Investing Insights: Earnings, Rising Rates, and Fund Flows
Our analysts discuss 3M, AT&T, Verizon, and Tesla, plus dividend picks in the energy sector and a PIMCO ETF.
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Joshua Aguilar: 3M's results were a little disappointing today, which prompted management to reduce both top-line and EPS guidance for the remainder of the full year. That said, we're not expecting a material change to our fair value estimate of $193. We've long been on the on low end of the range of price targets against our counterparts on the street. We see the stock's 7% dip as an overreaction to the news. We continue to view 3M as a high-quality, well-run company with about a 3% dividend yield. However, it's also a firm with more reserved growth opportunities across its addressable markets.
Looking at its segments' most recent results, it's a bit of a tale of two cities. The firm's healthcare segment saw organic revenue decrease over 1% year over year, primarily off a tough comp from last year's third quarter, as well as a slowdown in drug delivery. We're really not too concerned, as drug delivery is a project-based business which is tied to the pharma industry's regulatory cycle.
We're also looking forward to hear about what’s in the pipeline when 3M presents at its investor day next month. Incidents of respiratory disease is on the rise across the globe, so over a five-year period, we think there are still promising prospects with 3M's products like the electronic inhaler. The inhaler monitors and regulates a patient's use of his or her inhaler and sends the data back to an attending physician. So there are promising long-term prospects in projects like these.
Safety and graphics however, grew 7%. Only 2% of that was organic, but Scott Safety made up the difference, and the acquisition is tracking ahead of expectations. We see the personal protective equipment market as an important driver of long-term growth for the firm, and we expect this business can grow top line at strong mid-single digits CAGR over a five-year cycle. Secular drivers here include stringent government regulations regarding the use of this type of equipment, as well as growing awareness in worker safety around the world.
On balance, 3M continues its trajectory as a company with over 20% returns on invested capital and 100% free cash flow conversion. We ultimately believe that should benefit shareholders in the form of both buybacks and dividends.
Michael Hodel: Verizon's third-quarter earnings looked pretty solid. On the wireless business, they added postpaid phone customers at a solid clip, saw a nice increase in revenue per customer, and also a nice uptick in wireless margins. We think that reflects the strength of the Verizon business and the fact that management's focused most of their attention on wireless. It's by far the most important segment for the company.
On the flip side, AT&T, they've diversified their business quite a bit across a number of different segments. AT&T's wireless business looked OK. They did add wireless postpaid phone customers, which is a good achievement for the company, but they're not seeing the same improvement in margins and the same margin growth that Verizon is seeing. And some of that, I think, speaks to the relative positioning of the two companies and the pricing power that Verizon has versus AT&T in the minds of customers today.
The one area where AT&T is doing really well in the wireless business is on the prepaid side, which is an area where Verizon traditionally hasn't focused as much, again, because it focuses its attention on the higher end of the market where its superior network quality really comes into play.
But with AT&T, the big concern with this quarter was just the complexity of the firm's reporting, that with the acquisition of DirecTV a couple of years ago, with the acquisition of Time Warner here this year, the firm's reporting has gotten extremely complex and parsing out the numbers has become a challenge. AT&T, I think, is doing investors a bit of a disservice by trying to carve out this advertising segment to demonstrate the success of the effort to bring all of these various pieces together to advertise in new ways to consumers, but what that does is add a lot of accounting complexity that makes it harder to follow the numbers.
That's especially concerning in the entertainment segment, which I think is an area where investors have focused a lot of attention over the last several quarters. The entertainment segment includes the consumer fixed line business, which is primarily Internet access and the old DirecTV satellite television business, where we've seen revenue growth really stall as customers start to abandon the traditional linear television model and move to over-the-top or Internet-based products. That's really hurt revenue in that entertainment segment. And on top of that, there's been significant margin compression in the entertainment segment, and that, I think, has really caught investors' attention because AT&T did spend pretty aggressively to acquire DirecTV a couple of years ago. They put a big chunk of invested capital behind that business, and now it's really struggling to grow at all and it's struggling to maintain margins, which is a big concern as this evolution to new video distribution models takes hold.
I think that's where investors are focusing their attention on AT&T, some of the weaker spots in the quarter, in addition to just trying to get through the numbers, which are extremely complex, and then tying that all back to the balance sheet and to cash flow, where I think investors have some concern that AT&T isn't going to be able to reduce leverage as quickly as management hopes.
