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Investing Insights: Big Tobacco, Gold-Rated Funds, and CVS

We discuss healthcare shocks in retirement, an undervalued utility, and more on this week's episode.

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


Susan Dziubinski: Hi, I'm Susan Dziubinski from It isn't easy for a fund to earn our top Morningstar fund analyst rating of Gold. Funds that do so are best in breed, models in their respective categories. In fact, fewer than 200 funds across dozens of fund categories earn Gold ratings. Here are three funds that recently joined the Gold-rated fund club.

Adam McCullough: Fidelity Extended Market Index is a great option for investors looking to round out a large-cap equity position. This fund invests in nearly all investable U.S. stocks outside of the S&P 500. That means that it does own small- and micro-cap stocks even though it lands in Morningstar's mid-cap blend equity category. Because it does own smaller cap and micro-cap stocks this fund also carries a little bit more risk than the average fund in the mid-blend category. It's broad diversification should help in mitigate risks of single stock or sector exposures. Also, this fund is the cheapest of its kind. It only charges 5 basis points per year which is much lower than the mid-cap blend fee average. All said, this fund earns a Morningstar Analyst Rating of Gold because it's cheap, broadly diversified, and has a soundly constructed index.

Eric Jacobson: Things turned out a lot better than many people expected after PIMCO legend Bill Gross stepped down from that firm and Gold-rated Harbor Bond in late 2014. Gross had built a powerhouse organization full of top-notch managers and analysts, though, very few of whom followed him out the door and several of whom had already either been candidates or winners of Morningstar's Manager of the Year award. When Gross left, the firm appointed three of those managers to run its total return strategies, including this one, and made PIMCO Income manager Dan Iveson chief investment officer. Scott Mather, Mark Kissel, and Mihir Worah had been running the funds since Gross left. Like most of their peers they've stumbled here and there, but have otherwise produced very good record. They've done it with standard PIMCO methods, which include developing macro decisions in the firm's investment committee. The funds' managers then looked to PIMCO's vast fundamental research team, which covers just about every security type, sector, and geography. They put those inputs together to fill out their total return-style portfolios. That last part is notable because the team runs this portfolio for Harbor right along with PIMCO's flagship total return fund. The biggest difference is the Total Return offers institutional shares that are a little cheaper than Harbor Bond's but which you can only purchase if you've got at least a million dollars to put to work or can access through a third-party advisor or 401(k) plan. For the rest of us, Harbor Bond's thousand-dollar minimum, no-load shares are a great option.

Kevin McDevitt: Big changes have come for Artisan Global Value. The management team has been separated between Dan O'Keefe and David Samra. Those two have been managing both Artisan Global Value and Artisan International Value together for years, but the two are splitting. They will run two separate teams, one for Global Value, one for International Value, and in the case of Global Value, that team will now be led by Dan O'Keefe. This change was made for a variety of reasons. One was because I think the team was worried about retaining talent, losing senior analysts that had been with them for years. Really this was a chance to provide promotion opportunities for some of their top analysts. In this case that is Justin Bandy and Michael McKinnon who have become comanagers on the fund.

Also David Samra and Dan O'Keefe have formed separate legal entities as well. This creates far more flexibility in terms of how they can manage their funds; that is there are no restrictions on how big their positions can be, or at least there are far fewer restrictions in how big an individual stock position can be since these two portfolios are now completely divided legally. Really it comes back to them, an opportunity to both have more independence, have more flexibility in terms of how they invest, and finally the opportunity to promote some senior personnel. Hopefully that will lead to continuity down the road for this Gold-rated fund, Artisan Global Value.


Vishnu Lekraj: Over the last handful of years there has been a major trend within the healthcare services space between the major conglomerates that occupy their supply chain. Currently we have CVS looking to purchase Aetna, and we have Cigna merging with Express Scripts. We believe these two deals are significant and could provide significant returns for investors over the longer term. These key pieces of the healthcare services supply chain will combine into one company that will provide several services on several different fronts from major constituencies within the healthcare space.

Right now, we'd like to highlight the CVS-Aetna merger as being a key piece of the strategy or key piece of this trend. We believe the new company will be a very powerful player as it will combine retail pharmacy, PBM, and health insurance into one company. We believe the invested capital returns will be significantly above the weighted average cost of capital for this company moving forward, and as a result, we believe CVS is underappreciated and undervalued at the moment.


