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Investing Insights: Earnings Analysis and Tobacco Dividends

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Travis Miller: As we expected, the troubled California utility PG&E filed for bankruptcy on Tuesday. What it does now is kicks off a process where we really don't know what's going to happen. What we do know, and are pretty sure of, is that there will be equity value left for shareholders. We think there will be about $12.50 left for shareholders at the end. 

This brings up a unique question as to how that will be a positive equity value when typically you think about bankruptcy as wiping out shareholders. The situation here is a little different in that at the end of the day, regulators do have to end up with a healthy utility. What that means is health access to the capital markets. For equity shareholders, they need assurance that the wildfire liabilities will not continue, and will be capped at some reasonable level. Right now that looks like $8 billion to $10 billion. If they ultimately reach that goal and reach that amount, then there should be value leftover for shareholders.


Abhinav Davuluri: Apple reported first-quarter results in line with the firm's revised guidance from Jan. 2. Positively, non-iPhone segments, including services, Mac, iPad, and wearables and accessories, grew 19% year over year led by stellar services and wearables growth. After factoring in near-term iPhone headwinds in China and emerging markets, management's outlook for the second quarter was relatively consistent with our expectations. 

Shares rose after the report, as we believe the market is expecting far worse. We are maintaining our $200 fair value estimate for narrow-moat Apple, as we anticipate the firm resumes mid-single-digit sales growth from fiscal 2020 onward, following a modestly lower fiscal 2019. 

CEO Tim Cook attributed the iPhone challenges to negative foreign exchange fluctuations as a stronger dollar made iPhones more expensive in many emerging regions, reduced carrier subsidies, and Apple's battery replacement program that prolonged upgrades, as well as the aforementioned weakness in China. While the first three factors appear more transitory in nature, we have significantly cut our iPhone unit forecast for China going forward, as we anticipate a more competitive environment with lower switching costs in the region. Intensified by the current tepid macroeconomic backdrop in the region, and U.S.-China trade tensions. 

We note the firm's active-install base for iPhones for the past 900 million devices during 2018, up nearly 75 million in the past 12 months and supports our thesis of a rich and loyal customer base from which Apple can extract services and wearables revenue.


Ali Mogharabi: Facebook's fourth-quarter results easily beat expectations as the daily average user count grew sequentially in the largest ad spending markets, U.S. and Europe, even though the firm remains in the midst of addressing data security and privacy issues. In our view, Facebook's network effect moat source remains in tact as demonstrated by further improvement in user monetization during the quarter. We remain convinced that further growth in Instagram, IGTV, and stories users will continue to attract advertisers to Facebook's platform. 

Facebook's total ad revenue was up 30% year over year driven by strong user engagement and increases in both demand for and supply of Facebook's ad inventory. Overall MAUs and DAUs experience strong growth. And we were impressed with DAUs return to sequential and year over year growth in U.S. and Europe. Monetization of users continued to improve, especially within the highest ad spending markets. We expect continuing growth in ARPU during the next five years, although at a slower rate. 

Overall, we remain confident that with a strong network effect moat source, which has resulted in more than 2.3 billion users, Facebook will continue to attract advertisers to its platform. We are pleased with the company's further investments in product integration and data security, along with the introduction of new social network products and features, all of which we think will help Facebook maintain and further monetize its users. We upped our fair value estimate of this wide-moat name to $190 per share from $186. In our view, Facebook shares remain undervalued.


Scott Pope: Caterpillar came out with its fourth-quarter earnings this morning, coming in at $0.44 below consensus EPS. More importantly its guidance for 2019 EPS was both below our estimate and below consensus. The principal problem in Q4 was a lower margin in its construction industry segment and to a lesser extent, there was some onetime charges to the financial services segment. Taking these factors into consideration, we are anticipating a meaningful reduction in our fair value estimate. 

The four major takeaways from the earnings call this morning were, one, the U.S. economy looks strong for 2019, which supports healthy growth in Caterpillar's construction segment; two, Latin America was rather weak in Q4, and the recovery looks tepid; three, China was a little weak, and going forward we think that China revenue growth will be flat in 2019; and fourth, minor CapEx is expected to be strong in 2019 which would support healthy growth in Caterpillar's resource industry segment. 

Taking all this into account, we are still rather positive on Caterpillar. In 2018 it generated its highest earnings per share despite being well below its peak revenue. The larger issue with Caterpillar is that management has demonstrated its ability to contain cost, streamline operations, and continue ongoing product development. For all these reasons, we think Caterpillar still remains an attractive investment.


Christopher Franz: We recently upgraded T. Rowe Price New Horizon's Morningstar Analyst Rating from Silver to Gold due to its ability to remain a superb long-term option despite a massive asset base. 

The fund's success is due to manager Henry Ellenbogen's unique approach. As T. Rowe's CIO for U.S. Equity Growth, Ellenbogen works closely with the firm's analyst team to build an eclectic portfolio. While he anchors the fund in steady, long-term growers such as Vail Resorts and Burlington Stores, Ellenbogen sets the fund apart by also investing in promising, private companies before they go public. He's had considerable success here, but limits the fund's overall private stake to 5% to keep risk in check. 

