Où trouver de la valeur dans des marchés qui ont bien progressé ?

Dans cette série d'entretiens, Jeremy Glaser a interrogé les experts de Morningstar pour qu'ils partagent leurs vues sur les marchés aujourd'hui.

Jeremy Glaser 17.07.2014
Facebook Twitter LinkedIn

L'intégralité de l'entretien est en anglais. Ci-jointe la retranscription des entretiens conduits par Jeremy Glaser de Morningstar.


Jeremy Glaser: For Morningstar, I’m Jeremy Glaser. The first half of 2014 did not turn out quite as many investors had expected. Going into the year there were hopes that growth was ready to take off, thoughts that interest rates were almost certain to rise, and an expectation that stocks might take a bit of a breather after 2013’s big gains.

However, in reality the cold weather put a chill on economic growth, interest rates actually fell, and stocks continued to rally to new record highs.

This has created a vexing problem for investors. With stocks looking overvalued, bonds potentially at risk from rising rates, and with cash providing zero return, investors just don’t know what to do with their money.

To shed some light on what is happening in the markets and the broader economy, where investors can find value today, and how fund managers are handling this environment, we spoke to several Morningstar experts.

First up was Bob Johnson, our director of economic analysis. We asked him how the economy has performed so far in 2014 and if it has led him to change his forecast.

Bob Johnson: Starting the year, my forecast was 2%- 2.5% [for GDP growth], the same forecast I have had for the last three years, and I'm still sticking with that. But it will be at the low end of that range. We obviously had a disappointing first quarter that was actually down 2.9%, which will make it hard to get to the 2.5% growth, but it could still happen. But I really do still think we'll get 2%. I think there will be some inventory-adjustment things that come through and some improvements that we are already seeing in the second quarter. I really do think we'll be able to get to the 2% growth. But now that's kind of the top limit of where we can be, and not the 2.5%. It's a small change.

Glaser: What's driving some of this underperformance? Is it weather-related? Is it just timing, or are there some real fundamental influences?

Johnson: There are two things. Obviously housing has been a little bit fundamentally weak which has kind of impacted a lot of things across the board. But really the big negative number was probably very much related to weather and uncertainty relative to the Affordable Care Act and exactly how that would fit in the numbers scheme in the year ahead.

Glaser: Looking across as major drivers, what has surprised you the most in terms of the upside?

Johnson: Absolutely by far is that manufacturing is doing very well and has now for kind of three, four months in a row. And again the sad news is it's not a bigger part of the U.S. economy; [it accounts for less than] 10% of U.S. employment. So it's not that big a sector. On the other hand it's really done well, as the auto industry has kind of come back from the middle of the winter when things looked so bad. The industry really kept production up, and I was very scared about that for a while.

Now we've had a strong spring selling season in autos and the manufacturing now looks justified. And I think probably Boeing is doing pretty well, and just kind of a broader range of the manufacturing industry is finally beginning to do a little better. Maybe a little bit more [production is returning to the U.S.] and so forth. So we've had some nice manufacturing numbers. That's the nice upside surprise.

Probably the big downside was housing, as I've alluded to before, in the first quarter as in the fourth quarter. It was actually detraction from the GDP calculation, which hasn't happened for long, long time.

So it's good to see that it's finally looking, in the last few weeks' worth of data, that housing has kind of the turned the corner again. And I am not worried housing will get back, but it may not be as totally robust as we all thought it might be.

Glaser: Consumers are obviously a big part of that pie. In terms of GDP what does consumer spending looks like. Are people scared?

Johnson: They are not. We've had a couple of bad numbers here and there, but when you look at three months averaged together and appearing year over year, you can lay a ruler down. It's been 2% [growth in consumer spending] for the last three years, and that number continues. The consumer seems to have a rock-solid number that they kind of want to spend toward when gasoline prices go up or something and then they cut back in something else, or maybe they dip into savings a little bit. And then when times get good, they restock the savings a little bit. But really they've done a very good job of smoothing their consumption numbers.

Incomes have been a little bit more volatile because of inflation. But on the other hand the consumption number has really been solid, and I feel very good that it will stay in that range.

Glaser: Let's dive into inflation a little bit then. Are you worried that we are at the beginning of a big uptick in prices, or are things going to stay stable.

Johnson: I think we are going to be in a relatively narrow range. I think we have a few things going on. I think some of the commodity issues are pushing inflation up in the short run. We've got a drought in Texas, which has hurt cattle in the past several years, so beef prices are at a new record high. We've had droughts in California which are affecting fruits, vegetables, and eventually, this fall, nuts. So those will be impacted. And then we've got droughts in Brazil which are affecting coffee prices.

So you've got this trifecta things that are affecting food prices. Then there are the problems in Ukraine, and then you pile in the Iraq situation, and now you've got a situation where you've got oil prices higher than we thought they were going to be. We thought they might come in a little bit with the greater discoveries here in the U.S., but, no, that doesn't appear to be the case right now. So that's pushed oil prices up.

If there is one thing that changed in my forecast; I was saying 1.5% to 1.8% in terms of inflation. Now it looks like the numbers will be 1.8% to 2.0% for inflation this year. That's probably even a little bit optimistic; that assumes that maybe some of the things settle down in Iraq just a little bit.

Glaser: One region that would probably like a little bit more inflation is Europe and the European Central Bank has been acting to counteract that a bit. But what's your take on the European economy generally, and do you think the ECB's moves are going to be enough to jump-start the eurozone.

