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Vanguard’s Best Active Large Caps and Stable Dividend Stocks

A stock pick from the packaged food aisle, and why emergency funds are necessary for retirement.

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

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David Swartz: Department store stocks Macy’s, Kohl’s, and Nordstrom are high-yielding dividend stocks and we think each of them has currently stable dividends with growth potential. Moreover, we view all of them as undervalued at current levels.

Department stores have struggled with weak store traffic and a competitive apparel market in 2019. We acknowledge these challenges and expect that competitive pressures will continue. Yet, Macy’s, Kohl’s, and Nordstrom are among the largest U.S. retailers both in-store and online; none of them are in financial distress.

Macy’s pays an annual dividend of $1.51 per share, giving it a dividend yield of nearly 10%. We rate Macy’s as a no-moat company and our fair value estimate is $27 per share. Management has stated it will not cut its dividend but, given the very high yield, this must be viewed as a possibility. Macy’s raised its dividend consistently until 2017 but has kept it at the $1.51 level since, as it has prioritized debt reduction. We forecast Macy’s will pay about 52% of 2019’s earnings as dividends and expect a 45% dividend payout ratio in the long term. We project Macy’s will hold its dividend constant through 2022 as it continues to pay down debt, and then begin to increase its dividend again in 2023. We forecast it will generate more than enough cash free flow to cover its dividend for the foreseeable future. Also, Macy’s owns significant real estate which could be sold, providing an extra level of safety.

Nordstrom pays an annual dividend of $1.48 per share, giving it a dividend yield of just under 5%. We rate Nordstrom as a narrow-moat company and our fair value estimate is $55. Nordstrom raised its annual dividend consistently until 2015 but has held it at $1.48 per share since then due to investments in large capital projects, most of which are near completion. We forecast Nordstrom will pay about 45% of its 2019 earnings as dividends and, in the long term, we forecast a dividend payout ratio of 40%. We expect Nordstrom to begin to increase its dividend again in 2022 and think it will generate more than enough free cash flow to cover its dividends.

Kohl’s will pay a dividend of $2.68 per share in 2019, a dividend yield of more than 5%. We rate Kohl’s as a no-moat company and our fair value estimate is $75. Kohl’s began paying dividends in 2011 and has raised its dividend in every year since. We forecast Kohl’s will continue to increase its dividends over at least the next 10 years and pay about 55% of its earnings as dividends. We think it will produce more than enough free cash flow to cover its dividends.

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Christine Benz: Hi, I'm Christine Benz from Morningstar. Having an emergency fund is financial planning 101, but do you need a cash cushion in retirement? Joining me to discuss that topic is Judith Ward. She is a senior financial planner for T. Rowe Price.

Judy, thank you so much for being here.

Judith Ward: Thanks. It's great to be here.

Benz: Judy, you and the team at T. Rowe Price recently looked at contingency funds, cash cushions in retirement. Before we get into that, let's discuss how working folks should approach this, people pre-retirement. Do you think that standard three to six months' worth of living expenses is a safe emergency fund? Is that about what I should earmark?

Ward: Yeah, I think that's the general rule of thumb. And we at T. Rowe Price agree with that for the most part. I think if there's a single breadwinner, or your income might be sporadic or something, you might want to have a …

Benz: If you're a gig economy worker or something.

Ward: Yeah, you might have a little more. And the purpose of the emergency fund--and I always hear people talk about, oh, it's the big expense, it's, oh, you need the new roof. And to me, that's so cliché. There's a lot of things you can plan for. But I really see it as, if one of you were to lose your job, how would you make it through that period of uncertainty? I think that's the key reason for an emergency fund. It can also help with some of these larger unexpected expenses. But it's--you don't want to have to raid your retirement savings or put--you don't want to put a mortgage on a credit card, for goodness sake. So, how are you going to tide over during these periods of uncertainty? So, we think three to six months of expenses is reasonable. Like I said, maybe a little more if there's a single earner for the household or your income is disjointed.

Benz: How about if I have a high income or some really specialized career path? Should I be a little more cautious there too, maybe set aside a larger cushion?

