Investing Insights: Earnings, Utilities, and ESG Growth
Our analysts discuss cash flow in retirement, Dell stock, and a low-cost ETF on this week's episode.
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Sonia Vora: Coca-Cola's full-year results largely met our expectations, with sales of $31.9 billion, adjusted operating margin close to 31%, driven by its bottler refranchising, and adjusted earnings per share of $2.08 all near our estimates. We remain confident that the firm will be able to leverage its brand strength and pricing power, which underscore our wide-moat rating, to drive mid-single-digit organic sales growth over our 10-year forecast. Organic sales for the year grew 5% and included a 2% contribution from price/mix, lifted by the firm's continued focus on higher-value packaging formats. We expect contributions from price/mix to average around 2% over our forecast.
In North America, price/mix strengthened 2% in the fourth quarter, a significant improvement from the flat-to-negative performance in the prior three quarters, which helped offset the cost pressures that have been weighing on firms across the space. However, unit case volumes fell 1%, due to efforts to improve pricing for sparkling soft drinks, downsize juice packaging, and de-emphasize lower-margin tea products.
We continue to appreciate Coca-Cola's efforts to innovate within its portfolio and expect new product launches and line extensions to help it adapt to evolving consumer tastes, ensuring its share and pricing power remain intact over the long run.
Mark Cash: Cisco reported second-quarter earnings last night, with results that were in line with our expectations as the company grew 5% year per year. As we look forward, we believe Cisco will be able to sustain its growth rate, and we have raised our fair value to $49 per share from $46. We like that Cisco is gaining momentum in high-growth areas like software-defined networking and security for cloud-based environments.
We think that Cisco is becoming less reliant on a hardware refresh cycle as it grows its software-based sales and recurring revenue streams. In addition, Cisco announced $6.5 billion will return to shareholders in the quarter through buybacks and dividends. The company also announced a 6% increase to its dividend, raising the yield to 3%, and still has $24 billion to return to shareholders.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com.
There are three key ways to extract cash flow from your portfolio in retirement. Understanding the pros and cons of each approach is an essential first step in finding the right method for you.
The most obvious and intuitive method for generating cash flow from a portfolio is to rely on income-producing securities to supply your living expenses. That can mean focusing on dividend-paying stocks, bonds, and hybrid securities like convertible bonds or preferred stock.
There are a couple of big attractions to the income-centric approach. Relying on income from your portfolio is familiar; it's similar to the paycheck you had when you were employed.
Another big attraction to an income-centric approach is that relying on income for living expenses helps ensure that you won't prematurely deplete your principal. This is a big reason income-centric strategies tend to be popular among people who want to leave a legacy.
Income strategies may also be attractive during difficult market environments. As long as the portfolio is supplying the income you need, you may not care if your portfolio is moving up, down, or sideways.
Finally, yields have come up significantly over the past few years. That means that retirees don't have to stretch for income as they did following the financial crisis. On the other hand, yields aren't always guaranteed. Investors saw that during the financial crisis, when many banks, which had historically been a reliable source of income, slashed their dividends. Similarly, investors who had been relying on cash and bond funds for income had to make do on ever-smaller yields during the recovery.
In addition, yield-centric portfolios may not always be the best diversified, and they can court risk. Lower-quality bonds have historically had attractive yields, but their performance often moves in sympathy with stocks. On the stock side, dividend-centric stock portfolios often short-shrift higher-growth companies, which prefer to reinvest in their businesses rather than pay out cash to shareholders.
An alternative method is to build a well-diversified portfolio, reinvest all income distributions, and use rebalancing to shake out the needed cash flows.
The big advantage of this strategy is that because it's not focused on current income generation, the portfolio can be better diversified across security types and sectors.
Another advantage to this approach is that not relying on current income means a retiree can withdraw a fixed dollar amount annually, which enables a steady standard of living.
Finally, the process of rebalancing--periodically selling appreciated securities to meet cash flows--can reduce risk and enable a retiree to stick with his or her desired asset allocation mix.
The big drawback to relying on rebalancing to meet living expenses is that there may be years when there's nothing to rebalance. That was the case in 2018, when both stocks and bonds had a weak year.
