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Funds for Yield-Seekers, a Favorite Networking Stock, and 3M

Funds for Yield-Seekers, a Favorite Networking Stock, and 3M

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Joshua Aguilar: Wide-moat-rated 3M is one of five diversified industrial firms that has consistently paid an annually increasing dividend for over 60 years. The stock currently trades at a slight 10% discount to our fair value and pays a solid forward dividend yield of 3.1%. We'd be buyers of the stock at our 5-star price of just below $150 per share.

We believe the market has overreacted to two key variables: 1) 3M's latest guidance cut; and 2) 3M's potential PFAS litigation exposure. Since Mike Roman has been at the helm for nearly a year, 3M has been forced to cut guidance on five different occasions. That said, 3M consists of short-cycle businesses that are notoriously hard to predict. Most of the slowdown has come from three distinct end markets which make up over 30% of its revenue base, which include automotive, electronics, and China. And the company simply missed reacting to slowing demand.

Even so, 3M has a very flexible installed manufacturing base, and they're able to retool their operations to offset some of the slowdown in demand. More importantly, we still believe 3M has a portfolio that can grow at GDP-plus, primarily from their healthcare and safety businesses. 3M's healthcare portfolio is exposed to a number of strong secular trends, including an aging baby boomer population, rising incidents of chronic disease such as diabetes and asthma, a growing number of surgical procedures, as well as demand for efficient management of large volumes of medical data. From a strategic standpoint, the acquisitions of MModal and Acelity position 3M's healthcare portfolio to capitalize on these trends over the longer term. 3M's safety portfolio is really another area we're expecting outsize, GDP-plus growth from, driven by the need to replace aging infrastructure and increased urbanization in the developing world from rural areas.

PFAS litigation is another area we're closely watching from 3M. PFAS are a family of man-made fluorinated organic chemicals which been used since the 1950s. These are strong molecular bonds that simply don't break down easily in nature. But 3M phased out most of these compounds in 2002, with the remainder phased out in 2009. That said, these compounds have now been found in our water supply. So, 3M already booked a reserve of about $230 million related to its manufacturing liability in five sites--three in the United States and two in Europe. However, this reserve doesn't cover product liability. So, while the market fears this exposure could total tens of billions of dollars, we estimate that the cost of the liability could total about $3.4 billion, which we model into our explicit forecast.

Even so, we don't believe that exposure threatens 3M's ability to pay its dividend, though the acquisition of Acelity does mean 3M would have to shut off its buyback spigot in a 25% bear-case probability scenario. In sum, we believe 3M's culture of innovation that allows it to create value-additive products that sell at a 15% premium to the rest of the market remains intact.

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Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar.com. There's a lot to like about the idea of building an ultra-minimalist portfolio with just three index funds or ETFs. But investors who pursue this strategy leave a few asset classes on the cutting-room floor. Joining me to discuss those leave-behinds and how much they matter is Christine Benz. She is director of personal finance for Morningstar.

Christine, thank you for joining me today.

Christine Benz: Susan, great to be here.

Dziubinski: Let's take a step back and talk a little bit about what is the basic three-fund portfolio? What are the building blocks?

Benz: Right. First, I have to give credit to the Bogleheads and specifically, Taylor Larimore, one of the lead Bogleheads. He has been a big proponent of this ultra-minimalist, ultra-low-cost portfolio where you've got a total bond market index, a total U.S. stock market index, and a total international index. And the idea is that this set of three funds gives you very comprehensive well-diversified exposure. So, it is a great starting point for most investors.

Dziubinski: And then how would an investor allocate among those three funds?