Johnson: It depends we'll have to see if people really take the bait. The key things that the ECB has done so far are to encourage banks to lend, and so far the lending rates in Europe just haven't gone up all that much. Given that bank lending's a key part of their economy--it's little less so here in United States. Here we've got a bond market, a stock market, and all sorts of different ways that money can get into the system. But in Europe the banks are your main deal, and unfortunately the amount of money being lent out there hasn't gone up that much yet. We are going to have to see how effective these programs are to encourage banks to lend because these banks are scared; they've get new credit requirements.

Even though they are being encouraged by the ECB to lend, on the other hand they are kind of taking it back and saying per new capital requirements if [a bank] lends more money to, say, for example [a struggling country like] Spain or something, then maybe it's going to count against [the bank] a little bit.

I am not so sure [the current ECB policies are] the final answer, and I think that eventually you may see more direct quantitative easing being more effective than the bank lending programs.

Glaser: Do you see growth in Europe picking up at all, or is it still kind of a challenging environment.

Johnson: It's a challenging environment, and I think their demographics are worse than the U.S. I always think our demographics in the U.S. lead to about 2% to 2.5% of long-term growth; not just my short-term forecast but over the next 10 years. I think because of European demographics I'd have to argue that whatever our numbers are, European numbers will be slightly less because their fertility rate is lower and the immigration rates are lower. So those will tend to hold back the European situation.

I think they'll be a little slow for a while in Europe. I think they are doing some admirable restructuring. I've seen some data recently from our team out of Europe that suggest in some of the peripheral countries that wage inflation has come way back down and they are doing a decent job of adjusting.

So I'm feeling a little better about the European situation, but certainly, as you mentioned, inflation has not been nearly as high as people would like it to be. It's still about 0.5% year over year. In the U.S., as I mentioned it's over 2%. So it's really running quite a bit less in Europe right now.

Glaser: It sounds like the ECB is certainly being more accommodative at the same time the Bank of Japan is expanding its monetary base very aggressively. Do you think that this is one of the reasons why Treasury rates have actually come up so far this year even against the backdrop of the Fed taper.

Johnson: There is probably three different things going on in operation here. One is by the just competitive rates, by the fact that Europe and Japan have lowered their rates, all of a sudden U.S. interest rates look very attractive to some folks. You get a Spanish bond that trades for a lower yield than a U.S. bond in some cases, and people are saying, "Wait now that doesn't make any sense." And so people are kind of saying, "Maybe I'll go buy the U.S. bonds." And that's kind of depressed the rates a little bit. Now I did talk about the variable inflation rate a little earlier, so maybe [U.S. bonds are] not quite the bargain that some of the bond traders think.

The second is a situation, just technically, everybody was just so assured [that the U.S. Treasury yield would decrease]. I don't think I found a single forecast at the beginning of the year saying that the U.S. 10-year Treasury would go down from about the 3% that it was at the beginning of the year. I don't think there was a single forecast suggesting that it'll go down. So a lot of bond houses, a lot of investment banks, and a lot of investors positioned their whole portfolios on this concept that rates were going up. And then they didn't [go up]. Now it gets a little bit more painful each and every day [for these investors], especially for anybody who has any leverage in that bet. I think we're probably seeing some of capitulation, maybe [rates will] still go a little bit lower here, but you certainly got that situation going on.

The third is kind of a longer-term dynamic that I've been focusing on for a long time. It's that the long-term supply and demand for [financial capital] is really kind of changing. I think so many of the businesses that are growing fast today are actually cash generators, unlike 50 years when General Motors grew. The faster they grew, the more capital they needed, and the firm was just an intense eater of capital.

Now, something like a Google or a Facebook, as they grow faster, they generate more cash that sits in the bank. That certainly means a little less corporate demand for money. We've talked about mortgages several times, that more homes are being purchased for cash or by investors. So, there is less need for mortgages in the economy, so that's another huge demand for capital that's continued to move down.

Then on the other side of the equation, people who buy bonds, we've got more and more baby boomers who say, "I can't take another 50% [loss in stocks as seen during the financial crisis]. Yes, [bonds offer a worse potential] rate of return [compared with stocks]. Yes, maybe I'll lose 5% or 10% if bond rates go back up. But at this point in my life I cannot tolerate another 50% decline." So that's increased the demand for bonds.

That's a longer-term issue and not just here today and tomorrow. So, those are the things, I think, that have really surprised people and why rates are lower than I would have thought at the beginning of the year. My forecast was that we'd be up to 3.5% by the end of the year on the 10-year treasury, which looks like kind of an outlier forecast right now, but I'm sticking with it.

Glaser: Is there anything that can knock the Fed off its current path then? Is there anything they're seeing in the economy that could have to rethink the pace of the taper?

Johnson: It changed the Fed's mind. There are a few things that are going on with the Fed. I think with the tapering program, there were a number of people in the Federal Open Market Committee that were very, very uncomfortable about [the quantitative easing] program. I think that those people are continuing to say, "[QE] was an emergency measure. This is wrong. Our charter is to adjust short-term rates, let the rest fall where it may, and we shouldn't be in the business of buying huge percentages of the mortgage-bond securities out there."

I think that, almost no matter what, tapering goes away. The bigger issue is kind of what happens with rates next year and how soon does the Fed begin moving short-term interest rates back up. The consensus is kind of mid-year 2015 as the point for that.

