Jeremy Glaser: For Morningstar, I'm Jeremy Glaser, and welcome back to our Individual Investor Conference. In this hour, we're going to talk to three Morningstar specialists and get their best investment ideas today. First up is Russ Kinnel, he's our director of manager research here at Morningstar. We're going to talk about open-ended and active mutual funds. Russ, thanks for joining me.
Russ Kinnel: Good to be here.
Glaser: So, let's talk a little bit first about active management generally before we get into some of your best ideas right now. There's certainly been a flood of assets flowing towards more passive funds, those that track a broad market index. What's the case for active funds? Why should investors still be trying to pick managers?
Kinnel: Yeah, I think there's a few reasons you still want to hire active managers. One is, obviously, there's a potential for outperformance that can be different from the market in a good way. We do know there are some very good managers, and again, if you do that, combined with a low-cost active fund, the hurdle's a lot smaller. So, they can add value either through outperformance or through risk management, making a fund less risky than the market. They can also go places that indexes might not go. A lot of the fixed-income area is very hard to index and even where it isn't, the Bar Cap Agg, which is the broad bond-market index, that's a very government-heavy index. So, active managers you see are typically more heavily weighted in corporate bonds, mortgages, and other things that are outside of that. So, there are number of ways that an active manager can bring value to the table.
Glaser: But if an active manager doesn't look like an index, it means you could get some unusual returns. Recently we've seen some issues at Sequoia, for example, a very concentrated fund. How do you think about those risks when selecting an active manager?
Kinnel: That's right, I think with a concentrated fund, you want to understand what the risks are, and I think it's also about position sizing. So, if I've got a really focused, very volatile fund, I'm not going to make it a 10% position. If it's a focused, more stable fund, say it invests in high-quality, maybe that's OK, but I think you really have to choose the right position size, understand the risks. If it's a more volatile fund or a more focused fund, really think long-term. This is, if you've got a fund that's got 25 stocks do not buy it for the next three years, buy it for the next 10 years. A fund like that's going to have some major ups and downs, and you have to understand those risks and be patient enough to get the benefits; otherwise, you're probably not in the right fund.
Glaser: So talking about what kind of funds investors are buying right now--we look at these fund flows--what's that data showing you? What's popular with investors right now?
Kinnel: Well, what's not popular is U.S. equity funds. They are getting heavily redeemed. But on the flip side, people are still interested in bonds. They are still interested in foreign equity, both passive and active. Within U.S. equity it's very much skewed towards passive and ETFs. We saw an interesting move in the middle of the first quarter high yield had been getting killed, and all of a sudden flows started reversing. And high yield is one of the more interesting flow metrics because the flows seem to shift. We saw in '09, money zipped back into high yield faster than it did into equities. I think when yields get better, when yields get higher, money comes in, and so we actually saw high yield switching from being out in outflows to inflows about a month and a half ago.
Glaser: So, let's look at some of your best ideas right now then. The first up is Artisan Global Value Investor. Why is this a fund you think investors should consider?
Kinnel: Yeah. It's just a great fund. It's run by Dan O'Keefe and David Samra who used to work for Harris, which runs the Oakmark Funds. It's a sort of similar strategy, a focused, value-oriented portfolio. They really look for sort of where high-quality and value meet. They don't like a lot of debt. They like well-run companies. In the previous financial meltdown, they were very light in financials. I own the fund myself. Both managers have more than $1 million of their own money in the fund. So, just a great, focused portfolio. I like the fact that they had previously closed, because it means they are really watching out for shareholders.
Glaser: And the ticker on that is ARTGX?
Kinnel: That's right.
Glaser: And next in--also an Artisan Fund, Artisan Value Investor, ARTLX. What do you like about this one?
Kinnel: Right. This one I think takes--you'll have a look a little harder to find the appeal there. Since its inception in '06 it's slightly ahead of the category, a little behind the index. So, doesn't sound real appealing, but we like George Sertl and the value team there, because they've done a very good job with longer track records than Artisan Small Cap Value and the Mid Cap Value. This is their large-cap fund, and it's underperformed lately because they've got kind of energy, materials bias, which of course up until the last month or so has worked against it. But I like these sorts of funds that have slumped a little bit, have a lot of good characteristics, good managers, good strategies still working for them.
Glaser: So how would you use a fund like this? As a core holding, as more of a satellite holding? What would be good position size?
Kinnel: I think it's a core holding. I wouldn't make it a huge holding. But I think it's a good core holding, because it's a nice representation of value. It's concentrated--it's not as concentrated as say, a Fairholme Fund, but it is relatively concentrated. So, I think it's a good way to, say, get exposure to value. I wouldn't make it my only large-cap holding. I'd want something in blend or growth or maybe both, but it's a nice core holding.
