28 Undervalued Stocks

Karen Wallace
04 Apr 2018

Following 2017's spectacular 22% gain, the Morningstar Global Markets Index slipped 0.8% in
2018's first quarter as volatility ticked up. The market-cap-weighted price/fair value estimate
ratio for our equity analysts' coverage universe was 0.99 as of March 29, indicating that the
median stock we cover is about fairly valued.

Drilling down to the sector level, communication services continues to be the most undervalued
sector, with a price/fair value of 0.86, said Damien Conover, Morningstar's director of healthcare
equity research. Conover writes in his first-quarter stock market outlook that in addition to
opportunities in the communication services sector, we are also finding attractive valuations is in
the large-cap drug and biotechnology industries.

On the other hand, basic materials remains the most expensive sector, with a price/fair value of
1.34. Our belief that basic materials companies are overvalued is hinged on the expectation that
China demand will transition away from an investment-led growth model.

Below, our equity analysts provide their takes on the biggest themes and the best remaining
investment opportunities in each sector.

Basic Materials
On a market-capitalization-weighted basis, our basic materials coverage trades at a 30%
premium to our estimate of intrinsic value, remaining the most overvalued sector, says equity
analyst Charles Gross. This is primarily driven by our bearish perspectives on most mining and
metals companies.

"We expect a structural change in demand growth from China as its economy matures and
transitions toward less commodity-intensive and more consumption-driven growth. High-cost
miners and those with outsize exposure to iron ore and coking coal tend to look the most
overvalued," Gross said.
Communication Services
The communications services sector is the most undervalued in our coverage, trading at a
market-cap-weighted price/fair value of 0.86.

One theme our analysts see in Europe is the move to convergence along with increased fiber and
4G buildouts. Also, in telecom and cable, we continue to see migration from traditional pay-TV
providers to over-the-top offerings. The picks below are well positioned to benefit from these
themes.

Consumer Cyclical
The consumer cyclical sector is about 4% overvalued at present. We attribute this to rising
consumer and corporate confidence, a factor that should support spending across numerous
discretionary industries, said senior equity analyst Dan Wasiolek.

Specifically, Wasiolek sees consumer spending aided by baby boomer, millennial, and emerging-
markets demographic tailwinds over the next several years. Travel is one industry that stands to
benefit from favorable sentiment and demographics. Also, though many retailers continue to
cede share to online peers, Wasoilek believes there are some opportunities among strong niche
players and brand partners.
Consumer Defensive
After multiple quarters of slightly inflated valuations, the consumer defensive sector retreated
modestly and now trades at a roughly 2% discount to our fair value estimates. As such, we now
see a few more opportunities for patient investors to build positions in some competitively
advantaged names, said equity analyst John Brick.

Energy
Despite our bearish outlook for near- and long-term oil prices, we see pockets of opportunity in
the oil and gas space, says equity analyst Joe Gemino. Energy sector valuations look modestly
undervalued at current levels, with an average price/fair value estimate of 0.94.

Financial Services
The global financial services sector appears to be slightly overvalued, trading at a price/fair value
ratio of 1.04. In the near term, regulation and competition is leading to business model changes
and mergers among asset managers, wealth management firms, and life insurance companies.
Specifically, fiduciary regulations are increasing scrutiny on distribution strategies and the scale
needed to compete, says Michael Wong, director of financial services equity research for North
America.

U.S. banks, meanwhile, are likely to benefit from tax cuts being signed into law, expectations of
continued economic growth, regulatory relief that's already playing out, and a normalizing rate
environment. Our near-term outlook for bank performance is positive. Read our analysts'
regional and industry outlooks here.
Healthcare
In aggregate, valuations in the healthcare sector have slightly decreased to a price/fair value of
1.01, down from 1.04 at the start of the year. Drilling deeper, however, the differences in
industry valuations suggest drug, biotech, and drug supply chain industries are the most
undervalued areas, says Damien Conover, director of healthcare equity research. You
can read more on Conover's take on what corporate tax reform means for the industry, as well as
his top picks in the sector.

