Morningstar Advisor - October/November 2010 - 29

Exhibit 5 Low Yield Produces Low Returns
Monthly Rolling Five-Year Nominal Returns Delivered Depending Upon Starting Dividend Yield

January 1992–June 2005
18%

14

10

assets in REITs, because the firm estimated that the asset class would return about 9.1% per year in real terms over the next seven years. By Dec. 31, 2005, however, the fund’s real estate exposure was less than 1%, when the firm estimated that the asset class would return negative 0.6% per year for the next seven years. The GMO fund had less real estate exposure than did the PIMCO fund in the spring of 2004, but they both cut their exposure dramatically at roughly the same time. The GMO fund currently has no real estate exposure. At FPA Crescent, Romick has the ability to short stocks in addition to owning all types of securities he deems fit by his valuation analysis. In 2010, Romick is shorting seven REITs (among his 31 short positions) and has no long REIT positions.
Conclusion

6

2 4% to 5%
Source: NAREIT

5% to 6%

6% to 7%

7% to 8%

8% to 9%

Still, a business’ worth is the present value of its future cash flows, and taking a stab at forecasting what those cash flows might be has its merits. At the very least, it can indicate what sort of growth currently is priced into a stock, and Morningstar REIT analysts think more growth is implied in today’s prices than warrants a margin of safety for investment.
Learning From the Pros

in this issue’s Morningstar Conversation on Page 38.) At its inception in the spring of 2004, Arnott allocated 15% of the PIMCO fund’s assets to the real estate sector via PIMCO Real Estate Real Return PRRSX. Six months later, he had dramatically shed exposure to 6% of assets. By September 2005, the fund’s exposure was down to 3% and to less than 1% by June 2006. Today, the fund has no exposure to REITs. REITs soared by more than 30% in 2004 and by another 15% in 2005. Although dividend yields dropped from about 5% to about 4% during the time, Arnott effectively was shedding his exposure as he saw prices getting stretched relative to underlying values. The companies were gorging on debt and becoming less capable of paying the dividends, as evinced by more dividend cuts in 2008 and 2009. It’s true that the category soared again in 2006, making Arnott’s departure seem a bit premature, but in hindsight, his caution served his shareholders well. The GMO fund showed a similar pattern. In January 2002, Inker had 8.7% of the fund’s

Whether the reason is a search for yield or a case of chasing returns, investors are pouring money into real estate funds. Based on what three valuation metrics and the actions of three talented, go-anywhere managers are telling us, we question the wisdom of these investors. Price/FFO, dividend yield, and Morningstar’s equity analysis reveal that REITs currently don’t look cheap. They could trade at current prices until their underlying valuations grow into their prices, but current economic conditions don’t favor REITs. Investors committing capital to them now aren’t investing with a margin of safety. Managers Arnott, Inker, and Romick confirm our thesis. K
John Coumarianos is a senior mutual fund analyst with Morningstar. Mutual fund analyst Ryan Leggio contributed to this article.

The last leg of our analysis focuses on how flexible managers, instead of those running dedicated real estate funds, view the asset class. Because real estate funds have to own REITs, we think we get a more objective opinion by examining the portfolios of managers who have the flexibility to avoid or bet on an asset class based on their understanding of its valuation. We looked at PIMCO All Asset All Authority PAUDX, managed by Rob Arnott; GMO Global Balanced Asset Allocation III GMWAX, run by Ben Inker; and FPA Crescent FPACX, run by Steven Romick, to see how these managers view REITs. All three have a consistent outlook on REITs. (Inker and Romick also have a similar view of high-quality stocks, which they discuss

MorningstarAdvisor.com 29


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Morningstar Advisor - October/November 2010

Table of Contents for the Digital Edition of Morningstar Advisor - October/November 2010

