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Investing Insights: GE, Facebook Data, Ultrashort Bond Funds

Morningstar.com

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Joshua Aguilar: As expected, GE reported disastrous third-quarter results today. Even so, we anticipated the firm would disclose a kitchen sink of bad news. The stock is flirting with 5-star territory as the price of the stock has dropped below $10. If the stock drops down to our 5-star price, at just above the midpoint between $9 and $10 per share, we would be buyers of the stock. At that price, investors would be paying for what we believe are GE's wide-moat businesses in aviation and healthcare, which cumulatively have an enterprise value of about $160 billion, could attach all of GE's foreseeable liabilities, and get the remaining portions of the business for free. Note, these businesses alone are worth more than GE's current enterprise value, and GE has the benefit of having separate market values for both oil and gas, as well as transportation. Bottom line, we’re hoping Mr. Market beats down this stock to our 5-star price so investors can enter the stock at what we believe is an attractive price point.

The firm did cut its quarterly dividend, as expected, to a penny per share from 12 cents per share previously. While the cut is unfortunate, this was also something we anticipated and built into our model. Year to date, the company has paid out $3.3 billion in dividends but has only generated industrial free cash flow of negative $335 million. If anything, what we did not expect was that GE would preserve any remaining portion of its dividend, as we would have preferred the dividend being cut in its entirety. Danaher, which Culp ran from 2000 to 2014 only paid about a 3% to 4% dividend payout ratio, and we think Culp will use the cash to delever the balance sheet, as well as reinvest in the remaining businesses.

We also believe Culp will broadly stick to the aviation, power, and renewables plan. That being said, however, we expect important changes in execution, including as to certain business lines Culp might have GE exit. For example, GE announced it would split GE power into two units, with natural gas in one portion, and steam, nuclear, and grid in another. Culp claims after a review that power is too big to be run efficiently. We agree with this assessment and found that GE runs at about a 55% rate of efficiency compared to Siemens Power & Gas, when measured by segment profit per employee. That said, we would not be surprised if Culp looks to shed the future steam unit given the unattractive economics of coal over the long run. Assuming current margins, we expect that the net present value of selling this business is about 40% greater than for GE to retain it.

While it will take Culp and his team several years to turn around GE, we are confident in his ability to close the stock's gap between the market price and our assessed value.

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Ali Mogharabi: Facebook's third-quarter results came in mixed as they missed slightly on the top line but beat our expectations and consensus on the bottom line. The narrow miss on revenue was mainly due to the user count decline in Europe, which was a result of GDPR.

We note that the firm's total daily and monthly user counts still beat our expectations. In our view, no decline in Facebook's U.S. users was reassuring as it displayed that this wide-moat name's network effect moat source is intact. More importantly, albeit data and content issues that have surrounded the firm this year, advertisers continue to spend on Facebook as ad loads and ad prices both increased and further drove impressive double-digit growth in revenue generated per user.

We expect to see similar monetization in Facebook's newer products such as Instagram and Stories in one to two years. Management's guidance indicated slightly better than expected revenue growth in the fourth quarter while margin for next year may be coming in a bit lower than we had modeled. The two offset one another and did not impact our fair value estimate of Facebook.

We are maintaining our $186 per share fair value estimate. We currently view Facebook shares as attractive as they are trading at a 21% discount to our fair value estimate.

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Linda Abu Mushrefova: For investors seeking mid-cap value exposure, Diamond Hill Mid Cap is an excellent option. The fund was recently given a Morningstar Analyst Rating of Gold.

Chris Welch has been the lead manager on this strategy since its December 2013 inception and has been at Diamond Hill since 2005. He is supported by assistant managers Chris Bingaman and Jenny Hubbard as well as Diamond Hill's centralized research team of approximately two dozen sector analysts. The analyst team supports all of Diamond Hill's equity offerings and have proven their stock-picking abilities over time. For example, Diamond Hill Small-Mid Cap, which is also managed by Welch, has about 80% overlap with this strategy and a longer track record. Over a full market cycle, it tops its peers and index because of successful stock-picking.

