By John Gabriel
Evaluating equity exchange-traded funds for tactical investments
is not unlike the process of selecting individual stocks. Equity
ETFs are, after all, baskets of stocks. So naturally, we can apply
many of the same valuation techniques we use when evaluating
A valuation-based view of the world is helpful when making all
of your investment decisions. Even the most avid proponents of
passive investing estimate expected returns for various asset
classes when establishing their strategic asset allocation. Active
investors with more of a tactical bent are likely to rely on
valuation metrics to a greater extent. Investors in this more
active camp assume that over a given period of time the market gets
asset prices wrong but eventually corrects itself as new
information becomes available.
Let's take a closer look at the two most common valuation
methods: fundamental valuation and relative valuation. Whether your
strategy (or personal preference) favors fundamental or relative
valuation, it can be helpful to check both methods. Scrutinizing
your investment ideas from every possible angle will only help
bolster your confidence.
Discounted cash flow analysis forms the basis of fundamental
valuation. With the DCF approach the value of a stock is not how
much someone else thinks it is worth or is willing to pay for it.
Rather, the value of a stock is the present value of its expected
future cash flows, which are discounted back at a rate that
reflects the uncertainty of those cash flows.
As with all models, the information you get out is only as good
as the information you put in. Making accurate, or useful,
forecasts relies on using sound assumptions. This requires an
intimate knowledge and familiarity with a company's business model
as well as the competitive dynamics of the given industry and the
regulatory environment surrounding it. If you're feeling
intimidated, don't worry.
Morningstar has a team of 125 equity and credit analysts who
conduct fundamental analysis and derive fair value estimates for
more than 1,800 companies worldwide. Think of it as your very own
army of fundamental equity research analysts. Since these data can
be aggregated to the fund level, we can form an estimate of
intrinsic value for equity ETFs*, which are simply worth the sum of
their constituent parts.
Access to Morningstar's vast equity research resource gives us a
unique advantage in that we can use the research to form thematic
ideas about which sectors appear attractive and which investors
should avoid. The following table highlights the S&P 500
sectors, ranked from lowest price/fair value to highest.
click to enlarge
Currently, Morningstar analysts believe the market is about 12%
undervalued. Energy and financials look like the cheapest sectors,
with both trading nearly 20% below fair value. At the other end,
utilities look fairly valued after a string of strong performance
in the recent flight to safety and hunt for yield.
It's All Relative
The popularity of relative valuation stems in part from its
simplicity and convenience. Relative valuation estimates the value
of an asset by comparing the pricing of similar assets relative to
a common variable like earnings, cash flows, book value, or sales.
This much simpler and more straightforward method of valuing stocks
is most useful as a reference point, or sanity check. Investors
should keep in mind that there are limitations to using multiples
and that using them in isolation could produce misleading
Metrics like price/earnings ratios, or P/E, often contain a lot
of "noise." By now we have probably all heard of those infamous
special one-time non-cash charges that can wreak havoc on earnings
statements. But management also has several levers it can play with
to "massage" the income statement. For example, the waters can be
easily muddied by adjustments to the tax rate or an asset's
depreciation schedule. Because earnings can be easily manipulated,
many investors prefer using a price/sales ratio. But there are also
drawbacks with P/S--namely, it tells you nothing about
Another common relative valuation metric is price/book value.
This ratio can be useful when gauging sectors or industries that
tend to have tangible assets, like factories and production
facilities. We prefer this metric when comparing banks and
financial firms, as the businesses are essentially an assembly of
financial assets. On the other hand, it doesn't make much sense to
use P/B when analyzing the technology or health-care sectors; P/B
fails to reflect intangible assets such as intellectual assets,
which are often the lifeblood of technology and health-care
Understanding the shortcomings of various relative valuation
techniques is important and should help you make more informed
investment decisions. Below we highlight the P/E, P/B, and P/S
ratios, based on the trailing 12 months, or TTM, for each of the
S&P 500 sectors. For context, we compare today's ratios with
the historical 10-year averages.
Using relative valuation multiples on index investments, such as
ETFs, introduces another unique challenge. When interpreting
valuation ratios for an index, make a note of how the index
provider treats anomalies in the data, such as firms with negative
earnings, which will impact overall results.
Use the Right Vehicle
Before you go and screen valuations in the equity ETF universe, we
should lay out some ground rules. The first step to any good
investment requires developing a sound investment thesis. And to
boost your chances of success, write it down. Putting the idea on
paper and being able to articulate it to others will only help
shape and strengthen your thesis.
Also, make sure to select the investment vehicle that most
closely aligns with the thesis. ETFs are a great way to implement
thematic ideas because the diversification inherent in a fund
avoids the idiosyncratic risk of single stocks. On the other hand,
picking individual stocks offers the potential for spectacular
returns if you believe you have an edge or some sort of special
insight into a given company.
For instance, if your tactical investment thesis is based on the
success of a particular product, a specific corporate strategy, or
estimated synergies from mergers and acquisitions, then investing
in the individual stock will be the most effective way to express
(and hopefully capitalize on) that thesis. In such cases, you are
actually seeking exposure to the firm-specific risks that are
diversified away in the ETFs.
However, if you have a more thematic investment thesis, like
higher commodity prices in the future will boost profitability for
resource firms, an ETF could be the way to go. With the ETF, as
opposed to a single stock, we are essentially making a bet that a
rising tide will lift all boats. An ETF would also be the vehicle
of choice to take advantage of situations where you believe the
market has greatly over- or underreacted to a particular news
For example, a health-care ETF would have fit the bill if you
thought the market was unfairly punishing health-care stocks when
reform was introduced and uncertainty skyrocketed. In this case,
going with an ETF protects us from the risk of selecting a firm
whose internal miscues outweigh the impact of broader industry
trends on its performance. A surefire way to a poor investor
experience is having the right thesis but wrong execution. Be sure
to select the vehicle that most accurately reflects your investment
*Note that in order to apply fair value estimates to equity
ETFs, Morningstar analysts must cover at least two-thirds of the
ETF's total assets. Currently this valuation metric is available
for roughly 300 equity ETFs. Though this takes us most of the way,
there are some ETFs with significant small-cap or international
exposure that lack adequate coverage and therefore will not have
fair value estimates.
Morningstar licenses its indexes to certain ETF and ETN providers,
including BlackRock, Invesco, Merrill Lynch, Northern Trust, and
Scottrade for use in exchange-traded funds and notes. These ETFs
and ETNs are not sponsored, issued, or sold by Morningstar.
Morningstar does not make any representation regarding the
advisability of investing in ETFs or ETNs that are based on
Why Campbell Soup Is Fairly Valued