Morningstar CIO David Needham keeps his unconstrained portfolio at 40% cash.

Morningstar is concerned enough about valuations in U.S. markets that the firm’s chief investment officer, Daniel Needham, keeps his unconstrained portfolio at 40% cash.

As the name implies, unconstrained funds offer managers latitude to invest beyond the narrow dictates of a benchmark, which would rule out such a high level of cash in other stock or bond funds.

“We think it pays to hold a little bit of extra cash,” said Needham, at an investment roundtable on the opening day of the Chicago firm’s annual conference.

Needham sees just “pockets of opportunity,” a view bolstered by his colleague Michael Holt, Morningstar’s global head of equity and corporate credit research.

Holt’s team of 120 equity analysts were asked whether markets were overvalued, undervalued or fairly valued, and the firm’s consensus is that U.S. equities are 4% overvalued. Asia-Pacific equities, in contrast, are fairly valued.

“[Research Affiliates’] Rob Arnott is very bearish on U.S. equities, but you don’t see a lot of managers going to 40% cash [like Morningstar],” remarked Russ Kinnel, Morningstar’s director of fund research.

Bob Johnson, the firm’s director of economic analysis, put the firm’s dim consensus in the context of an economy that produced disappointing results in the first quarter — contracting to 1% growth annually — though the consensus view at the start of the year was that the U.S. was poised for expansion.

While Johnson gives the U.S. an 80% probability of picking up that growth track, Needham maintains that for now the investment “opportunity set is priced for below-average returns.”

The panelists gave special attention to areas where they thought their views diverged from the broader investment consensus.

Foremost in that category was the group’s dislike of high-yield bonds, whose low yields do not compensate for what they see as high risk.

The bonds, says Needham, are financing “low-quality businesses that are very pro-cyclical; when economy slows, they can go quickly from creditworthy to really under a lot of pressure. On a forward-looking basis, that’s not a good for high-yield. People take on debt in good times to pay for debt taken on in bad times.”

Adds Kinnel: “This is probably not the time to double down on credit risk.”

Real estate investment trusts, whose popularity has recently surged, similarly earns the scorn of panelists who say the securities are overvalued by investors taking on higher and higher risk to generate yield.

Another area of divergence, this time with Morningstar’s enthusiasm greater than the market consensus, is in the shale and natural gas opportunity.

“The market’s been punishing E&P firms because it’s worried about demand destruction,” says Holt.

But the equity research head says wells are constantly being depleted and the need for drilling is thus constantly renewed. The trick, therefore, is to “do your homework.” For example, he asys, there are many firms whose price-to-EBIDTA ratio is half that of overvalued Range Resources (RRC).

“The headline is: there are lots of ways to win; the market will find ways to use this gas,” he said.

Johnson was emphatic in endorsing this view, saying “people way underestimate” shale and noting that “electricity today costs one-third what it does in Europe,” giving U.S. manufacturers a huge competitive advantage.

The star analysts devoted a final segment to “actionable” investment ideas they currently favor.

Fund research director Kinnel expressed enthusiasm for American Funds International Growth and Income Fund.

“They’re taking their dividend strategies that they’re very good at in the U.S. and applying [them] overseas,” he said.

Equity researcher Holt waxed at length about Amazon.

“Forget about the phone,” he said of the new Amazon Fire smartphone announced Wednesday.

“Amazon’s so attractive because of its massive disruption in the retail space,” where its $61 billion in revenue last year, he said, was equivalent to the next nine biggest retailers.

“It’s their distribution model that gives them an advantage over their peers … Keep the faith; the profitability will take place. Spending money in international markets positions them for the future. In North America, they’re already seeing these margins … they need to take it to other countries.”

As an afterthought, Holt expressed great enthusiasm for the company’s new smartphone, saying it will “lock in” more customers.

As for global markets, Needham was bullish on Japan.

“I like the fact that macro investors have a negative view of Japan because that creates opportunities for investors like me,” he said, acknowledging the high level of governmental debt that “creates future risk.”

But Japan has emerged through difficulties like its housing bubble before, he said, and “the fact that everybody’s worried about Japan gives me some comfort.”

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