Underspending in Retirement and Value Standouts
We highlight dividend opportunities in telecom and share our stance on Sherwin-Williams.
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Robby Greengold: Over the 10-year period ending September 2019, more than two of every three actively managed large-value funds failed to beat the total returns of the Russell 1000 Value Index. Mid-value funds fared even worse, with nearly nine out of 10 lagging their Morningstar Category index. Across the board, relative results for value funds have been disheartening for proponents of active management. The fierce competition for alpha begs the question, What flavors of value investing are out there, and what are the ingredients for success? Among value investors who take a fundamentals-based, bottom-up approach, a few distinct philosophies stand out. Some value investors focus on finding bargains, which they shop for through the lens of intrinsic valuation--they ask themselves, "what's the worth of this company's assets today, on a per-share basis, and how does that compare to its stock price?"
The managers at Gold-rated AMG Yacktman are reliably valuation-conscious, which sometimes leads to hefty cash stakes when the team can't find cheap stocks to buy. Contrarian value investors look for stocks that are out-of-favor--companies that the market has punished for one misstep or another but that offer a better fundamental outlook than the market appreciates. The managers of Invesco Comstock, a Silver-rated large-value fund, often go against the grain. They conduct rigorous analysis of a company's financial statements and growth drivers, in addition to macro, industry, and idiosyncratic factors, all in order to gauge a stock's upside potential and downside risk. Weathering the storm of a controversial bet can take time to pay off, but the managers are patient as their investment theses play out. Other value investors prioritize quality over discounts. For example, Silver-rated MFS Value aims to emphasize companies with competitive advantages, solid balance sheets, and relatively high margins. That focus has contributed to the fund's historical resilience over the long run. For almost any fund that picks stocks using fundamental analysis, success relies heavily on the strength and stability of the team involved. Does the team stand out for its ability to construct a benchmark-beating portfolio that responsibly manages risk? For the three value-oriented funds we've discussed here, the answer is a resounding "yes."
Michael Hodel: For most of 2019, we've been recommending AT&T shares as the most attractive in the U.S. telecom industry, sporting a generous yield in addition to trading at a significant discount to our $37 fair value estimate. However, over the last several months, AT&T shares have rallied strongly, especially after Elliott Management started to take an interest in the company and push for changes in the management team and the corporate strategy.
With this stock now trading at a little bit of a premium to our fair value estimate, we don't see a ton in the U.S. telecom industry that's particularly attractive for dividend-seeking investors. Right now, if we were to pick one stock in the sector, we would look at Comcast. While Comcast shares don't yield as much as AT&T or even Verizon, they still yield about 2%. And importantly, the company doesn't pay out nearly as high a percentage of its free cash flow as AT&T or Verizon do. Comcast pays out about half as much as those two companies, roughly 25% to 30% of its free cash flow, and that gives the firm a lot more room to grow its dividend over time. So, while AT&T and Verizon have been growing their dividends about 2% annually, Comcast most recently raised its dividend 10%. And we think that dividend growth is set to continue over the next several years as Comcast digests the Sky acquisition, continues to repay debt, and continues to shift its focus more towards the dividend and away from share repurchases. And Comcast, we expect, will eventually return to share repurchases once it gets its leverage down to a more comfortable range. But we do think that that dividend will make up a more important portion of the firm's total capital return over time.
And with regard to the balance sheet, Comcast and AT&T have similar leverage. So, Comcast after the Sky acquisition has about 3 times debt to EBITDA, which is a little bit higher than where AT&T is at, at about 2.7 times, but AT&T also has its pension obligations that aren't factored into that metric. So, on an apples-to-apples basis, the balance sheets between Comcast and AT&T are roughly comparable. And so, we think Comcast has equal if not a little bit better credit profile than AT&T does.
So, Comcast isn't a compelling bargain today. It trades right in line with our $45 fair value estimate. But relative to AT&T and Verizon, which again are trading at premiums to our fair value estimates, we view Comcast as somewhat more attractive today.
Christine Benz: Hi, I'm Christine Benz for Morningstar. Many retirees are terrified of running out of money in retirement, but they need to balance that worry against a competing consideration: underspending and not enjoying their retirements to the fullest. Joining me to share some thoughts on how retirees can strike the right balance is Joel Dickson. He's Vanguard's global head of advice methodology.
Joel, thank you so much for being here.
Joel Dickson: Great being here, Christine. Thank you.
Benz: Joel, when I heard we were sitting down, I wanted to discuss something with you that came up when you taped our podcast, our Morningstar podcast. And we were discussing this whole thing about retirement plans, sustainability, and people like you and me think a lot about how can we make sure this person doesn't run out of money. But you raised a really provocative point, which is that it's a big deal if someone way underspends during their spending horizon. So, let's talk about why you think that issue is under discussed.
