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Investing Insights: GE's Downgrade and Grantham's speech

Berkshire's cash, two fund picks, and Christine Benz’s take on staying cool in volatile markets.

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This video is part one of five from GMO's Jeremy Grantham's address at the 2018 Morningstar Investment Conference. You can also watch parts two, three, four, and five.

Jeremy Grantham: In the interest of full disclosure, I should say that I am all in on the topic of climate and toxic damage to the environment; 98% of my net worth is either in two foundations or is committed to it. Fortunately, I come from a vastly overpaid industry, ours, and so that still leaves me enough to have two houses and a Tesla Model 3, if they would just deliver it to me. I'm going to give you first a broad overview of this topic, which I'll read to save time, because if I ad lib all this we'll be here all day. Then I'll give you lots of backup data with slides. 

You could call this presentation the story of carbon dioxide and Homo sapiens. You may not know, but if we had no carbon dioxide at all, the temperature of the Earth would be minus 25 degrees centigrade, and we would be a frozen ball with no life except bacteria perhaps. 200 to 300 parts per million of carbon dioxide has taken us from that frozen state to the pretty agreeable world we have today. CO2 is therefore, thank heavens, a remarkably effective greenhouse gas. The burning of fossil fuels has played a very central role in the development of civilization. The Industrial Revolution was not really based on the steam engine, it was based on the coal that ran steam engine. Without coal, we would have very quickly run through all our timber supplies, and we would have ended up with what I think of as the great timber wars of the late 19th century. The demand for wood would have quickly denuded all of the great forests of the world, and then we would have been back to where we were at the time of Malthus, living at the edge of our capability with recurrent waves of famine as every other creature on the planet does. A few good years, the population expands and bad years, you die off. 

A gallon of gasoline has at least 400 hours of labor equivalent. It means that ordinary middle-class people have the power that only kings used to have in the distant past. And what that has done, that incredible gift of accumulated power over millions of years is to catapult us forward in terms of civilization, in terms of culture and science. It's created an enormous economic surplus with which we could do these things for the first time in history. And above all agriculture has benefited allowing our population to surge forward. 

The sting in this tale however is that this has left us with 7.5 billion people going on 11 or so billion by 2100. And that can only be sustained by continued heavy, heavy use of energy. Fossil fuels will either run out, destroy the planet, or both. The only possible way to avoid this outcome is rapid and complete decarbonization of our economy. Needless to say, this is an extremely difficult thing to pull off. It needs the best of our talents and innovation, which almost miraculously, it may be getting. It also needs much better than normal long-term planning and leadership, which it most decidedly is not getting yet. Homo sapiens can easily handle this problem, in practice; it will be a closely run race, the race of our lives. I like to say never underestimate technology and never underestimate the ability of Homo sapiens to screw it up. 

If the outcome depended on our good sense, if we had, for example, to decide in our long-term interest to take 5% or 10% of our GDP--the kind of amount that you would need in a medium-sized war--we would of course decide that the price was too high I think, until it would be too late. It is hard for voters to give up rewards now to remove distant pain particularly when the pain is deliberately confused by distorted data. It's also hard for corporations to volunteer to reduce profits in order to be greener. Given today's single-minded drive to maximize profits, it's nearly impossible. 

But technology, particularly, the technology of decarbonization has come leaping to help us. This is the central race. Technology in my opinion will in one sense win. When we come back in 40 years, I'm pretty confident that there will be a decent sufficiency of cheap green energy on the planet. And in 80 years perhaps it's likely we will have full decarbonization. Lack of energy, green energy will not be the issue that brings us down. If only that were the end of the story. The truth is we've wasted 40 or 50 years. We're moving so slowly that by the time we're decarbonized and have reached a new stability of plus two and a half to three and a half degrees centigrade, a great deal of damage will have been done. And a lot more will happen in the deeper future due to the inertia in the environmental system, for even if we stop producing a single carbon atom, ice caps, for example, will melt for centuries and ocean levels will continue to rise by several perhaps many feet. 