And I think, again, if inflation continues to worsen--I mentioned it's 2% year over year, and a lot of that is food prices--but if we saw a generalized increase in inflation, I think the Fed could step in just a little bit sooner [and raise rates] if need be. So, higher inflation rates, especially in wages, might be one thing that would encourage them to step in sooner.

On the other hand, if the economy falls apart here, which I don't think it is, but if it did, certainly the Fed would have to reconsider how long they keep [the current bond-buying program] in place, and they will do what it takes. Everybody says we'll have to see what the Fed does. Well, you know what? You really have to know what the economy does because the Fed will just follow what that does to make their decision.

Glaser: So most investors, you think, are too focused on Fed actions, and instead they should be more focused on the real fundamentals?

Johnson: Absolutely.

Glaser: One of the other impacts of the tapering program were on the emerging markets, and particularly last year we saw some big currency and bond movements. What do the emerging markets look like so far in 2014, both from fundamental level, and also what has the market performance looked like?

Johnson: The market performance has been a little better. I mean, emerging-markets bonds in the first quarter were the absolutely the best-performing asset class that was out there. So, clearly as interest rates came down and the taper tantrum was over, some funds actually flowed back to emerging markets. Those bonds and those stock markets did a little bit better. We were all worried about what was going to happen in the first quarter with emerging-market stocks, and they probably did as close as to as well as the U.S. stocks did. So, certainly, there was not a big impact there.

Now the economies are a still a little bit dicey. I think for China, if anything, everybody thinks it is growing a little bit slower. [The Chinese government has] actually taken some measures right now to kind of speed up their economy to make sure it kind of stays in that 7%-7.5% band for economic growth. Certainly we have seen some slowing in emerging-markets fundamentals.

Glaser: If you are a U.S.-based investor, what kind of impact will, say, a slowing China have on the U.S. economy and potentially have on the U.S. stock market?

Johnson: I think certainly the thing that I always remind people of is that China [constitutes] only 1% of U.S. exports. As an economist, I can say that if China slows, it's actually probably good news for the U.S. economy as long as it doesn't get out of hand. This is because one of the things that hurts is when China's demand is strong. It pushes up a bunch of commodities prices, it pushes up food prices, it pushes up oil prices, and that's not a good thing for the U.S. consumer. And for the little bit of stuff that we shift directly to China, it is probably not worth the extra growth.

Now, it is not the same question for S&P 500 companies, which do sell a lot into China. But most of that stuff is manufactured somewhere in other emerging markets, or in Europe, or maybe just a little bit out of the U.S. But most of the benefit the S&P 500 companies are getting from selling into China is benefiting other countries, not the U.S. So you got to separate the economy and U.S. jobs from S&P 500 companies.

Glaser: What do you think one of the big surprises will be on the economic front in the coming year?

Johnson: I think the biggest one probably will be that I think the U.S. economy, in particular--but maybe even some other markets too--will be facing labor market shortages in the year ahead. We've talked so much and the Fed has gotten so focused on the unemployment rate, but I think the real issue in the year ahead is going to be a shortage of workers. And you're already seeing it in a number of industries. The trucking guys all the time are talking about the average age of a truck driver is 55, and it's very hard to hire and maintain workers. It's actually benefiting some of the larger trucking companies because they can control people and have a greater recruiting effort. So, you are seeing that.

Airlines and pilots are noting there have been a lot of retirements, and it's very hard for the regional airlines to staff their forces.

Anybody in manufacturing would tell you if you needed a skilled craftsman that those are hard to find. Even in homebuilding, even things like putting up wallboard and so forth, there is a shortage of people that can do that and do that well, quickly and inexpensively.

Actually in select markets, we've already seen some shortages, and I think there is going to be more in the year ahead. I think we're approaching a situation now where we've seen the working-age population--those people that are between 22 and 62--is actually going to decline starting next year for the first time than we've seen in a long, long time. We were adding as many as a million people a year in that category at the beginning of the 2000s, and now like I say, we're actually going to start shrinking that number between 22 and 62, the typical working-age population.

So I think we're going to be actually talking about working shortage when we sit down here at this meeting a year from now.

Glaser: Even if labor markets continue to improve, the U.S. looks set to experience pretty slow growth in the years to come.

So what does this mean for equities? Do fundamentals justify today's valuations? Or are stocks simply too expensive.

I asked Mike Holt, our global director of equity and corporate credit research, where he sees valuation levels today.

Mike Holt: Right now, we see our stock coverage universe as being about 4% overvalued, but it's important to understand how we got there. It's not just some magic number that we pull out of a hat. We do all our research at the company level and the security level. So for every company in our coverage universe, we're saying, "What is our estimate of the intrinsic value of that firm, and how does the market price relate to that?" So you get a ratio. If it's slightly overvalued, it might be 1.05; if it's slightly undervalued, it might be 0.95. But what we do is we take all those companies and aggregate them up, and then we look at the median company. And that's where we get that 4% overvalue for the median company in our universe right now.

Glaser: It doesn't seem like a huge amount of overvaluation. Is that vastly different from where we were about a year ago, or how has that changed?

Holt: I would say, it's up about 4%. So, about a year ago, we were seeing things as pretty much fairly valued, and if you go back longer during the last 10-12 years, you'd see it get as high as 15%-20% overvalued--that might be the max--and it might be as low as 25%-30% undervalued.

Glaser: How even is this? When you look across sectors, do some sectors look like they're much more overvalued than others?