Dickson: I do think there's been so much focus on the worry about not having enough resources during your accumulation years to then be able to meet a retirement approach, a retirement spending approach. And a lot of times, it's like, the headlines about people aren't ready for retirement, they're not going to be able to spend how they want, maintain their standard of living. And in many ways, I think that's overblown. Not to mean it isn't important! People need to think about, you know, what do I need for retirement. But where I look at it is that we have kind of the standard assumptions for how we define success and whether you will have sufficient resources to meet your retirement needs. And I think it's really important to look and understand what those assumptions are. And a big one in retirement is, the standard approach in advising around success and retirement: retire at age 65, plan for a 30 year or more retirement.
Dickson: And success is basically,do I run out of money by the time of the end of that planning horizon? So, for 100% of people, we are using a planning horizon of let's say, age 95 or age 100 to which less than 5% of people will probably actually survive--at least under current mortality assumptions. So that 5% case is extraordinarily, in some ways, conservative. Now, there will be people that make that…
Dickson: …that far and we need to worry about.
Benz: Right. Plus, there's a real connection with wealth and longevity, right?
Dickson: There is.
Benz: So, people watching us probably, I'm guessing have portfolios, they are wealthier individuals, they may be a little closer toward that 30 year time horizon.
Dickson: Yes, very much so, but at the same time, even to the extent let's even say it's 10% of people that make it that long. In many ways, you're going to have not so much of retirement savings crisis, but a retirement spending piece of, there's going to be money left over. Not a bad thing necessarily, but you know, it's more of, could you have enjoyed that during your lifetime, in a different way? And I think it gets back to working with your advisor or talking with yourself, your partner, and so forth about what does success look like in retirement? What is it that I want to accomplish and achieve? Because what I call the "bounce my check at the funeral" approach, which is, hey, do I run out of money by the time I'm age 95 or 100? And I'm just going to spend to that piece, right? Actually, it doesn't reflect how people have generally, at least how we've seen people spend money in retirement.
Benz: OK, so have that discussion about whether a bequest is a big deal to you. If it's not, then you may want to spend a little more actively from the portfolio, or how should you approach that?
Dickson: I think especially in the early years of retirement, those are the years that most people can enjoy the spending. There's often another part of the assumption in the whole planning process of, I have this 85% number of my final income, that I'm trying to target. And it's going to grow with inflation. You know, in terms of what I'm spending in retirement. What we see in terms of actual spending, all those things like healthcare spending, tends to increase over the retirement period. Overall spending tends to decline in inflation-adjusted terms. So, what we end up seeing is actually--and in part, my 80-year old parents are very much in this situation right now--it's not that they don't necessarily want to spend, but they don't really have the ability to spend on things, like they just can't go on trips in the same way they did or come visit the grandchildren in the same way that they did. And so those types of physical, mental limitations and so forth as we get older. One question is whether that spending can be shifted a little bit early. So maybe you spend a little bit more in early retirement years when you may be more able to do that, recognizing that your spending will probably adjust automatically or you may adjust it based on resources as well later in retirement.
Benz: Right. So one other complicating factor--and we could talk about this all day--if the market is not so great in your early retirement years, when you were hoping to really do a lot of your spending, that can be a problem, especially if you are needing to spend from an equity portfolio that's declining.
Dickson: Yeah. It's interesting because, this whole sequence of returns question, which is that point: Does it matter when the returns of the market happen in terms of your own retirement journey? I actually still see that as a longevity question not so much as a market question, which is that sequence of return only matters if you live a long time. If you only end up living to 85, then the sequence of returns if you have otherwise been said to be sufficient to age 95 or 100, the fact that you live to 85, probably that sequence of returns isn't as important. So, it's ultimately a longevity thing. And can you think about ways to protect against that longevity risk while still spending from your portfolio in a way that just doesn't say, I'm going to forgo spending now because I'm worried about potentially running out of money later.
And that's why things like, think about, we talk in a kind of a Vanguard global retirement framework standpoint, about different buckets of money--not buckets in the ways the same way, Christine, that you talk about it for investing. But in terms of things like your basic level of income or discretionary income or spending. We kind of bucket that all together when we talk about, oh, you have an 85% chance of not outliving your resources. But probably what most people want is 100% chance or as close as possible to being able to meet the basic everyday living expenses. Yeah, I've got some sort of roof over my head, I've got the food, I've got my basic medical needs taken care of.
Benz: Don't have to move in with the kids.
Dickson: Exactly. It's the "don’t be a burden," sort of, "I don't want to be a burden to someone else" piece. If the discretionary pieces now, on top of that, it's like, well, yeah, OK, I'd love to do it. But if I can't, I'm still not being a burden. That piece of it I think, thinking about it from that standpoint and focusing on what's the basic level of income that I really need to insure against, and that's being the first piece. And that may be covered by Social Security, it may be covered by you having defined-benefit income, you might even early in your years work part-time. There are any number of ways.