Glaser: So, let's talk about BBH Core Select, BBTEX. Why is this on your list today?
Kinnel: Yeah, so this just reopened March 9, because it had about $1.7 billion in outflows. So, for me outflows sometimes tell me, well this is kind of good. It's a good contrarian play. Again a really good focused fund. I think it makes--works as pretty well as a core holding despite been focused because they're looking for companies with sustainable competitive advantages, decent valuations and historically, this is a fund that--its holdings are stable enough that it rarely really gets smacked hard. But if you look at that track record, it's just outstanding. And I've been wanting to buy for a while, but now it's reopened. So you can. So a lot of appeal there.
Glaser: Then the Vanguard Total International Stock Index, that's VTIAX. Now we're talking about index funds. Why is this your preferred way, or a preferred way to approach this part of the market?
Kinnel: Yeah, you asked about active funds. I think sometimes people think maybe we just like active funds, but in fact we like both. We have Gold ratings on both kinds. I have both in my portfolio. This one has a little bit of contrarian appeal because it's actually underperformed the foreign large-blend peer group over the last three and five years, and the reason is, its index has a 20% emerging-markets weighting, which makes it a heavy emerging-markets weighting relative to the peers, which means it's underperformed. But 12 basis points, really broad exposure, everything you look for in an index fund, and I think foreign index funds are often overlooked a bit. So I think it's a good one worth taking a look at.
Glaser: So we actually have a question from a user on index funds, who has a question about the [Morningstar Medalist Rating]. We say that a medalist is going to outperform its category over time, but how does that make sense in the context of an index fund, if it's going to give you the market return. What does it mean to have a medalist index fund?What are our expectations for it?
Kinnel: That's a great question. That's right; obviously with an index fund we don't think it's going to beat its index. That would be great, but that doesn't often happen. We think it's very likely to be, outperform its peer group. If it's a Gold [rated fund] that means we think it's the best-in-class within its index. So, an S&P 500 fund that rates Gold is going to be one that is well-run and is low-cost. So, we look at how has the fund been run over time. There are funds that have had some hiccups, not so much with an S&P 500 Index, but some that track bonds and others have had some issues, but also it just comes down to costs. So, the very cheapest, the best-run are going to be Gold. And others may have some structural issues. We look at either some problems with the index they follow, or maybe it's little more limited so that might make it a Silver or Bronze. So, it's similar in terms of how we think about it versus the category, but obviously the end performance versus its own index does not come into the equation.
Glaser: So, your final pick today before we get to some more user questions is Wasatch Core Growth, WGROX, and it's another Gold-rated fund. Why do we like this?
Kinnel: Right. So, this is may be a little less contrarian. It's actually got some pretty good performance, but we just raised it from Silver to Gold, which we only do that a few times a year. So I think it's really worth highlighting. JB Taylor has just done a great job looking for companies with competitive advantages, but kind of the steadier side of small-cap growth, and that's made it a pretty steady performer. Wasatch really is a great small-cap specialist and [Taylor has] just kind of consistently added value. He's got over $1 million in the fund. So, just a really good fund and there's no new dramatic news that's happened. It's just kind of the fund's performance has kind of consistently impressed us and we just felt like yeah, it really deserves to be a Gold-rated fund.
Glaser: So, we're going to get some questions. We'll remind users they can send in their questions to email@example.com and we'll try to get to as many as we can. The first one here is, just asking your opinion on these flexible, going-anywhere bond funds. We have been mostly talking about equity so far. These unconstrained bond funds, what's your opinion of them, and do you think they have a place in a lot of investors' portfolios?
Kinnel: We talked about position sizing with focused equity portfolios, same thing with these go-anywhere bond funds. Don't make them a big part of your holdings, especially if you've got--if bonds are a big part of your overall stake. I don't think you want this to be a big part of that, because that flexibility is a hard thing to make work. I think it was mentioned earlier in the fixed-income panel, it's just hard to really make all those macro calls right, and generally the record's been pretty disappointing, which is why you saw funds like PIMCO Unconstrained go from huge inflows to huge outflows. We've got that fund rated Neutral. Just the record is not that great because they have that flexibility, but in general that flexibility works against them. So I would say that they are useful, but don't go nuts with them.
Glaser: So our next question is about the advantages or potentially disadvantages in the way that PRIMECAP manages mutual funds, the idea of having managers responsible for different sleeves of portfolio. Could you describe that process a little bit, and generally our thoughts on if that's a good way to think about funds?
Kinnel: That’s right. PRIMECAP emerged from the American Funds mold. So you have these managers operating separately. So as a result, particularly the bigger PRIMECAP-run funds tend to be a little diffuse. They don't have huge biases. But what matters is the managers and the analysts on those funds are just outstanding stock-pickers. Tremendous stability at the firm, people make a career of it and they've attracted really good people.