The approach adopted here drives all of Diamond Hill's equity strategies. The team conducts deep analysis to identify attractive companies trading at a discount to their estimated intrinsic value. Analysts are responsible for modeling cash flows on a five-year time horizon, which includes looking at each name's balance sheet and income statement to estimate cash flows, normalized earnings, and an appropriate growth rate. Welch then decides which names to invest in and oversees portfolio construction. The team's thoughtful approach has rewarded investors in similar strategies, and we have confidence in their ability to deliver similarly attractive results over a full market cycle in this offering.

Finally, this fund is priced attractively relative to peers. Overall, its disciplined process, proven team, and attractive price tag contribute to our confidence in this fund's ability to reward investors over the long term.

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Christine Benz: Hi, I'm Christine Benz for Morningstar.com. With not-cheap equity valuations and still-low bond yields, many market experts are suggesting that investors temper their expectations for market returns. 

Joining me to discuss the potential implications for a portfolio construction is Fran Kinniry. He is a senior leader with Vanguard Investment Strategy Group where he is the global head of portfolio construction.

Fran, thank you so much for being here.

Fran Kinniry: Thanks, Christine.

Benz: Fran, let's start with market return expectations. Some people might say, well, you shouldn't even think about that. But we do actually need to be operating with some idea of what the market will return because that influences how much we save and so forth. Let's talk about that.

Kinniry: I think sometimes market forecasting gets a negative connotation, but there's really only a couple of ways you can do this. You can use history, and that would be agnostic to initial conditions. You would ignore what yields are, ignore what valuations are, and do a Monte Carlo off of that. That I would say is very problematic, especially if yields are at 3% when history shows 5%. No matter how many times you Monte Carlo that, you are going to get back to 5%.

What we do in the Vanguard Capital Markets Model is we take in the key initial conditions--on equities, they tend to be valuations, such as price to earnings valuations; on bonds, they tend to be yields--and then, we form a distribution to give people expectations of what that distribution may look like relative to history. So, to your point, it allows them to do financial planning. You can't really determine how much to save, what you may end up with, how you will allocate your assets without having some information of market outlook.

Benz: Let's talk about the current environment right now. For a while now, market watchers have been suggesting, investors temper your expectations, market returns might not be so good, yet, they've continued to be quite good. Let's talk about your and Vanguard's expectations for market returns. Is your view that investors should set expectations for lower returns going forward?

Kinniry: Yes. I think what differentiates us from what others may be forecasting is, we are really not into point estimates. We are not going to tell you that we think the market next year is going to give you 4.2%. We have a distribution of returns, and we really feel more confident in 10-year outlook, which again, is back to a financial planning horizon. 

And so, clearly, there equities are elevated, and they have been, as you mentioned. That isn't a signal to do wholesale changes to your portfolio, meaning, sell all your stocks and go into bonds, because it still is a distribution. Low equity returns do not mean negative equity returns. And so, clearly, we have been in a low equity forecast. Same thing on bonds, because bonds' yields have been lower than history. So, low equities, low bond forecasts. You put that together for a balanced portfolio and balanced portfolios look low relative to history.

Benz: Can you give us a ballpark of where Vanguard would be in terms of a 10-year forecast for, say, a balanced portfolio?

Kinniry: For a balanced portfolio, depending on the asset allocation, somewhere like 4% to 6% would be the central tendency of a distribution. But we wouldn't be surprised if an investor got 8% or an investor got 2%, again, back to this distributional approach.

Benz: It seems like my time horizon should influence how much I should care about that. If I am in my 20s or 30s, probably don't have a reason to care a lot about what the next 10 years hold. But if I'm just about to embark on retirement, that matters more for me, right?

Kinniry: We have a 10-year outlook. I think the most important thing is, people have to update their outlook every year or quarter, because if we have a bear market--let's say, you get a 20% or 30% sell-off on stocks--that's going to have a negative headwind for the return. But then initial conditions of valuations become more reasonable. Your next time series is high. Same thing, if interest rates go from 3% to 4%, you may lose a little principal, but your forward returns now are 4% instead of 3%. You have to update this on a regular basis. Clearly, it matters closer to when you need the money. I wouldn't necessary, say if it's a 20-year-old versus a retiree, if I'm a 20-year-old saving for a car or a house in five years, then those returns may matter more than a 60-year-old who is retired who may not need those assets until they are 90.