Benz: Use an annuity perhaps in that context.
Dickson: Use an annuity, exactly. Potentially also long-term care insurance in retirement to, I guess, again, managing some downside risks, although that market is complex and probably needs some guidance...
Dickson: ...In looking at that. But there are a number of things that, if we focus on what's the kind of basic level of income, that then frees up, kind of the flexibility in the discussion for other sources of income and how you then think about enjoying that, and maybe you can even then front-load some of that early in the retirement years.
Benz: OK, Joel, great insights. Always great to hear your perspective. Thank you so much for being here.
Dickson: Thank you, Christine.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.
Charles Gross: Narrow-moat Sherwin-Williams is among the largest producers of architectural and industrial paint in the world. We assign a $340 per share fair value, well below the prevailing market price of $590. With shares trading well into 1-star territory, we strongly recommend clients avoid purchasing shares, or divest their current holdings.
The market price currently bakes in two key assumptions that we disagree with. The first is that Sherwin-Williams will gain unrealistic amounts of market share over the coming decade. The second is that the company will achieve record-breaking adjusted EBITDA margins and sustain them over the economic cycle. Both outcomes appear highly unlikely to play out.
Digging into the first argument--Sherwin-Williams grows its share of the coatings market by opening new stores. Over the last two decades, the company has been able to grow its footprint by about 2% to 2.5% annually. In order for us to generate a fair value comparable with the current market price, we have to assume that the company can accelerate that opening pace to 3.5% per year--more than 200 new stores each year--into an increasingly saturated market for paint. The constraints that will prevent the company from reaching those expectations come down to labor constraints and only so many attractive new storefront locations. Management has already noted how challenging it is to maintain current growth rates of new store growth, let alone opening twice as many stores going forward.
On margins, today's market price implies substantial profit gains on both the retail and industrial side of Sherwin's business. On the retail side, Sherwin would need to achieve and maintain EBITDA margins of 27%--that's not only well above the best-ever performance Sherwin has generated, but it's well above the best performance we've seen in the entire industry over the last 20 years. On the industrial side of the business, the company would need to maintain EBITDA margins consistent with the highest levels seen across the industry since 1999 indefinitely. We think neither outcome is realistic.
We think future energy or pigment price shocks will be enough to shake Sherwin's share price back to earth. About half of each can of paint is linked to energy prices. Even though paint companies are often thought of as industrial businesses, their margins are clearly correlated with changing input prices. The company benefited significantly from the energy price collapse in 2014 and 2015, which we think is part of why investors are so optimistic about future margin levels. Even in the absence of an input price shock, we think competition over market share will be enough to prevent record-high margins from lasting indefinitely.
Susan Dziubinski: Hi, I'm Susan Dziubinski. Morningstar director of personal finance Christine Benz just put the finishing touches on the content of our annual Portfolio Makeover Week. Christine is here to share some of the key lessons from the week that we can all learn from.
Christine, thanks for joining us today.
Christine Benz: Susan, it's my pleasure.
Dziubinski: Now your first lesson is for people to think about getting help planning for their retirement. Do we all need financial advisors?
Benz: Well, possibly. One thing I would say is when I looked through the submissions, and we got a lot this year, many of them were from people who were just getting ready to retire. So, they're trying to figure out, do I have enough? If when I embark upon retirement, I'm looking at my portfolio, how much can I withdraw from it each year? Really hard questions. And I do think that because retirement decumulation is inherently more complicated than accumulating assets for retirement, it is a good spot to stop and get some help.
What I would say though, Susan, is that not everyone needs ongoing portfolio handholding. So don't assume that if you have an advisor who you're using to help with your retirement plan that you necessarily need to sign on for an ongoing engagement. You might just get maybe a one-time check on your plan, and then maybe checks every couple of years, as you go along. You might not need that ongoing handholding. So, I leave it to each of our viewers to decide how much help they need. But it's definitely helpful, especially at this life stage to seek out the help of a tax-savvy financial advisor.
Dziubinski: Now, you noticed that a number of people who had submitted portfolios said that they were planning to delay their retirement, which--there's nothing wrong with that. But you suggest that people have a backup plan. Why is that?
Benz: Well, I love to hear that. And I will say, for example, one of the couples who I profiled, he was 80, she was 70. They had really enjoyed working, they work together actually, and they were just now getting fully retired. So, we're seeing this more and more I think in our lives, too. And there's a lot to be said from the standpoint of finances when it comes to delaying retirement. The thing I come back to, though, is what Mark Miller says, Morningstar contributor Mark Miller says, which is that delaying retirement is a worthy aspiration, but it's not a plan.
