Investing Insights: Dividends, Mid-Caps, Social Security
On this week's podcast, our take on Guidewire, a suite of foreign-stock index funds from Fidelity, and what curbing rebates could mean for drug manufacturers.
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Dan Wasiolek: Most are probably familiar with the Venetian casino resort on the Vegas Strip, or the Super 8 hotel brand found across the U.S., but the Las Vegas Sands and Wyndham Hotel companies that operate these facilities offers some of the most attractive dividends in the travel and leisure universe.
Las Vegas Sands initiated a regular dividend of $1.00 per share in 2012 and grew that to $3.00 per share in 2018, representing a payout of around 100% of its annual diluted earnings per share. And we project the company to more than double its dividend to over $7.00 per share in 2028, supported by its industry-leading balance sheet and regulatory intangible assets advantage. In our view, Sands' dividend growth potential is buoyed by its low 1.4 times 2018 leverage and solid interest coverage ratio that ended last year at over 8 times. Further, Sands' dividend outlook is reinforced by its leading gaming share in Macau and Singapore, where demand far outstrips the limited number of gaming licenses awarded by the government. In our opinion, this leading presence will in turn allow Sands to win one of only two projected urban licenses in the large Japanese gaming market around 2025. As a result of Sands' competitive positioning we forecast free cash flow as a percent of sales to average 21% over the next 10 years, providing high visibility on future dividend growth for the company.
Wyndham Hotels’ 2018 spin-off offers investors the opportunity to own a high-quality hotel operator that paid out 46% of its diluted earnings last year. And we forecast that Wyndham can maintain around a 40% dividend payout over the next 10 years. This stance is supported by its leading brands within the economy and midscale price points, where it competes, as well as by the large loyalty presence of 75 million members. This in turn drives a pipeline that represents 22% of its current room base, above its roughly 5% global hotel room share. Further, its balance sheet is healthy, with an industry norm 3 times leverage and 5 times interest coverage ratio, reinforcing our view of sustained dividend growth potential for the company.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Should we be worried about the solvency of Social Security? Joining me to discuss that topic is Tim Steffen. He is director of advanced planning for Baird.
Tim, thank you so much for being here.
Tim Steffen: Thanks, Christine.
Benz: Tim, the Trustees, Social Security Trustees, released their most recent report. Can you sum it up?
Steffen: Sure. The Board of Trustees--every year they issue a report that, kind of, gives the status of what happened over the last year and what to look forward to. In this year's report, it was actually a little bit of good news. A year ago, we were anticipating, or they were anticipating that 2018 would be the first year of deficits for the first time in quite a while. As it turned out, operations were a little bit better than they expected in 2018. So, they actually ran a little bit of a surplus, which is good news. Still not great news long-term, but, for the short term, 2018 ended up being a little bit better than what they thought it would be. So, that's good.
Benz: The Trustees did propose some fixes, and certainly people who have been paying attention to this issue have heard some of them. Let's talk about some of the things that could shore up Social Security long-term.
Steffen: The plan right now is that--if things go as they continue to forecast--is that 2035 is the year when the fund would completely run out of money and then benefits would just be paid based on ongoing tax revenue that they collect from those who continue to work. What the Board of Trustees has said is that to shore up the fund for this 75-year window--which is their long-range forecast, that's what they like to target--is you can do one of three things. Any one of these would fill it up for the next 75 years. And that is: Either increase the payroll tax by 2.7%. So, you think about that 6.2% that we all pay into on the FICA tax in our wages--increase that by 2.7%. That can be paid either by the employee or the employer, or some combination, but it would go up by 2.7%. You could also cut benefit payments to everybody who is receiving them now and would receive in the future by 17%. Or the third option they said is if we're going to leave current retirees alone and just cut benefits for future retirees, cut them by 20%. Any one of those three things would allow the trust fund to meet its 75-year target of solvency. Of course, they say you could also combine those and maybe lessen the impact on any one of them. But if you just were going to do one thing; it'd be one of those three perhaps.
Benz: It seems like another fix I sometimes hear about is lifting the cap on wages that are subject to Social Security tax. That's an option, too, right?