Benz: Let's talk about portfolio construction in what might be a fairly low-returning next decade. Are there any things that people should think about when they are attempting to assemble a portfolio that will perform well, areas that they would underweight or overweight? How would you approach that?

Kinniry: I would say there's probably a lot more of what they shouldn't do than should do, and we are seeing a lot more of what they shouldn't do. What I mean by that is, reach for yield, reach for risk, believe in maybe high-alpha strategies such as a hedge fund or something like that. There's nothing wrong with alternatives, but I think sometimes the allure or the promise of them and the costs of them are quite high. We see a lot of investors not willing to accept low returns. They go toward, I call it, high-cost hope, higher-cost mandates and hope that they get the return. 

Some things that they can do is really make sure that they have their asset allocation right in advance, make sure that they have really low-cost funds, broadly diversified; if you are in a taxable portfolio, highly tax-efficient. Those would be the things you can do.

Benz: One thing you alluded to, Fran, was the fact that starting yields tend to be a good predictor of what bonds will return over the next decade. Does the fact that yields have been picking up, does that make the picture a little more sanguine when you think about fixed income over the next decade?

Kinniry: We've always hoped that we would have a gradual rise in interest rates. At Vanguard, we've actually been one of the few who have said, as far back as 10 years ago, we didn't think hyperinflation was going to come out of the global financial crisis. You remember back to all the printing of money and QE, people thought inflation was going to run away. We were pretty early and alone in saying we thought interest rates were going to stay low. And now, recently, if they are going to rise, rise at a very gradual pace. That actually will help investors. A little bit of principal loss, I think if you look at bond returns this year, down 0.5% to 1.5%, but the forward returns, instead of it being 2% are now 3%, 3.25%. And so, if we have that general rise, and you have the long enough holding period, rising interest rates can somewhat be helpful in a nominal world; maybe not in inflation-adjusted world, but in a nominal world.

Benz: Well, that was my follow-up question, because a countervailing force is that we have seen inflation begin to tick up a little bit. Does that concern you with respect to cash and fixed-income investments?

Kinniry: It concerns us just a little bit, not a lot, because what we actually had a for a long time is negative yields. Meaning that the yields were so low that they are running below inflation. A conservative, a low-risk portfolio was actually giving up to inflation. What we have seen is interest rates have risen a little bit faster than inflation and that's good because you are actually returning to normal. This normalization of the interest-rate environment is quite helpful for investors.

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

Kinniry: Thank you, Christine. I appreciate it.enz: Thanks for watching. I'm Christine Benz for Morningstar.com.

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Jeff Holt: Target-date funds have continued in their strong-growth trend through the first nine months of 2018. Looking across all 12 Morningstar Categories of target-date funds, assets totaled nearly $1.19 trillion as of the end of September, up from $1.11 trillion at the end of 2017. The growth in assets has come through both investors putting more money into the funds and the generally positive returns from the funds over that time.

Coming off a record year when they saw $70 billion in net flows from investors, target-date funds have already seen $45 billion in net flows year to date through September. The 2035 category's $8.6 billion in net flows was the highest, while the 2020, 2015, 2000-2010, and Retirement categories saw net outflows. And those outflows don't come as a surprise since funds in those four categories are intended for investors very near or already in retirement. As we've seen in recent years, target-date funds that hold in low-cost index funds continue to be popular.

Target-date funds also produced positive absolute returns in general year to date through September. The average return for the target-date fund categories ranged from 0.7% in the Retirement category to 4.3% in the 2060+ category. However, market declines through the first few weeks of October has taken those year to date returns into negative territory.

Still, given their role as the default investment in many defined contribution retirement plans, investors can expect to see assets in target-date funds continue to rise over the long run.

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Susan Dziubinski: Hi, I'm Susan Dziubinski for Morningstar.com. Funds in the ultrashort bond category are generally high quality. You have some sector flexibility. Although they maintain durations of one year or less, they aren't replacements for FDIC-insured bank money market funds or certificates of deposit. That being said, here are three Morningstar Medalists in the ultrashort bond category that investors can use to diversify their cash holdings.