Ward: You could, but you have to think about what are the expenses that you're going to still have to pay if you're out of work and how long might it take you to find another job. So, that's really, I think, the considerations for how much should be in your emergency fund. And you don't need to fund everything. If you're in a--there are ways that you can cut expenses, but it's like, the mortgage payment, the important payments that you want to make sure keep going. So, again, you don't have to take money out of your retirement account. So, this is money that should be set up outside of your retirement accounts. Because you really want to try to keep your retirement goals on track even during this period of uncertainty.

Benz: So, let's turn and talk about retirees and how much of a cash cushion they could think about or should think about. You have been looking at that topic. Let's talk about why they may want to run with an even larger cash cushion or contingency fund than the people who are still bringing a paycheck.

Ward: Right. So, now that you're in retirement, you don't have the paycheck anymore, you can get to your retirement account. So, it's really--the purpose I think has changed a little bit from when you were working, the whole reason is, we didn't want you to have take money out of your retirement account or use credit cards. Now, in retirement, it's more around, I call it a safety net, a contingency. A friend of mine calls it his "sleep-at-night money." It's kind of to protect you when maybe markets go down, when you do have maybe a large unexpected expense, that you have this contingency reserve. I like it especially in case of market volatility. It gives you an alternative to pull money, rather than your portfolio where in case it's all down at the same time--not that we've seen that that often--but it's just this contingency reserve. We think one to two years of expenses might be a good amount. And the reason we came to that was we looked at, again, probably a worst-case scenario, in 2008, how long did it take a portfolio to recover. And a 60-40 portfolio using just broad-based indices, it took about two years, up to two years to recover. So, you might have to draw on that for a year or two, while you let your portfolio recover. So, we think that's a reasonable amount for retirees to consider.

Benz: So, when you say one to two years' worth of expenses, am I thinking just in terms of like my portfolio withdrawals, because my expenses are going to be covered in part by Social Security, maybe a pension, right?

Ward: Yeah, that is a great point. So, it is more of what you might be drawing from your portfolio. Not necessarily all expenses. If Social Security is covering a lot of your expenses, you're still going to have your Social Security payments. If you have a defined-benefit pension, that might be covering some expenses. So, it's really to help with an alternative to drawing from your portfolio.

Benz: So, you can overdo it, though. You said that two years is probably the high end that you'd want to think about. Because there is an opportunity cost to having too much in cash, right, that will tend to underearn your long-term portfolio.

Ward: Right. Yeah. And when we're talking about this cash contingency, we're talking money market, bank account, maybe CDs, maybe ultra-short or short-term bond. So, there is an opportunity cost there for growth potential. And we think, in retirement, you could be in retirement for 20 to 30 years or longer. So, you still need that growth potential that stocks provide, maybe a more-balanced approach. So, yeah, the more money you have in cash is more money you have not working for you. So, you have to consider that as well.

Benz: So, in terms of where to hold it, if I'm retired, I guess, I should locate my cash wherever I'm pulling my withdrawals from currently. So, if I'm subject to RMDs, it goes in my IRA, is that how I would think about it?

Ward: Yeah, I would--RMDs are going to have to come out anyway.

Benz: Right.

Ward: So, you want to approach it as to, again, where the money is coming from. With RMDs you can't help but pull from there. If you're not at RMD age yet, perhaps you do want to have it kind of outside of your retirement accounts. And that's something you can work towards prior to retiring, is maybe building that up. So, yeah, you would have to look to where you're naturally kind of pulling that money.

Benz: Judy, you know I'm a believer in the bucket strategy.

Ward: Yeah, that's right.

Benz: So, this fits with it really well.

Ward: Yes.

Benz: Thank you so much for being here.

Ward: Thanks for having me.

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

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Erin Lash: We’ve long held that the merits of Kellogg's move away from direct-store distribution (in favor of warehouse delivery) in 2017 would prove advantageous. But the market has been more skeptical, with shares edging up less than 3% between January and July 2019, versus a nearly 20% appreciation in the Consumer Staples Index over the same period.

From our vantage point, this divergence reflects Kellogg's failure to boast an improving top line as of yet (unlike peers). However, with its revised strategic playbook, we think Kellogg is poised to crack the code on profitable and sustainable sales growth.