Ellenbogen is patient with his picks, and his willingness to hold on to industry disrupters has pushed the fund's average market cap upward, recently landing it in the mid-cap growth Morningstar Category. The fund's size is worth noting, and at nearly $24 billion, it's one of the largest actively managed strategies in both the small- and mid-cap growth categories. 

Still, there's no denying Ellenbogen's success, highlighted by a banner year in 2018, as the fund gained ground while its index and peer group lost value. The fund is closed to new investors, but those with access to this great manager should stay put.


Greggory Warren: Given the cyclical and secular headwinds the U.S.-based asset managers are facing, we've taken a much harder look at the moat sources, economic moats, and moat trends of the companies we cover.

At this point, we believe that only two of the U.S.-based asset managers--BlackRock and T. Rowe Price--have wide economic moats, as they not only have the ability to differentiate themselves from the competition with low-cost fund offerings and repeatable investment strategies but have demonstrated a willingness and an ability to prudently adapt to the changing competitive environment.

For the narrow-moat firms that remain, we expect them to struggle over the next five to 10 years, but still outearn their cost of capital over the next decade. 

As for the no-moat firms, we expect these companies to struggle to consistently earn excess returns, as limitations in their product mix, fee structures, and/or abilities to adapt to a changing competitive environment impact their competitive positioning.

While some of the firms we cover are currently trading at multiples not seen since the financial crisis, we recommend long-term investors focus on quality over price by sticking with BlackRock and T. Rowe Price, which have generated solid organic growth and higher operating margins than their peers, the two main things investors have been willing to reward in the past.

We believe BlackRock, which is more of a bet on passive investing, will continue to thrive in a more selective product environment. Organic growth will primarily be driven by the company's iShares platform, and unlike most of the other U.S.-based asset managers, BlackRock should see a slight expansion in operating margins over the next five to 10 years, driven by the increased scale of its ETF business and efficiencies created by technology investments.

As for T. Rowe Price, which is more of a bet on active investing, the firm's above-average investment performance is a huge advantage. While organic growth will be challenged by the ongoing baby boomer retirement phase, we see the firm picking up business in the retail-advised channel the next five to 10 years. The firm should also see less fee and margin compression than its peers given the better fee and performance positioning of its funds.


Phil Gorham: Tobacco valuations have taken a big hit over the last 12 months with large-cap global players Phillip Morris International and British American Tobacco down 30% and 50% respectively. Dividend yields are now at a very attractive range in the high single digits, and although we think dividend growth is likely to slow to the low single digits over the next few years, we do think the the dividends are safe and this represents a buying opportunity for investors. 

Investors have been concerned about two things. First, the more assertive approach by the FDA to regulating the industry with proposed measures including a potential ban of menthol flavorings and even a reduction in nicotine levels. And the other thing investors are concerned about has been the recent weakness in the performance of the heated tobacco category in Japan. Iquos, PMI's popular heated tobacco device, will be making its way to the U.S. soon--perhaps this year--and investors that were hoping that heated tobacco would pick up the slack of falling cigarette consumption have been disappointed by a sudden slowdown and growth of the product in Japan. 

On the regulatory front, the FDA's proposed measures are a risk, but the market has assumed the worst-case scenario, and we think that even in the event of a menthol ban, some smokers would switch to nonmenthol cigarettes as has happened in Canada, since it banned menthol in October 2017. In terms of the heated tobacco category, history tells us that disruptive consumer goods rarely follow a straight line growth path and that adoption happens in stages. Investors are overlooking the fact that products coming in the pipeline, including a disposable version of Iquos, could solve some of the issues with first generation devices that have not, so far, appealed to the late adopters in the market. If this happens, we think revenue, earnings, and of course, dividends, can grow for longer than is currently being priced into the stocks.


Christine Benz: Hi, I'm Christine Benz for John C. Bogle passed away on Jan. 16 at the age of 89. Joining me today is Russ Kinnel, Morningstar's director of manager research. He is going to discuss some of the less discussed or even misunderstood aspects of Bogle's legacy.

Russ, thank you so much for being here.

Russ Kinnel: Glad to be here.

Benz: Russ, let's start by talking about indexing. So many people believe that Bogle was a proponent of indexing because he was a believer in the Efficient Markets Hypothesis. Not the case, right?

Kinnel: That's right. He was very much a believer in indexing, but he put out that CMH mattered more than EMH--CMH being the Cost Matters Hypothesis. Essentially his point is that in the aggregate mutual funds are more or less the market and therefore, your returns are going to be the market's returns minus costs. So, even if the market is not that efficient, index funds are going to come out ahead because they have such a huge cost advantage. He also was a believer in low-cost active. If you look at many of Vanguard's big funds when Bogle was there, they are charging just slightly above what index funds are charging, so very low-cost management. Hhe really strongly believed in low-cost active as well. So, for him, it was costs first, passive second.

Benz: We'd often hear him say you get what you don't pay for.

Kinnel: Exactly.