Alaina Bompiedi: As its name implies, Fidelity Conservative Income Bond is indeed conservative, but it is not risk free. The fund invests below the one-year mark on the yield curve in a mix of commercial paper, floating rate, and short-term debt. That's pretty similar to other funds in the ultrashort bond category, but compared to money market funds, this one has a wider investment range. It can invest in taxable municipals, corporates, as well as foreign bonds. But the team that manages this fund allocates across those risks prudently. They limit the fund's investment in midgrade BBB bonds to 5%, and the fund is not allowed to hold below investment-grade bonds. With that, the fund's performance has been relatively placid in its category. Its five-year trailing return is about average, but we think that's a good sign that the fund is fulfilling its mission of providing incremental return and capital preservation.

Eric Jacobson: Bronze rated BBH Limited Duration looks for undervalued bonds that have enough income to compensate for the liquidity and credit risks and that have an extra margin of safety. That's not a novel idea, but its process, both quantitative and qualitative, is meant to keep the fund invested in proven robust structures or time and battle tested guarantors. The fund is run by Andrew Hofer and Neil Hohmann, and in the case of asset back securities underpinned by loans or leases, for example, they stick with markets that have endured multiple credit cycles. Each asset pool is tested against levels of trouble, including at least a 250% hike in their base case loss projections. Hofer, Hohmann, and their analysts use a structure they describe as being built on four important elements of durability, transparency, appropriate structuring, and good management. Part of that involves looking to understand every element of an issuer's business model, underwriting, and servicing capabilities. They like to steer clear of those without a long record of underlying rigor and consistency, whether they're buying an issuer's debt or securities that they've packaged from other assets or loans. When it comes to the latter, the team sticks with those issuers holding an economic interest in the long-term health of their deals. They will work only with those issuers they view as having easily understandable and very transparent balance sheets. Financial firms dominate issuance in the short end of the market, though, and Hofer argues that management's attitude toward risk across market cycles is ultimately an investors first and last line of defense. Just relying on the look of a company's balance sheet in that space can get you into trouble, since, as Hofer has said, their financials can look entirely different short order when they're not managed well. Among other factors, the depth, rigor, and success of its methods have helped support its Bronze Morningstar Analyst Rating.

Miriam Sjoblom: One of my favorite ultrashort bond funds is PIMCO Enhanced Short Maturity ETF, which gets a Gold analyst rating. One of the reasons we like it, it's got a very experienced team. Jerome Schneider's been running it for nearly a decade and he's supported by PIMCO's vast resources across pretty much every bond sector globally. While Jerome has the expertise to invest pretty much anywhere, he actually plays it extremely safe here. The fund's duration is kept under one year, which means it has very little interest-rate risk. Also, he avoids some more volatile sectors such as currencies and high yield bonds, so he's really focused on downside protection. The fund charges a 35 basis-point expense ratio, and while that's not especially cheap relative to ETFs, actually when you look at it versus the active open end fund universe, it's actually a pretty good deal. Adding it all up, this one's tough to beat.

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Sonia Vora: Shares of Boston Beer have soared since the beginning of the year, as improving depletion trends have bolstered confidence about the firm's top-line prospects. However, we think the market is overly optimistic about the company's prospects in a slowing craft beer market and suggest investors wait for a more attractive entry point.

While we expect ongoing premiumization trends will help craft beer volumes outpace the overall beer category longer term, we see evidence to suggest that craft momentum is slowing. We estimate volume growth in the craft segment, which now holds a nearly 13% share of domestic beer volume, fell to a midsingle-digit clip in 2016 and 2017. While this pales in comparison to the roughly 15% rate averaged over the prior five years, it is still more favorable than the roughly flat overall beer market. 

We expect competition within this slowing category to remain intense, as both the largest beer players and small craft producers aim to drive volume gains in the high end of the beer market. This should constrain Boston Beer's top line to midsingle-digit growth longer term, which is in line with our outlook for the broader craft beer category.

However, we maintain Boston Beer has secured a competitive edge, thanks to its flagship Sam Adams brand and entrenched relationships with retailers and wholesalers. We think the firm will be able to leverage these relationships to support a positive growth trajectory, despite further SKU rationalization in the beer aisle. 

Boston Beer's efforts to trim costs from its operations should also strengthen its bottom line, ensuring it has the resources needed to reinforce its brand investments and maintain a solid pipeline of innovation, which we view as essential to support its volume recovery.



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