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Investing Insights: Hidden Fund Gems and Cheap Cruise Lines

We examine backdoor Roth IRA conversions, McDonald's versus Starbucks, and ultrashort bond fund picks.

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Editor's note: We are presenting Morningstar's Investing Insights podcast here. You can subscribe for free on iTunes.

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Christine Benz: Hi, I'm Christine Benz from Morningstar.com. Many mutual funds from the big shops are very large, but a handful of them are quite small and undiscovered. Joining me to discuss some noteworthy ones among them is Russ Kinnel, he's director of manager research for Morningstar.

Russ, thank you so much for being here.

Russ Kinnel: Happy to be here.

Benz: In your latest issue of Morningstar FundInvestor you wrote about some of the relatively undiscovered funds from the big shops--Fidelity, Vanguard, T. Rowe Price. I wanted to talk about a handful of them today. Let's start with--and we'll go from Bronze to Silver to Gold--let's start with a Bronze-rated fund. This one is from Vanguard it's a pretty new fund this is Vanguard International Dividend Appreciation. Let's talk about that one.

Kinnel: A lot of people are probably familiar with the domestic version of Vanguard Dividend Appreciation, which has been a pretty big hit, because it seeks stocks that are going to grow their dividend. The idea is simply let's apply that outside the U.S. Again of course with low fees and it's a pretty new fund less than three years. I think a lot of the good things that work for the U.S. version ought to work for international, we don’t know yet for certain. But again, you have low cost and I think a really sound approach to international investing, as well as obviously you are going to get some income from it too. I think there is a lot of appeal its fairly new, I definitely think its one to watch and we rate it Bronze.

Benz: This is an index fund, correct?

Kinnel: Yes.

Benz: You mentioned income, and any time someone sees dividend in the name they might think that it would have fairly high income, but here not necessarily the case--you are not going to find a 4% yield or anything like that.

Kinnel: That’s right. Because its going after dividend appreciation, not maximum dividend yield. To find dividend appreciation you have to have companies with good balance sheets and decent growth. If you think about emphasis on high yield, you are going to get lots of utilities and other companies that are really slow growth. This is going to have lower yield, but companies with more growth potential and obviously over time ideally your income will grow, too, because those companies are growing and you'll also get some capital appreciation along the way. Again, early days for the fund, but I think very promising.

Benz: Moving on to a Silver-rated fund that is not yet too huge Fidelity International Growth. Let's talk about that one, it has a long-tenured manager, actually, and still not a lot in assets. Let's talk about it.

Kinnel: That’s right Jed Weiss has been at the fund since it was launched in 2007. Yet it's kind of flown under the radar for people, but he's really produced great results. The fund is about 200 basis points a year ahead of the index which is pretty darn impressive, yet again somehow kind of slipped people's notice. We recently upgraded it to Silver. We like the process, he looks for firms with competitive advantage which tends to be in growth. But he also looks for cyclical names with pricing power. Really it kind of has some blend and growth characteristics.

Benz: In the case of this one it's a large-cap fund, correct? Is the fact that it is still not huge going to confer any particular advantage to it, or do you tend to see that having a small asset base is more advantageous if you got focus on smaller mid cap stocks?

Kinnel: I think its advantages of being smaller are fairly modest as you imply, that it's not buying really small names. Of course, Fidelity has other big international funds which are going to be after some of the some companies I am sure. I think in this case its more about highlighting a company, a fund that might have flown under your radar that's really worth investing in. It's not so much let's get in this small fund and there will be special advantages.

Benz: Finally moving on to a Gold-rated fund that you think is relatively underfollowed, underdiscussed--T. Rowe Price Tax Free Income, that's a Gold-rated fund. It's looked a little sleepy recently in terms of its results. Let's talk about what you and the team like there.

Kinnel: What we like is the fund has a really nice approach to credit. They have 11 analysts who do a good job doing research, and we've seen that the fund consistently holds up better when credit gets hurt--in other words when there is concern about the economy or any particular muni issues, the fund consistently does better than it's peers. Yes overall it hasn't been that impressive and I think partly because we have a strong economy and for the most part taking credit risk in the last 10 years has really been rewarded. This is a fund we feel pretty good about owning whether there is recession in the next five years or not. A nice steady fund--just what you'd expect from T. Rowe really, well diversified, well managed, fairly quiet fund.