Industrials
We consider the industrials sector to be slightly overvalued at a market-capitalization-weighted
price/fair value estimate ratio of 1.06. Demand for industrial products is healthy, and most
industrial firms are executing well, says director of industrials equity research Keith
Schoonmaker. He also believes that U.S. corporate tax law changes will benefit many industrial
firms "both directly from lower cash tax outflows, and also via stronger capital purchases for
customers."

Real Estate
Morningstar's real estate coverage appears fairly valued at current levels.
Equity analyst Brad Schwer views themes in commercial real estate as generally defensive in
nature, with lingering concerns about increasing bond yields associated with future rate
hikes. Despite these concerns, though, Schwer says underlying performance has remained
healthy overall, as REITs have been focused on repositioning and strengthening their portfolios,
deleveraging, and capital recycling.

Technology
We view technology stocks as overvalued at a market-cap-weighted price/fair value of 1.08,
writes director of technology, media, and telecom equity research Brian Colello in his fourth-
quarter technology sector wrap-up. The shift toward enterprise cloud computing remains the
single most important trend in technology, which has ramifications for dozens of stocks across
our coverage, Colello said. Another ongoing trend in technology remains mergers and
acquisitions.

Utilities
Earnings and dividend growth will be the story for utilities investors in 2018 and 2019, says
energy and utilities strategist Travis Miller. Utilities across our domestic coverage universe--
which now trade at a price/fair value of 0.97--have aggressive investment plans with mostly
constructive public policy support. As long as energy prices remain stable, we expect 5%-7%
annual earnings and dividend growth across the sector during the next few years, Miller said.
Healthcare: Values Among Drug, Biotech,
and Supply Chain Firms
Damien Conover, CFA

30 Mar 2018

In Focus

 AET
 AGN
 CI
 CVS
 ESRX

 In aggregate, valuations in the healthcare sector have slightly decreased to a price/fair value of
1.01, down from 1.04 at the start of the year, but the differences in industry valuations suggest
drug, biotech, and drug supply chain industries are the most undervalued areas. Within these
industries, our top picks are Allergan (AGN), Roche (RHHBY), McKesson (MCK,) and Shire
(SHPG).
 In the United States, the passage of tax reform is significantly reducing tax burdens and should
boost cash flows over the long term. However, other newly passed U.S. regulations have caused
drug pricing concerns in the most profitable region of the world, but we still expect strong drug
pricing power in the U.S.
 The healthcare consolidation trend continues, with several companies looking to increase scale
for competitive positioning as new threats emerge and cost pressures continue.
 In the Big Pharma and Big Biotech industries, innovation continues and supports strong pricing
power despite the increased pricing pressures from governments and pharmacy benefit
managers.

Regulatory changes in the U.S. have provided a mixed picture for healthcare, with the positive
benefits of tax reform offsetting the minor negative legislation on drug pricing. With the U.S.
corporate tax rate falling to 21% from 35%, many global companies' tax rates have fallen by
several hundred basis points. However, changes to payments to some of the U.S. drug programs,
including Medicare Part D, will create a minor headwind to prices in the U.S., but pricing should
remain strong relative to other geographies.

On the mergers and acquisitions front, partly aided by tax reform as well as a need to increase
scale to lower costs, companies continue to consolidate. The announcement of Cigna (CI)
buying Express Scripts (ESRX) signals the need for firms to increase scale to lower costs. This
deal follows the merger announcement of CVS Health (CVS) with Aetna (AET), which also is
looking to scale their business lines. Outside of the healthcare supply chain, we expect further
consolidation within the drug and biotechnology industries as large firms look to redeploy strong
cash flows by buying smaller firms with new drugs, augmenting internal research and
development efforts.

On the innovation side, new advancements in drugs continue to support strong pricing power
despite increasing pricing pressures from governments and insurance groups. In
particular, Merck (MRK) reported positive data for its immuno-oncology drug Keytruda in the
large unmet medical need area of first-line lung cancer. Also, Sanofi (SNY) and Regeneron
Pharmaceuticals (REGN) reported positive outcomes data for the cholesterol-lowering drug
Praluent. We expect further data like these studies to support strong long-term pricing power of
drugs despite pressures to lower drug costs by payers.