Benz: Another perhaps less understood aspect of Bogle's legacy is that he was single-mindedly devoted to index funds, that there weren't other aspects of the asset management industry that he thought could be better. Let's talk about that. What were some of his other passionate pursuits within the asset management industry?

Kinnel: Well, another aspect of Vanguard, of course, was that it was mutually owned by fund holders, and as he said, that meant they served one master. He viewed other fund companies as serving two; they may be publicly traded and therefore, served their shareholders but also fundholders and of course, that means you have to make compromises along the way. So, Bogle very strongly believed in people being fiduciaries every step of the way and really focusing on clients. And of course, that also meant he believed that intermediaries, advisors, and planners should be solely serving investors' best interest, not merely being sales people who kind of looked out for investors but also looked out for their own profits.

Benz: And he certainly was a vocal part of the debate about a fiduciary standard for financial advisors.

Kinnel: Very much.

Benz: Another thing that you said is maybe a little bit less understood is the fact that Vanguard wasn't always the giant that we know it to be today. Now we know it to be one of the very largest asset managers but didn't necessarily obviously start that way and even wasn't that way in the '90s.

Kinnel: That's right. In the '90s it was--most of the time in the 90s--it was the second or third largest fund company. I think it really was a big difference not just in terms of their size but also in terms of the debate out there that before ETFs really became popular, Vanguard, and to a degree DFA I guess, were out there talking about passive investing. But everyone else had a job of selling against it. There weren't really a lot of other places to go for passive investments. And so, the dominant voice out there was for active. When ETFs became big all of a sudden, there were a lot of people out there who could make money selling ETFs, and the debate changed and you had a lot more vocal advocates of passive investing. But it was a long time from Vanguard's founding in the '70s to becoming the dominant player in the 2000s. It really took Bogle's perseverance to get it there.

Benz: Another aspect of Bogle's legacy that perhaps hasn't been so discussed, as we've talked so much about his impact on the industry, has been his impact on individual investors, people like us. Let's talk about that.

Kinnel: You really saw it on Twitter, other social media when Bogle passed away, so many people talked about their experience meeting with him and how it was a highlight of their career. We had that experience, too. He would come visit our office, tell us how important Morningstar is. He would really get us motivated, get analysts here motivated because he was really an evangelist. So many of the people we talk to in the financial industry, even if they are smart and care about investors, they are also selling something. Bogle wasn't really selling something so much as he was selling the idea of supporting investors, doing everything for investors, doing the right thing even when no one is looking. I think it really is a tremendous motivator. I think that's part of why Vanguard's culture became so strong was that Bogle wasn't just someone promoting indexing. He was someone who really believed in doing the right thing for investors across the board.

Benz: Such important points, Russ. He was a giant. Thank you so much for being here to share your perspective.

Kinnel: You're welcome.

Benz: Thanks for watching. I'm Christine Benz for


Christine Benz: Hi, I’m Christine Benz for

No matter your life stage, streamlining the holdings in your portfolio is a worthwhile goal. You'll have fewer holdings to monitor and that will allow you to focus on really important issues like your asset allocation and whether you're on track to meet your financial goals.

I have a couple of tips for streamlining. The first is to start at the account level, merging small straggler accounts into a single larger account. For example, old 401(k) assets and smaller IRAs can be rolled over into a single large IRA in your name.

Another key way to streamline is to use total market index funds as the core building blocks for your portfolio. You can find total U.S. stock, international stock, and bond funds. Such funds should be very inexpensive, and they make it easy to monitor your portfolio's asset allocation. They are usually quite tax-efficient, too.

If you've devoted the bulk of your portfolio to inexpensive total market index funds, that means that more specialized holdings--like sector funds, style-specific funds, or region-specific holdings--probably will be redundant. These types of holdings can also add to your portfolio's costs.

As you cull holdings from your portfolio, just take care to factor in the tax costs of selling. You won't owe any taxes if you make changes to your tax-sheltered accounts, but selling from a taxable account can entail tax costs.

Thanks for watching; I’m Christine Benz for 


Christine Benz: Hi, I'm Christine Benz for

Your portfolio's mix of stocks and bonds will have a huge impact on how it behaves, but for many investors, setting a portfolio's asset allocation seems like a wild guess. And in some ways it is; we don't know what stocks, especially, will return. We only have long-term market history to go on. But investors can get themselves into the right ballpark for their stock/bond mix by thinking about risk tolerance and risk capacity. 

You can determine your risk capacity by thinking through your proximity to spending your money. If you have a long time horizon until you'll begin spending, you can afford to be in higher-return, higher-volatility assets like stocks. But if you're going to begin spending soon, you'll want to hold at least some of your portfolio in lower-volatility assets like cash and bonds.

Risk tolerance relates to your ability to psychologically withstand the fluctuations in your investments and your whole portfolio. Even if a portfolio is in line with your risk capacity, it's not a good asset allocation if it keeps you up at night or if you retreat to more conservative holdings at an inopportune time.

Both concepts are equally important in setting your asset allocation, so you need to balance them against one another.

Thanks for watching; I'm Christine Benz for