Dave Whiston: Tesla reported a really good quarter Wednesday night that's likely going to lead to about a 20% increase in my fair value estimate. I've been expecting some pretty good numbers on the back half of 2018 as Model 3 production and deliveries ramped up. But honestly the scale, in particular the free cash flow generation, was really impressive. They generated $881 million in free cash flow; that was about $1.6 billion improvement from second quarter. But also a $2.2 billion improvement from the burn they had in third quarter last year.
Model 3 momentum is just really hot right now, and it's going to probably continue into the fourth quarter. It was really interesting to see Tesla disclose that over about over half of the vehicles that get traded in to buy a Model 3 were priced under $35,000 at the time of their purchase. Now obviously there's a time value of money component that Tesla's ignoring, but as Elon talked about in the second-quarter results, the top five trade-in vehicles are vehicles like the Prius, Honda Civic, Nissan Leaf, also the BMW 3 series. A lot of these vehicles are really more from what we call volume segments or mass market segments, rather than purely from a 3 Series Mercedes C-Class, Audi 384 customer. So there's a lot of mass market appeal for a premium vehicle that the Model 3 really is, it's not a cheap vehicle. I think the momentum there is going to continue for awhile.
Also, they'll be moving the Model 3 deliveries into Europe and Asia in 2019. So there's a lot of positive things about Tesla right now. The $3 billion cash balance makes me pretty comfortable now, about their ability to pay off that convertible debt that comes due in March of $920 million.
Let's just keep in mind there's good momentum now, there remains to be seen how this will all carry into 2019 and a recession. Mitigating that somewhat is that the Model 3 deliveries will be moved and expanded into Europe and Asia. But at the same time if consumers really start to get truly panicked and scared their going to be very hesitant to buy what can be a $40,000, $50,000, $60,000 car.
Interesting longer term is just going to be the emergence of Tesla's autonomous business. They've got a new Harbor software update coming in, Version 9.0 really soon. And ultimately they want to compete with the likes of Uber and Lyft with autonomous ride-hailing. A subtle difference will be that if you own a Tesla personally you are going to be able to allow your vehicle to go into the Tesla fleet, while you're not using it and make some extra money. It remains to be seen how it's all going to shake out, how big it's going to be, and how many Tesla owners will really be willing to let someone else use their vehicle for many hours at a time while they don't need it.
Joe Gemino: Some of our best energy dividend growth stocks are among some of our top calls in the sector.
Five-star rated wide-moat Enbridge offers 50% upside and also gives investors an attractive 6.3% yield. More impressively, we think that the company will meet its planned 10% annual dividend growth through 2020. Enbridge sports a near-term CAD 22 billion in commercially secured capital projects in its growth portfolio, which is highlighted by the Line 3 replacement project. We expect the growth portfolio to generate almost CAD 4 billion in incremental EBITDA, which will support the dividend growth with a healthy distributable cash flow ratio of 1.4 times the dividend, which is more than enough buffer.
If the stock price doesn't appreciate from current levels, we expect it to yield 7% at the end of 2019 and 7.7% at the end of 2020 when Enbridge increases its dividend each year.
Narrow-moat 4-star rated TransCanada offers 40% upside coupled with a 5.3% dividend yield. Like Enbridge, the company expects to grow its dividend, but in the 8% to 10% range throughout 2021. TransCanada boasts CAD 32 billion in commercially secured growth projects in its portfolio, highlighted by the Keystone XL.
If the stock price doesn't appreciate from current levels, we expect it to yield 5.9% at the end of 2019, 6.5% at the end of 2020, and 7.1% at the end of 2021 when TransCanada increases its dividend each year.
It's worth noting that the Keystone XL is not one of the projects that we expect to underpin near-term dividend growth. If the project is successfully placed into service, we could see further attractive dividend increases after 2021.
Christine Benz: Let's talk about Vanguard's forward-looking outlook for the U.S. economy over the next decade. I know you do it in bands. You don't sort of have a blanket growth target. But let's talk about where you are seeing the economy going in the decade ahead.
Joe Davis: Just to fix the audience's--what's average or expected. Most, including the Federal Reserve, expect the growth to be 1.5% to 2%. Now, that's roughly half of what it used to be. Some of that's demographics. I personally think demographics as a force, although it matters, is overrated. The biggest reason why individuals and most economists expect lower growth going forward because of lower productivity growth.