Benz: Well, that's an important question. So, for young accumulators, you probably want to have a more equity-heavy portfolio. You might be sort of equally represented between foreign and U.S. stocks. I often recommend that people use target-date funds as kind of a starting point for saying, "Well, for someone with my general anticipated retirement date, what are these professionals recommending?" I think that can be a good starting point. For people who are in retirement, I think it pays to put a little bit of a finer point on it. As you know, I'm a big proponent of the Bucket approach to retirement portfolio allocation. The basic idea is that you are putting a couple of years' worth of portfolio withdrawals in cash to meet near-term spending needs. Then you're stepping out on the risk spectrum. People can read about some of these bucket allocations that I've used, but I've typically thought of like another eight years' worth of portfolio withdrawals going in bonds and then the remainder of the portfolio going into equities.

Dziubinski: Now, these three-fund portfolios are very well-diversified as you mentioned, but obviously, they are leaving some asset classes out. Let's talk a little bit about what isn't represented in those three-fund portfolios.

Benz: Right. One of the biggies that I just mentioned, Susan, is cash holdings. So, it's up to each of us to really think about what we have going on to determine how much is an appropriate cash allocation. For people who are still working, you definitely need that emergency fund, which at a minimum would be like three to six months' worth of living expenses held in true cash investments. For retirees, I think they want to think about their portfolio withdrawals, their anticipated portfolio withdrawals. As I mentioned, I've typically recommended one to two years' worth of portfolio withdrawals in cash investments.

Dziubinski: So, clearly, we all need to think about sort of managing that cash piece outside of our three-fund portfolio. But for those people who are retiring or about to retire or in retirement, some other omissions that are important for us to talk about. One would probably be short-term bonds?

Benz: I think so. So, when you think about your retirement portfolio and you've maybe got that cash allocation, well, you think about, "What if at some catastrophic environment where I've spent my cash, where do I go if I still need additional living expenses, what will I tap?" And I think that's the value of having a dedicated allocation to a short-term bond fund in a portfolio. Short-term bonds do in fact appear in a total bond market index tracker. But unfortunately, you can't tell your fund manager that you just want that piece of the portfolio. You'd need to sell a whole chunk of it, and it may or may not be a good time to do so. So, that's one reason why in my bucket portfolios I have in fact recommended a dedicated allocation to short-term bonds.

Dziubinski: Now, another type of slice of the bond market that could be very important for retirees are Treasury Inflation-Protected Securities. Now, those aren't represented in the three-fund portfolio, are they?

Benz: They aren't. So, if you buy a total bond market index tracker, it will not include an allocation to TIPS. So, here's one to think about if you are assembling a portfolio, especially if you are getting close to or in retirement. If you are a younger investor, probably no reason to worry about carving out a dedicated allocation to TIPS. But once you are putting more of your portfolio into bonds and into nominal bonds that aren't giving you any inflation adjustment, I think it's important to think about, "Well, how do I inflation-hedge that portion of the portfolio?" So, when I look at the allocations to Treasury Inflation-Protected Securities recommended by some of our colleagues in Morningstar Investment Management, when they put together portfolios, typically, 25% to upwards of 30% of the fixed-income portfolio goes into TIPS for retirees. So, that's an allocation that you might want to think about carving out a specific fund for.

Dziubinski: And then, what about high-yield bonds? Is this something we should be considering if we're building these portfolios?

Benz: Well, it's important to note that a total bond market index tracker would not include an allocation to high-yield bonds. There are some very low-cost ETFs that do have at least a small allocation to high-yield bonds. One our team likes is called iShares Core Total USD Bond Market Index. The ticker is IUSB. So, you could use that as kind of your core bond fund. But in terms of whether a total bond market index, if it's a significant omission that it doesn't include an allocation to high-yield, I would say not so much. In part because when we look at high-yield bond performance, what we see is a pretty high correlation to the equity market. So, if you go without high-yield bonds, I don't think it's a disaster.

Dziubinski: And what about non-U.S. bonds?

Benz: Well, this is an area of consideration and where there's been some research recently looking at how much value a hedged non-U.S. bond portfolio adds. There is some modest diversification benefit. So, if you don't mind having an additional holding, that might be a category to consider. But by all means, I would focus, for a retirement portfolio, on a hedged bond product. Because anytime you have an unhedged bond product, you are getting a lot of currency-related volatility, which probably isn't what you want from your bond portfolio. So, if you are looking to perhaps add a little bit of a diversification to your bond portfolio, think about a hedged international fund and make sure you're focusing on one that has very low costs because this is a pretty low-returning asset class.