And to sort of accentuate that fact, I would point to some research from our colleague David Blanchett, who's Morningstar Investment Management's head of Retirement Research. And David's research has shown that people oftentimes don't retire at the point in their lives when they expected to. So oftentimes, people who expected to delay are forced to retire earlier than they expected. It might be their own health considerations. It might be spouse’s or parents’ health considerations. It might be that they were maybe forced out of that higher-paying job sooner than they expected to. So, I think it's always worthwhile to lay a backup plan. If your plan is to extend out your working years, put in place a plan for what you would do in case you couldn't keep working.
Dziubinski: Now, Portfolio Makeover Week is usually about, sort of the investments in the portfolio. But you can't deny the importance of Social Security and sort of the equation of retirees. So, can you talk a little bit about how impactful delaying Social Security can be, and what you found with the makeovers.
Benz: It's huge. And so, you know, we'll run through sort of various scenarios using portfolios with different asset allocations, and different withdrawal rates, and changes that we can make at the portfolio level. But some of the changes that you can make with Social Security delay date, if you're willing to extend that a little bit can be just so much more impactful. So, an example I would give from the Portfolio Makeover Week is that one of the people was a 60-year-old woman, and she was sort of toying with retiring at full retirement age claiming Social Security benefits at what Social Security calls her full retirement age. So, like 67 versus waiting all the way until age 70. And what she found was that the differential was like between $2,500 a month and $3,200 a month, so a $700 a month differential for delaying. And it's just impossible to make that kind of gain in a portfolio value with changes.
Dziubinski: With some tweaks.
Benz: Right, right. So, it's just one of the biggest-ticket changes that you can make to a plan. The thing I would say is that delaying Social Security doesn't necessarily mean delaying retirement. So, it may be that someone retires, pulls from their say, Traditional IRA assets first, and then delays Social Security and is able to claim that benefit later. So, there are a lot of moving parts here. But it doesn't necessarily mean that delaying Social Security means a later retirement date, part-time work can also figure into the mix.
Dziubinski: Now, it always pays to be sober about market return expectations. But you noted in the in the makeovers that that's especially true for pre-retirees and retirees. Why is it so important for that cohort?
Benz: Well, because that the first say 10 years of retirement is a really important time in retirement, and you want to make sure that you're not drawing too much from your portfolio, or expecting too much from your portfolio during those early years. So, when I was plugging in return assumptions for people who are getting ready to retire, I was using very muted return expectations, in part because of the current market environment that we're in. So, we have very low bond yields, currently. We have not-cheap equity valuations, although I've been singing that same song for a couple of years now, and things really haven't changed, things have continued to be really quite good. But nonetheless, I think it is probably just prudent when you're thinking about the next 10 years to be mindful that market returns might not be that great. You definitely don't want to extrapolate from the past 10 years for the next 10, because we rarely see things work out that way.
What I would say, though, Susan, for folks who have longer time horizons who aren't so concerned about near-term retirement, but maybe they're planning to retire in 50 years or 40 years, or something like that, well there I say if you have an equity-heavy portfolio, go ahead and use long-term market return assumptions, maybe 8% or so for the equity market. Because I do think over long periods of time, it's the best we have to go on. And you probably don't want to give your return expectation that much of a haircut if you have a really long time horizon.
Dziubinski: And speaking of people, investors who have longer time horizons, you had a few makeovers this past week that focused on older folks who are either entering retirement or nearing retirement, but you did have a couple of younger portfolio makeovers this year. And for those, there's an emphasis on remembering to balance the short term and the long term. Can you talk a little bit about that?
Benz: Yeah, it's really interesting to me. One was a younger individual not yet married, the other was married couple, three young children. And so what really struck me in looking at their plans was, yes, they needed to prioritize retirement funding because they can take advantage of compounding, all those things we hear about, the advantage of getting started early on your retirement fund. But they were also balancing here-and-now considerations and in both of their cases, what I saw is, in my view, they're pretty underfunded in terms of their emergency fund. So, I think a little multitasking is in order. Both were trying to purchase homes in fairly high, expensive property markets. So that was another challenge.
So, one thing that I would say is kind of a tip for people who are trying to balance the long term and the short term, is to think about using a Roth IRA for part of the plan. And one reason that I have always talked about the Roth IRA being such a nice multitasking vehicle, is that you can withdraw your contributions at any time and for any reason without taxes or penalty. So even if your intention is to leave the money to grow until retirement, if you need to get at it sooner, you can get in there without many strings attached. So, I think that's a nice vehicle to consider maybe in addition to taxable accounts that you might have for emergency fund needs.
Dziubinski: Great. Well, Christine, thank you for sharing these lessons today and thank you for the makeovers this week.
Benz: Thank you, Susan.
Dziubinski: I'm Susan Dziubinski from Morningstar.com. Thanks for watching.