Benz: Russ, thank you so much for being here to call attention to these three funds that as you say are hiding in plain sight.

Kinnel: You are welcome.

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

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R.J. Hottovy: The restaurant industry has been going through a number of changes in the past several years, and it's not just things like delivery, mobile orders, and healthier menu options. 

Over the past five years, franchise ownership in the quick-service restaurant space has increased from 80% to 96% as companies have sold locations of franchisees, taken on additional debt, and returned the proceeds to shareholders in the form of larger buyback programs and dividend hikes.

Not surprisingly, the restaurant space has become a more popular space for dividend investors. But what is the best bet in the space for dividend investors? Let's look at two names today: McDonald's and Starbucks.

McDonald's is the world's largest restaurant company based on systemwide sales, with $91 billion in sales at its company-owned and franchise restaurants during 2017, or roughly 4% of the $2.5 trillion global restaurant industry. Starbucks is the largest specialty coffee chain in the world, with roughly $31 billion in systemwide sales.

Both names are currently trading at a discount to our fair value estimate, which is $190 per share for McDonald's and $64 for Starbucks. Restaurant industry trends could be choppy over the next several months because of the ripple effect from Amazon-Whole Foods and aggressive countermeasures by grocers and as well as restaurant chains. 

We believe both of these names offer intriguing dividend plays. McDonald's is expected to pay a dividend of almost $4.20 per share in 2018, representing a payout ratio of 55% and a yield of 2.5%. Starbucks is expected to pay $1.25 per share, representing a payout ratio of 40% and a yield of 2.5%. 

Which is the better dividend play? We believe it all depends on your risk tolerance.

We believe Starbucks has the higher dividend growth potential, with our model forecasting midteens dividend per share growth over the next five years. However, earnings have the potential to be choppier at Starbucks over the same period as the company works to improve its digital platform, adds new menu innovations, and makes changes to its store base to maximize throughput potential.

McDonald's on the other hand, will likely see dividends grow at a slower pace, with roughly 10% growth the next few years before fading the to high single-digit range. However, with its franchisees owning 93% of McDonald's locations and responsible for a sizeable percentage of capital requirements at the store level, McDonald's dividend is likely to be more stable over the same period.

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Jaime Katz: We continue to believe that long-term supply side concerns surrounding new ship deployments in the cruise industry remain overblown. Rather, we believe demand-side growth should more than offset supply increases ahead, thanks to ongoing efforts to tap into new cruisers--which tend to become repeat cruisers. Through entry into new markets, like luxury--which Royal has pursued with its Silversea partnership--or millennials--with its refurbishment of the Mariner of the Seas--Royal has sought to tap into new demographic segments that can become lifetime loyalists to the brand.

We remain impressed that the major cruise operators continue to differentiate their operations by segmenting offerings to cater to specific consumer cohorts rather than a single total addressable global market, protecting their individual brand equity. We think increased target market segmentation and geographic diversification should alleviate concerns over the supply of cruise capacity set to arrive in the next five years, ensuring that new ships don't merely cater to the same existing customers.

Additionally, over the near term, profitability across the cruise companies should remain robust despite the headwinds these companies face from last year's extreme hurricane season, alongside rising fuel and currency costs. Most recently, Royal Caribbean maintained its full year earnings outlook despite $0.35 in fuel and foreign exchange headwinds. Furthermore, the firm reassured investors that the demand environment remains healthy, and 2019 is currently tracking at record rates and volumes. 

While all three of the cruise companies are trading in 4-star territory, Norwegian remains the most undervalued, trading at a more than a 25% discount to our $69 fair value, providing the widest margin of safety for investors looking for exposure to the cruising cash flow.