I don't worry too much about Miami or Boston, that's just the kind of thing that capitalism tends to handle pretty well. The more serious problem posed by ocean level rise will be the loss of the great rice producing deltas around the world--the Nile, the Mekong, Bangladesh, Thailand, and others, which produce about a fifth of all the rice grown in the world. They're all heavily populated areas. The great Himalayan rivers, which support one and a half billion people, depend on the normal springtime runoff of the glaciers which are now diminishing in size at an accelerating rate.

Agriculture is in fact the real underlying problem produced by climate change. But even without climate change, it would be somewhere between hard and impossible to feed 11.2 billion people, which is the median U.N. forecast for 2100. It will be especially difficult for Africa. With climate change, there are two separate effects on agriculture. One is immediate, the droughts, the increased droughts, the increased floods, the increased temperature reduce quite measurably the productivity of a year's harvest. Then there's the long-term, permanent effect, the most dependable outcome of increased temperature is increased water vapor in the atmosphere, currently up over 4% from the old normal. And this has led to an increase, a substantial increase in heavy downpours. It is precisely the heavy downpours that cause erosion.

In a rain, even a heavy rain, the farmers are not stupid, they lose very little. It's the one or two great downpours every year or two that cause the trouble. We're losing perhaps 1% of our collective global soil a year. We are losing about a half a percent of our arable land a year. Fortunately, the least productive half a percent. It's calculated that there are only 30 to 70 good harvest years left depending on your location. In 80 years, current agriculture would be simply infeasible for lack of good soil. We have to change our system completely to make it sustainable. With conservative farmers to deal with, it will take decades and we haven't even started. 

One of the impressive parts of new technology though is in fact in agriculture from intense data management where you know square meter by square meter exactly what is going on to the isolation of every single micro-organism that relates to the plant.

This race too is finely balanced. A separate thread also closely related to fossil fuels is that we've created a toxic environment apparently, not conducive to life from insects to humans as we will see. We must respond rapidly by a massive and urgent move away from the use of complicated chemicals that saturate our daily life. Finally, in terms of this introduction, a subtext to all of what I have to say is that capitalism and mainstream economics simply cannot deal with these problems. Mainstream economics largely ignores natural capital. A true Hicksian profit requires that the capital base be left completely intact and only the excess is a true profit. And, of course, we have not left our natural capital based intact or anything like it. The replacement cost of copper, phosphate, oil, and soil and so on is not even considered. If it were, it's likely that the last 10 or 20 years for the developed world anyway has had no true profit at all, no increase in income, but the reverse. 

Capitalism also has a severe problem with the very long term because of the tyranny of the discount rate, anything that happens to a corporation over 25 years out doesn't exist for them. Therefore, grandchildren, I like to say, have no value. They the corporations also handle externalities very badly. Even the expression "handle badly" is flattering for often they don't handle them at all, they're just completely ignored as are the tragedies of the commons. We deforest the land, we degrade our soils, we pollute and overuse our water, and treat air like an open sewer. We do it all off the balance sheet and off the income statement. Indeed, sensible capitalist response is deliberately slowed down by well-funded and talented programs of obfuscation by what is called the merchants of doubt, familiar in the past with tobacco particularly in the U.S., but here also the U.K.

One of these merchants, Richard Lindzen, a professor at MIT actually went seamlessly from defending tobacco--where he famously puffed cigarettes through his TV interviews--to denying most of the problems of climate change. Let me just add this doesn't happen in China or India, Germany, Argentina. This is unique to the three English-speaking, oily countries--the US, the UK, and Australia.


Susan Dziubinski: For Morningstar, I'm Susan Dziubinski. Market volatility has returned with a vengeance this year. I'm here with Christine Benz, our director of personal finance, to talk about what's been driving that volatility and what investors should do about it.

Christine, thanks for joining me.

Christine Benz: Susan, it's great to be here.

Dziubinski: What's been driving the volatility so far in 2018?

Benz: We had some volatility earlier in the year back in February, and that seemed to center around concerns over inflation, fears that maybe the tax cuts would be inflationary and also concerns about rising interest rates. More recently I would say, the market volatility has been focused around worries related to tariffs and trade wars. I would say more broadly with the market being, in Morningstar's view, pretty fairly valued, we tend to see the market more sensitive to some of these headline risks that crop up, inevitably. I think that that enhances the potential for volatility.

