Bank Dividend Stocks and Choosing Target-Date Funds
We break down Vanguard’s view on ETF trends and what makes United Rentals attractive.
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Eric Compton: Bank stocks are often relied on for their dividends, and with CCAR 2019 in the rearview mirror, dividends for the banks under our coverage are more or less established through Q2 of 2020.
Today, Huntington, KeyCorp, and Wells Fargo have the highest dividend yields under our banking coverage, with Huntington north of 4%, and KeyCorp and Wells Fargo closer to 3.9%. For reference, many of the banks under our coverage have yields in the mid-2% to low 3% range, so a high 3% to 4% yield is meaningfully higher.
For Huntington, we view the bank as fairly valued, and the bank typically devotes a higher percentage of its earnings to dividends, closer to 40%-45%, hence the higher yield. In our opinion, we think this is about as high as the payout percentage will get, therefore we would expect dividend growth to roughly match earnings growth going forward.
For Wells and KeyCorp, the higher dividend yield is at least partially due to, in our view, the undervaluation in the stocks. Wells and KeyCorp have been two names we have viewed as undervalued for essentially all of 2019, but both stocks are closing this gap. With a fair value estimate for KeyCorp of $21, and a fair value estimate for Wells Fargo of $57, the dividend yields may fall just under half a percentage point for each, if they can close what we view to be a valuation gap. But shareholders, in this case, would be rewarded with share price appreciation, and dividend yields which would still be in the mid-3% range.
In general, with dividend payout ratios in the 30% to 40% range for most of the banks under our coverage, we view current dividends and payout structures as stable, meaning we view it as unlikely that the dividend payments would come under threat in the event of a downturn, with banks instead being able to adjust their share buybacks in response to earnings pressure.
Christine Benz: Hi, I'm Christine Benz for Morningstar. Are most investors buying total market ETFs and calling it a day, or are more finely tuned ETFs getting their attention? Joining me to discuss the exchange-traded fund landscape is Rich Powers. He's head of ETF Product Management in Vanguard's portfolio review department.
Rich, thank you so much for being here.
Rich Powers: Thanks for having me, Christine.
Benz: Rich, let's talk about fund flows from Vanguard's perspective. From where we sit at Morningstar, it seems like we're observing most of the assets just going into the big building-block total market index trackers. Is that Vanguard's perception as well?
Powers: It is. Actually, if you look more broadly in the industry, that tends to be the case. But if you zoomed in on Vanguard's areas of cash flow interest this year, what you're finding is the total market fund, be it VTI, which is the U.S. equity market, or BND, which focuses on U.S. investment-grade bonds, or even BNDX, which focuses on international fixed income, those have been very popular, along with VOO which tracks the S&P 500. The International Fixed Income cash flows are kind of interesting in light of the interest rate environment we find ourselves in…
Benz: Very low yields, negative yields in some cases.
Powers: That's right. What we take from that is perhaps that investors are starting to appreciate the benefits of diversifying their exposures across different yield curves, so removing some of the home biases that you see in fixed-income portfolios.
Benz: Okay. So, let's get back to this interest in sort of the total market trackers. Do you think it's--let's talk about what's driving it. Is it that advisors are saying, I'm not going to monkey around with large growth, large value, et cetera; I'm just going to get U.S. equity exposure with this single building-block? What are the forces that you think are driving the interest in the very basic products?
Powers: I think across the spectrum it depends on the investor type that you're talking about. I think there are some advisors saying, I don't want to kind of carve up the marketplace, give me a simplified portfolio and the totals actually allow them to do that and spend their time on other value-added activities on behalf of their clients. Others might be starting with those products as the core and then complementing them with perhaps a factor strategy or tilting towards corporate bonds, but using that as the core of their portfolio. I think the other thing you can argue against is the cost. And so, if you look at the expense ratios for these building-block portfolios, they're all low single digits. And in many cases, the spreads are a basis point. So, the total cost of ownership for these types of products is incredibly low today.
Benz: Okay. So, speaking of costs, I want to talk about commission-free trading in the ETF space. It seems like all of the barriers have broken down. Are you concerned about the commission-free trading environment, may be stoking investors to trade more than they should?
Powers: Yeah, it's really exciting. And actually, the commissions have been reduced across so many different platforms. It's something that we probably started about a year ago when we made commission-free investing available for all ETFs on our platform. I think a concern that folks have articulated is that the lack of a speed bump, the commission, will invite investors to embrace some bad activities, so trading a little bit more. We've actually looked at the level of activity on our own platform the year before we went commission-free relative to where we've been the last year or so. And there's been no discernible change in terms of trading activity. On average, an investor is making six transactions in ETFs and most of those are actually them adding more to the existing ETFs, versus them trading from one to another. And so, the before and after experience, for those who are on our platform, tells us that commissions being removed didn't invite them to take on some of those activities that are going to harm their long-term results.