Steffen: Yeah, there's a lot of options out there. This is not a one-solution problem here. There are a lot of things they can consider. And in fact, one of the things the Trustees do is they look at all these proposals that people have given out there: changing inflation factors, changing tax rates, investing in private accounts. All these different strategies that they've come up with, and they give a forecast of how long they think some of those things might actually improve the fund. The reality is most of them don't make a lot of impact. Many of them are single years, three- to five-year impact. Some of the larger ones would be like really increasing the tax base. So, if you were to, for example, remove the cap on wages--right now, it's roughly $125,000 or so that's subject to the 6.2% tax. If you were to eliminate that cap, that would add decades to the fund. It would also be a significant tax increase on everybody who is over that threshold. So, there's some things to weigh there. There's a lot of options. No one option is going to be enough to change everything. It's going to take a combination of things most likely.
Benz: So, these are the recommendations from the Trustees, but ultimately, congressional action would be required to make a change. So, let's talk about that. It seems like we are in the midst of major gridlock in Washington. So, is real action on Social Security even realistic?
Steffen: Yeah, we've been seeing this gridlock for a long time. It seems like we need almost one-party control to really see any kind of progress. Whether you like that progress or not, that's the only time we really see anything significant done. Yeah, it's going to take something like that. If you think about, kind of, how in human nature we all work best with deadlines, right? The last time there was a major Social Security forum back in 1983, there were projections that said Social Security was within months of running out of money, not the years or decades we have right now, which is still an urgency, but even within months. It may be until we get something along those lines to get closer to it. The fact that the Trustees report actually had some good news in it this year, probably slowed a little bit of that urgency, which maybe unfortunate. But as we get closer to these deadlines, hopefully something will happen. Unfortunately, the longer we wait, or the longer congress waits, the more draconian the fixes are going to have to be--bigger tax increases or bigger cuts.
Benz: So, let's talk about how individuals should approach this. I talk to even very well-informed people who sometimes say, "I'm looking at the information about when Social Security is going to run into problems; I'm taking my benefit early; I don't care what you say about delaying and the benefits of delaying." How should people approach this?
Steffen: Yeah, the old bird in the hand type thing, right?
Steffen: Yeah. And we hear the same thing. A lot of people are very concerned about it. The one thing I tell people is that even if the trust fund ran out of money today, they would again still be able to pay benefits, as we said, for the people who continue to work. It'd be about a 20% cut. So, they could still fund about 80% of the promised benefits. But I think most people understand that at some point along the line something will be done to fix this. We may not like the fix. It may be an expensive fix, and it may involve a combination of tax increases and cutting benefits. But something is going to happen. So, we still tell people that unless you have the worst-case scenario about Social Security, you're still likely better off waiting to start benefits. The 8% per year that they give you for waiting from age 62 to age 70, roughly, it's about 8% a year, that's a pretty impressive return they can give you and that's a nice benefit. So, if you can hold out, you're probably off waiting for that. We do see a lot of families, kind of, hedging their bets a little bit. We'll see maybe one spouse take benefits at full retirement age while another spouse delays and waits till later in life just to kind of take a little bit now and leave a little bit for later. We tell them again--to your longer-term financial benefit if you can wait, but I understand people's urgency and want to take money now, too.
Benz: So, you mentioned that 8% return. One comment I sometimes hear is, "Well, I think I can invest better than that." What's your response to that?
Steffen: You know, in a year like 2019 where we are seeing double-digit returns only a third a way through the year, I understand that. But last year it was a different story. So, yes, 8% on any one given year, you might be able to beat that. To do it over a longer-term period, like the eight-year window from 62 to 70, that's a hard thing to do, over multiple years like they have to consistently get that 8% rate of return. So, we still say that 8% is pretty significant and you want to let them pay that for a guaranteed ...
Benz: And it's guaranteed. It's impossible to beat.
Steffen: I mean, it's guaranteed as long as they don't change the law, which I guess is always a possibility. But for now, that's as guaranteed as you can get.
Benz: Finally, Tim, I sometimes hear from younger investors who say, "I'm not planning on any Social Security. I don't think it'll be there for me." That doesn't seem realistic either, does it?
Steffen: It doesn't. I've been doing this for a long time, and some of those people who I used to talk to who were the younger ones who are now getting close to taking it, those pessimists who didn't think they were going to get it, are now starting to plan how they are going to get it. So, yes, it's easier to sit back and say, "I'm never going to get it. I've never going to get it." And frankly, if you want to plan your retirement on not getting it and just treat Social Security as a bonus, that's fine. That's probably ultra conservative. But I understand why people do that. I think realistically it's going to be there for the long haul.
Benz: Tim, always great to get your perspective. Thank you so much for being here.
Steffen: Yet bet, Christine.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.