Dziubinski: Is the volatility we're seeing historically abnormal, or is this just a return to the more normal levels of volatility historically?

Benz: Yeah. In a lot of ways, it is a return to more normal levels. I was looking at the VIX, which is the CBOE's benchmark of volatility. What you see from 2012 through really last year, 2017, was a remarkably placid period, a little spike up in volatility back in 2015. But when you look at the volatility we've seen more recently, it just really does look quite similar to the period prior to that 2012 through 2017 period. I think we all got a little bit a little bit spoiled. We were used to having our equitylike returns but didn't have to endure a lot of price volatility to get it.

Dziubinski: In periods of market volatility that we've seen recently and that we've seen in the past, you often suggest that investors focus on the big picture. What do you mean by that specifically?

Benz: For one thing, step away from those holdings, because when the market is volatile, I think a lot of us are naturally inclined to get in there and say "OK, what are my problem children in my portfolio? What's holding up well." We move directly to that portfolio. I think it does make sense to take a step back, think about how you are doing in relation to your plan. If you're someone who is still accumulating assets for retirement, think about your savings rate. Maybe you've been relying too much on the market to do the heavy lifting of enlarging your balance, so make sure that you are saving as much as you possibly can.

I think a good benchmark is 15% of salary to try to save, but certainly if you're a high-income earner, you may be able to set aside a higher amount of your paycheck maybe 20% or even 25%. If you are someone who's retired the key thing you want to look at in terms of how you are doing is your personal spending rate, your portfolio spending rate. Check up on that if you haven't done so recently. With portfolio balances enlarged, I think perhaps some retirees have gotten maybe a little bit loose on the spending front. They've seen their portfolios nicely growing, so they've perhaps been taking a little bit more than they otherwise would, get back to looking at what is a sustainable withdrawal rate for you. We've certainly written a lot about this topic on, but this is another area where a financial advisor can be a great help in terms of putting a little bit of science around whatever withdrawal system you're using.

Dziubinski: If investors are looking at their plans and their portfolios either because they are doing a midyear checkup or because of the market volatility, what sort of return expectations would you suggest that they use going forward?

Benz: It's a great question, and my view given where we are in terms of market valuations is that investors should be conservative. When you're thinking about your equity portfolio, I would be careful about using a return assumption much higher than midsingle digits. If you have say a 10-year time horizon, you'd want to be pretty conservative about what you'd expect from the equity piece of your portfolio.

If you are someone with a long time horizon, so maybe you are an early accumulator, and you have many years until you'll retire, there I think it's safe to get back to maybe a long-term historical market returns to help guide your expectation, so maybe high single digits. For the bond market it's a little easier, because historically starting yields have been a good predictor of what to expect from the bond market over the subsequent decade. With the Bloomberg Barclays Aggregate Index currently yielding about 3%, I think it's safe to plug that in as your return expectation for fixed income markets.

Dziubinski: You've also been talking and writing about the importance of investors re-examining their asset allocation and possibly rebalancing. Can you talk a little bit about that in this environment?

Benz: That's another thing if you're thinking big picture, focus on your asset allocation before you move into individual position management. Use Morningstar's X-ray tool help see how you are actually positioned based on the composition of your portfolio. If you've been super hands off with your portfolio, and maybe you had a 60/40 portfolio back in 2009 when this great rally began, you'd be over 80% equity today. Many investors I think have been kind of coasting. It's been easy to feel complacent because market performance has been so good. Take a look at your current asset allocation, compare it to your target. 

A lot of people might say, I don't have a target, in which case, I would say there are some quick and dirty ways to figure out an appropriate asset allocation. I often say look at Morningstar Lifetime Allocation Indexes as a benchmark. You might also look to a good target-date fund geared toward someone in your age band. This is also a spot where a financial advisor can provide some really helpful guidance in terms of customizing your asset allocation based on your own situation.