Benz: Okay. So, another question I'd like to cover with you, and it's a big one, but as we've seen this gusher of flows going to ETFs and in traditional index funds, a question is, at what point will indexing be too large, are we close yet? Let's get your perspective on that question.
Powers: Yeah. I would argue that indexing isn't big enough at this point, be it in the mutual fund or an ETF. If you just looked at the U.S. equity market index assets, call it about a third of all industry assets are in a passive strategy. If you looked at fixed income, less than 5% of industry assets are in passive fixed income. And so, in both cases, active managers represent the vast majority of the assets. And if you zoomed in on trading, the numbers become even more compelling in saying that indexing isn't very large at all. Less than 5% of all trading activity in the market is driven by index equity ETFs. And so, this notion that index ETF cash flows or index fund cash flows are harming price discovery, the data simply doesn't prove that out.
Benz: Okay. So, it sounds like you still think ETFs have room to grow. I'm guessing you do. But let's talk about how in what other ways you expect that the ETF landscape will look different five years from now versus where it is today.
Powers: Yeah, I think there's a couple things that are really interesting around what's going to happen in the ETF industry. We've done some studying of this over the last couple of months as to how do we think the world is going to unfold. I think you'll see more and more investors using ETFs. So, we looked at a couple different studies and ETF usage across different client types. Less than 20% of all registered investment advisor assets are in the ETF structure. If you looked at broker-dealers, the number is closer to 10%. So this idea that advisors use ETFs almost exclusively in their portfolio construction--a bit of a myth, right? Because only 10% or 20% of their portfolio construction is in ETFs. So, more headroom for them to grow there. And then, if you zoomed in on the individual investor, I think they're just getting started in terms of ETF adoption. Less than 10% of individual investors use ETFs in their portfolios. And so, I suspect what we'll see with ETFs is not so much the complexion of the industry evolves, but rather the buying base will be very different.
Benz: Okay. So, another thing that I've been thinking about is just--investors are buying index funds, total market trackers; performance has been very good, especially if you look at sort of the U.S. total market index. Are you concerned that maybe some investors have unrealistic expectations about the product? Is that something that worries you?
Powers: We're really less concerned about that. We've been offering index products, be it funds or ETFs, for over 40 years now, and what we find is that index investors tend to be much more long-term and more likely to not take action during environments when the market gets bumpy or even market returns are negative. In fact, actually, if you dial the clock back 10 years ago, one of the great catalysts for greater ETF adoption over that period of time was index funds providing market-like returns while many active managers struggled to deliver there. And so, to the extent that there's another challenging market environment, that might actually be a further catalyst for investors looking at index funds or ETFs as a solution.
Benz: Okay. Rich, great to get your perspective. Thank you so much for being here.
Powers: Thanks for having me.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.
Scott Pope: As industrial and construction companies pursue asset-light business models, they have increasingly relied on rental companies to provide the critical equipment they need. One company, United Rentals, has emerged as a clear leader in the equipment rental industry with a 13% share of the growing $55 billion North American market. We believe that it is poised to expand its capabilities, market share, and pricing power to further extend its lead over rivals. United Rentals is currently a 4-star-rated stock trading 25% below our fair value estimate of $185, which equates to 11 times our 2019 EPS estimate.
Since United Rentals became a publicly traded company in 1997, its revenue has grown 16-fold. A sizable component of this growth has been realized through M&A activity, including $8 billion worth of acquisitions in the past decade. The fragmentation of the equipment rental market represents a significant opportunity for United Rentals and its acquisition-heavy business model. The top three rental companies only control 23% of North American market. Much of the remainder is served by smaller, less sophisticated companies focused on local business. We believe that customers will ultimately be better served by a national firm such as United Rentals with advanced customer-facing technology, a large catalog, and superior logistics capabilities.
Core to our investment thesis is our belief that the firm will garner revenue synergies through a reduction of competition in certain markets combined with expansion of specialty equipment with lower price transparency than its traditional fleet. That said, our current fair value estimate only incorporates a 1% long-term increase in operating margin. We believe these advantages and potential margin improvements are largely underappreciated by the investment community. Therefore, we believe United Rentals’ current trading price is an attractive entry point for investors seeking a long-term investment opportunity.
Jeff Holt: An investor looking to put their retirement savings in a target-date fund simply selects a fund with a target date in its name that most closely corresponds to the year they plan to retire. For example, if a 43-year-old investor plans to retire at age 65 in the year 2041, they would select a target-date fund with 2040 in its name. Target-date funds have diversified portfolios and are designed to be the single holding for retirement savings, so investors generally do not need to invest in multiple target-date funds.