Holt: I think it's actually really interesting to start at that market level and then go a layer deeper at the sector level, the geography level, and also the quality level. At the sector level, you see a pretty wide divergence. So, at the top you'll see sectors like utilities and tech being at 9% or 10% overvalued. Meanwhile, you'll see the basic materials and energy sectors being right at the fairly valued mark.

Glaser: There are some divisions there. You mentioned geographies. What parts of the world are looking a little bit more attractive comparatively?

Holt: If we think our coverage universe is about 4% overvalued, in the U.S. we're actually seeing the market is about 6% overvalued. Europe's about right at our market average at 4%, and then Asia-Pacific looks a little more attractive at kind of that fairly valued mark.

Glaser: In terms of quality, when you look at higher-quality companies, do those seem to be trading at a premium to lower-quality ones?

Holt: They actually are at a better value right now, which is interesting and not something we typically see. But if you look at the U.S. market, our coverage in the U.S., you'll see no-moat firms trading at about a 9% premium to what we think they're worth, whereas if you take wide-moat companies they're trading at kind of at that fairly valued to maybe 2% overvalued mark.

Glaser: Generally speaking, there still are some values out there, or is it really just very difficult to find places to invest right now?

Holt: Well my takeaway from this is that, on average, many stocks are overvalued. So, what that means is you have to really do your homework. You have to look harder. You have to really understand and do your homework to find those values, but they're out there, absolutely.

Glaser: But just how many values are there among these wide-moat firms? Morningstar equity strategist Mike Hodel says that nothing looks dirt-cheap, but he does think there a few ideas that long-term investors should consider.

Mike Hodel: Everything is relative. Wide-moat names may be somewhat more attractively valued than no-moat names, but we still don't see a ton of screaming bargains in the wide-moat segment of our coverage universe. We don't have any 5-star wide-moat stocks currently, for example.

But we do see a number of names that have underperformed recently because of issues that we don't think have an impact on the firm's long-term competitive positions. And this creates opportunities we think for long-term value-oriented investors.

One of the names that we think looks really attractive right now is eBay. eBay has had a number of issues come up recently with a data breach that they announced in May. They had some issues with Google Search results that shifted the ranking of eBay's webpages somewhat. They've had an executive departure. And you had Amazon launch a payments platform that competes with eBay's PayPal service. We don't think any of these issues necessarily has a huge impact on the eBay over the long term.

Even in combination, we don't think there's much of an issue here with the firm's long-term competitive positioning. But the stock has been weak on this sort of a series of bad news. The company is trading right now at around 85% of our fair value estimate, which, in the grand scheme of things, relative to the market overall, looks pretty attractive. And we think eBay is a classic network-effect business. That network effect remains solidly in place. And we think the market's pricing of the stock currently undervalues the technologies that eBay has at its disposal.

Similarly, Core Labs, it's a firm that is in the oil and gas services business. They manage well production for oil and gas exploration companies. They've had a string of disappointing results also. Earlier in the year, expectations were very high for Core Labs; the stock was flying high, hitting all-time highs. Since then, because of project timing, they've had to lower expectations for 2014 revenue a couple of times, which clearly has caused investors to flee the stock. Core Labs currently trades at about 85% of our fair value estimate, which, again, in this market looks pretty attractive.

Glaser: Another way to find values in this environment is to look for a trend that the broader market is underappreciating but that is having a major impact on the competitive landscape.

I spoke to our director of consumer equity research, Adam Fleck, about how the rise of online commerce is creating new opportunities in that space.

Adam Fleck: If you look at the overall e-commerce space in the U.S. it's now about 6% of total retail sales, so it’s a growing number. It continues to grow at a very rapid clip, in the double digits; [it grew] 15% in the first quarter. And we see some industries more susceptible to the online threat than others. Generally those that are more commodifized products don't have a high-value, in-store type of service need or where consumers don't have an immediate need for the product, think apparel or books. These are areas that are going to be more susceptible and their moats are going to be more under threat from the online space.

Glaser: What firms in those areas do you think really look like no-moat firms and you are seeing a lot of deterioration there?

Fleck: If you look at many of the retailers, even a company like say William Sonoma, which is one of the higher-quality retailers in our space, or Bed Bath & Beyond, these are very high-quality strong operators within the consumer space, but nonetheless don't have a moat in our opinion because of the threat of online.

William Sonoma has done a nice job building their own online channel and certainly most competitors are trying to do that, but there are still very few switching costs in their core Williams kitchenware.

Glaser: Looking at those online firms, have they really been able to make money from this? Are they just kind of selling things at cut-rate prices, or are they actually getting good returns on invested capital?

Fleck: If you look at Amazon, we think it has a wide economic moat; the same goes for eBay. These are businesses that are doing very well and, of course, also investing in growth platforms. If you look overall, one of the knocks on Amazon has been that the profitability probably hasn't been what it should be and they don't seem concerned on growing a profitability. We think they actually will. If you look in North America, their operating margins are pretty strong. They continue to return that into new core investment areas like the Kindle, like the Fire TV. We think those are interesting areas to continue to build the moat, grow the overall ecosystem, and as we saw with the Prime membership price increase, try to monetize that down the road once you've captured those consumers.

Glaser: The fact that people are shopping online is not news; it's a big trend for people. Is this already priced into the stocks? Do you really find any value in some of the companies that could benefit from this over time?

Fleck: We actually think Amazon and eBay both are currently slightly undervalued. We have 4-star ratings on both of them. We think the overall market underappreciates Amazon's ability to grow its margin and profitability longer term.