We're not as bearish as that. We're slightly above the consensus longer term. We are doing deep research to see what potentially could lead to the next productivity wave. It matters because that drives everything from growth expectations to what central banks would call R-star which is an esoteric way of saying where neutral short-term interest rates are. But we are a little bit more optimistic than the consensus, but not in the next two years. I think that's a little bit longer term thing. But we are pairing that with valuations on the equity market which are still extended.
Benz: That's what I want to talk about, how this translates into investors who are thinking about their portfolios today, how this translates into how they might be positioning their portfolios, stocks relative to bonds. Let's start there.
Davis: Expected returns do matter to get a sense "on the efficient frontier" or this trade-off between, let's say, stocks or more aggressive investments and more conservative ones. It doesn't just have to be stocks and bonds. That's where valuations can come in. Because if we are looking out, like we believe one can do over the next 10 years, is that what is a reasonable range of expected returns, they are generally lower across the entire asset class distribution, bonds and stocks. Part of that is because of somewhat lower expected returns for cash, the risk-free rate. That's where valuations for the U.S. We are seeing expected returns for the U.S. market on a strategic basis being roughly 200 to 300 basis points lower than overseas markets. We are stressing, don't just focus on U.S. investments. Unfortunately, the risk/return trade-off, the expected returns in regard of any portfolio have fallen. And so, we characterize this as a lower-return environment.
We don't think it's permanent, but it's going to last to the next business cycle. And so, it's going to be with us for several years. I apologize sometimes to investors, but hope shouldn't be a strategy. I think it would be hope, if we are hoping for these sorts of returns we've had either in the past decade or historical.
Benz: For investors who are getting close to retirement and they are looking at maybe a shortfall, it's their additional contributions that probably are going to have to make up the bulk of that …
Davis: It's going to be the savings clearly. Although, that's not palatable.
Benz: No, it's not fun.
Davis: I mean, if I'm listening to it, it's not fun. I think also the staying invested. I think there's going to be headlines--we had some in February--there's going to be headlines where one is going to, I feel them personally, one is going to want to withdraw from the market. All the more reason to stay invested in a lower-return environment. It's going to be patience and diligence that I think over the next five years are the emotions that we are going to have to harness to be successful because we are not going to have the tailwind of powerful low P/E ratios, high near-term interest rates that give us a boost to our portfolios. We're not going to have those tailwinds.
Benz: You touched on the international versus U.S. question. It sounds like you are suggesting maybe a little bit of relative undervaluation in foreign stocks. For investors who haven't looked at that, how about the value versus growth bifurcation where we've seen value stocks dramatically underperform?
Davis: Dramatically underperform. If one is comfortable taking some, I'd call it, active risk relative to their policy or portfolio--let's just say with 60% stocks, 40% bonds, Christine--if they are willing to tolerate periods of underperformance, that's at least a framework I would be looking through to say, if I'm going to tilt my portfolio. Personally, I'm one of those investors. What I tend to do is, say, what are valuations in the market on a smooth, long-term basis. That would tell me that I should be rebalancing my portfolio and even potentially putting new money into work, into overseas markets, into value, parts of the market that have underperformed.
I know personally I will never get the timing right. It's a long-term, discretionary or automatically rebalancing to those parts of the market that have just underperformed. That's a nice disciplined approach. Any one year, it may not seem like it's paying off. But I do know from the research that over--and you've done some as well, Christine--over 10- or 15-, 20-year period you can add, I don't know, roughly 50 basis points in, I'd call it, rebalancing alpha. You could call it, slightly tilting one's portfolio. But one has to stick with it and be systematic in it.
Benz: Let's talk about bonds briefly, your interest-rate outlook and your outlook in turn for the bond market. And then I'd also like to talk about just quickly, if you could, the corporate--we hear things about corporate credit bubble that maybe that's the next looming crisis for all of us. Can you talk about those things?
Davis: The fixed-income market, the credit, high-grade corporate bonds, spreads are really tight. The high-yield market has had some strong performance. Working closely with our active fixed-income team, we do have concerns in some of the riskiest part of the market, parts of the high-yield market, I would call the lowest creditworthy components of the investment-grade, like, BBBs, we are seeing a continued reach for yield. We think in the next downturn, clearly, those parts of the market, as they have historically, will significantly underperform. I would just caution investors, if they are thinking about or tempted for that extra 50 basis points in stated yield, just eyes wide open.