Top Picks

Allergan (AGN)
Star Rating: 5 Stars
Economic Moat: Wide
Fair Value Estimate: $263
Fair Value Uncertainty: Medium
5-Star Price: $184.10

Unlike most of its peers in specialty pharma, Allergan retains one of the most attractive product
portfolios and innovative pipelines, particularly in its core markets of aesthetics, ophthalmology,
gastroenterology, and central nervous system. Allergan's diverse portfolio, key durable products
including Botox, and healthy pipeline support a wide economic moat and mid-single-digit
organic earnings growth over the next five years, in our view. The company has used a nice mix
of focusing on core internal research and development strengths while supplementing its pipeline
with M&A, which creates numerous capital-deployment opportunities following the $40 billion
sale of its industry-leading generics unit to Teva Pharmaceutical (TEVA) in 2016.

McKesson (MCK)
Star Rating: 5 Stars
Economic Moat: Wide
Fair Value Estimate: $210
Fair Value Uncertainty: Medium
5-Star Price: $147
Despite major near-term headwinds, McKesson will remain an essential link in the
pharmaceutical supply chain. Several headwinds have pressured the firm's operations and stock.
Increased competition for small/independent pharmacy market share has formed a confluence of
negative variables that have built in significant near-term uncertainty for the drug distributor.
However, we believe these are near-term issues and that McKesson will be able to power
through the recent volatility as it is a critical partner to both retail pharmacy clients and drug
suppliers. While there are some remaining headwinds associated with potential contract losses,
we believe McKesson will be able to effectively offset this issue, win its share of contracts in the
future, and thrive long term. Additionally, we believe near-term drug price inflation trends
should not have any material impact on McKesson's valuation. McKesson has also positioned
itself as a critical player in the lucrative specialty pharmaceutical market niche, bolstering its
wide economic moat.

Roche Holding (RHHBY)

Star Rating: 5 Stars
Economic Moat: Wide
Fair Value Estimate: $43
Fair Value Uncertainty: Low
5-Star Price: $34.40

We think the market underappreciates Roche's drug portfolio and industry-leading diagnostics,
which conspire to create sustainable competitive advantages. As the market leader in both
biotech and diagnostics, this Swiss healthcare giant is in a unique position to guide global
healthcare into a safer, more personalized, more cost-effective endeavor. The collaboration
between its diagnostics and drug-development groups gives Roche a unique in-house angle on
personalized medicine. Also, Roche's biologics constitute three fourths of its pharmaceutical
sales; biosimilar competitors have seen development setbacks while Roche's innovative pipeline
could make these products less relevant by their launch.

Shire (SHPG)
Star Rating: 5 Stars
Economic Moat: Narrow
Fair Value Estimate: $205
Fair Value Uncertainty: Medium
5-Star Price: $143.50

We view Shire's diversified rare-disease portfolio and neuroscience franchise as warranting a

narrow moat rating, and while the pipeline is thinner than most large-cap biotechs, we think the
portfolio is quite defensible, particularly the rapidly growing immunology franchise. We think
the market has an overly bearish view on Shire's hemophilia portfolio, and even with more
severe erosion from Roche's Hemlibra (launching 2018), we think Shire's valuation looks
attractive. Given the stability of the firm's core businesses, we're not concerned about Shire's
financial health. We believe synergies between Shire and recently acquired Baxalta on the top
line--including Shire's ability to use Baxalta's international footprint for its own products, as well
as the hospital overlap between Shire's hereditary angioedema and Baxalta’s immunology
business--have not been fully appreciated. The immunology franchise--including what we see as
the best portfolio of immunoglobulin therapies--appears to be gaining share internationally and
seizing on trends for increased subcutaneous use in the U.S. Along with newer product launches
(rare-disease drugs Gattex and Natpara), the launch of dry-eye drug Xiidra, the launch of HAE
drug lanadelumab, and stabilization of generic pressure on GI drug Lialda, we think this will
help Shire drive growth despite expected hematology losses.

Quarter-End Insights

Stock Market Outlook: Stocks Look Slightly Overvalued Today

4- and 5-star stocks are harder to come by in today's market, but a few values are still out there.

Credit Market Insights: A Decidedly Negative Quarter for Fixed-Income Markets

Rising rates and widening credit spreads took their tool in the first quarter of 2018.