Christine Benz: Hi, I'm Christine Benz from Morningstar.com. To some investors, mid-cap stocks represent the best of all words, in that they're still nimble and growing, but they're through their initial growing pains. Joining me to share some favorite actively managed mid-cap stock funds is Russ Kinnel. He's Morningstar's director of manager research. Russ, thank you so much for being here.
Russ Kinnel: I'm glad to be here.
Benz: Russ, let's just talk about the thesis for mid-cap stocks. I think some investors do think that they kind of represent the sweet spot in a lot of ways. But, I guess, as an investor, do I need to carve out a dedicated fund that focuses specifically on mid-cap stocks, or is there another way I could play it?
Kinnel: Well, certainly if you have total stock market or extended market index funds, or some other funds that dip into mid-caps, you might not need it. But I do think it's an important part of the overall market, and obviously it's a good point for companies, because typically you're talking about a company between $2 [billion] and $12 billion market cap, and that's often a really good growth spot. So "the sweet spot" may be a little overselling it, but it is a good place to invest.
Benz: So here again, this is an area where if you want a dedicated allocation to mid-cap stocks, you're perfectly fine doing an index fund, say a Vanguard mid-cap index or something like that, that is focused on mid-cap stocks. But we're going to talk about some favorite actively managed funds. And one that you like, along with the team, is called Parnassus Midcap. People might know its large-cap funds, but this mid-cap fund might be a little less familiar. This one has an ESG mandate. Let's talk about what that is and how this fund approaches that.
Kinnel: So, the ESG mandate means they are screening out companies that pollute, sell tobacco, defense companies, alcohol companies. A lot of screening out but also looking for companies that are good, sustainable companies to invest in as well.
Benz: There's a growing appetite for funds that do have an emphasis on ESG, but I know that you and the team think that there's a lot to like here from an investment standpoint as well. This is a fund that tends to behave, as far as I can tell, pretty well on the downside, so it's not going to be the best, maybe, in a roaring bull market, but it'll earn its keep when things are going down.
Kinnel: That's right, and it's kind of unusual, because it's a fairly focused portfolio. Usually you think of more volatility because there's more issue risk. But because of the quality focus in their strategy, you're right, it actually makes the fund relatively defensive, which is a really appealing way to go--that stock picks have a big impact, but at the same time you're not paying a big price in terms of volatility.
Benz: Vanguard Selected Value is another one that is on your list. It has multiple managers. It lands in Morningstar's mid-cap value category. It's a Vanguard fund, so its cheap price tag is an attraction. I guess a question is, since it has several managers, three managers, I believe, how do they keep it from kind of looking like a mid-cap value index?
Kinnel: Yeah, you know, they do have three subadvisors who are running mid-cap value dedicated strategies, so it is style-pure. In that way, it's like an index. It charges 36 basis points, so in that way it's like an index. But you do have three managers making stock picks, and it really shines through. Barrow Hanley has a majority of the asset, so it's not evenly divided. Pzena and Donald Smith handle the rest. So you have three variations of kind of deep-value strategy. It really is a fairly distinctive-behaving fund. You can see, in years like 2018, it had a rough go of it because of all that exposure to deep value, has a lot in industrials, not that much in tech and healthcare, so it's a relatively volatile fund. When you hear three subadvisors, you expect kind of big, bland indexlike performance. But if you look at the performance, it's actually been pretty distinctive.
Benz: And this is one that we have in Morningstar's 401(k) plan, actually. Another fund on your list, I think this one'll be probably familiar to most of our viewers, Fidelity Low-Priced Stock. I guess the question is, with a veteran manager in place, and there's so much to like about that, but also a very large asset base, why do you and the team continue to have a lot of enthusiasm for this fund?
Kinnel: Yeah, you're right, it's a really amazing fund. $31 billion in assets, 800 stocks. It really shouldn't work. It should be a really boring fund at that point. But Joel Tillinghast is one of the more amazing investors out there. He just really has an incredible acumen for understanding the details. He's got a value tilt to his strategy, likes relatively cheap companies, likes good yield, but it doesn't have to have a good yield, and just has built a tremendous portfolio. It's a wide-ranging one. Vanguard Selected Value is kind of focused on that mid-value space. Tillinghast's portfolio really is all over the market. You see a lot of large-cap, some small-cap, some blends, some value. It's really a wide-ranging portfolio. But at the end of the day, he's just done a great job by any way you look. Now, someday, if he retires, then I'm probably not going to be as enthusiastic about the fund, but he's still going great guns, he's still doing a great job at the fund. Every once in a while we'll try and trick him. You know, we'll ask him about the 700th company on the list, and he knows it flat. He's not just delegating all that authority. He really knows his companies.