So to me they are maybe the best growth manager out there. They are a little contrarian, which means they pay attention to valuation, which is also often what trips up good growth managers--they just get too enthusiastic. But if you look at what PRIMECAP does, they tend to buy on dips. And because they go deeper than most growth managers, I think they are able to have the conviction to buy on dips, whereas maybe some other people don't.
So the record is outstanding actually on three different PRIMECAP funds. So, clearly, I believe in it. Their fees are supercheap with Vanguard. Their PRIMECAP Odyssey ones, which are the ones that are still open, are pretty reasonably priced, too. So, I just think they are outstanding funds.
Glaser: So, let's talk a little bit about international. We mentioned an index earlier, but that covers often a lot of large companies. If you are looking to get into international small caps or even mid-caps, who do you think are some managers that are doing a good job in that space?
Kinnel: Yeah, it has become a little tougher to find good ones, because there just aren't that many good international small cap. For starters I actually like a passive-- DFA's International Small Company is really good option. And Vanguard actually has a fund that does something similar passively. I like the passive options. Columbia Acorn does some good things, but Acorn has been a little challenged. So there are some issues there. So there is not that many really good foreign small-cap funds, unfortunately.
Glaser: So as a follow-up maybe to both the bond panel that we had earlier today and our discussion now about picking an active bond fund. Other than cost, what else should you be looking at for just kind of a core bond fund manager? What are some of the attributes that should be on your radar screen?
Kinnel: Well, you want a proven manager with a lot of depth. So you want someone who has got a really good long-term track record, but also some depth. We see that firms like PIMCO, Western Asset are often among our favorites. And you want to understand how do they add value. I think there is a big difference between the ones that like a PIMCO Total Return, it's mostly about macro bets, versus some like Fidelity's muni group, it's much more issue selection. Dodge & Cox's bond fund, it's much more issue selection.
So those issue selectors, the swings in performance are less dramatic, but I think you are talking about a sustainable competitive advantage for a company, that's a sustainable competitive advantage for a fund company to have the depth of analysis to do that. So I think those are among the things you want, as well as, of course, low costs.
Glaser: So, of course, about manager changes, when you do see a manager change in a fund that you own, that is obviously a risk of active management. How do you think about that? What's the best way to assess if the new management team is going to be able to continue the strategy or continue to be the reason that you bought the fund in the first place?
Kinnel: Yeah, it's actually every month in [Morningstar FundInvestor] I have a little section of FundInvestor devoted to my take on the latest manager changes. And it is a thorny issue. I think you want to understand how much did the new manager have to do with the fund's past success; how experienced are they; do they have a track record doing this strategy, even if it wasn't at that fund? If the answer to those is yes, then maybe you want to hold on.
If not, if say, you sometimes see this at smaller Fidelity Funds, maybe the new manager only had a track record at a sector fund or something, then it's probably time to move on. And I think you also want to know if the manager's previous fund, maybe they managed it differently than the current fund. So in a case like that, I'm going to want to watch it really closely to see is that how they are really running it. We saw this turnover at Columbia, where the Value and Restructuring fund went from a value manager to a growth manager. And initially we got mixed signals about whether the manager was going to keep it a value fund or make it growth fund, and it turned out the fund gradually became exactly like his growth fund, which is why you want to keep watching, come back every six months or so, to see how is the new manager really running it. Maybe this fund no longer fits the reason I wanted it in the first place. Maybe it's changed enough that it's throwing my portfolio off.
Glaser: So we now have a [Morningstar Style Box] question--the idea that you have managers in the large, small, and mid areas and also with growth, value, and the blend there. How do you think about allocating your assets across the style box, and then selecting funds that go into the different parts of the box? Is that something you should be very focused on or should you just be focused on managers first and just kind of seeing where those styles end up?
Kinnel: If you look at year-to-year performance, there can be a really big difference between large and small, value and growth. So I think it does make sense to try and have a good balance between all of that. But at the same time, I don't think you want to get so extreme that you feel like you have to precisely dial-in, say, match everything perfectly or precisely, match the Vanguard Total Stock Market. I think it's OK to have some differences.
Most active managers are not going to be in one of those nine grids entirely; they're going to be spread out among a few. So you want to look at Morningstar.com's [Portfolio Manager] tool. Put all of your holdings together, see how that all fits together. Do I end up with any unintended bet--say, I've got way more in value, or I've got way more tech. And in a case like that, then maybe I want to make a change. And you can run your any potential addition through that.