We think the market probably also underappreciates eBay's PayPal business. We think this is a very strong operator; eBay, of course, is known for its marketplace. But we think most of the value in that company is in its PayPal business.

Glaser: It sounds like for some of these other retailers, investors need to exercise quite a bit of caution?

Fleck: That's true, especially those that are more susceptible to the online space. We actually do see value in retailers where we think there's a bit of a misperception. Some areas are naturally less susceptible to online. We think about home-improvement stores where there is a lot of value to be added from the expert network within the store, or off-price retailers like TJX that constantly turns over its inventory and draws consumers in that way, or even Dick's Sporting Goods, where the touch and feel of the sporting equipment is an important decision factor in many consumers' eyes.

We think these are areas that naturally lend themselves to hold off the e-commerce threat a little better, Companies like Kingfisher in Great Britain, and TJX and Dick's Sporting Goods, these are also 4-star names that we think look attractive right now.

Glaser: Mike Holt thanks that investors need to understand the full impact that the U.S. energy boom is having.

Holt: We've had a major energy boom in the U.S. We've got the Marcellus Shale; we've got the fracking that everybody has heard about. But what this really means is, there's a ton of natural gas that's being pulled out of the ground and put into the market. And at 70 billion cubic feet a day, that's actually more than anybody knows what to do with today, and that has sent the prices of the companies that produce this gas tumbling.

Now, we actually think that this situation will resolve itself over the next couple of years, and what I mean by that is, you've got to find a steady state for a natural gas production that incentivizes people to continue pulling it out of the ground, but also incentivizes demand. We're looking at natural gas prices to settle in at $5 to $5.40 per Mcf in the long run, and if you look back the last couple of years, it's dipped all the way to below $2.

Now, that recovery has occurred somewhat already partially due to the very cold winter we had, but it's still a long journey ahead. And I think the market hasn't really rallied around this concept that natural gas will have a sustainable price where these exploration and production companies can produce at a profitable level.

Glaser: What's a firm that you think is going to benefit from these higher natural gas prices?

Holt: I think one firm that's really on our radar is Ultra Petroleum; and what this comes down to is, we're in the middle of an energy boom. There's a lot of natural gas that's being brought to market and actually more than anybody knows what to do with right now. So, that has sent natural gas prices tumbling. They're starting to recover, but they're still not in that $5 to $6 range that we think is sustainable. And that sweet spot of sustainable prices is really where you're seeing incentives to keep producing natural gas, but you're not seeing demand destruction where if prices get too high, people don't want to use it.

So, there are a lot of ways for the story to play out, a lot of ways for natural gas pricing to go higher. First, would be exports on the demand side. Second, would be the amount of investment going into industrials. So, a lot of businesses are saying, "Oh, cheap natural gas. That's great." There's something like $100 billion going into the industrial complex around the Gulf Coast. And there's also power generation; so, people are switching over from coal and other more costly sources of power generation.

Then on the supply side, you're seeing that people have to keep drilling. We're at 70 billion cubic feet [of natural gas production] a day right now in the U.S. If we stop drilling, that would fall dramatically even in the first year. So, there's a lot of forces that work here. There are a lot of ways for this story to play out, and a lot of ways to win on the natural gas thesis.

Glaser: Why Ultra in particular?

Holt: We think with Ultra that the market isn't pricing in a very optimistic scenario around natural gas. So it's trading at about a 25% discount to our fair value estimate. And we really like their positioning. It's a very pure-play on natural gas in terms of good acreage, lots of proven reserves, and a good useful life of those reserves. We see a long runway in what they are able to pull out of the ground and what they will be able to sell it for.

Glaser: But of course individuals aren't the only ones dealing with this limited opportunity set. Equity-fund managers are also grappling with stretched valuations. I sat down with Russ Kinnel, our director of manager research and also the editor of Morningstar FundInvestor newsletter, to see how managers are coping.

Russ Kinnel: There is definitely muted enthusiasm; I guess that's the nicest way to put it. Managers are just not very enthusiastic. Most of them are continuing to buy. They are still saying, "We find some values here or there." But by and large, there is not a lot of enthusiasm, I think. It just makes sense five years into a strong bull market that there are not a lot of great bargains out there, and we certainly hear that from most of the managers we talk to.

Glaser: Given how well the market's been doing, have you seen any equity managers who've had some notable outperformance this year, or any of who have really underperformed compared with the market?

Kinnel: Yes. On the outperformance side, Bill Nygren [manager of] Oakmark Select, is doing really well with just kind of a wide variety of names; it's not a particular sector. But when you have a focused fund and two or three of those names hit, it can have really strong performance. So, Nygren is one who is doing really well and has done well in recent years, too.

On the flip side, Royce Low-Priced Stock, run by Whitney George, is doing really well for a change after some years of really terrible performance. And the reason he's doing well is the fund has a lot of materials and energy stocks, which had been getting hit. But they've rebounded this year, and the fund is finally having a good round of performance.

Glaser: What funds have really lagged so far this year?

Kinnel: You know it's interesting. Two funds that have lagged are CGM Focus and PIMCO Total Return. What's interesting is it's the same reason. They both bet against long-term Treasuries. CGM Focus did that much more dramatically so, and so it's had a bottom-percentile performance. PIMCO Total Return is just modestly lagging, but again, Treasuries may be the biggest surprise this year. They've really rallied, particularly at the long end, just when people thought rates were going to back up again. So, that surprised people, and they're kind of wrong-footed, both PIMCO Total Return and CGM Focus.