Investors should note that the investment approach varies by target-date provider. And while target-date funds are meant for investors who want to hand over the asset-allocation decisions to professionals, there’s a few things that investors can peek at to build their confidence in their choice.
First, they can look at the strategic equity glide path. This glide path shows how the funds’ managers plan to balance the stock/bond split at different points before and after retirement. Investors may want to pay close attention to the expected equity exposure at the target date, and what happens after the target date, to make sure they are generally comfortable with the approach. Comparing a glide path with the average also provides insight into how relatively aggressive or conservative it may be.
Second, investors may want to look at a fund’s expense ratio to make sure they aren’t paying too much. Target-date funds that invest only in index funds generally have expense ratios around 0.10%, whereas ones that hold actively managed funds typically have expense ratios closer to 0.50%.
There’s much more to target-date funds than the equity glide path and expense ratios. Morningstar analysts issue forward-looking ratings on the most prominent target-date funds available, digging deeper into the portfolio management teams, the execution of the approach, and underlying sub-asset-classes, among other factors. Investors can use the Morningstar Analyst Ratings as an independent view formed after comprehensive evaluation.
Christine Benz: Hi, I'm Christine Benz from Morningstar.com. Morningstar recently split its intermediate-term bond category into two groups: core and core plus. Joining me to share some of his favorite picks in the core-plus group, and talk about the core-plus group in general, is Eric Jacobson. He's a senior analyst at Morningstar.
Eric, thank you so much for being here.
Eric Jacobson: It's great to be with you, Christine. Thanks.
Benz: Eric, you and the team recently decided to split that intermediate-term bond group into two pieces. Let's talk about why you decided to do that. And also, can you give us a flavor for the complexion of each of these two new categories, core and core plus?
Jacobson: Sure. Well, the original category, which was just intermediate-term bond, was arguably sort of the S&P 500 of the bond universe, sort of the real core of the taxable space, if you will. And that was how a lot of funds ran themselves. Over the years you started to get more and more funds that today we would call core plus, where they would hold the sectors that are in what is now the Bloomberg Barclays Aggregate Bond Index, mainly Treasury bonds, government mortgages, Ginnie Mae, Fannie Mae, Freddie Mac, and then high-quality corporate bonds, and then a little bit of asset-backed and so forth. That's what's pretty much in the index and has always been in the index. The mixes have changed over the years.
After the financial crisis in particular, we started to see more and more funds do what had been done by some of the big names like Pimco all along, but add choices that had a little bit of high yield, maybe a little bit of emerging markets, a lot more of securitized things that aren't in the index, such as CLOs, non-agency mortgages, all these other things. And it's incremental in the sense of how different they are, but the core space is still home to all the funds that are much more like the index, and the core-plus space is home to funds that will go out and maybe hold some more in high yield and all those other things. Those funds, as I said, they always did exist under the old regime. But as the market evolved over the years, you really started to seek the size of each get to the point where it made sense to split the group in half.
Benz: So, the core-plus group, they're prescribed by prospectus in terms of how much they can invest in some of these more exotic bond types, right? They just can't go crazy with them. Isn't that correct?
Jacobson: Exactly. Now, we don't do the category just solely based on what's in the prospectus. But you will find that most funds that we have in that category aren't likely to ever go, say, more than 30% or more than 35% at the most in anything really outside the norm. Most of them will probably traffic between 10% and 25% in some mix of, like I said, high-yield corporates, or things that have more currency risk, perhaps, or something like emerging-markets debt as well.
Benz: So, as investors look at these two groupings now, how should they approach them from the standpoint of adding bond exposure to their portfolios? Is it that they'd want to have both core and core plus? Or is it one or the other? How should investors go about making that decision?
Jacobson: I think the average investor probably doesn't need too many different bond funds. I think a good, well-run core-plus fund that's had decent risk control and has performed well in rough periods over the years can probably serve you well as a core for your portfolio, even though we may call it core plus.
I think if you have a lot of money in bonds, and you're at the point where you're looking to diversify things, it might make sense to start with a core fund as your base, and then add a core-plus fund. Just by way of example, if you look at how pension investors and other large institutions invest, most of them when they have large bond portfolios, they scatter it among several different kinds. They'll use one manager for the core and another for the core plus. So, again, it kind of has to do with how much you have and how diversified you feel you must get in terms of the manager.
Benz: So, my guess is that a core intermediate-term bond fund would tend to be maybe a little better shock absorber in some big equity market correction, whereas the core-plus fund is going to give me a little more income on an ongoing basis, but might not perform quite as well on the downside. Do you think that's a reasonable way to think about it?