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Emory Zink: With two Federal Reserve rate rises so far this year, and the broader markets anticipating continued lifts in the federal funds rate in the near future, the landscape for ultrashort bond funds is at a dynamic point. Ultrashort bond funds blend the higher quality and more liquid bias of money market funds with a sector flexibility that is more similar to short-term bond funds, investing across geographies and in corporate debt and municipals. In a period when interest rates are on the rise, investors may find these types of funds attractive given their lower rate sensitivity relative to short or intermediate-term bond funds. The average duration of the ultrashort category is around a half year.
 
These funds aren't devoid of risks, though. There is a temptation to load up on lower quality paper and drive up yield, but when liquidity dries up in a credit crisis, ultrashort bond funds that have taken this approach can be hit hard. Yields are also lower at the front end of the yield curve, and a fund with significant fees has an inherently higher hurdle to clear before generating positive return for an investor. Ultimately, it is important for investors to remember that while this category of funds is attractive to an investor wishing to enhance or diversify a cash strategy, the options are not a replacement for a savings account or bank money market fund.
 
Two of our picks in the category include Bronze-rated Fidelity Conservative Income--a high quality, lower volatility fund with broad sector flexibility--and Silver-rated PIMCO Short-Term Institutional, a fund that manages duration actively and is run by Morningstar's 2016 Fixed-Income Manager of the Year, Jerome Schneider. 

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Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Eight years after their arrival, backdoor Roth IRAs are alive and well. Joining me to discuss the maneuver is IRA expert Ed Slott. He is author of the newly revised "Retirement Decisions Guide."

Ed, thank you so much for being here.

Ed Slott: Great to be back here in Chicago.

Benz: We're thrilled to have you in the studio. One topic that comes up a lot with our readers and viewers on Morningstar.com is this idea of the backdoor Roth IRA. Let's talk about who should consider using the backdoor Roth IRA maneuver and really who doesn't have to consider it.

Slott: It's exactly as you say. It's a maneuver; it's a made-up term, backdoor Roth IRA. Here's the situation: It's a way to get money into a Roth IRA when you otherwise wouldn't qualify. Just to be clear, there's two ways to get money into a Roth IRA. The big money is in the conversions. You can convert $1 billion, if you had the money, and there's no income limits on that. But if you want to put $5,500 in a Roth IRA as a contribution, then we are going to lower the boom, then we want limits. This is out of control. Nobody knows why. Why do they have limits on such smaller amounts compared to the larger conversions. But that's where we are.

We are not talking about conversions, which are unlimited; anybody can do those. We are talking about the $5,500 a year Roth IRA contributions, or $6,500 if you are 50 or over. They do have income limits. Nobody knows the reason, but they have limits. It's not available to higher income taxpayers. The limits are relatively high for most people. There's a lot of people watching now that are over those limits that would like to make a Roth contribution. 

What developed over time has become known as a backdoor Roth or a workaround. And nobody liked that term, especially, we are just finding out now people at IRS, never liked those terms. There was a spokesperson that just came out recently and said, that was the only problem we had--we just didn't like the name.

Benz: Sounded illicit or something like that.

Slott: Here's how it works. You start with a traditional IRA. Why? Because unlike a Roth IRA contribution that has income limits, there are no income limits for who can contribute to a traditional IRA. Now, I'll just stop there because some people will say, no, no, there are income limits.

Benz: Absolutely, right.

Slott: That's only for deductibility if you are active in a company plan. But there are no income limits for who can contribute. You just may end up with a nondeductible IRA. That's all.

The process starts with a contribution to a nondeductible IRA, for which there are no limits. You can make $1 million a year and you can contribute the $5,500. Then you convert it to a Roth. Now, you are right back where you wanted to be. You have the same $5,500 or $6,500, in a Roth IRA, even though you are over the limits. Now, there was a lot of chatter about this over the years--that's illegal, you are getting to a place where the law says you are not allowed to be, people called it a step transaction and other illegal things. You don't have to worry about any of that anymore. I'm not even going to get into that. I was never in that camp by the way. I always thought it was fine.

