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Friday Five: The Negative Rate Experiment

There is little precedent for how the ECB's aggressive stimulus measures might play out. Plus, Olive Garden gets cooking, Dick's looks undervalued, and more.

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Christine Benz: Hi I'm Christine Benz for Morningstar.com. Welcome to The Friday Five. Joining me to discuss five of the top business and market headlines from the past week is Morningstar markets editor Jeremy Glaser.

Jeremy, thank you for being here.

Jeremy Glaser: You're welcome, Christine.

Benz: Let's start with the European Central Bank. They announced a new round of stimulus programs. What are they doing to try to prop up inflation in the eurozone?

Glaser: ECB head Mario Draghi is trying to pull out of the stops to kick-start inflation in the eurozone, which has been stubbornly low for some time now. It was expected they were going to come out with some new stimulus measures, but this was even larger than expected, with more bond buying. They are going to start buying investment-grade corporate bonds, something they hadn't done before.

Also they moved interest rates further into negative territory. I think negative rates are probably one of the most interesting experiments that's happening right now. We're seeing it in Europe and elsewhere. Central banks are trying to push past that zero bound in an attempt to get banks to loan more money, because if they leave it with the central bank, they basically have to pay the bank to hold the money.

Unfortunately this also acts as a tax on the bank, so it's very hard to pass this type of negative interest rate on to customers. When you have European banks whose capital positions may not be as strong as American banks, for example, that's creating some worries. We just don't have a lot of history with negative rates; we just don't know how they are going to react.

This has caused some market skittishness. We don't really know if this is going to be an effective policy or not. Mario Draghi did say that he doesn't expect pushing even further into negative territory. To be fair, he's said things like that before and has still pushed lower. So you have to be somewhat skeptical of that.

I think it's also interesting to look at what's happening in Europe versus what's happening in the U.S. As the Federal Reserve continues to push to raise rates--they might not do so at their meeting next week, but it looks like potentially in June or even maybe before that--we will have divergent monetary policies in two large economies. It certainly will be interesting to watch. We don't necessarily have a lot of historical precedent for how that's going to play out.

Benz: We also got some earnings news from retailers this week. Let's start with Dollar General--pretty good numbers from them.

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Glaser: They had a strong quarter, which is interesting because there is lot of worry around Dollar General. There are fears that Walmart is moving into these smaller-format stores; that's going to pressure them. Walmart raising wages [could] mean that they are going to have to raise wages, too. That's going to hurt profitability. Consumer spending is relatively weak; incomes aren't rising very quickly. That's going to put a big squeeze on their customers.

It turns out that maybe a lot of these fears were overstated. They had a 2.2% increase in same-store sales. They are able to increase operating margins. Things are looking pretty good for them.

We saw earlier this year that Walmart actually pulled out of a lot of their smaller stores. That's another sign that Dollar General, which is a narrow-moat company, probably has some sustainable advantage there. We also think they still have growth prospects. Given how small their stores are, there are little tuck-in locations that currently aren't served. Dollar General may have the ability to go in there.

Unfortunately a lot of these growth prospects are now priced into the stock. We don't think there is a lot of value there. If we were to see another pullback in Dollar General, it could be an interesting one for the radar screen.

Benz: Another retailer that was in the news is Dick's Sporting Goods. There has been some concern about sporting-goods retailers.

Glaser: There has been, and 2015 is not going to go down as a banner year for Dick's. Last quarter they had a 2.5% decline in same-store sales to cap that off. But Paul Swinand, who covers Dick's for Morningstar, thinks there is lot of opportunity for them to gain traction and to grow market share in the years ahead. Some of their peers like Sports Authority are closing stores; we're seeing a lot of consolidation there. We think that Dick's is in a good position to take over some of that. They are focused higher-performance gear that's difficult to find elsewhere and that people do want to buy in-person and not necessarily online. That is something that will help them over the long term. They will be able to expand their store base. When you do that they can spread their costs out more. That should help boost profitability. So even if they didn't have the best quarter in the world, we still think the long-term story is intact.

There is risk here for sure. It's not necessarily going to be easy for them to take market share. But we do think that there is a margin of safety for investors, given where the stock is trading right now. Investors are being paid to potentially take that risk. The shares do look undervalued right now.

Benz: Another company in the news is United Continental. It looks like there is a battle brewing for the board.

Glaser: This was a fight that seemed to be happening in private that is now very much happening in public. Two large shareholders that own about 7% of the company are nominating six new directors to the board, including the former CEO of Continental, to try to shake up what's happening at United. Shareholders point out that their stock performance has trailed a lot of their peers, who have been performing quite well as low oil prices and relatively high yields have helped the airlines. But United continues to lag behind, and the merger with Continental still hasn't paid off in the way that they were hoping.

This happens at a time when United's new CEO, after their former CEO was ousted, is coming back from medical leave next week. There has been somewhat of a transition there. Current management nominated three new people to the board, trying to get some fresh blood in there to maybe hold off some of what was happening from activist investors. Maybe they'll add a fourth.

There is quite a bit going on in terms of management turmoil at the top, and I think we'll be hearing about this for some time. Investors are hoping to get past this, so instead of management being focused on these issues with the board, they can focus on improving operations and earnings, and hopefully that will translate into a better stock price. We'll see how long this takes to resolve.

Benz: Last news story is Darden Restaurants--Olive Garden is under that umbrella. It looks like they had a good quarter.

Glaser: They did. If you remember, Starboard Value is the activist investor that ended up winning a proxy fight for Darden, the parent of Olive Garden. One of their complaints was that they weren't salting the pasta water before they were throwing the pasta in, in order to keep the pots lasting longer so they wouldn't get pitted from the salt. Given the preliminary results they announced, maybe they have started to add some salt to the water. It seems like some of their initiatives are starting to pay off. They are getting better restaurant traffic; they are improving the experience. They are using technology to improve pickup orders in order to boost profitability there.

Management provided guidance that was above expectations both from a sales and profitability standpoint. R.J. Hottovy, who covers Darden for Morningstar, thinks this is in the beginning stages of what could be a pretty impressive turnaround for the company. We've been tracking this for a couple of quarters now. It's just further confirmation of this.

The shares aren't cheap. It isn't a secret that they have to started to make some progress. But again, if there were to be a sell off, investors who have a higher risk tolerance may want to keep this stock on their radar.

Benz: Jeremy, thank you for being here.

Glaser: You're welcome, Christine.

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

Christine Benz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.