Jacobson: Writ large, absolutely. I mean, there's going to be some crossover, there's always going to be some overlap. The less aggressive core-plus funds will look a little bit more like the more aggressive core funds, but you'll probably find the core to be pretty homogenous. And I will say this, as you know, expenses are really important across universe. But even more so--I would say incrementally even more so in core. They're going to be super important in core plus, too. But a core fund, that's limited to almost very, very--excuse me--investing very similarly to the Ag Index--is going to need to have it keep its expenses low enough that they don't overwhelm what--because right now, as you know, yields have been low for a long time. The margin for error is pretty small.
Benz: And before we leave the topic of core funds, an index fund would be a perfectly reasonable core intermediate-term bond fund, right?
Benz: So, you have been covering these, what we now call, core-plus funds for a long time. And so, let's talk about some of the ones that you cover that you really like, and a couple of them are Pimco funds, and Pimco has sort of a long lineage in this space. Let's start with kind of the main core-plus fund out there, one of the bigger ones, this is Pimco Total Return. You still like it.
Jacobson: I do. And one of the reasons I wanted to talk about is, just because people know it so well and regardless of all the history there, lots of people still own it. So, I think the great thing about it is that it's still a very good fund. If you have or haven't followed the saga, when manager Bill Gross left a few years ago, a lot of people took their money out of the fund because he had a big, big personality and reputation. And what wasn't clear, I think, to a lot of those people is that the staff that he left behind was fantastic. And to his credit, despite all of the tribulations and the noise that surrounded it, he left behind a fantastic team. And not just that, but from others as well. And so, that fund has done pretty well since then. It really is at the level of a core-plus offering. It's going to give you Pimco's best ideas and best effort and it's still a fantastic shop. So, I think that there's a lot of reason for people to continue to look at it that way.
Benz: Another fund that you like in this space also run by Pimco, this is an ETF--Pimco Active Bond. The ticker is BOND. Let's talk about that one. Not quite as familiar as Pimco Total Return.
Jacobson: Well, I thought this would be an interesting one to talk about, because it used to be sort of an ETF version of Pimco Total Return. That's really what it started out as. And then, sometime after Bill Gross left and interest in it waned a little bit, Pimco decided to convert it to this new name Pimco Active Bond, and they took off the old managers who were all very good, and they added three new ones. One of them is a fellow by name of Jerome Schneider, short-term specialist; Dan Hyman, who's a mortgage specialist; and David Braun, who comes from more of an income perspective, he has a lot of history in long-term liability investing. And so, what's interesting about that is, it's a little bit more aggressive in some ways than the more basic version of the fund, but I would call it almost like a Pimco Income light, and Pimco Income, as you may or may not remember, is a much more aggressive version of Pimco offering in the sense of, it holds a lot of non-agency mortgages and things and it's in our multi-sector category, which makes it quite a bit more aggressive than a regular core-plus fund. This one does qualify for core plus, but it's got a little bit more freedom than a more basic fund and it's interesting, and it's had a good record so far. And the main thing is that we really like the managers and think that this is a very interesting offering…
Benz: And costs are reasonable?
Jacobson: Costs are reasonable.
Benz: Another one you like is PGIM Total Return. Let's talk about that one. Not a Pimco fund.
Jacobson: Not a Pimco fund, absolutely. So PGIM is the new branding name for a group that used to be part--it's still part of the Prudential insurance conglomerate. But PGIM is its own firm and then PGIM Fixed Income runs this offering. It's actually a huge organization, but because they've been sort of behind the scenes in institutional and insurance and so forth, a lot of people probably don't know who they are.
What I really like about this fund though, in addition to the fact that it's--it really is sort of team-managed in a way that I think a lot of other firms give flip service to, this is a very, very team-managed fund. They have a lot of resources. They've got very, very big analyst teams, a lot of history in corporate investing, as you might expect from a firm that focuses a lot on insurance money, for example. But one of the things I also really like is, their risk controls are very well thought out, well-designed, and sort of act as great backstops. And part of the thing that I really like about them--and other firms do some version of this--but they do a really good job of explaining, this is how much risk we want to take, and these are the different risk factors we're going to use, and if we decide to take a lot of risk in one area, we're not going to take as much in the other because that will push us up against our limits. And they're really good at elucidating what those are and keeping people aware of where they are in that mix. And you get what you know what you're going to get. You get what you pay for, but you get what you've been sold, you get what you've been promised when you buy this fund, and they've done really well.
Benz: Eric, it's always great to get your perspective. Thank you so much for being here.
Jacobson: I'm glad to be with you, Christine. Thanks for having me.
Benz: Thanks for watching. I'm Christine Benz from Morningstar.com.