Basic Materials: Still Overvalued Despite Protective Tariffs

Our bearish view on the mining and metals sector means the basic materials coverage universe
trades at a market-cap-weighted 30% premium to our fair value estimates.

Communication Services: The Most Undervalued Sector We Cover

We see value in several firms as consumers migrate away from traditional TV bundles and
Europe invests in fiber and 4G.

Consumer Cyclical: Confidence, Demographics Support Consumption Gains

E-commerce market share gains present challenges for some, but trends continue to support
healthy profitability for many companies.

Consumer Defensive: Looking to M&A, Online Sales for Growth

We see a few values for long-term investors amid intense competition.

Energy: Looming U.S. Shale Supply Should Temper Optimism

Huge output decline boosts near-term fundamentals, but lofty prices likely to trigger dangerous
shale growth later.

Financial Services: Regulations and Interest Rates Remain in the Spotlight for 2018
We see financial services stocks across the globe as fairly valued today.

Industrials: Healthy Demand, But Few Values

Among a mostly fairly valued industrials sector, some good values remain.

Real Estate: Rising Rates Won’t Derail Strong Fundamentals

REITs have focused on strengthening their portfolios, deleveraging, and capital recycling in the
face of higher bond yields and new construction.

Technology: Shift to Cloud Computing Most Important Story

The sector looks modestly overvalued as a whole, but there are some attractive firms in
enterprise software and IT services.
Utilities: Under Pressure in Early 2018
Utilities sell-off presents opportunities for long-term investors.

Venture Capital Outlook: Despite Slow Volume, Liquidity Prospects Remain

We expect ample opportunity in the VC-backed IPO market as alternative liquidity routes gain
popularity.

Private Equity Outlook: Carveouts on the Rise as Fundraising Slows

As dealmakers look to innovate their origination process, we anticipate a continued rise in take-
privates and corporate divestitures.

Damien Conover, CFA does not own shares in any of the securities mentioned above. Find out about
Morningstar's editorial policies.

P&G's Pullback Is Investors' Potential Gain

Erin Lash, CFA

04 Apr 2018

In Focus

 PG

We think the pullback in Procter & Gamble’s (PG) share price has created an even more
attractive entry point for long-term investors. Beyond the attractive valuation, shareholder
returns stand to be enhanced by a 3.5% dividend yield. We believe returning excess cash to
shareholders will remain a priority and forecast mid- to high-single-digit dividend growth over
the next 10 years.

Top-line growth across the industry remains elusive. Despite the market’s seeming lack of
confidence, we believe the benefits of P&G’s more focused investments should yield
improvements across its product mix, bolster sales and volume growth, and subsequently
strengthen the brand intangible asset source of its wide economic moat. We believe P&G is
poised to increase underlying sales at a 4% clip longer term, with nearly two thirds of its annual
growth from increased volume and the remainder from higher prices and improved mix. But we
don’t think these top-line gains will come at all costs; rather, we think P&G is working to
reignite sales while also beefing up its profitability. We expect its current $10 billion cost-saving
effort will lead to 500 basis points of operating margin gains, yielding a 24% margin over the
next 10 years, and fuel spending behind product innovation and marketing to combat competitive
pressures.

Focus on Highest-Return Opportunities

Following a multiyear effort to cull around 100 brands from its mix, leaving it with 65 brands,
P&G appears poised to benefit from an enhanced focus on its highest-return opportunities.
Recent results, which have included a return to low-single-digit sales growth, suggest the
company is beginning to realize the fruits of these efforts. More-targeted brand spending should
also enable P&G to more effectively respond to evolving consumer trends, which we view as key
in light of the ultracompetitive landscape and sluggish growth prospects around the world.

We believe even a slimmed-down version of the leading global household and personal-care
company will carry clout with retailers, maintaining its scale edge. The 65 brands P&G continues
to operate include 21 that generate $1 billion-$10 billion in annual sales and another 11 that
account for $500 million-$1 billion in sales each year. We think that by supplying products
across multiple categories, including fabric care, baby care, feminine care, and grooming, trusted
manufacturers like P&G are critical to retailers looking to drive traffic, both into physical stores
and onto e-commerce platforms.