Benz: Russ, always great to get your recommendations. Thank you so much for being here.
Kinnel: You're welcome.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.
Dan Romanoff: We see wide-moat Guidewire as an interesting long-term investment opportunity in the mid-cap space. The underlying growth thesis revolves around a modernization theme for the core software systems the P&C insurance industry uses. We think both the initial penetration and subsequent cross-selling opportunities are tremendous, given so many carriers lack a modern core system and the advanced add-on features that go alongside it. We see earnings growth compounding at 20% for a decade, as the company has low-single-digit market share in at least a $10 billion market. Our fair value estimate is $117 per share and implies a P/E of 65 times on adjusted 2020 earnings.
Guidewire is the largest software provider focused exclusively on the property and casualty insurance market. It provides the core operational software suite that allows a P&C insurance company to analyze risk, write policies, collect premiums, manage the claims process, manage an army of agents, create new products, do business in a digital world, and help perform related financial and statutory reporting. The three main pillars of its solutions are ClaimCenter, BillingCenter, and PolicyCenter, but Guidewire has been busy introducing important new solutions in the last couple years, including predictive analytics, digital portals, and, more recently, a move to the cloud.
Insurers are highly risk-averse and have been reluctant to change, so many insurers are still using legacy COBOL-based mainframe type of systems. Over the last 10 years, Guidewire has had sales meetings with virtually all insurance carriers, demonstrating what modern software can offer relative to custom-built legacy systems. This helped the company rise to a substantial product and market share lead. Still, carriers have been adopting on-premise software and are only now beginning to move to the cloud. Given the slow-moving nature of the P&C insurance industry, we believe the modernization theme will take place over more than a decade, and Guidewire will lead the way.
Daniel Sotiroff: Investors that use index funds for their foreign stock allocation can simplify their portfolio by holding a total foreign market index fund. These are some of the broadest and most diversified foreign stock funds available because they invest in a wide selection of stocks across both developed and emerging markets.
Surprisingly, not many of these funds exist. The best known funds are Vanguard Total International Stock Market ETF and iShares Core MSCI Total International Stock ETF. But Fidelity also offers three low-cost alternatives.
The first and most comprehensive is Fidelity Total International Index fund. It tracks the MSCI All Country World Ex USA Investable Market Index and costs only 6 basis points per year. It not only spans developed and emerging markets but covers large-, mid-, and small-cap stocks, making it the broadest of the three.
The second alternative, Fidelity Global ex-U.S. Index Fund, tracks the MSCI All Country World ex USA Index. It cost slightly less, at 5 1/2 basis points, but only focuses on large- and mid-cap stocks.
Fidelity Zero International Index is the third option and is only available to investors with a Fidelity account. It tracks a benchmark of large- and mid-cap stocks and is the cheapest option as it charges no annual fee.
All three of these well-diversified funds charge low fees and are worth considering. As an added bonus--Fidelity does not charge investors on its platform to trade these funds.
Karen Andersen: The regulatory landscape for branded prescription drugs in the U.S. has become dynamic, with many proposals on the table for reducing drug spending. And with nearly half of revenue at top drug firms stemming from U.S. branded drugs, this has become a key issue in our analysis. Overall, we see the wide economic moats held by most of the large-cap drug firms we cover as steady, and as pricing pressure from competition and regulatory changes are countered by stronger patents, faster FDA reviews, and strong innovation. Our coverage in this area is on average more than 10% undervalued, as compared to a more fairly valued broader universe of stocks.
One controversy in drug pricing surrounds drug rebates, or the kickbacks that drug firms pay to middlemen and payers. These rebates can help lower net prices and keep insurance premiums down, but they can also leave patients exposed to higher out-of-pocket costs. Early this year, the Department of Health and Human Services proposed eliminating rebates in Medicare. This change could go into effect in 2020, followed by potential changes in private coverage. We think this would be a negative development for distributors and insurers, but it has an uncertain impact on drug firms themselves. Some drugs could see higher prices in this system and higher volumes, but drugs losing patent protection or facing stronger competitors could see sales erode more quickly.
Given this uncertainty, we favor names like Roche, which has been less exposed to rebates because of its therapies that are administered in hospitals and doctors' offices and not sold directly to patients at a pharmacy. We also think Roche's ability to defend its growth with strong new launches in oncology, MS, and hemophilia is underappreciated.
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