Connor Young: Although Chautauqua International Growth only launched in 2016, lead manager Brian Beitner has successfully executed this strategy through a separate account--Baird Chautauqua International Growth--since 2006. Beitner launched this strategy while at TCW Group, where he worked under veteran investor Glen Bickerstaff. In 2009, he took the record with him and founded Chautauqua Capital Management; the firm was acquired by Baird in 2016 but is still run autonomously. 

Beitner, now backed by a team of five that includes two former TCW colleagues, continues to seek companies with sustainable competitive advantages that can benefit from long-term trends. Expect volatility here; the portfolio is concentrated with just 30 to 40 stocks, and Beitner doesn't mind paying up for firms with his preferred characteristics. Indeed, since the fund's April 2016 inception through August 2018, it's had a higher standard deviation than the foreign large-growth Morningstar Category average. However, investors have been well-compensated for that risk: The fund outperformed its typical peer on a total and risk-adjusted basis during that time. 

While fees are above average, they stand to come down as assets grow. This fund is on our radar.


We've lowered our moat trend ratings for British American Tobacco, Imperial Brands, and Philip Morris International to negative from stable due to the evolution in the market for next generation products.

Initially, we had assumed that the cigarette brand equity of tobacco manufacturers was transferable to next generation products, and early signs supported our assumption. But recent evidence suggests otherwise. Greater adoption of cigarette alternatives now seems more likely to erode big tobacco's cost advantage, pose risks to margins from volume declines, and hit overall returns on capital.

Although we have become incrementally more concerned about moats and margins in the tobacco space, we still believe in Big Tobacco's wide economic moats. Though it may seem counterintuitive in a declining industry, we have conviction that our wide-moat ratings are appropriate, because we believe Big Tobacco is very likely to continue generating excess returns on invested capital for the next 20 years. Cigarette pricing remains strong, and most markets have headroom for multiyear price increases that should more than offset volume declines.

The market appears to be pricing in a dire scenario for the industry and is far too pessimistic, in our view. In fact, we think there is value in tobacco stocks today. Our current picks in the market are Imperial Brands and Phillip Morris International. Both of these low-uncertainty stocks are trading at a greater than 20% discount to our fair value estimates.


Charles Fishman: Over the past couple of years, the market has not been kind to unregulated power plants, or what is referred to in the industry as merchant generation. Weak electricity demand, falling natural gas prices, and tremendous growth in wind and solar energy have squeezed margins. FirstEnergy eliminated its merchant generation exposure by separating from its unregulated unit FirstEnergy Solutions, or FES, earlier this year.

Without the support of its parent, FES immediately filed for bankruptcy. To avoid years of litigation, FirstEnergy settled with FES creditors with guarantees and payments totaling roughly $2.7 billion. The market applauded the move, and the shares have been one of the best performing utilities in 2018, with a total return over 22%, double the S&P 500's total return.

Even after this year-to-date performance, we think the shares remain undervalued. We believe the market fails to fully appreciate the company's ability to invest over $2.5 billion per year in its wide-moat transmission businesses, which provides an almost guaranteed economic benefit to shareholders and narrow-moat utilities in constructive state regulatory environments, which together will account for 90% of earnings.

We believe solid earnings growth and a growing dividend will be the catalysts for the market valuing FirstEnergy shares more in line with its regulated-utility peers with economic moats.


Christine Benz: Hi, I'm Christine Benz for How do healthcare shocks affect retiree spending? Joining me to share some research on that topic is David Blanchett. He is head of retirement research for Morningstar Investment Management.

David, thank you so much for being here.

David Blanchett: Thanks for having me.

Benz: David, the retirement planning community is increasingly thinking about the role that healthcare costs play in retirement planning. Let's talk about the latest data runs. I know Fidelity annually puts out some data about healthcare spending for couples who are age 65. What does that look like in aggregate?

Blanchett: It's pretty scary. Fidelity says about a quarter of a million dollars, is the cost of healthcare …

Benz: Yeah, even higher, I think.

Blanchett: Right. Others will say up to, say, $400,000. If you just look at healthcare, medical expenses in retirement, it's a pretty scary number.