We believe P&G is looking to drive sustainable and profitable growth over the long term, which
we view as prudent. The company is working to extract another $10 billion in costs, aiming to
reduce overhead, lower material costs, and increase manufacturing and marketing productivity.
In our view, P&G is unlikely to let the entirety of these savings fall to the bottom line; instead,
we expect these funds will fuel brand investment to prop up sales and support the intangible
assets (entrenched retail relationships and leading brands) that underlie our wide economic moat.
We forecast margin expansion at the gross as well as operating income lines.

Valued Retail Partner

We assign Procter & Gamble a wide economic moat resulting from its intangible assets and cost
edge. With its leading market shares (more than 25% of baby care, about 65% of blades and
razors, over 25% of feminine protection, and more than 25% of fabric care), we think P&G is a
valued partner for retailers, supporting its intangible asset moat source. We believe the company
maintains the resources to bring new products to market (spending nearly 3% of sales or $2
billion on R&D annually) and tout that fare in front of consumers (spending around 11% of sales
or $7 billion annually) to drive traffic into stores and onto e-commerce platforms, subsequently
enhancing the stickiness of its retailer relationships. In our view, trusted manufacturers like
P&G, which operate with a product set that spans the grocery store, are critical to retailers that
are reluctant to risk costly out-of-stocks with unproven suppliers. Despite the bargaining power
garnered by a consolidating base of retailers, leading brands like P&G’s still drive store traffic.
Bolstering its competitive position is the size and scale P&G has amassed over many years,
which enables the company to realize a lower unit cost than its smaller peers, resulting in a cost
advantage.
P&G’s slimmed-down portfolio still carries significant clout with retailers, and we think its
enhanced focus supports the company’s brand intangible asset and cost advantage. The 65 brands
it continues to operate had already accounted for more than 85% of its top line and 95% of its
profits. As such, we didn’t anticipate P&G would sacrifice its scale edge but would be able to
better focus its resources (both personnel and financial) on its highest-return opportunities.
Returns on invested capital including goodwill have averaged more than 11% annually over the
past 10 years, exceeding our 7% cost of capital estimate, and we think the company can continue
to outearn its cost of capital over the next 20 years, supporting our take that P&G maintains a
wide moat.

Subject to Consumer Spending

Like others, P&G has fallen victim to muted consumer spending and persistent cost inflation that
has yet to fully abate. Promotional spending the past few years has conditioned some consumers
to expect lower prices, and lackluster innovation has in some instances failed to prompt
consumers to pay up for new, higher-priced products. Further, with around 60% of its sales
derived outside the United States, P&G is exposed to changes in foreign exchange rates, which
could have a negative impact on its financial performance, as the company isn’t always
manufacturing in the locations where it’s selling, a challenge that is unlikely to fully abate.

We don’t think P&G’s issues are limited to slowing global growth, competitive pricing, and
unfavorable foreign exchange. We think the problems have run deeper, as the company
overextended itself in the past to build out its product mix and geographic footprint. While P&G
was slow to react, management has responded with another cost-saving effort to reduce head
count and overhead, improve manufacturing efficiency, and free up funds to reinvest in its
business. We also view the pruning of the brand portfolio as a positive.

From a category perspective, grooming remains a challenge, as consistent organic sales growth
has proved elusive. Competition from lower-priced upstarts as well as demographic trends
favoring facial hair the past few years are partly to blame, but we think this underperformance is
also attributable to lackluster offerings. The company is working to recalibrate its pricing,
investing in on-trend new products, launching its own subscription-based sales model, and
driving trials by sending razors to 18-year-old U.S. males, but competition is unlikely to subside
following Unilever’s deal to acquire Dollar Shave Club. As such, we expect low-single-digit
sales growth will persist.

Erin Lash, CFA does not own shares in any of the securities mentioned above. Find out about
Morningstar's editorial policies.

The Wide Moat Focus Index Adds 11 New

Holdings
Karen Wallace

28 Mar 2018
In Focus

 BEN
 BK
 BMY
 CMCSA
 CPB

Every quarter, we reconstitute one subportfolio of the Morningstar Wide Moat Focus
Index. When we do this, we re-evaluate the index's holdings and add and remove stocks based on
a preset methodology. This helps keep the index true to its aim of providing exposure to
competitively advantaged (wide-moat) stocks selling at the lowest current market price/fair value
ratios.