At least, I would suggest to my family and friends to say, look, how those assets have performed, I don't know, during 2008 or 2010. If one is comfortable with that, fine. But there's an asymmetric return profile for some of the riskier parts of the fixed-income market in the years ahead, because spreads have really compressed and the search for the yield has been really strong. Next year, we will be entering very likely a more restrictive Fed policy environment. The history shows that that's when those parts of the market may not perform as well as they have in the past.
Benz: How about high-quality bonds?
Davis: High-quality bonds, like, I'm not changing my--I'm investing. If they are underperforming, then I'm rebalancing into them, because I'm going to be very happy, much like 10 years ago, when I had them because I'm generally a more aggressive investor, just for me personally, I'm more of a 90-10 investor. I need ballast in that 10% for the 90% of the market. I look at my fixed income really to diversify that 90%. That's why theoretically that's a more efficient portfolio for me. I'm not worrying about eking out incremental yield in my 10% of portfolio.
If I was in the opposite investor, I'd just say, if you are trying to generate more income and yield, the fixed-income part of the portfolio is not the only way one can do it. You can look at equities, and this thing about that stock/bond mix, if one needs to achieve a higher return objective.
Benz: Joe, always great to get your insights. Thank you so much for joining me today.
Davis: Thank you. Thank you for having me.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.
Sarah Bush: PIMCO Active Bond ETF draws on PIMCO's many strengths. The strategy and team here have seen some changes in recent years. The ETF previously shared a name and investment team with the firm's flagship, PIMCO Total Return. However, in May 2017, the fund got a new name, a new strategy, and a new management team.
While such changes can be cause for alarm, PIMCO has been thoughtful about this fund's new mandate and has carved out a niche separate from PIMCO Total Return. Under its new guise, the fund is focused on income, which sets it apart from the flagship fund's total return mandate. In keeping with this focus, the fund has increased flexibility to invest in high-yield, which can now reach to 30% of the portfolio.
The new team is also well suited to the fund's approach with members offering complementary skill sets. Dan Hyman is a mortgage expert; David Braun heads up the firm's U.S. financial institutions group portfolio management team and also has experience managing tax-aware and income-focused portfolios; finally Jerome Schneider, a past winner of Morningstar's Fund Manager of the Year award, brings expertise in managing liquidity and active ETF portfolios. The three managers are supported by PIMCO's usual depth of analytical resources.
The mutual fund industry has a bad history with income-driven strategies that court excessive risk, so it's encouraging that this fund has shown restraint so far. Indeed, high-yield accounted for just over 4% of the portfolio as of October 2018. While this fund's flexibility to hold junk bonds could mean that it looks more aggressive at some point in the future, PIMCO takes a thoughtful approach to risk management.
All in all, PIMCO Active Bond ETF is an attractive choice and earns a Morningstar Analyst Rating of Silver.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. What do fund flows say about investor sentiment? Joining me to discuss the year's biggest asset gatherers and losers is Russ Kinnel. He is director of manager research for Morningstar.
Russ, thank you so much for being here.
Russ Kinnel: Glad to be here.
Benz: Russ, let's discuss some of the top categories in terms of inflows, and this encompasses both exchange-traded funds and traditional mutual funds. It's kind of an odd group as you portray it. Foreign large blend, intermediate-term bond, and ultrashort bond. Are there any commonalities among these?
Kinnel: It is an odd mix. Usually, you see a distinct theme. Everyone is going at equities or bonds or one area. I do think there are a couple of themes. I think the first theme is passive. Foreign large blend, of course, if you're buying a foreign index fund, that's going to be a category, but also people like active foreign equity as well. Then intermediate bond, again, there's a big passive component to that.
I think another reason you see intermediate bond and ultrashort bond is interest rates have been rising. Inflation expectations have grown. Interest rates are rising. Obviously, it means in the short term there's some pain because that means bond prices are hurt to adjust for that, but it does mean there's a lot more yield in intermediate bond and ultrashort bond whereas two or three years ago, a lot of the categories outside of high-yield had very low yields and were not very appealing. I think as yields have grown, investors are coming back.