Benz: The thing is though, when you look more closely, you see that these healthcare costs vary hugely by households. Some households have giant out-of-pocket outlays and some households have less. How should retirees approach that fact?

Blanchett: Most healthcare expenses are quite known. Things like Medicare premiums. I think the scary item is things like nursing home stays or home health stays--things that require this significant, unexpected out-of-pocket cost, and that's really hard to plan for. So, when I think about things like that, I often think that maybe home equity is the asset of last resort should that event occur.

Benz: Let's talk about how these costs can affect retiree spending. Certainly, if you have some big healthcare shock, that has implications for your overall spending. But I guess the thing you examined in the paper was whether it had repercussions for spending in other parts of the budget. What did you find?

Blanchett: The question I looked at was, if you have a household that experiences a health shock--this is not going to be a Medicare premium, it's an unexpected health expense--what happens in the future? Does that household, if you compare future expenditure, spend less needed before the health shock or less. Because in theory, maybe expenses rise because they have additional health expenses, maybe they fall because they kind of adapt. 

What I find is that the larger the expense, the more future expenses fall in retirement. And what we are seeing then is that households adjust their spending based upon this expenditure. To me, it just suggests this idea that households experience this large health shock and then spend the same or more in the future doesn't tend to hold at least on average.

Benz: So, the question is, are households that experience the healthcare shock reining in spending because they want to or because they have to because they feel the budget crunch?

Blanchett: So, that's a great point. If you look at different types of spending--you can look at total spending or discretionary and nondiscretionary--where you see almost all the reduction is in the discretionary spending. There wasn't a significant reduction in nondiscretionary spending. You have to pay a mortgage, you have to pay for other things. But in those areas, you can control spending, that's where it declined the most.

Benz: This follows on some research that you had done more broadly about retiree spending where you actually looked at trends over the retirement life cycle and found that across different income bands, even for people who had great financial wherewithal, you did find some tapering off in spending toward the middle part of retirement, is that right?

Blanchett: That's right. And so, what's interesting is, again, this was the same data set--almost every household, about three fourths of the households had lower consumption in today's dollars over time. It was those households that had the higher shocks that even reduced by more.

Benz: And that's where you wound up with that what you call the retirement spending smile--higher early on, sort of tapering off and then back up, but only for some households.

Blanchett: But if you can live that long, that's right.

Benz: The question is, if I'm a retiree attempting to get my arms around this issue and factoring in healthcare expenditures, potential shocks in my plan later in life, how do I do that? How do I embed some safeguards in my plan to guard against these big healthcare shocks?

Blanchett: There's no easy answer to that question. 

Benz: You mentioned home equity though.

Blanchett: I would say that home equity is one. I'd say to me a bigger issue here is, those numbers that come out by Fidelity and others, they are good to know, but they are really scary. My perspective is, we don't calculate the value in today's dollars of what your food is going to cost, what your home is going to cost, what your education--whatever you are spending money on is going to cost. To me, healthcare is one part of a much larger puzzle. And if you have a healthcare expense, if it goes up, you can usually spend less somewhere else. I'm not saying don't worry about it, but view consumption when you are spending collectively and then have things like home equity when things happen to pay for those things as they come up.

Benz: I guess, another point is that healthcare expenses aren't a brand new cost for most of us in retirement, that we've been shouldering them, but maybe through our paycheck deductions while we are working. It's not this brand new cost that we never had before.

Blanchett: Right. One thing that I think is really uncertain is what will happen 20 years from now. I think that we have a pretty good handle on where Medicare premiums would go in maybe next year. But there is this uncertainty, what will happen if healthcare costs keep rising by 7% a year. I don't know how to answer that question either. But that is something you just need to be aware of for someone thinking about, well, how much do I save for retirement, how do I save for retirement. That's where things like HSAs are valuable because it can help someone prepare for retirement in a tax-advantaged way to help fund those healthcare expenses.

Benz: You mentioned inflation, I guess, that also calls for embedding some inflation protection into my portfolio plan as well, right?

Blanchett: Right. Assets that track inflation better, like TIPS or real estate, really are more attractive investment options for someone who is in retirement versus someone who is, say, much younger.

Benz: Great research, David. Thank you so much for being here to discuss it with us.

Blanchett: Thank you.

Benz: Thanks for watching. I'm Christine Benz for does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.