Morningstar Advisor - October/November 2010
Contents
New on MorningstarAdvisor.com
Contributors
Letter From the Editor
What estate-planning strategies are you and your clients doing before the end of the year?
Next Steps for ETFs
Investment Briefs
Taking It Personal
A Model Practice
Find the Right Fit
Will REITs Put You in the Penthouse?
Prepare for the Worst
Tips for Common Family Situations
Might Makes Right
Built to Last
Four Picks for the Present
Tactical Strategies Miss Their Mark
Time to Hop on the Commodities Bandwagon?
Retailers Balance Caution and Catalysts
In Search of … Recession Survivors
Turmoil-Tested Small-Cap Funds
Mutual Fund Analyst Picks
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
VA Sales Rise in Second Quarter
The Third Rail
Morningstar Advisor - October/November 2010 - Intro
Morningstar Advisor - October/November 2010 - Morningstar Advisor - October/November 2010
Morningstar Advisor - October/November 2010 - Cover2
Morningstar Advisor - October/November 2010 - 1
Morningstar Advisor - October/November 2010 - 2
Morningstar Advisor - October/November 2010 - Contents
Morningstar Advisor - October/November 2010 - 4
Morningstar Advisor - October/November 2010 - 5
Morningstar Advisor - October/November 2010 - New on MorningstarAdvisor.com
Morningstar Advisor - October/November 2010 - 7
Morningstar Advisor - October/November 2010 - Contributors
Morningstar Advisor - October/November 2010 - Letter From the Editor
Morningstar Advisor - October/November 2010 - What estate-planning strategies are you and your clients doing before the end of the year?
Morningstar Advisor - October/November 2010 - 11
Morningstar Advisor - October/November 2010 - Next Steps for ETFs
Morningstar Advisor - October/November 2010 - 13
Morningstar Advisor - October/November 2010 - Investment Briefs
Morningstar Advisor - October/November 2010 - 15
Morningstar Advisor - October/November 2010 - 16
Morningstar Advisor - October/November 2010 - 17
Morningstar Advisor - October/November 2010 - Taking It Personal
Morningstar Advisor - October/November 2010 - 19
Morningstar Advisor - October/November 2010 - A Model Practice
Morningstar Advisor - October/November 2010 - 21
Morningstar Advisor - October/November 2010 - Find the Right Fit
Morningstar Advisor - October/November 2010 - 23
Morningstar Advisor - October/November 2010 - 24
Morningstar Advisor - October/November 2010 - 25
Morningstar Advisor - October/November 2010 - Will REITs Put You in the Penthouse?
Morningstar Advisor - October/November 2010 - 27
Morningstar Advisor - October/November 2010 - 28
Morningstar Advisor - October/November 2010 - 29
Morningstar Advisor - October/November 2010 - 30
Morningstar Advisor - October/November 2010 - 31
Morningstar Advisor - October/November 2010 - Prepare for the Worst
Morningstar Advisor - October/November 2010 - 33
Morningstar Advisor - October/November 2010 - 34
Morningstar Advisor - October/November 2010 - 35
Morningstar Advisor - October/November 2010 - Tips for Common Family Situations
Morningstar Advisor - October/November 2010 - 37
Morningstar Advisor - October/November 2010 - Might Makes Right
Morningstar Advisor - October/November 2010 - 39
Morningstar Advisor - October/November 2010 - 40
Morningstar Advisor - October/November 2010 - 41
Morningstar Advisor - October/November 2010 - 42
Morningstar Advisor - October/November 2010 - 43
Morningstar Advisor - October/November 2010 - 44
Morningstar Advisor - October/November 2010 - 45
Morningstar Advisor - October/November 2010 - Built to Last
Morningstar Advisor - October/November 2010 - 47
Morningstar Advisor - October/November 2010 - 48
Morningstar Advisor - October/November 2010 - 49
Morningstar Advisor - October/November 2010 - Four Picks for the Present
Morningstar Advisor - October/November 2010 - 51
Morningstar Advisor - October/November 2010 - Tactical Strategies Miss Their Mark
Morningstar Advisor - October/November 2010 - 53
Morningstar Advisor - October/November 2010 - 54
Morningstar Advisor - October/November 2010 - 55
Morningstar Advisor - October/November 2010 - 56
Morningstar Advisor - October/November 2010 - 57
Morningstar Advisor - October/November 2010 - Time to Hop on the Commodities Bandwagon?
Morningstar Advisor - October/November 2010 - 59
Morningstar Advisor - October/November 2010 - 60
Morningstar Advisor - October/November 2010 - Retailers Balance Caution and Catalysts
Morningstar Advisor - October/November 2010 - 62
Morningstar Advisor - October/November 2010 - 63
Morningstar Advisor - October/November 2010 - 64
Morningstar Advisor - October/November 2010 - 65
Morningstar Advisor - October/November 2010 - In Search of … Recession Survivors
Morningstar Advisor - October/November 2010 - 67
Morningstar Advisor - October/November 2010 - Turmoil-Tested Small-Cap Funds
Morningstar Advisor - October/November 2010 - 69
Morningstar Advisor - October/November 2010 - Mutual Fund Analyst Picks
Morningstar Advisor - October/November 2010 - 71
Morningstar Advisor - October/November 2010 - 72
Morningstar Advisor - October/November 2010 - 73
Morningstar Advisor - October/November 2010 - 50 Most Popular ETFs
Morningstar Advisor - October/November 2010 - 75
Morningstar Advisor - October/November 2010 - Undervalued Stocks With Wide Moats
Morningstar Advisor - October/November 2010 - 77
Morningstar Advisor - October/November 2010 - VA Sales Rise in Second Quarter
Morningstar Advisor - October/November 2010 - 79
Morningstar Advisor - October/November 2010 - The Third Rail
Morningstar Advisor - October/November 2010 - Cover3
Morningstar Advisor - October/November 2010 - Cover4
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