Now, under the new tax law--this is not in the new tax law--but in the congressional conference report this--this backdoor Roth, not mentioned by name, but the actual procedure or the mechanism--is mentioned four times. Four times they state explicitly that this is allowable. They say you can make a contribution to a traditional nondeductible IRA and covert it to a Roth. IRS came out recently and said, if Congress says it's OK, we are good with it, we won't challenge it. And that's where the spokesperson who said that said, we really just were uncomfortable, we just didn't like the name.

Benz: There had been some advice out there in the past that you referenced. People had a sense, well, if I do this, I should wait between these two transactions--fund my traditional IRA and then perhaps wait a year even until I do this conversion. Is there a reason to wait around between these two transactions in your view?

Slott: Not anymore. But I was one of those people. I think, right on this program maybe a few years back I said--I never said wait a year--I always said, have it show up. Even today I might do that just for the tracing rules to see where it went. Have it show up, make your contribution to a traditional IRA. Wait till one statement, say, a month, so you can see it in the traditional IRA and then convert to a Roth. You don't have to, but if you want to see where it came in, you see it one account and then another, it's a clear path. It's absolutely legal. IRS won't challenge it.

There are cautions to it. Not everybody qualifies. And remember, this whole process starts with a contribution to a nondeductible traditional IRA. To make a contribution to a traditional IRA you have to be eligible. You can't just put money in just because IRS says the backdoor Roth is OK. You still have to qualify, which means you have to have earnings, W-2 income, self-employment income like you would to make any IRA contribution. 

Also, you can't be over 70 1/2, because currently, the tax rules say after 7001/2 you can no longer make traditional IRA contributions. It's odd because with the Roth, it's opposite. There is no age limit. 

There's a proposal now floating around Congress saying to eliminate that 70 1/2 rule. We'll see if that happens. But for right now, once you are over 70 1/2, this won't work for you. Because remember, the process starts with a contribution to a traditional IRA and if you are not eligible, you can't start the process. 

Also, you have to be aware because some people, I have seen even financial advisors say, this is a great thing, take your $5,500, put it in nondeductible traditional IRA, convert it to a Roth, no tax. That's not always the case. In fact, it's not the case for the most people. Most people have other IRA balances, including SEP and simple IRAs.

Benz: Traditional IRA balances.

Slott: Right. Right. For example, let's say, you want to do this with $5,000. You do a contribution to a nondeductible traditional IRA for $5,000, you convert it to a Roth. If your total IRA balance including all your other traditional IRAs is $100,000, then 95% of that conversion will be taxable. It's called a pro rata rule. You have to take the other funds into account. 

Now, it's not the end of the world because we are only talking about the tax on a $5,500 contribution or $6,500 contribution. The other thing is, this money goes in as a Roth conversion, not a contribution. There's a big difference here, but it's only a difference if you are under 59 1/2. With a Roth contribution when you put that contribution money in, you can withdraw it anytime, for any reason, tax and penalty-free.

Benz: The contribution itself.

Slott: Right. But not the conversion. The converted funds have to be held five years. And that's only if you are under 59 1/2 for the 10% penalty. If you are over 59 1/2, this makes no difference for you. It's just to keep in mind. if you are going through the effort of doing this, you are probably going to keep it for the five years anyway, why would you go through all this if you needed the money. But you never know.

Benz: You referenced that Congress has looked at harmonizing the rules about Roth and traditional IRAs. A question is, if this loophole is here and seemingly on the up and up, why doesn't Congress just officially bless it by lifting the income limits on Roth IRA contributions?

Slott: They should do it. Are you listening? Do they watch Morningstar? I mean, it seems like a no-brainer, especially when conversion money where all the big money is, there's no income limits. Why are there income limits? Just one of those things that got in the tax code and just never got out. You're absolutely right. Why don't they just get rid of all this and say, no more income limits for making Roth IRA contributions. 

Now, some people say that's another big break for the wealthy. But you are only talking about a $5,500 contribution or a $6,500 contribution each year. Why should there be income limits?

Benz: Ed, important topic. I know a lot of our viewers have been really interested in this backdoor Roth thing. Thank you so much for being here to clarify it. Thank you.

Slott: Thanks. Great to be here.

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

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