So I want to be in the ballpark, but I'm not rebalancing to try and keep everything super precise, because I think that's needlessly precise. I just think you want good balance.
Glaser: So we have a question from Howard about expenses, and he says that some of the funds we have talked about today do have expenses over 1%. How do you know when it's--you can justify higher expenses in active management? When do you know that you're getting that value there?
Kinnel: Yeah, it's a really tough question. I think you're right. Some of those were over 1%. I think you want one that's ideally at least below average for the peer group. Occasionally, I am willing to make that sacrifice if I think they are adding a lot of value; maybe they are keeping the fund smaller and assets in order to add greater value, in order to maintain the integrity of their strategy. And that might mean that fees don't come down quite as much.
So I think occasionally, but I think you want to have a very high bar. Generally, low costs are a great predictor. That's why I have passive funds in my portfolio, too--it brings that total cost down. So, occasionally maybe buy an average fee fund, but don't go--don't do that too often. We mentioned PRIMECAP. There are a lot of really good active funds for low cost. Vanguard, obviously, has a lot, Fidelity has some, American Funds has some, T. Rowe has some.
Glaser: So, time for one last question. I know that when we look at the most researched stocks at Morningstar.com, Vanguard Dividend Growth, VDIGX, is up there almost every single week. Can you just talk just little bit about your thoughts on that fund?
Kinnel: I love this fund. We rate it Gold. I was just talking about great low-cost actively managed funds. This is one of the best. What's really intriguing about it is dividend growth means you're buying a company that is paying a dividend, but has the potential to grow that. In order to do that, that means the company has to have both growth potential, but also a decent balance sheet; they are not overly indebted or they wouldn't be able to grow that dividend. And what that meant was the fund held up really nicely in '08, '09, which was all about debt. Companies with bad balance sheets got crushed, but a fund like this clearly showed it had some additional defensive characteristics that are little different from, say, Vanguard Equity Income, which is more heavily tilted towards yield. And so I think that's a really nice fund. I think this is the definition of a good core holding.
Glaser: Well, Russ, thank you for joining us on this snowy Saturday here in Chicago. I appreciate you coming out.
Glaser: We will be back with Ben Johnson, our director of global ETF research in just a moment.
And welcome back to our Picks Panel. I'm joined by Ben Johnson, he is our director of global ETF research, for his thoughts on the best ETFs to buy today.
Ben, thanks for joining me.
Ben Johnson: Glad to be here, Jeremy.
Glaser: So let's talk a bit about passive management. We talked to Russ, obviously, about why active management makes sense sometimes. But he said that indexing makes sense sometimes as well. When do you think that it's a good idea to maybe look at an index fund, just to owning the whole market?
Johnson: Well, let's put aside the concept of indexing for a moment and focus on some of the key attributes of indexing. So, as Russ alluded to, indexing is inherently low-cost. And it's inherently low-cost very explicitly in that index funds and ETFs tend to levy much lower fees relative to actively managed ones. They don't have to pay star portfolio managers, they don't have to pay armies of analysts, they are inherently more fee-efficient in that respect.
Now, there are other sort of bigger components--not bigger, but less sort of explicit or apparent components of that cost equation, things like tax efficiency, things like the fact that indexes, broad-based market-capitalization-weighted indexes, will have far lower turnover relative to an actively managed strategy, and turnover begets costs both frictional costs in terms of brokerage, commissions, the fees that are being paid as the portfolio managers are buying and selling securities, and there are also tax implications that spring forth from that turnover as well.
So whether it's indexing or whether it's active, costs matter, perhaps more than anything else, and index funds are just inherently cost-efficient to the extent that they have low fees, they have low turnover, and as a result tend to be more tax-efficient relative to actively managed funds.
Glaser: But not every index and not every ETF are credit equal.
Johnson: No, absolutely not. So in the beginning, indexes were created to be a barometer of market movements. They were designed to be printed across the top of the fold of The Wall Street Journal, the Financial Times, to tell us what is going on in the markets at large. Only subsequently in 1975 were indexes, the raw stuff, the blueprint for funds, so the first retail index mutual fund was launched by Vanguard's Jack Bogle in the mid-70s.
Now, indexes have evolved quite a bit since the days of the Dow Jones Industrial Average and the S&P 500, and most recently what we've seen is that indexes increasingly have active bets embedded in them. And this is a category that we at Morningstar refer to as strategic beta, which in its essence is really a new form of active management. These are indexes that by design have an active bet or bets embedded in them, but then they are implemented passively just like a total stock market index or a total bond market index. So not all indexes are created equal, and sort of the differences, the heterogeneity of the index universe, has grown exponentially with time.