And in contrast with an income-centric approach, a pure total return approach doesn't have a built-in safeguard against running out of money. A retiree's withdrawals need to be sustainable for a total return strategy to work.
The last method combines income and total return together. With this strategy, a retiree can use income distributions for spending money, and turn to rebalancing for additional cash-flow needs.
On the plus side, those income distributions can provide some peace of mind because they ensure some cash is always coming in the door regardless of market climate. One other attraction to this approach is that a retiree isn't actively reaching for yield, so the portfolio can be better diversified.
I also like that this approach allows for ongoing rebalancing, which can help reduce a portfolio's risk level. For example, a retiree using rebalancing would likely have been selling stocks after 2017's good market performance, which would help reduce risk coming into 2018.
Like the pure total return approach, this hybrid approach won't ensure a retiree won't run out of money. Spending current income can also be a drawback in that there may be times when it would be better to reinvest instead. This type of hybrid strategy can also be more complicated to implement than either an income-centric or pure total return approach.
All of these strategies have the potential to run into problems at various points in time, which is one reason why I like using a cash bucket alongside whatever cash-flow-generating strategy you decide to employ.
Thanks for watching. I'm Christine Benz for Morningstar.com.
Travis Miller: Most U.S. utilities these days are in good financial health with good dividend growth prospects and well-covered dividends. We're going to highlight three that we think are particularly good for income investors.
We think Edison International offers investors both upside to our $66 per share fair value estimate, 4.5% yield, and also 6% dividend growth. It's been caught up in some of the wildfire concerns in California, but we don't think that risk is nearly at the level of its northern neighbor PG&E, which pays no dividend.
The second name we like is Dominion Energy. It's been growing its dividend upward at 9%. We don't think that it'll grow that fast in the future, but it is our only wide-moat stock and we do think it has significant upside on the stock price.
The third, Sempra Energy, also another California utility caught up in some of the California wildfire concerns. But in this case, California is only half of its business. We think it's going to invest upward of $5 billion a year. Even though it trades at a 3% dividend yield, we think it can grow 9% for the next few years and possibly even as much as 11% in 2021 and beyond.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. We recently released the Sustainable Fund Landscape Report. I'm here with its author, Jon Hale, he is our director of sustainable investing research, to go over some of the big key takeaways.
Jon, thanks for joining me.
Jon Hale: Good to be here.
Glaser: Your first takeaway was that the universe of sustainable funds, of ESG-focused funds, really continues to expand at a rapid clip.
Hale: Yeah. In fact, this year we had 351 open-end and ETFs in the study; last year only 235. So, quite an increase in just one year.
Glaser: You second point is really around flows. Are people interested in these funds? Are they just launching or are they actually attracting investments?
Hale: It was very interesting. This year, despite market headwinds that actually produced a bad year for net flows for most long-term funds in the U.S., for the third year in a row sustainable funds had record flows, about $5.5 billion into this group of funds that we label as sustainable, the third year in a row, as I said, that was a record.
Just to put it into context, I went back for the 10 years following the financial crisis--the first four years of that, so that'd be 2009 to 2012, the average inflow per year for these funds was about $135 million--very, very small, tiny. Now, for the past six years the average flow has been about $4.5 billion and $5.5 billion just in the last year. So, still not huge compared obviously to the overall fund universe, but an immense amount of growth during this decade.
Glaser: The third point is around active/passive, always a hot topic. ETFs are taking a bigger share here. Why are those starting to catch on in this world?
Hale: We've seen a lot of issuance of new ETFs in the past three years. It is now possible for sustainable investors to develop a market-based portfolio using ETFs or other passive instruments that are open-end as well. I think it's something that clearly follows the trend toward ETFs. ETF providers think this is an area where flows will materialize, and they have started to do that just in the last year.
Glaser: As this universe begins to expand are you seeing a breakdown of where funds are landing in terms of the strategy that they are using to kind of hit these ESG factors? What's that looking like?