Dziubinski: What if an investor looks at his or her plan and finds, my asset allocation is out of whack, relative to where it should be and, in many cases, I would suspect these investors are going to see they are maybe too light on bonds. What do you think about bonds right now? Isn't it a little bit risky to be going into that part of the market, specifically right now?

Benz: Certainly, investors are concerned. We have seen yields trending up. The Federal Reserve has taken action to increase interest rates back to more normal levels. They've indicated that there will probably be further rate increases later this year. Investors are maybe quite reasonably spooked about what's next for bonds.

A couple of key things I would say is that, while there might be some price-related volatility in the near term, as interest rate suggest upward, over time if you have a long time horizon, higher yields are to your benefit if you are someone who owns bonds in your portfolio. Then another key thing to keep in mind is that, even a really bad period for bonds is going to be nothing like a really bad period for equities.

I think some perspective is in order. Even though we do expect interest rates to trend higher, I don't think anyone is assuming that Armageddon is upon us for the bond market. I think that rate hikes will probably proceed in a pretty deliberate fashion. I think in my view that investors are overdoing a little bit in terms of worries about the bond market.

Dziubinski: Let's say an investor has taken a look at the big picture and is taking care of that, you've also recommended playing small ball. What do you mean by that?

Benz: Naturally, you'd want to take a look at how your various holdings are performing. But I think, take a step back from that and focus on holdings' quality and certainly, we have a lot of great resources on for checking up on holdings' quality. If you're an equity investor, you'd want to look at star ratings, moat ratings and so forth. If you are an ETF, an exchange-traded fund, or mutual fund investor, you want to look at our analyst Medalist ratings.

Start by checking up on holdings' quality. Also, take a look at expense ratios if you've managed products in your portfolios. Take a look at tax efficiency. Make sure that you are maxing out all of the tax-sheltered vehicles that are available to you, if you're someone who's accumulating assets for retirement. If you have taxables or nonretirement assets, make sure that you're managing those as tax efficiently as you possibly can. Really focus on those things that are within your sphere of control. I think that's a good way to kind of take back some control in an uncertain market environment.

Dziubinski: Christine, so much great practical information. Thank you for joining us today.

Benz: Thank you Susan.

Dziubinski: From, I am Susan Dziubinski. Thank you for watching.


Christine Benz: Hi, I'm Christine Benz from Multifactor funds have grown in number, and they have also grown in assets. Joining me to discuss the key criteria to bear in mind when evaluating multifactor funds is Alex Bryan. He is director of passive strategies research for Morningstar in North America.

Alex, thank you so much for being here.

Alex Bryan: Thank you for having me.

Benz: Alex, I want to look at multifactor funds. They have grown rapidly, and they have also proliferated in number as I said. But before we get into how to look at a multifactor fund, let's talk about what a multifactor fund is and before we do that, we need to talk about what a factor is.

Bryan: A factor is basically a characteristic that is predictive of future stock returns or future asset returns. If you think about something like market capitalization, so stock size, historically, smaller stocks have tended to offer higher returns than larger stocks. That's an example of a factor that can help explain the returns that we see in the market.

Benz: A multifactor fund bundles together several different factors, and these funds do this in various ways. They try to capitalize on different factors in different ways, correct?

Bryan: That's right. The basic idea behind a multifactor fund is that it's not a bad idea to diversify across these different factor strategies, because although each factor strategy, like targeting stocks with low valuations, small market capitalization, high-quality, good momentum, all those things have tended to work well over the very long term, but they each go through their own cycle of outperformance and underperformance. The basic idea is by putting these different factors together in a portfolio you can diversify your risk reducing the risk of underperforming for an extended period of time, and we think that that would make it easier to stick with a multifactor fund than to try to go it alone with a single factor.

Benz: A big question before we get any further down the multifactor rabbit hole, let's talk about why one might consider a multifactor fund versus just a very inexpensive total market-capitalization weighted-index product?