Glaser: Certainly, you mentioned that people are not very excited about the market. Where are some places where maybe people are finding values, or they do think that there are relatively more attractive stocks?

Kinnel: At [the 2014 Morningstar Investment Conference], I would say emerging markets was maybe the one area cited most often as a place offering some attractive values. The emerging-markets stocks have not kept pace with those in the U.S. or even Europe in the last few years. Many are saying that you've got some good growth prospects and some reasonably priced stocks, albeit with some greater risks and some greater volatility.

Glaser: There are some funds that maybe, because of their mandate, can't hold a lot of cash, but some can. Of those managers that do have the option to be in cash, have you seen people holding on to a lot of dry powder?

Kinnel: Yes, for sure. Funds like Longleaf Partners Small Cap has a lot of cash; IVA Worldwide, Yacktman, FPA Crescent [all are holding onto cash]. So, a lot of the funds that can hold cash are holding large sums of cash for the reflection of, I think, that people do see the market as a little pricey, and the more cautious ones who can hold cash, they see it as particularly pricey. Longleaf has gone so far as to say, feel free to redeem because we really can't find much to buy.

Glaser: That is a good question: If you are an investor, and you see this opportunity set that looks pretty bad, what kind of funds do you think can thrive in this sort of environment? Who are some managers who you think will be able to do a good job?

Kinnel: I think it is a challenging environment, but it's really hard to know where we're going. So I think you still just look for good managers with low costs and just good strategies and hope things work out. I don't think it changes too much except that maybe like the cautious funds such as Franklin Mutual Series funds and IVA Worldwide, though IVA is closed--I think the more cautious strategies naturally have some appeal. FPA Crescent is another one that has some appeal in these times. But I think also just good plain-old stock-pickers, such as Dodge & Cox and Primecap, don't go into cash. If we have a bear market, they're going to get hurt. But they are very good stock-pickers. I think you can also go that way, as well.

Glaser: Looking at fund flows, where are investors putting their money? Are those cautious funds getting a disproportionate share of flows?

Kinnel: No. To the contrary, many times not. It's interesting we saw in May, there were some interesting flow changes. We saw people getting out of equity funds and getting out of bank-loan funds. I'm not sure really why that is because both have performed pretty well. But it's something to keep an eye on. It may just be a blip because it's only one month for equity funds or a couple of months for bank-loan funds that people are bailing on them. But elsewhere, people are showing enthusiasm for emerging markets. I think even though the returns haven't been that good, investors hear the macro story of emerging markets doing better than the developed world, and so, investors are still buying emerging-markets funds oddly enough.

Glaser: Have the flows into any of these categories created an asset-bloat situation? Are any of these funds just getting too big?

Kinnel: Bank loan had been getting a lot of money, and I worry a little bit about that because it's an area with much less liquidity, and it's grown so much that we really don't know how it would behave in a down market for bank-loan funds. There's a lot of credit risk in bank-loan funds, so let's say, we had an economic setback that maybe hurt bank-loan funds. Will people redeem, and if so, will it cause its own downward spiral? It's possible. We just saw a blip in flows out of bank-loan funds, not enough to be an issue, but it's really one area I'm keeping an eye on.

Glaser: On the fixed-income side the debate over when and how fast interest rates are going to rise remained a key question.

I spoke with Eric Jacobson, our co-head of fixed-income manager research about how managers are grappling with this question and also how individuals should think about their bond holdings.

Eric Jacobson: I think there is a little bit of a disconnect between the reasons that people are fearful about rising rates. What many managers and economists believe, not everybody, are the most likely causes that may eventually trigger rising rates. What I mean by that is that there is a lot of focus on how low yields have gotten. And this idea that because they have gotten so low, they have nowhere to go but up, and they are going to go up. And at some point we're going to get a shock, and they are going to soar. On the other side of the table are people who are saying, "Look, that's not going to happen, unless we have an economic situation that demands it--an economic situation that produces growth and inflation, whatever the case may be, enough to scare the market into selling off from an interest-rate perspective."

These are arguments that are going to continue to go on and on because the U.S. is an unusual place compared with how other bond markets work in some ways. But that's kind of how we got to where we are.

Glaser: Rates did in fact fall this year despite the Fed taper, despite some of the other things that that were going on. How did bond managers react to this? Were their portfolios positioned to take advantage for this at all?

Jacobson: I think a few more were than we might have expected back, say, last year because you started to see a little bit of--I don't want to say capitulation, that's really not the right word--but a few more managers being willing to suggest rates may stay low for a while and that they could even fall a little bit.

We didn't see were a lot of bets to that degree. You didn't have a lot of managers saying, "I have a strong conviction. I'm going to take on 6 years of duration in order to play this bet." But you did have, like I said, a few more willing to expect maybe a [drop in rates]. The problem is that because this interest-rate thing is really zeitgeist to the retail bond mutual fund story right now, no manager wants to get caught on the wrong side of it. No one wants to be the outlier that gets hurt when rates spike if everybody else is going to avoid it.

Glaser: For investors who maybe were moving away from fixed income because rates could go up or were worried about duration risk, what should they do now? Should they keep looking at kind of your regular core intermediate-term bond fund?