Dziubinski: Got it. Thank you very much, Christine, for joining us today to talk about some ways we might supplement the three-fund portfolio if we so choose.

Benz: Thank you, Susan.

Dziubinski: Thanks. For Morningstar.com, I'm Susan Dziubinski. Thank you for tuning in.

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Nick Watson: Silver-rated Delaware Small Cap Value benefits from a long-tenured team that implements a consistent approach.

Lead manager Chris Beck has been at the helm of this strategy for over two decades. His process emphasizes free cash flow. He looks to identify attractively valued firms that he believes can generate sustainable free cash flows over the long term. That long-term outlook is evident in the portfolio’s low turnover ratio--Beck tends to hold on to his winning picks, which will often appreciate into mid-cap territory. As a result, the portfolio’s average market cap has historically been higher than its Russell 2000 Value benchmark’s.

A key source of this strategy’s competitive edge is its stable and experienced analyst team. Three of the four team members have been working together with Beck since 2010, and they added an additional analyst in 2016. They’ve shown that they can consistently identify quality opportunities over the long term.

Each of the fund’s five share classes offer a solid cost advantage as well, which rounds out the case for this strategy.

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Christine Benz: Hi, I'm Christine Benz for Morningstar.com. World-stock funds are incredibly flexible. They can invest in the best companies in the world regardless of where they are based. Joining me to share some favorite world stock actively managed mutual funds is Russ Kinnel. He is Morningstar's director of manager research.

Russ, thank you so much for being here.

Russ Kinnel: Glad to be here.

Benz: Russ, let's just talk about these funds at large. They can invest in foreign or U.S. stocks, and that seems really appealing. But as a practical matter, how do these funds typically allocate between U.S. and non-U.S. stocks?

Kinnel: The typical fund in world stock has slightly more in U.S.; about 52% U.S., 44% foreign, and the rest in cash. So, there is a slight U.S. tilt. Of course, the U.S. has been doing much better than most foreign markets over the last five to 10 years. So, that may also be a bit of simply appreciation or trend-chasing. Maybe the next few years of foreign outperformance, I wouldn't be surprised to see that even up a little more.

Benz: So, that's kind of in line with the global market capitalization. Actually, maybe the U.S. right now, I think, is a little more than 50%. Let's talk about using just an index fund to give you global stock exposure. That's an increasingly viable option, right? There are some good products that do that.

Kinnel: Exactly. You can buy total world stock index funds for very cheap today. Or you can buy an international and a U.S. total market. Glue them together, you get the same thing. Depends how much flexibility you want. But you are right, once again, this is an area that indexing does well.

Benz: But let's look at some of your favorite actively managed funds. Starting with Vanguard Global Equity, the advantage of this one is that it's a good cheap fund, but it is actively managed. Let's talk about what you and the team like about it. It earns a Silver rating currently.

Kinnel: That's right. Vanguard often talks about how it's not active versus passive--it's cheap versus expensive. So, when you have an active fund from Vanguard charging 48 basis points to cover the whole world, that's a pretty good deal. In this case, the fund has two subadvisors, Marathon and Baillie Gifford. Two very good advisors. Marathon is a little more core; Baillie Gifford is a little more growth. So, you kind of end up on that blend/growth line in the style box. But if you look at the long-term results of the fund, they are very strong over the 10- and 15-year period. Again, you have good subadvisors and a very low cost. That's why some of these Vanguard actively managed funds are so appealing.

Benz: Let's look at Oakmark Global. This is a fund that, I think, has a lot of appeal in that we like Oakmark's U.S. funds and we like its international funds. So, it makes sense that they should have a good global fund.