Glaser: So security selection still important to ETFs: You can't just buy something that maybe the name sounds like the part of the market that you want. Let's talk about some of those ETFs that you like. First, I just want to get your opinion of what's the best fund just for complete, you know, equity kind of plain-vanilla exposure, could be the core of our portfolio. What do you think is the best option there?
Johnson: So investors are spoiled for choice now in the realm of total stock market ETFs. So if you look at the Vanguard Total Stock Market ETF, if you look at the Schwab U.S. Broad Market ETF, if you look at the iShares Total U.S. Stock Market ETF, these funds give you immediate access with an ante as little as a single share. So I can log into my brokerage account, buy one share of VTI, which is the Vanguard ETF; ITOT, which is the iShares ETF; or SCHB, which is the Schwab ETF, to get access to virtually every stock in the U.S. market for a rock-bottom near-zero fee. So, 5 basis points in the case of the Vanguard fund and 3 basis points in the case of the iShares and the Schwab funds. This is a fantastic option for a huge spectrum of investors for a core portfolio building block.
Glaser: So looking at maybe some more specialty ETFs and especially in the dividend space, this is an area that we get a ton of questions about, a lot of interest in. Everyone wants to access the dividend. They like all these dividend products. What are some of your favorites, and how do these differ between them?
Johnson: So when we look at the crop of dividend-oriented ETFs, I divide that whole field roughly in half. And on the one hand, we have what I'll call growers, firms that--or indexes that are looking to invest in firms that have sustainable and ideally growing dividends, and on the other hand, we have the camp which is loosely defined as yielders. So that index that underlies the ETF is screening first and foremost on the basis of yield, looking for higher-yielding stocks.
Now, in the growers' camp what you get tends to be a less-volatile, higher-quality group of underlying stocks, given that these are stocks that have been again maintaining and ideally growing their dividends with time. That's indicative of a quality franchise, a franchise that in all likelihood has a wide economic moat, as Morningstar might define it.
So two ETFs that we really like that look to harness a portfolio of growers are the Vanguard Dividend Appreciation Fund, VIG; and the Schwab U.S. Equity Dividend ETF, SCHD. Now, these two funds have more in common than they are dissimilar. They are both rock-bottom in terms of their fee levels. So sub-10 basis points very, very low cost, which is paramount. Both look for, again, a portfolio of dividend-payers that are consistent and ideally growing their dividends, and what you see as the net result of their indexes is a high-quality core portfolio building block that is broadly suitable for people who are looking for a little bit of additional income, and ideally an income stream that will grow with time to at least keep pace with inflation and ideally outstrip it.
Now, let's move over to the other camp, the yielders. So in the yielder camp, our favorite there is the Vanguard High Dividend Yield ETF, VYM. So, VYM is interesting in that it's a yielder with a bit of a quality bent to it. So it's looking for higher-yielding stocks, but it's looking for higher-yielding stocks that may be having or sporting higher yields temporarily and not having higher yields because it's an indicator of some sort of financial stress, some sort of impairment of the underlying franchise. So, oftentimes high yield can be indicative of a high degree of risk. It might indicate that that dividend is unsustainable. So VYM gives you a little bit higher yield with an added element of sustainability relative to the other yielders.
Glaser: Let's look at fixed income now. In the bond panel we spoke about kind of the rise of indexing and when you may want to go active, but if you do want to go index, what are some of--some good options there?
Johnson: So the counterparts to the VTIs, the ITOTs of the world, would be broad-based, highly diversified market-capitalization bond ETFs. So the Vanguard Total Bond ETF, BND; and the iShares Aggregate Bond ETF, AGG, can easily be paired with one of the total U.S. stock market ETFs to provide in the sort of appropriate combination for your risk preferences, your time horizons, et cetera, a two-fund portfolio. It can really be as simple as that. You can have a very well-diversified, very low cost, very tax-efficient portfolio by simply putting two of these ETFs together, be it 80/20, 70/30, 60/40, whatever makes the most sense for you. So, those two, which track the Bar Cap Aggregate Index, are core portfolio building blocks, favorites amongst the crop of bond ETFs.
Glaser: Let's look at some of the strategic beta ETFs you talked about before. These are the funds that are making more of an active bet. Are any of these reasonable holdings or is it more of a marketing spin in discussion of some of these factors?
Johnson: There are elements of both. So strategic beta or what others call "smart beta" is certainly an arena that had a lot of marketing spend behind it because all of the white spaces been covered off in the land of ETFs. So there are nearly 1,900 ETFs today. And if you look at those 1,900 ETFs, the 100 largest ETFs account for nearly three quarters of all investors' money. So, investors are, in most cases, keeping it very simple and keeping it very cheap. So, asset managers have sort of looked to cover the waterfront and the little real estate that's left is in increasingly exotic, more complex, more active, as is the case with strategic beta, fare.