Bryan: When I start by saying that an inexpensive market-cap-weighted product is actually not a bad place to be; that should be the default unless you have confidence in something else. I think a multifactor fund can make sense for those who are hoping to earn a higher rate of return than the market. I think that multifactor funds, at least low-cost and well-constructed multifactor funds, can deliver that. The basic idea here is that you get an opportunity to earn higher returns while still diversifying your risk in an effective manner.

Benz: You authored a white paper where you developed a framework for evaluating these multifactor funds. I think that can be useful for investors who might be inclined to take a look at these products. Can you, kind of, walk us through the key factors that you think are important to that analytical process?

Bryan: There's a few key questions that I think it's important for investors who are evaluating these products to ask. Number one, you need to understand what factors these funds are targeting. It's important to stick to funds that are focusing on well-vetted factors and defining them in a very simple and transparent manner. 

What do I mean by well-vetted factor? There's only a handful of factors that many academics have looked at and independently determined are robust enough that you would expect that they would continue to work. There is good economic rationale for why we would expect these to work and they are not the just product of data mining. These factors include: low valuations, so being a value investor; momentum, so targeting stocks that have recently outperformed because recent performance tends to persist in the short term; quality, companies with high profitability, strong economic moats tend to offer better performance over the long term; small market capitalization, smaller stocks have tended to outperform; and then low volatility, those stocks have tended to do well on a risk-adjusted basis. You want to stick to funds that kind of focus on those things and define them in a very simple and transparent manner to reduce the risk that you might be buying into something that's overly engineered or data-mined to look really good in the back test but may not do as well going forward. 

Looking at the factors that you are targeting. Number two, it's important to look at how aggressively these funds are going after those factors. There is a trade-off here. When you invest with a fund that targets those factors more aggressively or tries to target stronger factor tilts, that increases your potential outperformance, but it also increases your risk of underperformance. Some people who really believe in those factors might be comfortable taking stronger factor tilts and going over more aggressive fund. Others might prefer to rein in those factor bets and be cognizant of how well the fund is going to do relative to the broader market, and for them, maybe a more modest factor fund might be the way to go.

Benz: In the case of the more aggressive funds, that might mean that they would end up with very different sector positions, for example, relative to the broad market, is that correct?

Bryan: That could very well happen. But typically, what it means is that if you are, basically you are applying a higher threshold for stock inclusion. If, for example, I am targeting stocks with low valuations, an aggressive way to do that would be to say let's target the cheapest 10% of the market. Then I am going to get a lot of really risky companies in that portfolio. They may well have higher expected returns, but they are a lot more volatile than if I had, for example, just taken the cheaper half of the overall market where I would get better diversification. That's the key trade-off. It's the amount of risk that you are taking versus the amount of expected outperformance you might be getting.

Benz: One key point of differentiation that you made in your paper was on portfolio construction and you really put the funds into one of two key categories. One, are the funds that use an approach called mixing, and the other would be funds that use an integration approach to portfolio construction. Can you discuss the differences and why that is an important distinction?

Bryan: Mixing is a way of combining different factors. It's basically very similar to an approach that you might take as an investor buying several individual factor funds. It's basically taking several different portfolios that each target stocks on a different factor, and then it combines them together in a single portfolio. The benefit of that approach is it's very simple, it's very easy to do performance attribution to understand where your returns are coming from, and you get pretty good diversification out of that. Typically, with a mixing approach you are going to have less aggressive factor tilts because stocks that look really good on value, for example, will tend to maybe not look quite as good on momentum. A lot of times you might overweight a stock in this bucket, but you might underweight it in a different bucket in your multi-factor portfolio. This is conducive to good diversification and modest factor bet. If you are looking to kind of limit your risk of underperformance, a mixing approach might be a good way to go.

Benz: The integration approach then?

Bryan: Now, the integrated approach is taking a more holistic approach. And basically, what it's doing is, instead of targeting the cheapest stocks, for example, or the stocks with the best momentum, it's looking at stocks that have the best overall combination of factor characteristics. The stocks that look cheap and have good momentum together. Now, the benefit of this approach is that you can achieve stronger factor tilts by avoiding stocks that only look good on one factor characteristic and look really bad on another. That can help you use your capital more effectively to get more potent factor exposures.