The index consists of two subportfolios with 40 stocks each. The subportfolios are reconstituted
semiannually in alternating quarters, on a "staggered" schedule. Because stocks are equally
weighted within each subportfolio, the reconstitution process also involves right-sizing
positions.

The Adds
After the March reconstitution, half of the portfolio swapped out 11 positions. The net result is
that the index now holds 52 positions.

One discernible theme is that wide-moat consumer defensives look cheap. Companies
like Procter & Gamble (PG), General Mills (GIS), Campbell Soup (CPB), The Hershey (HSY)
, and PepsiCo (PEP) are known for producing trusted brands of household products such as
diapers, cereal, and soft drinks. Firms such as these tend to have more predictable, steady cash
flows; therefore, their share prices tend to decline less during a market downturn compared with
stocks of firms that are more sensitive to business cycles.

As director of consumer sector equity research Erin Lash wrote, although consumer defensive
firms have been laser-focused on driving efficiencies, these efforts to extract costs have failed to
offset languishing top-line trends.
"This has been evidenced in soft volumes (compared with historical levels) combined with
price/mix that has generally still been under pressure."

Lash also points out that the growth of the hard discounters in Europe, Australia, and
increasingly in the U.S., and the emergence of the e-commerce channel, are lowering barriers to
entry in the consumer defensive space and intensifying price competition. Meanwhile,
consumers are looking for alternatives to the big brands, either seeking better value from
unbranded alternatives, or trading up to more niche, artisan products such as craft beer, she said.

These competitive pressures have helped create opportunities for long-term investors who want
to build positions in these competitively advantaged names.

Likewise, utilities such as Dominion Energy (D) , which supplies energy primarily to consumers
on the East Coast, and cable company Comcast (CMCSA), which benefits from a subscription
model, benefit from steady cash flows that help protect them from market sell-offs. (Though
Comcast's pay TV model has faced competitive pressures from various corners of late, equity
analyst Neil Macker believes Comcast has a wide economic moat rating based on cost advantage
and efficient scale inherent in its residential broadband business and cost advantage in its
business services segment.)

The Drops
On the flip side, 11 stocks were removed because their price/fair values rose beyond our buy
range.

There weren't many broad themes among the companies that were removed owing to high
price/fair value ratios--mostly just strong individual performance. For instance, CBRE Group's
(CBRE) fourth-quarter results exceeded management's guidance and Morningstar analyst Brad
Schwer's expectations.

"Revenue and earnings reached all-time highs in 2017 as the global economy continued to
grow," Schwer said.

Bristol-Myers Squibb (BMY) has benefited from two positive developments in the past few
months. First, the pharmaceutical firm reported slightly better-than-expected fourth-quarter
results. Also, Bristol reported positive combination-therapy data in a recent non-small cell lung
cancer (NSCLC) study.

Healthcare sector director Damien Conover said this positive data "[supports] our expectation
Bristol will gain close to a quarter of the $12 billion NSCLC market. We don’t expect any major
changes to our fair value estimate following the data, but the continued strength of Bristol’s
positioning in immuno oncology helps reinforce the company’s wide moat."

Veeva Systems (VEEV), which provides customer relationship management software for the
life sciences industry, rose around 33% in the past three months after it reported a strong fourth
quarter, with an impressive 23% increase in revenue.

We removed Patterson Companies (PDCO) because we recently downgraded our moat rating to
narrow from wide due to concerns that Patterson's competitive position in the dental wholesaling
market has significantly deteriorated.

"We believe Patterson faces significant pressure from alternative sourcing options for dental
consumable products (fillings, gauze, latex gloves, disinfectants, swabs)," said senior equity
analyst Vishnu Lekraj. "From what we can gather, there has been increased competition from
online-based wholesale players that can source consumables from the cheapest suppliers
nationwide."