Jacobson: It's really big conundrum if you are looking at putting money in that you don't have there now. Here is what I would say. I would back up and say, "What does my portfolio look like? Do I have any bonds in it? Do I not? Why wouldn't I?" And if the reason [you don't have bonds] is just that you want to avoid all rising interest-rate trouble, you might want to rethink that because the fact of the matter is, is that your bonds are there to provide a certain amount of insurance. I've said this many times, so it's a little bit of a broken record, but if you go back and look at what happened in the third quarter at 2011 and especially in 2008--when other kinds of assets and pretty much anything that had any risk sold off--Treasuries rallied like crazy because it was a flight to quality.

That's your insurance policy. The idea shouldn't be to protect your entire portfolio from ever losing any money. It should be to have some balance and use that diversification. [It shouldn't matter] if your bonds are a little bit weak. If you only have 10%-15% [in bonds] and the rest of your money is in highly volatile stocks, ideally your stocks go up and your bonds don't do as well. But hopefully, if you have a big risk sell-off in which your equities are getting punished, ideally, you've got some duration and some interest-rate risk in that bond portfolio to act as an insurance policy.

Glaser: How about some alternatives to your standard core bond funds? Bank loans continue to be very popular. What's happening with that asset class?

Jacobson: The issue with bank loans is kind of complicated. Just a handful of years ago it was a little bit of a simpler story because bank loans have these very short resets in terms of their interest rates. What that means is they aren't very sensitive to rising rates or falling rates. In turn they generally have a lot of credit risk. So, that's a pretty good profile, and that's a lot of the reason that people have piled into them. They figure [bank loans will offer] better returns and less interest-rate risk, so what could be wrong with that?

Well, there are two problems. One, is the money has flowed in so strongly and not just from retail investors, but we've also seen a revival in collateralized loan obligations sucking up, if you will, market share of the bank-loan world. So, the yields have gotten very low relative to what they would have been, and as we say the spreads are very tight. In other words, the valuations are very high. So, if you go in to bank loans now, they are kind of priced almost for perfection in the eyes of a lot of people.

There's one other problem which is that, the big portion of this market has been issued with what are called Libor floors. Without getting into too much complexity and down in the weeds, the bottom line is that a lot of these loans will not instantly reset their higher interest rates if and when short-term rates go up. So, if the Fed moves [interest rates up], for example, only by 25 basis points or only even by half a point, these loans' interest rates are not going to go up immediately like they maybe would have in previous periods because of this so-called Libor floor. That's another reason why they are not the perfect solution that people I think expect them to be.

Glaser: What about things like unconstrained bond or these go-anywhere bond funds? Where are those managers been looking, who have these broader mandates? What are they finding attractive?

Jacobson: Another area that we've talked a lot about before, the biggest issue there is when you take out the rate sensitivity of the portfolio, which is really what they've been doing. They've sold these things on the basis of the idea that they have massive flexibility to bring duration negative or take it very, very long. In practice, they've just been keeping duration mostly pretty low because they are trying to stay away from that rate volatility.

Without that interest-rate sensitivity as a consistent lever of returns over time, these managers have to do something else. As you said, where are the other opportunities? There aren't a lot because valuations are very tight on anything that has yield.

However, most of these funds have taken on a lot more credit risk than any kind of interest-rate risk. So one of the stats that's very interesting to look at is the average intermediate-term bond fund--which is the core world--has about 11% in below-investment-grade debt as of the last time we'd looked. If you go look at the nontraditional or unconstrained strategies, we're talking about 36% on average. It's not a disaster. I'm not raising a red flag and saying everybody needs to get out of there. People need to understand they're taking on a lot more credit risk usually in those unconstrained strategies than they would've with their core fund.

Glaser: If you are looking to have that insurance policy, those unconstrained funds may not really perform like that; that credit risk could come to bite you if the equity market sells off.

Jacobson: Right, as long as you understand that you're going to be much more highly correlated to equities, as you just said, there's a different kind of risk. If you go look at the correlations, these things are great in the sense of they don't have very much interest-rate risk, but you're getting rid of one risk and taking on the other.

Glaser: So, there's no free lunch there.

Jacobson: That's exactly right.

Glaser: We've had a pretty benign interest-rate type of environment this year with the rates continuing to go down; it still seems that rates are likely to rise eventually. Do investors need to be still thinking about that--even if it's not going to be in the next year or the next two year--that rates will really start to come up significantly.

Jacobson: The way I look at it is this. First of all, as I said before, interest rates go, for the most part, with the economy. So if you think that the economy's going to be sluggish and just chugging along, you probably don't want to believe that interest rates are likely to shoot up because there has to be a catalyst, and that's usually the big one to watch out for. That said, yes, rates are very, very low. That risk is there. The biggest thing is, how much will they go up and over what period of time, to the degree that it's a relatively slow process and even with some spikes in the way, but, if we're talking about over a handful of years, as those rates go up, more income comes into the portfolios.

If you go back and look at the interest-rate shocks that we've had over the last many, many years, most of them in hindsight haven't been these big severe double-digit losses that people are used to seeing with their stocks. So, I think some perspective there is probably needed, and, again, the big question goes back to, do you want or do you not want to have that insurance policy in your portfolio?

Glaser: On the municipal-bond side, there's still a lot of discussion about things like the Detroit bankruptcy or with Puerto Rican bonds continuing to be on investors' minds. How should people think about muni bonds and when they might make sense or not make sense versus those core taxable-bond categories?