Benz: In terms of the top categories in terms of outflows, where investors have been pulling dollars, kind of an odd group again. Large value, I guess, that one is maybe obvious given that we've had underperformance in value stocks; high yield, and large growth. Let's talk about those.
Kinnel: As you say, large value--one, we know value is underperforming because FAANG stocks are where it's been at for the most part. But again, I think another part of it is people putting money into core equity index funds, so that means large blend, and they are selling their large value and large growth which are predominantly active funds to buy in. As we've touched on before, it's not that dramatic a move, if you, say, sell a large-growth and large-value fund and then you buy a total market index fund, you really aren't changing your overall exposure very much. That's a big part of it for sure.
Then I think high yield, maybe people are scared that there have been some sell-offs in high-yield and also just you can now get decent yields from lower risk funds.
Benz: The headline when we look across categories is that U.S. equity has had inflows year to date, but they have been pretty tepid. Meanwhile, taxable bonds have been seeing $170 billion in inflows. This despite the fact that the U.S. market has performed really quite well so far in 2018.
Kinnel: That's right. The old model for predicting flows is you look at the last few years and whatever is the best returns explains that. But obviously, that's not the case at all, because equity returns have been far better than bond returns, but all the money is going into bonds. This almost looks like the year after a bear market. I think a lot of it is a movement into higher yielding bonds, because again, as I mentioned, bonds have a nice yield for a change. You may see money that's coming out of CDs and money markets because now intermediate bond funds and some other kinds like that are now paying a decent yield, though obviously even CDs and money markets have a better yield than they used to. Then equities, I guess, there's just a wariness. We can blame some of it on active/passive when earlier, but you can't blame the aggregate obviously, right?
Kinnel: It's really an interesting move and I think we really have to watch it closely.
Benz: In terms of the specific funds getting the biggest inflows, one interesting data point that you noticed was that just four of those in the top 20 are active. You've mentioned the stampede that we've seen to index products. Let's talk about those active products that have been getting new money. Toward the top of the list, PIMCO Income, Lord Abbett Ultra Short Bond, PGIM Total Return Bond. What's the attraction among those funds? Or what's the commonality, if any?
Kinnel: I think really strong performances. Maybe at an allocation level, people aren't chasing returns, but within categories, maybe they are. These funds have all had very strong performance, better yields than their peers, and I think people are responding to that.
To me, it looks like a little changing of the guard versus a few years ago, if you looked at the funds that brought in a ton of money when Bill Gross left PIMCO …
Benz: The fixed-income funds.
Kinnel: Right. Some of those are not on this list, some are even in outflows, funds like DoubleLine Total Return, MetWest. Really, it seems like we've got a bit of a changing of the guard.
Benz: In terms of active bond funds?
Kinnel: In terms of active bond funds. Yes.
Benz: Okay. At the fund family level, in terms of inflows, this won't be a surprise to anyone who has seen us cover flows before, Vanguard has seen the most in terms of new inflows in 2018. Fidelity, you note though is interesting on this list, in part because so many of its new inflows are coming from passive products.
Kinnel: That's right. Fidelity came out with the zero fee index funds and they have been big sellers. In a sort of unusual twist now, Fidelity is third on our list of biggest selling fund companies, and passive is a big part of it.
Benz: And historically, the Fidelity story has been an active story?
Kinnel: Historically, an active story, historically, a place they used to really have a lot of disdain for index funds, and now here they are leading the way on index funds. At least credit for being open to new ideas and coming up with competitive products for investors' demand.
Benz: Right. Because Fidelity does have some very good index products.
Benz: Let's talk about the outflows. Franklin Templeton is toward the top of the list. You say that really a lot of the key ingredients in Franklin Templeton's lineup just aren't in market favor right now.
Kinnel: That's right. If you look at their equity funds, there's a strong value tilt to both Templeton and mutual series legacy funds. They do have some growth exposure. Really, Franklin Templeton leans toward the value side. And then in fixed income, you've got Michael Hasenstab's funds which are pretty aggressive emerging-markets-leaning funds, and emerging-markets debt has had trouble; Argentina, for instance has been in the news a lot. They have had some challenges there. Really a lot of things are working against Franklin Templeton and they don't have much on the passive side. Again, kind of in the wrong spot at the moment on a lot of different places.
Benz: Russ, interesting insights. Thank you so much for being here.
Kinnel: You're welcome.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.
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