Now, the downside is, anytime you take stronger factor tilts, you have a bigger risk of underperformance. You also have more complexity with this approach. And so, it's harder to do performance attribution. It's harder to understand where your returns are coming from and how different stocks got into the portfolio because you are combining all these things together. But overall, we think that both of these approaches can work, but it's just important understand which your fund follows and what that trade-off is.

Benz: You bought a couple of favorite multifactor ETFs that you and the team like. Let's start with one that uses the mixing approach, the first approach that you just talked about.

Bryan: One of the funds that we really like that uses the mixing approach is the Goldman Sachs Active Beta U.S. Large Cap Equity ETF, ticker GSLC. And what this fund does is it starts with a universe that looks very similar to the S&P 500 and then it basically targets stocks that have low valuations, high profitability, low volatility, and good momentum. It's doing all of this while explicitly limiting its expected tracking error to its target universe. This is a way that you can get very similar exposure to the S&P 500 with modest factor bets meaning that you have a chance of outperforming the market by a little bit. But you are also reducing your risk of underperforming because the tilts are relative modest. Now the good thing about this fund is it has a low expense ratio.

Benz: Well, that’s what I was going to ask, because if it's taking just modest bets one would hope that it's expenses would be nice and low.

Bryan: That's right. In fact this fund charges 9 basis points which is the same fee that the SPDR S&P 500 ETF charges. So, yes you are not going to shoot the lights out with this fund, but you are paying a very low fee. We think over a full market cycle this has a good chance to slightly outpace the market.

Benz: And then an example of the integrated approach to portfolio construction.

Bryan: One fund that we really like that uses the integrated approach is iShares Edge MSCI USA Multifactor ETF, ticker LRGF. What this fund does is it looks for stocks with the best overall combination of low valuation, momentum, small size, and high-quality characteristics. Again, it's looking at the intersection of all those different characteristics. This fund takes a lot more active risk than the Goldman Sachs fund. What that means is that it has greater potential upside but also greater potential downside risk. It is following a bit more of a complex approach, it uses an optimization framework to basically maximize exposure to all those things while at the same time trying to match the same risk level of the parent index. There is lot of moving parts there. But we think that this is a really good way of getting very potent exposure to factors that we think will pay off over the long term. Now this fund is a little bit more expensive but its still reasonably priced at 20 basis points. So that's not that much more than cap weighted alternatives.

Benz: If I am looking at one of these multifactor products, obviously expenses are a key thing to focus on. What should be sort of the cut off, what's too expensive in this realm?

Bryan: It depends, but I would say you would want to, at least in the U.S. market, you wouldn't want to pay a lot more than 20 basis points, because the fund that we just talked about that’s a great fund. In order to justify a fee that’s much higher than that the fund would have to be doing something quite a bit different. In our view there isn't lot out on the market that could justify an expense ratio that was a lot higher than 20 basis points when you have a really good option at 20 basis points. That's kind of where the industry has coalesced a lot of multifactor funds that have been launched in the last few years are priced anywhere between the 9 basis points where the Goldman Sachs fund is and about 30 basis points. Now outside the U.S. funds are a little bit more expensive, but if you are looking at a U.S.-centric fund I would be very skeptical paying anything more than 30 basis points.

Benz: Alex interesting research. Thank you so much for being here to discuss it with us.

Bryan: Thank you for having me.

Benz: Thanks for watching. I'm Christine Benz from


Greggory Warren: A big topic for us of late with regard to wide-moat rated Berkshire Hathaway is the company's growing cash hoard and the changes it could produce in capital allocation decisions longer term.

With the firm expected to generate $5 billion to $10 billion in quarterly free cash flows going forward, and valuations for both public and private businesses elevated, we envision Berkshire surpassing the $150 billion balance sheet cash threshold that CEO Warren Buffett said would be difficult for him to defend longer term.

As we see it, Berkshire has five uses for its cash: acquisitions, stock investments, capital expenditures, share repurchases, and dividends.