So the underlying index might not have a lot of live track record. There is no such thing as a bad-looking back-test here, and that's something investors should approach with a very healthy degree of skepticism, because not all of these funds will fare well and certainly you are not going to see one that in hindsight has performed poorly, because all the bad-looking back-tests were killed before they ever saw the light of day.
Glaser: So what are some of your favorites there?
Johnson: So one of our favorites amongst the broad-based U.S. equity strategic beta ETFs is the Goldman Sachs ActiveBeta U.S. Large Cap Equity ETF, and the ticker for that is GSLC. Now, at the top of the list of our likes for this fund is its fee. This fund charges 9 basis points, which is not only a tiny fraction of the average fee levied by all funds in the U.S. large-blend category, but it's also about a third of the average fee that's charged by other strategic-beta ETFs in this same category. So right out of the gate, it's got a head start in the form of a very low fee.
Further to that, it makes a diverse set of bets across a number of different factors--factors that we believe in, that have been vetted by academics and others. And these bets are muted. So it keeps an eye on tracking error. It doesn't want to stray ever too far from its starting point, the U.S. large-cap market. We think that this is a low-cost, efficient way to make a muted active bet that is fairly well-diversified across a number of factors, and has the potential for very modest outperformance relative to the U.S. large-cap market at large, over the long term.
Glaser: Ben, we have a few minutes left, but I do want to get to some reader questions. The first is from Helen, who wants to know all your thoughts on the Japan equity and the hedged Japan-equity products that have been quite popular.
Johnson: So, there has been an absolute sort of mania within all things currency-hedged, because going along Japanese stocks and short the yen, going along European stocks and short the euro was a trade that's worked fairly well over the course of the past few years. Now, certainly, currency is a risk embedded in investing in overseas equities, but it's one that tends to wash out over long time horizons.
So if you look at a very long stretch of time, there is really not much, if any, net benefit to hedging currency exposures, and there is a very minimal likelihood that you will effectively time currencies; so swapping from a hedged to an unhedged currency or Japanese equity ETF. So my advice to investors is, if you're going to pick one method, stick with that method, don't think that you can time currency markets, because as far as I know no one has ever done so successfully. And if you're able to do so successfully, odds are you are lucky and not necessarily good.
Glaser: For a final question from Brian, he wants to know about fixed-duration bond ETFs and maybe building a ladder of those versus just buying the entire bond market, what would be some of the pros and cons of that strategy?
Johnson: Yeah, so these are really interesting ETFs. So they have a target maturity similar to an individual bond, but in reality they are a fund with a diversified basket of underlying bonds. So Guggenheim's BulletShares and iShares iBonds are the two players in this space. I think they're very interesting options for people who've been building bond ladders historically using individual bonds in that, one, again, they are diversified. So you're getting rid of some of that idiosyncratic risk associated with owning just one bond from one issuer.
The other element of it is that they are more liquid. So you might not think you'll need to sell that position. But if you do ultimately need to sell that position, these are exchange-traded funds. So the exchange--there are other investors out there on the exchange that are there to provide you liquidity, that will buy that for you, and the cost of that liquidity is much lower relative to owning the individual bond. So I think these are great building blocks, great substitutes for individual bonds in building a bond ladder.
Glaser: Ben, thanks for your picks today.
Johnson: Thanks for having me.
Glaser: Please stay tuned. Next, we'll have Elizabeth Collins, our director of equity research for North America, with her stock picks.
Welcome back. I'm now joined by our final panelist, Elizabeth Collins. She is the director of equity research for North America. Elizabeth, thanks for joining me today.
Elizabeth Collins: Jeremy, thank you for having me.
Glaser: So let's start by looking at the stock market as a whole. Looking at valuations, the first quarter was a bit of a roller coaster, but now that we're into the second quarter, where do you see valuations as a whole right now?
Collins: Sure. So Morningstar equity analysts cover about 1,500 companies globally ,and based on our fair value estimates for each of those companies and then looking at the market overall, we think that the market is slightly undervalued, trading at a discount to our fair value estimates. So based on that, we think that the market is slightly undervalued, price/fair value of about 0.992.
Glaser: So not an enormous discount, but when you look across sectors, are there some parts that look more undervalued, less undervalued, or is it more even?
Collins: No, there are definitely wide divergences. So the most undervalued sectors right now are consumer cyclical, financials, and healthcare, and then, in fact, for basic materials, we think it is a somewhat overvalued sector.
Glaser: And then we like to also look at competitive advantage, things like your long-term competitive advantage, economic moats. When you look at valuations across that, are wide-moat stocks selling at a discount versus narrow moats or no moats, or is that not a very prominent part of the valuation picture right now?