For one, although its U.S. cereal business (which accounts for one fifth of sales in aggregate) has been fighting an uphill battle, we believe the market fails to appreciate the attractive dynamics of its vast snacking mix (which accounts for 50% of sales). Further, changes to its pack formats to include more on-the-go offerings should allow for increased penetration in alternative outlets.

We also think recent acquisitions (including smaller niche startups like RXBAR) afford the opportunity to grease the wheels of its own innovation cycle to more nimbly respond to ever-changing consumer trends, particularly as it relates to health and wellness, and taste. By abandoning direct-store distribution, Kellogg stands to elevate brand spend, rather than expending resources on its distribution footprint, to support its entrenched retail relationships--which we view as key in the intensely competitive landscape in which it plays. And we expect efficiencies will remain a pillar to fuel these investments while also aiding profits.

With a 4% dividend yield and trading at a 20% discount to our $78 fair value estimate, investors should consider buying shares in this wide-moat name, a rare bargain in the packaged food aisle today.

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Alec Lucas: Well known for indexing, the Vanguard Group also has an underappreciated active management business, especially in large-cap equities. The bulk of Vanguard’s more than $300 billion in equity assets are outsourced to external subadvisors who run 15 separate strategies, ranging from domestic large-growth, -value, and -blend funds to an emerging-markets offering and even a recently launched ESG fund. Morningstar rates 12 of the strategies and assigns a Morningstar Analyst Rating of Bronze or higher to 11 of them, including four Gold-rated and three Silver-rated strategies.

The three Vanguard strategies run by Pasadena, California-based Primecap Management Company stand out. All three are rated Gold, and while closed to new investors, reopening at some point isn’t out of the question. Investors on the outside looking in must be ready to act quick, though. Vanguard Capital Opportunity, one of Primecap's funds, reopened to new investors in April 2013 only to close again in December of that year. The other Gold-rated strategy, Vanguard Dividend Growth, run by Wellington Management’s Donald Kilbride, had been closed to new investors since July 2016 but reopened on Aug. 1 of this year. Its reopening presents investors with a chance to buy into a resilient, mega-cap-oriented strategy that has proven its ability to growth wealth over time.

Vanguard’s three Silver-rated strategies are all open to new investors. Wellington Management’s Michael Reckmeyer runs roughly two thirds of the assets of Vanguard Equity-Income, with Vanguard’s own in-house Quantitative Equity Group overseeing the remaining third. The Scottish investment management firm Baillie Gifford subadvises half of the assets of each of the two Silver-rated strategies. Baillie Gifford is paired with Marathon Asset Management on Vanguard Global Equity, and Baillie Gifford is paired with Schroder Investment Management on Vanguard International Growth.

All of Vanguard’s actively managed strategies come at a very cheap price. Those low fees allied with subadvisors like Primecap, Wellington, and Baillie Gifford give Vanguard’s actively managed large-cap equity lineup considerable appeal. So, too, does Vanguard’s Portfolio Review department, which provides oversight for each of the 15 strategies, making subadvisor changes when necessary.

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John Barrett: Last month, we initiated coverage of narrow-moat, payroll processors Paycom and Paylocity with fair values of $173 and $82, respectively. We think both companies are modestly overvalued right now, but we awarded them a narrow moat due to switching costs.

Paycom and Paylocity are similar businesses that offer payroll processing and human capital management software to small to medium-size businesses. The target employee count for Paycom and Paylocity is 100 to 1,000 employees. Both are fast-growers with over 20,000 customers and have been taking share from incumbents ADP and Paychex. The companies’ native cloud software with unified database architecture provide an improved user experience compared to its competitors. For this reason, roughly half of Paycom and Paylocity’s new customers are conversions from either ADP or Paychex. Unlike many of their software peers, both companies are already profitable and should be able to attain some additional operating leverage as they continue to grow double digits.

There are some minor differences in the companies. Paycom recently started targeting  companies with up to 5,000 employees, while Paylocity has remained focused on companies with lower head count. Additionally, Paylocity utilizes a broker network for roughly 25% of new business wins, while Paycom exclusively uses direct salesforce.

In summary, we think both companies have strong qualitative profiles and that the importance of timely and accurate payroll processing for small businesses helps earn Paycom and Paylocity narrow moats. However, we think investors should wait for a pullback before considering investing.