Kinnel: If you think about it, in a way it's almost a complete opposite of what we're talking about--a world stock market index fund that's going to have thousands of securities; this one has just 40. You've got a pair of U.S. managers, a pair of foreign managers. Clyde McGregor, who we know from Oakmark Equity Income; David Herro from Oakmark International. Just 40 names. And they've obviously proven to be very good stock-pickers. So, when you have great stock-pickers covering the world, it's really an appealing package.

Benz: So, I know one thing that you and the team have been keeping an eye on is that Clyde McGregor has announced that at some point in the relatively near future he will retire from the fund. Do you feel like there is a good succession plan in place?

Kinnel: Yeah, there is. Oakmark has got some--I mentioned there are four portfolio managers. So, they've already kind of got the implied successors, really, for both Herro and McGregor on this fund--seasoned managers who we expect to maintain that strategy going forward.

Benz: Causeway Global Value is your last of these three world stock picks. I know that Causeway International Value has been a fund that we've long liked. What about this Global Value do you like, and what gives you confidence in Causeway's ability to manage U.S. equity assets?

Kinnel: Yeah, you're right. So, this is a more recently launched fund--still very small asset base, which is pretty appealing. But they've actually been running a version of this since 2000, and this fund has a good record albeit going back to '08. Though more recently, it hasn't done that well, partly because of its value tilt, partly because it's tilted more towards foreign than the U.S. But it's run by the same managers--Harry Hartford, Sarah Ketterer--in a value strategy that's very appealing. So, on the surface level, you see recent performance isn't that good. But again, there's a lot to like here.

Benz: What's its approach to emerging markets? I know that International Value tends to be mainly developed markets. Does this one avoid emerging markets as well?

Kinnel: Yes, it does. So, it's a little unusual beast as well.

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

Kinnel: You're welcome.

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

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Matthew Dolgin: We added CenturyLink to our Best Ideas list in June because the market is pricing in more dire prospects than we expect, and the valuation has gotten too compelling. The stock is trading at less than 4 times our 2019 free cash flow estimate, and it has a dividend yield of almost 9%. We project free cash flow to remain stable at around $3 billion each year throughout our five-year forecast. We also see the dividend as safe because free cash flow should cover it by about 3 times, and we think management would be very reluctant to cut it again after reducing it by more than 50% at the beginning of 2019.

We do see the numerous challenges CenturyLink faces, and we expect sales to fall every year of our forecast. There’s deflationary pricing throughout enterprise networking. Higher-priced legacy offerings are being replaced by low-priced software defined solutions. The company’s consumer network is inferior to cable competitors and has consistently been losing customers. And voice services are on a long-term path toward extinction. We just think these issues are more than priced in, and we expect sales declines to improve as the weaker and lower-margin offerings make up a smaller portion of the company’s total revenue.

Keep in mind that CenturyLink has a lot of debt and therefore more risk, but the maturity schedule and free cash flow generation ease our concerns and make the stock attractive. Our $18 fair value estimate implies more than 50% upside from current levels.

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Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Many investors love income, but focusing disproportionately on yield can invite risks, too. Joining me to discuss that topic is Alex Bryan. He is Morningstar's director of passive strategies research in North America.

Alex, thank you so much for being here.

Alex Bryan: Thank you for having me.

Benz: Alex, let's talk about how equity investors can encounter some peril sometimes in chasing yield. In fact, there's that famous quote that more money has been lost by chasing yield than at the point of a gun. That's a little bit dramatic. But investors can get themselves into trouble. Let's start with the equity piece, investors who are disproportionately focused on dividend alone at the expense of some other considerations.

Bryan: So, if you think about how high dividend yields happen, there's really one or two ways that you get there. Either one, a company is paying out a large share of its earnings as dividends and that leaves less money to reinvest back into the business. It also leaves less of a cushion to continue those dividends should earnings fall, which can happen from time to time. So, that's one way that you can get to a high dividend yield. The second way is if you're trading at really low valuations. And oftentimes, low valuations are indicative of high business risk. So, the company may be going through some operational challenges, may be experiencing some slow growth. So, its earnings and potentially its dividends could be cut sometime in the future.