Collins: We don't see any major themes as we have in the past, where we say that "Oh quality is...you just can't find quality at a discount right now." The only thing that's cheap are really not very high-quality companies. But right now the picks I'll be discussing with you come from both narrow-moat and no-moat universes.
Glaser: So when we look back kind of through an historical lens, where do stocks look like today versus where they have been over the last couple of years? It seems like we've had this this big runup. Are we kind of more...or do valuations look little bit stretched compared to where they have been historically?
Collins: Compared to the end of 2015 to through the first part of 2016, stocks did become more attractive. In more recent times, I mean throughout 2015, we were saying that the market was maybe just a skosh overvalued.
Glaser: So let's go ahead and look at some of these stock picks they we brought with us today. The first kind of a midmarket investment bank, can you talk to us about this company?
Collins: Sure. Stifel Financial, so again, midmarket investment bank, they also have a major wealth management division. And let's not sugarcoat things. Near-term earnings won't be pretty. The volatile markets that you and I have been talking about mean that their merger activity and other related activities won't be driving earnings, and they are digesting some costs.
So it's not going to look good, but because of that, we think that the market is focusing on the near term when earnings won't look good, but longer-term we think that Stifel can really grow faster than its peers because it will have the capacity to--it's well-capitalized, and it will have the capacity to either grow its balance sheet or repurchase shares, or acquire other companies. So we do think it's trading at a significant discount to our fair value estimate. It's a no-moat company, but we are accounting for that in our fair value estimate, and we think it's pretty cheap.
Glaser: When you think about potential regulatory concerns, be it the fiduciary standard or Dodd-Frank, are these things that could potentially weigh on the stock?
Collins: Sure. The DOL is something that will factor into Stifel's future, but ultimately we think that it can be consolidator in the industry.
Glaser: So now for something a little bit different, Ralph Lauren. Why do we think that this luxury name looks attractive today?
Collins: Sure. So, Ralph Lauren is a narrow-moat company. Even though consumer apparel is a very attractive--competitive market, we think that they have a very strong brand image. They have really strong relationships with high-end department stores that really allow them to charge premium prices for what is really, clothes are essentially a commodity. But they have been facing near-term headwinds due to currency swings, as well as concerns about weaker tourism-related traffic to some of their megastores. But longer-term we really think that they have opportunities for growth in terms of we really do think that there is strength long-term in the emerging-markets consumer and we think that Ralph Lauren has the ability to expand in some of its categories. It's relatively underexposed in both accessories and women's apparel, compared to other high-end luxury-goods manufacturers.
Glaser: We have a question here that that's probably relevant about the difference between wide and narrow moats. I know that can be a little bit complicated. Can you just walk us through how those things differ?
Collins: Sure. So taking a step back for a second, an economic moat is a sustainable competitive advantage that allows a company to generate returns on invested capital that beat the weighted average cost of capital for an extended period of time despite competitors trying to attack the company's markets. For a wide-moat company, we think that those returns will last for at least 20 years, and for a narrow-moat company, we think that the returns can last for 10 years.
Glaser: So let's move on to a few more picks. These next two are from the healthcare industry, from the drug industry. The first is Vertex. Why is this trading for such a discount?
Collins: So Vertex plays in the cystic fibrosis market and that is a serious affliction that has a relatively small population globally. And since it's such a serious condition and Vertex has some therapies that can really help people living with cystic fibrosis, they can charge attractive prices for these drugs. And we really think that growth is still ahead of the company because one of their more important drugs was recently approved in 2015.
Glaser: And how about BioMarin?
Collins: BioMarin, they are also a player in rare diseases and they have a wider set of drugs--still narrow, it's not big pharma. But we think that they have a narrow moat again, owning to the fact that they are serving limited populations, which means that they have some pricing power. They also work in enzymes to treat these rare genetic disorders. And enzymes are harder to manufacture, which is another way that barriers to entry are created.
Glaser: Now, I know our healthcare analysts think that some of these concerns over political pressures on drug pricing are overblown. Why is that? Why do they think that won't be a big weight on these firms and others?
Collins: Well, there is a lot of political rhetoric right now and it's very easy to get mad about some drug prices getting too high. In some cases the drug companies did get way, way ahead of themselves, charging exorbitant prices for drugs that really didn't offset the cost of the R&D investment or the ongoing capex to man the manufacturing facilities. But in other cases, high prices for rare drugs do make economic sense. It's in the best interest of everybody if the drug companies get the incentive to invest in the R&D to treat rare diseases, otherwise these populations will go on and on and on for years without treatment for--that can improve their quality of living or extend their lives.
Glaser: So, let's look at Micron Technology. They produce somewhat of a commodity, in memory chips. Why do we think that this business is trading at such a significant discount?
