morningstar's favorite ETFs that target dividend-paying stocks is Adam McCullough. He is an analyst in our manager research group focusing on passive strategies.

Adam, thank you for joining us today.

Adam McCullough: Happy to be here today, Susan.

Dziubinski: Now, the first pick you wanted to focus on today is the only ETF that focuses on dividend-paying stocks that also happens to get a Gold fund analyst rating from us. It's also an ETF that focuses pretty much exclusively on dividend growth stocks, and it's Vanguard Dividend Appreciation. Why don't you tell us a little bit about that one?

McCullough: This is a fund looking for stocks that are willing and able to raise their dividend payments. So, it won't be the highest-yielding dividend-focused fund. It lands in Morningstar's large-blend category and its yield could be probably a little bit higher than Russell 1000, but it's looking for those stocks that are of high-quality and profitability that will be able to maintain their dividend payments.

What it does is, first, it applies a backward-looking 10-year screen for stocks that have raised their dividend payments for each of the last 10 years. That shows, one, that they are profitable enough to raise their dividend payments each year; and two, that their management is willing to raise the dividend payments in each of the last 10 years. This is good and bad in that it finds the more profitable names but precludes names that could probably sustain their dividend payments, like Apple, that haven't been paying dividends for the past 10 years.

Next, what it does is after it has this list of stocks that have raised their dividend payments, it weights them by their market cap. It skews toward the largest names of that set. All told, it holds about 180 stocks, and it's looking for those profitable names. It should hold up better during market downturns than the average fund in the category. In fact, during the financial crisis it only lost 46%, whereas the Russell 1000 lost about 55%. To boot, it's cheap. It only charges 8 basis points a year, which is also what supports its Morningstar Analyst Rating of Gold.

Dziubinski: The second ETF that we are going to talk about today is also another Vanguard dividend-focused ETF, but instead of focusing on dividend growers, this ETF focuses on higher dividend-paying stocks, is that right?

McCullough: That's right. This is Vanguard's answer to where is the yield. This fund averaged over the past five years has been about 3.4%. It's Vanguard High Dividend Yield ETF, easy enough. What this fund does is it looks for the top half of dividend payers based on their forward-looking yield and then it weights them by their market capitalization. This fund owns about 400 names, and it's less discerning than Vanguard Growth. It's not looking for quality metrics. It's saying, we're going to look for higher-than-average dividend payers but be so well diversified that we can withstand the impact of a stock that cuts its dividend payment or is at risk of cutting its dividend payment and has a price drop because of that. Whereas the Vanguard Growth Fund is a little bit more nimble, this is your tank that's going to be able to withstand dividend cutters but also offer that higher yield. It's a little bit riskier than the Vanguard Dividend growth fund, but it still earns a Morningstar Analyst Rating of Silver because the process is still solid in that it finds the larger dividend-yielding names and also, it's well-insulated against those that may cut their dividend, and it charges the same fee. It's only 8 basis points a year for this fund as well.

Dziubinski: The third ETF that we wanted to talk about today is also a Silver-rated fund. It also focuses on those higher-yielding dividend-paying stocks.

McCullough: This is the Schwab Dividend U.S. Equity Fund and it's a bit newer to the game. I think it came out in 2011. This is a bit of a hybrid between the Vanguard High Dividend Yield approach and the Vanguard Dividend Growth approach. What this fund does is it looks for, again at rank order stocks that are higher-than-average dividend payers. But then it scores them on some quality metrics.

This will look for stocks that have high ROEs, return on equities, so it can cover their dividend payments; better debt flow or cash flow to debt ratio, so it can keep those payments flowing to the end investors, but also look for dividend growth and dividend yield. It has kind of a 4-metric composite score that it assigns to all of these high-yielding companies, then it picks the top 100 of those and then weights those by market cap. It's going to own bigger stocks that pay higher dividend yields than the average stock but there's a little bit of a quality component to it. You have the extremes in Vanguard High Dividend Yield, Vanguard Dividend Appreciation.

The Schwab fund lands a little bit in the middle. It's still more toward the high yielding side. It lands in the large-value category. Yield here over the past five years, an average has been maybe 3.2%. Whereas Vanguard High Dividend Yield, 3.4%, and then Vanguard Dividend Appreciation's fund yield is probably 2.2% over the past five years. This fund is also cheap. It charges 7 basis points a year, and we think that its solid process to look for higher dividend payers but also apply some quality screens and then market-cap weight them will set it up to do well versus its category peers over the long haul and support its Morningstar Analyst Rating of Silver.

Dziubinski: It sounds like there's a lot of reasonably priced ETFs for dividend seekers to be considering. 

Adam, thank you so much for your time today. We appreciate it.

McCullough: Absolutely. Thank you.

Dziubinski: For Morningstar.com, I'm Susan Dziubinski.

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Seth Goldstein: We recently published a deep dive report highlighting our bullish outlook for global electric vehicle penetration. Based on our findings, we see a number of attractive long opportunities that will allow investors to capitalize on increasing electric vehicle production. 

For background, in 2017 electric vehicles accounted for only about 1% of total light vehicle sales globally. By 2028, we expect this number to increase to 15%, which is above consensus estimates of 11%.

A key driver of this outlook is our analysis that, over the next decade, electric vehicles will reach cost parity with internal combustion engine vehicles. Battery innovations will increase driving range and shorten charging times so that electric vehicles will no longer be an inferior product versus internal combustion engines. 

Although we have an above-consensus global electric vehicle penetration outlook, our research indicates that electric vehicle adoption will vary widely by region. The density of charging infrastructure will be the key factor that either spurs or limits electric vehicle adoption in a given region. China will build the world's largest electric vehicle charging infrastructure system. Combined with the strongest regulatory push, we forecast electric vehicles to account for 25% of all new light vehicle sales in China by 2028. Europe, with solid charging infrastructure and tightening fuel standards will be second at a 20% electric vehicle adoption rate. The U.S. will lag the global average at 12.5% due to fragmented regulatory policies that will limit electric vehicle adoption.

Our top picks for industries that will benefit most from growing electric vehicle adoption are lithium producers and utilities. Lithium will be needed in all electric vehicles, regardless of battery chemistry or auto brand. Meanwhile, utilities that grow their rate base by building electric vehicle charging infrastructure can offer the security of regulated returns to investors.

Our top picks to play the electric vehicle adoption trend are Albemarle, BMW, BorgWarner, Edison International, General Motors, and SQM.

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