On the acquisition front, we see some deals that the firm could do in the near term--including wide-moat rated Colgate-Palmolive and John Deere--that would meet the criteria Buffett looks for in stand-alone businesses. We also expect Berkshire to be a consolidator in the utilities/energy segment, once prices get more attractive.

The problem for Berkshire, though, is that it needs to continuously do sizable deals to keep cash from building up on its balance sheet, something it has had little success doing the past 10 years. While the company has put some capital to work in common stocks of late, there are limits to what Berkshire can do with equities, owing to the size of its $200 billion stock portfolio.

As for capital expenditures, we don't believe Berkshire will get the same level of relief from its capital-intensive businesses that it has in the past, with both Berkshire Energy and BNSF coming off abnormally high levels of capital spending.

This really leaves share repurchases and dividends as the only way for Berkshire to meaningfully reduce its cash balances in the near term. Despite having a share repurchase program in place, though, Berkshire has not bought back any stock since December 2012. This has been due to the fact that the company's shares rarely trade below 1.3 times book value, let alone the 1.2 times book value per share threshold required for the company to start buying back stock. Even if Berkshire were to lift the company's share repurchase threshold, perhaps to 1.3 times or higher, it's likely that that the perceived floor that exists under Berkshire's shares would be raised as well.

Failing to find opportunities to put a large chunk of its growing cash hoard to work before it reaches $150 billion, and unwilling to buy back shares at a higher price/book threshold, Berkshire may have no choice but to consider issuing a special one-time dividend to return capital to shareholders. While Buffett came out against this at the company's annual meeting this year, we think that he has painted himself into a corner here, and that absent a run down of cash balances he may be left with no choice but to return some capital to shareholders via a special one-time dividend in the near to medium term.


General Electric was once heralded as "America's most admired company." While we agree there is a lot to admire about the company, we no longer believe it merits a wide economic moat and are downgrading its moat rating to narrow. We are also lowering our fair value estimate to $15.70 from $19.

Our moat downgrade stems largely from the drag of GE Capital and recent significant revenue and margin reduction in the large revenue power segment; however, we still believe GE's aviation and healthcare segments boast wide moats. And while the firm this week announced plans to separate healthcare, existing shareholders will still own 80% of this attractive asset after the corporate action. Nevertheless, subpar returns from GE Capital will mask the earning power of the firm's moatier assets in the short term.

Meanwhile, our fair value estimate reduction ties to the negative contribution from GE Capital as the portfolio de-risks; slightly reduced revenue and margin assumptions; as well as a higher weighted average cost of capital stemming from a higher cost of equity due to greater than anticipated revenue cyclicality.

On the bright side, we consider many actions taken by new CEO John Flannery to be bold steps in the right direction. Flannery has embarked on a turnaround of GE, wisely choosing to restore accountability and focus on three core businesses: aviation, power, and renewable energy.


Patricia Oey: Merger-arbitrage funds seek to capture the spread between the discount at which an acquisition target trades at prior to the completion of a merger relative to its acquisition price. These types of strategies can offer diversification benefits as they usually have a low beta to stocks and bonds, and thus can help stabilize a portfolio when equity markets become more volatile and/or in a rising rate environment. Currently, merger and acquisition activity may benefit from last year's corporate tax cuts, which is putting more cash on company balance sheets. The recent court approval of AT&T's acquisition of Time Warner is also likely to buoy sentiment for deals in the near term. Rising M&A deal volume is a positive for merger arbitrage funds, as it broadens their investment opportunity set.

There are two merger-arbitrage mutual funds with relatively long track records and experienced managers. One is called Merger, and the other is called Arbitrage, and each carry a Morningstar Analyst Rating of Bronze. Each, on average, invest in about 40 to 80 deals, but their portfolios tend to not have much overlap, and this can result in some performance differences. Merger usually tilts more toward larger cap and has a small allocation in event-driven ideas. Arbitrage focuses more on mid-caps, where spreads might be slightly wider, and they do not have an event-driven sleeve. Merger and Arbitrage carry fees of 1.22% and 1.26%, respectively, which is reasonable relative to equity alternative peers but a bit pricey on an absolute basis.