Jacobson: I think the most obvious determinant that most people try to go by is how much of a tax advantage do you pick up? And if you're in very high tax brackets and depending on where you live, it may make a lot of sense to lean pretty heavily toward munis. You do want to, of course, remember that it's a narrower market in the sense of higher quality. Not that you'd want to go down too far in quality, but you can't pick up as much yield unless you go into what may be really risky, what we call nonrated bonds, a lot of smaller projects and things that aren't widely followed. It could be kind of risky. But the bottom line is, if you're paying enough taxes, then it's probably worth it.

The next issue, though, is you've got to sift. As you've said, you've got Puerto Rico, you've got Detroit. There are a handful of big issuers out there, such as [the city of] Chicago and [the state of] Illinois, where you've got these underlying pension-obligation risks especially that make them a little dangerous. There is always an ongoing debate about individual bonds versus funds. Certainly, we can go round and round on that. I'm a big believer in funds because of the professional research, as long as you're not overpaying. If you're hiring a manager to do all that work for you at a relatively low cost, it's a pretty good idea to help you avoid those land mines.

Glaser: If you do look at your portfolio and decide that you really do need this insurance, whether it be core bond funds or maybe munis depending on your tax bracket, what managers are doing a good job right now? What are some funds investors might want to take a closer look at?

Jacobson: On the municipals side, we've always been a big fan of Fidelity and the way that they run their research operation and their municipal research especially. They haven't been as impressive on the upside as they maybe were a couple of years ago. There are a lot of reasons for that. They've been a little bit more careful and conservative than a lot of other shops, but overall, that's a firm you really can't lose with in almost any of their municipal funds.

As far as the taxable universe, a lot of the old standbys are still pretty good to keep an eye on. I think Dodge & Cox is a very good firm. We always have liked the Metropolitan West, which is TCW now. We still like what PIMCO has to offer. There are lots of reasons to sort of take a look and ask, "Do I understand what's going on here and so forth?" But [PIMCO manager] Bill Gross and that team that he has are still very, very solid. So our favorites haven't really changed that much over the years. But again, it's about that core exposure. You don't necessarily want to give it up.

Glaser: Interest rates weren't the only thing on fixed-income investors' minds so far this year. The high-profile departure of Mohamed El-Erian from PIMCO was also a hot topic of conversation.

Jacobson: I don't want to say that PIMCO is an exceptional child necessarily, but I will point out that over the years they have had turnover. It hasn't been massive. I think there's an impression that it has been, but to the degree that they've had that turnover, they've almost always had other managers waiting in the wings who were just spectacular and able to step up, fill their shoes, and be great.

I'm not saying that that's exactly what we're dealing with here. It's a little bit more complex with what went on this year. But by and large, PIMCO has got a very, very deep bench. There are other reasons that you may or may not want to choose PIMCO depending on the kinds of bets you want to take. The core funds like Total Return don't take on a lot of corporate-bond risk for example. [The strategy is] much more driven by macro-caused, yield-curve, et cetera. And so a lot of people blend it. They maybe take some PIMCO Total Return. Maybe they own some TCW. Western Asset Management is another one that I didn't mention earlier. There are ways to combine them.

But as far as PIMCO goes, I think that it's always something that you want to watch in terms of manager turnover. And I think a lot of times, it depends on the size of the firm, too, and again, what those backup resources are. At a smaller firm, naturally certain kinds of turnover are going to raise a much bigger red flag.

Glaser: Russ Kinnel also shared his thoughts on some other high-profile manager departures that happened so far in 2014.

Kinnel: To me the next headline would be Brian Rogers leaving T. Rowe Price Equity Income. He announced it well in advance. He is leaving October 2015, so we have a long runup, but even so that will be 30 years [of Rogers at the company]. And he's done a great job. He's going to be replaced by John Linehan who's done a pretty good job at T. Rowe Price Value up until '09, and then he took a more senior oversight role. Now he's coming back to portfolio management. But we've downgraded the fund to Bronze just because Linehan's record obviously does not match Rogers'. So I think that's one worth noting.

At Third Avenue Value, I thought was interesting that Ian Lapey is gone, replaced by Chip Rewey III. Chip doesn't have much of a record. He has about a seven-year record, but he was only one of six managers, so we don't have that much to go on. We lowered that fund's Analyst Rating to Neutral.

The last one I'd mention, Ivy Asset Strategy, where Ryan Caldwell is leaving. We lowered our Analyst Rating on that fund to Neutral. Caldwell was a key contributor to the fund, so that is why we have it at Neutral. Originally when his departure was announced, they said he was going to another company, but they would use him as a consultant to keep contributing to the fund, which we thought was a really unusual arrangement. I think [that would've created] all sorts of potential conflicts of interest and compliance problems, and that's probably why they then changed gears and said, "We're just cutting ties, and he won't be a consultant."

So, on the one hand, you lose a good manager who is contributing. On the other hand, it seems a lot cleaner to me.

Glaser: Clearly this is a challenging time for investors. But as we've heard from our Morningstar experts that doesn't mean it is time to panic. Stocks may be somewhat overvalued, but there are still pockets of opportunity. Fixed-income may deserve a place in your portfolio even in a rising-rate environment. And the economy may not be firing on all cylinders, but it is moving in the right direction.

Investors with a long-term time horizon and the right plan can still prosper.

For Morningstar, I’m Jeremy Glaser. Thanks for watching.


Facebook Twitter LinkedIn

A propos de l'auteur

Jeremy Glaser  Jeremy Glaser is the Markets Editor for Morningstar.com.