Hale: All ESG/sustainable funds are not alike. I identify in the report four different types, actually, of funds that you can tell based on both their holdings, how they do in the Morningstar Sustainability Rating, but also just what they say in their prospectus. There's a lot of funds out there previously launched, open-end funds that have added ESG to their prospectus indicating to me that they are now considering ESG as a part of their process which otherwise remains unchanged. We will have a lot of those kinds of funds now. The sort of more standard approach to ESG, I call ESG integration, which are funds that really try to use ESG in a more comprehensive and holistic way than the consideration funds, and they also do a lot of active ownership engaging with companies that they own.
Then thirdly, there's impact funds. That's a new trend as well. Funds that in addition to wanting to deliver financial return, they want to deliver some sort of discernible measurable impact, societal impact, environmental impact to their investors, and they are calling themselves impact funds and they are really focusing on how they convey that idea to their investors.
Then, finally, funds that have been around for a long time, sustainable sector funds, I call them, are focused really on those areas of the economy and those companies that are involved in the transition to a low-carbon green economy.
Glaser: Finally, what has performance looked like?
Hale: Performance was good last year, very good. In fact, if you look at on average funds in the universe, half the funds would finish in the top half of their Morningstar Category. Sustainable funds, which can be found now in dozens of different Morningstar Categories, 63% of sustainable funds finished in the top half of their Morningstar Categories last year. Only 18% finished in the bottom quartile. So, very good performance last year really across the board. All these different types of funds did pretty well. Equity funds did especially well. They tended to hold up well during the difficult market environment.
Glaser: Jon, thank you.
Hale: My pleasure.
Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.
Mark Cash: We recently initiated coverage of Dell Technologies with a fair value estimate of $56 per share, and we view this no-moat, stable moat-trend name as slightly undervalued. However, we assigned a very high uncertainty rating to the company due to its substantial debt load and concentrated ownership profile.
Made up of eight brands, including an 81% ownership stake in narrow-moat VMware, Dell Technologies offers products that cover the entire IT infrastructure ecosystem. We expect a gradual slowdown in the PC market to force Dell Technologies to rely on growth elsewhere. In our view, the company is well-positioned to execute on rapidly growing trends like flash-based storage, hyperconverged infrastructure, and software-defined networking.
We believe Dell Technologies has substantial cross-selling and upselling opportunities across its brands, which could increase switching costs over time. In the marketplace, we are seeing Dell EMC hardware paired with VMware software alongside solutions like Dell Technologies' cloud-based software platforms being offered together. We are fans of these collaborative efforts and expect this trend to continue.
Lastly, investors should understand that Dell Technologies has a sizable debt balance. While we believe the company should cover its immediate debts, there is potential that the company misses out on the next big thing due to its obligations. Also, shareholders are largely beholden to Michael Dell's strategic vision, and past Dell deals may not have always been for the public shareholder's best interest.
With that said, we believe the company has a sound strategy for the changing IT infrastructure landscape and that Dell Technologies will be a key cog in the world of hybrid-cloud IT ecosystems.
Alex Bryan: iShares Edge MSCI USA Quality Factor ETF is a compelling, low-cost fund that should offer better risk-adjusted performance than the market over the long term.
This Silver-rated strategy invests in great businesses. It targets large- and mid-cap U.S. stocks with the best profitability, strongest balance sheets, and most consistent earnings growth relative to their sector peers. This sector-relative approach to stock selection leads to cleaner comparisons, but it can also cause the fund to own stocks with lower absolute quality characteristics than it otherwise would.
To further mitigate unintended sector bets that might otherwise creep into the portfolio, the fund matches its sector weightings to those of the broad market. These adjustments effectively reduce its exposure to tech stocks, and increases its exposure to energy and utilities stocks.
The portfolio favors stocks with durable competitive advantages, like Starbucks, 3M, and Facebook. These stocks often carry above-average valuations, which tends to give the fund a growth tilt.
This strategy has tended to hold up a little better during downturns than most, but it has lagged a little during strong market rallies. Still, since its inception in July 2013 through the end of January, it beat the MSCI USA Index by 25 basis points annually.
Its low 0.15% fee and focus on strong businesses give it a good chance to continue offering a favorable risk/reward profile over the long term.
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