Collins: Sure. This is lower-quality company, but we do think it's trading at a significant discount to intrinsic value. Yes, like you said, it creates memory, which is entirely commoditized. Over the long term we expect memory prices to decline as technology improves and gets cheaper. But we think that near-term fears are overblown for Micron. PC demand has been weaker and there has just been oversupply in the memory-supply chain, which means that pricing has been especially weak. And we think that longer-term, our analysts think that Micron can do a bit better, because their product mix is going to improve. Pricing should alleviate a little bit and they've made some heavy investments in R&D, and that should abate and margins should improve.
Glaser: So, we have a question from a user here asking that if you do buy a no-moat company like this, a company with more, maybe some question marks over the long term, does that mean that you should sell it sooner than maybe a wide-moat company that you hold? What would be the discipline there?
Collins: Sure. So, that's a really great question, and it's very nuanced. But the moat rating impacts our fair value estimate, because our fair value estimate is based on our discounted cash flow (DCF) models. And the moat rating, how long we think the firm can be really competitive, impacts how much economic profits we think that they can generate over the long term. So, all else equal, a wide-moat company is worth more than a no-moat company. So the moat rating is really wrapped up into that fair value estimate.
Now, there are other uncertainties out there--cyclicality, operating leverage, financial leverage, and litigation risk or political risk--things of that nature might affect our uncertainty ratings. So, for example, Micron, we have a very high uncertainty rating on that company, so we require a 50% discount to our fair value estimate before we say it's a 5-star company, 5-star stock. So, with all that said, I would say that we think of it as, the uncertainty rating affects the margin of safety and the moat is already wrapped up in the fair value estimate.
Glaser: Then returning to your final pick, Fiat Chrysler. Why is this automaker our pick over some of the other ones that are out there?
Collins: Sure. Again, no-moat company, not necessarily a high-quality company, trading under significant discount to our fair value estimate, you know seventh-largest automaker globally, but we really think that they do have some opportunities to grow. They were late to enter the Chinese market and they now have Jeep exposure there. And as the Chinese were relatively excited about long-term consumer-led demand in China, and Jeep should do well there. They also have some operating leverage opportunities in China as well as Brazil. So we think that their brands can do well especially in emerging markets long-term.
Glaser: So there is lot of talk about M&A and Fiat Chrysler. Do you think that that plays into investors thinking about the company?
Collins: I think that management has made missteps with the guidance and disappointments and M&A activity, but really our view in our DCF model is focused on the core businesses and what global auto demand will be, and regional auto demand and what prices they can convey and how lean their manufacturing will be. So, we don't really look for major calls and M&A activity in our call on this stock.
Glaser: Great, so let's look at some more user questions here. The first is about the take on the steel industry. We talked about basic materials for a moment in our valuations. Can we see steel companies as not particularly attractive right now?
Collins: Steel companies are in a very precarious situation. They had benefited from a decades-long run in Chinese demand for steel because they were building massive investments in commercial and residential real estate, as well as their industrial complex. We simply see that that demand cannot continue. Not only will the investment-led demand slowdown, but scrap supply will start increasing and because of that the steel companies are going to face much tougher times, and not many of them have competitive advantages. And, the fair value estimates are very much dependent on steel pricing. So, it's really hard to find attractive opportunities in steel these days.
Glaser: We have a question from Jack about healthcare, saying that we think it's one of the best undervalued sectors, but it's also been one of the worst performers--one of the reasons it is undervalued. Is that just the drug pricing concerns or are there other things that are dragging these stocks down?
Collins: I think the drug pricing concerns are one of the major things that are holding back the healthcare sector right now. As you mentioned, Morningstar has a long-term time horizon and we're a valuation shop, so we look at stocks based on what their intrinsic value is, and that means that we will be pounding the table when things are out of favor. As such, since they are down, and we've stuck to our valuations in many cases, we think that the healthcare sector is attractive now.
Glaser: We have time for one more question about utilities. I know the valuations are kind of all across the board in that sector, but are there still opportunities left in utilities for people who are looking for that more defensive play?
Collins: Sure. You are right that regulated, safe utilities are fairly to overvalued right now. Simply there are not many attractive opportunities there. All of their earnings potential is already priced in. We do see some opportunities in the boarder utility sector, in companies that are more exposed to commodity power prices, and we also see some opportunities in diversified utilities in Europe.
Glaser: Elizabeth, I really do appreciate you coming in today.
Collins: Thank you, Jeremy.
Glaser: Thank you for joining us for our picks panel. Up next will be Christine Benz providing a presentation on building a tax-efficient portfolio. For Morningstar, I'm Jeremy Glaser. Thanks for joining us.