High-Quality Stocks in the Bargain Bin

The table below lists the 10 cheapest stocks in the index, ranked by price/fair value. The median
stock in the Wide Moat Focus Index is trading at a weighted average price fair/value of 0.81. By
comparison, the broad Morningstar US Market Index is close to fairly valued, trading at a
weighted average price/fair value of 0.95 .
Disclosure: Morningstar, Inc. licenses indexes to financial institutions as the tracking indexes
for investable products, such as exchange-traded funds, sponsored by the financial institution.
The license fee for such use is paid by the sponsoring financial institution based mainly on the
total assets of the investable product. Please click here for a list of investable products that track
or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management
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any investable product that tracks a Morningstar index.

Karen Wallace does not own shares in any of the securities mentioned above. Find out about
Morningstar's editorial policies.

Your Market Downturn Toolkit

Christine Benz

12 Feb 2018
"Stay the course."

"Stick with your asset allocation plan."

"Focus on what you can control."

Those are worthwhile pieces of advice during market corrections like the one we've experienced
recently. But they can ring a little platitudinous for some investors. How do they know if the
course they're on is the right course? What if they don't know what their asset allocations are, let
alone whether they're reasonable? And which factors do they actually control, and how can they
control them?

To help investors address those questions and cope with the market volatility in a concrete and
productive way, we've put together a Market Downturn Toolkit. It outlines some worthwhile jobs
to tackle during a downturn--or any time, really--along with the tools you need to get them done.
Not only will knocking off those jobs give you more confidence in your plan--or at least focus
your attention on the steps you need to take in order to get it in better shape--but it will also serve
to distract your attention from activities that aren't helpful, like compulsively checking your
portfolio balance or the S&P's minute-by-minute fluctuations.

Job: Check Up on the Reasonableness of Your Stock/Bond Mix

As markets have trended up for the better part of the decade, it has been easy to let equity
winners ride. The net effect of that inattention is that untended portfolios have become
progressively more equity-heavy and volatile: A portfolio that was 60% stock/40% bond in 2009
is more than 80% stock today, even factoring in the recent sell-off. Thus, a key job for investors
attempting to see if their portfolios are too risky is to assess their asset allocations. Morningstar's
X-Ray functionality, accessible via Portfolio Manager or the Instant X-Ray tool, enables you to
see how your portfolio is positioned today, taking into account the underlying holdings of the
mutual funds in your portfolio. Armed with that information, you can then compare your data
with that of a sensible benchmark. Morningstar's Lifetime Allocation Indexes are a good starting
point; checking out your allocations relative to those of a good target-date fund geared toward
your retirement date, such as Vanguard's and BlackRock's Lifepath Index series, can also be
useful.

People who are retired or getting closer to retirement can use their own portfolio spending
amounts to dictate a sensible asset allocation framework, as discussed here. My Model
Portfolios, which use Morningstar’s Lifetime Allocation indexes to shape their asset allocations,
provide an additional tool for benchmarking the reasonableness of an asset allocation. Don't
forget to check liquid reserves: My Bucket portfolios for retirees include one to two years' worth
of portfolio spending needs in true cash instruments. For folks who are still working, three to six
months' worth of living expenses in cash is a good baseline. High-income earners, contractors, or
those with more specialized careers should shoot for a year or more of living expenses in cash
reserves.

The Toolkit
Morningstar Portfolio Manager
Morningstar’s Instant X-Ray Tool
Morningstar Lifetime Allocation Indexes
Model Portfolios for Savers and Retirees

Job: See If Your Plan Is on Track

Many investors naturally wonder if an investment downturn is going to be so severe that it
derails their plans. Will retirement--which seemed so close just a few short weeks ago--need to
wait? Are there any ways to make a save?

The gold standard for getting a check on the viability your plan is to sit down with a fee-only
financial planner; this article provides a checklist you can use when seeking professional advice.
There are also plenty of online tools available for DIYers aiming to get their arms around
whether their retirement plans are on track. I've long recommended T. Rowe Price's Retirement
Income Calculator, but it's worthwhile to sample a range of opinions. The Bogleheads site
includes a helpful compendium of retirement-planning calculators with links. For the truly time-
pressed, Vanguard's Retirement Nest Egg Calculator and Fidelity's Retirement Score tool are
worth checking out. All calculators require you to plug in some return assumptions; this article
takes stock of market experts' long-term forecasts.