I think chasing yield can lead you to some riskier areas of the market, where yes, a company may have paid out a really fat dividend in the past, but there's a risk that it may not be able to continue that. There's lots of examples of companies that have had high yields but have had to cut, like GE, ConocoPhillips. So, it's important to look beyond just the dividend yield and look at the whole picture to make sure that those dividends are sustainable. And more importantly, to make sure that you are not going to buy into a stock with deteriorating fundamentals. Because even if you are earning a really nice dividend, if you are losing a lot of money from the stock price going down, you're not really benefiting from that.

Benz: Let's talk about fixed income. The risks of focusing strictly on yield when you are shopping among fixed-income instruments. What are the problem spots potentially?

Bryan: So, nowhere is there a stronger link between risk and yield within the fixed-income market. So, anytime you are chasing yield within fixed income, you are typically going to venture into riskier areas of the market, be that securities with greater credit risk--meaning greater risk of default--or securities that have greater interest-rate risk. So, there's a pretty strong link between risk and yield within fixed income. So, you just want to make sure that you're not biting off more risk than you can chew, particularly if you are looking at securities that have a lot of credit risk. Credit risk tends to be highly correlated with equity risk. So, if you dip into the high-yield area of the market, a lot of times you might lose some diversification benefits that safer bonds might provide.

Benz: Let's talk about some yield-producing funds that you like, that you feel like nicely do deliver income while also addressing some of these risk factors. You've kind of arranged them from most conservative to a little more aggressive. So, let's start with the conservative idea.

Bryan:

So, in terms of a more conservative pick for income generation, I like sticking within the investment-grade part of the market for investors who are a bit more risk-averse. But if you were to invest in something like the

So, you get a little bit of a yield pickup by owning corporates rather than Treasuries or agency debt, but the risk profile is still pretty conservative. This is a really well-diversified portfolio, so even if you have a few payers that get downgraded, the impact from the overall portfolio should be quite modest. So, I think that's a pretty good pick. It's one of the cheapest options in the category. It charges only 6 basis points for basically the entire U.S. investment-grade corporate market.

Benz: Your next fixed-income ETF that you like that delivers income but controls for some of the risks is a high-yield product. Let's talk about that.

Bryan:

So, this is a bit more aggressive in that it ventures into the high-yield market. But this is the

It is riskier than my last pick, because high-yield bonds do have greater risk of default. But I think this is a really good option, because one, it's using market information yields to try to mitigate risk by favoring the lower-yielding high-yield bonds. And two, it's really well-diversified. So, again, here, defaults or credit rating downgrades within a few areas of the market aren't necessarily going to have a big impact on this overall portfolio. So, I think, this is a really good option for investors who want a little bit more yield but want to get that in a risk-controlled way.

Benz: And just to clarify, high-yield in any individual investor portfolio would typically be kind of a supporting player holding it, would not be a core fixed-income position, right?

Bryan: That's right. That's right. Yeah. So, high-yield bonds--even the relatively less risky part of the high-yield market--that's actually pretty highly correlated with stock holdings. So, you should kind of think about your high-yield bond sleeve really as kind of like an equity-type replacement rather than a core bond replacement. Because again, you are taking on quite a bit more risk here than you would get with an investment-grade bond fund.

Benz: Let's talk about your last pick. This is an equity fund.

Bryan:

So, this is

And number two, because this portfolio owns half of all U.S. dividend payers, it's really well diversified. So, if a few companies in the portfolio cut their dividends or run into some operational difficulties, it shouldn't have a huge impact on the performance of the overall portfolio. This is also one of the cheapest dividend strategies available. It charges 6 basis points and that's made this very difficult for active managers and smart beta dividend strategies to beat this particular index fund. So, this is one of my favorite picks and I think it's a good option for getting a bit more yield but not taking on too much risk.

Benz: Alex, always great to hear your perspective. Thank you so much for being here.

Bryan: Thank you for having me.

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

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