To keep your plan on track on an ongoing basis, an investment policy statement is invaluable.
You can customize yours to suit your own needs, but at a minimum, your document should state
your investment goals (date, amount, duration), ongoing contribution amounts, basic asset
allocation framework, and what qualities you're seeking in your investments. Retirees and pre-
retirees should also maintain a separate retirement policy statement that documents their
withdrawal-rate system, among other key retirement planning factors.

The Toolkit
Choosing a Financial Advisor: An Investor's Checklist
T. Rowe Price Retirement Income Calculator
Vanguard Retirement Nest Egg Calculator
Fidelity Retirement Score Tool
Investment Policy Statement Worksheet
Retirement Policy Statement Worksheet

Job: Check Up on Investment Quality

After you've assessed your portfolio's asset allocation and viability, take a closer look at the
quality of the investments you've chosen to populate your plan. Of course, Morningstar.com
features a dizzying array of data for stocks, mutual funds, and ETFs. Rather than being blinded
by short-term gains (or losses), try to focus instead on the big picture. Do your holdings align
with the qualities you've laid out in your investment policy statement (above)? Is your portfolio
as streamlined as it can be, or can you identify redundancies? Do your holdings earn strong
ratings from Morningstar's analyst team--medalist ratings for funds and exchange-traded funds,
ratings of 3 or better for stocks?

The Toolkit
Morningstar's Medalist Mutual Funds
Morningstar's Medalist ETFs
Morningstar's Highly Rated Stocks

Job: Check Up on Your Spending

Investors are often exhorted to focus on what they can control when the markets are uncertain
and volatile. At the top of the "In Your Control" list should be your savings and spending rates:
How much you are able to invest on an ongoing basis will be by far the biggest determinant of
when and whether you reach your financial goals. A strong market and enlarged portfolio
balances can stoke a "wealth effect," making it more comfortable to spend than you otherwise
would. If you haven't done a budget recently, there are a host of online tools and apps for
tracking your expenses on an ongoing basis. Alternatively, you can create a budget the old-
fashioned way, using an Excel spreadsheet or other budget worksheet.

The Toolkit
Budget Worksheet

Job: Check Up on Investment Costs

Since we're on the topic of expenses, do you know what you're paying for your portfolio on an
ongoing basis? Most investors don't, even though managing investment costs is one of the best
ways to improve your take-home return. If you have a portfolio saved in Morningstar's Portfolio
Manager, you can find valuable summary statistics about what you're paying in the Fees &
Expenses section of the X-Ray overview: your average mutual fund expense ratio, the expense
ratio of a similarly weighted portfolio with average expenses, and your total expenses in dollars
and cents. If your portfolio's expense ratio isn't comfortably below average, click the X-Ray
Details tab, then Fees & Expenses below that, to see how each of your holdings stack up relative
to their category peers. The Expense tab for individual mutual funds and ETFs provides a wealth
of comparative and historical expense data.

The Toolkit
Morningstar's Portfolio Manager (click on X-Ray, then X-Ray Overview; the Fees & Expenses
section is at the bottom of the left column)
Morningstar's Instant X-Ray

Job: Check Up on Tax Efficiency

In a related vein, are you managing your portfolio with an eye toward reducing the drag of taxes?
Are you taking maximum advantage of your tax-sheltered options? If you have taxable,
nonretirement holdings, have you populated that portion of your portfolio with investments that
limit taxable income and capital gains distributions?

With 1099s rolling in for the 2017 tax year, it's a good time to take stock of the drag that taxes
are exerting on your returns. By clicking on the "Tax" tab of mutual funds and ETF reports, you
can see a suite of tax-efficiency data that compares each holding to its peers. If you see a long-
term tax-cost ratio of 1% or more, that's a red flag that a holding is a better fit for a tax-sheltered
account. Bond investors can use the Tax-Equivalent Yield function of Morningstar's Bond
Calculator to determine if municipal or taxable bonds are a better bet for their taxable accounts.
The Toolkit
Conduct a Tax Audit of Your Portfolio
Tax-Equivalent Yield Calculator (compares taxable bonds with municipal bonds)