Morningstar
submits:
By Michael Rawson, CFA
Although exchange-traded funds are often thought of as passive
vehicles, active investors in ETFs can still benefit from equity
research. Morningstar has over 100 equity and credit analysts who
conduct fundamental analysis on companies, focusing on sustainable
competitive advantages and a discounted cash flow-derived fair
value. Since these data can be aggregated to the fund level, we can
form an estimate of the worth of the ETF, which is only worth what
the constituent parts add up to.
We can use their research to form thematic ideas about which
sectors appear attractive and which to avoid. ETFs are a great way
to implement thematic ideas because the diversification inherent in
a fund avoids the idiosyncratic risk of single stocks. While
picking individual stocks offers the potential for spectacular
returns, we can gain some efficiency by using sector or industry
ETFs. After all, a rising tide tends to lift all boats. Based on
their analysis, the financial and heath-care sectors are currently
the cheapest sectors on a price/fair value basis. The two most
expensive sectors on a price/fair value basis are energy and
materials.
Financials: Stick With Large-Cap Banks
Many of the large money-center banks have repaid TARP funds and are
now much better capitalized. Remember when bank stocks rallied
after the successful conclusion of the "stress tests" in 2009? It
worked so well the first time; the government is going to run it
again. The Fed wants to evaluate how fit the banks are and if they
are capable of paying out larger dividends. Nineteen banks will
submit plans to the Fed seeking eligibility to raise dividends or
buy back stock, or in the case of a handful of big banks that have
not repaid TARP (such as Regions Financial (
RF
)), how they plan to repay TARP. Those banks that can not repay
TARP may become acquisition targets, such as Marshall & Ilsley
(
MI
). Despite its conservative Wisconsin roots, MI got overzealous
with expansion into Nevada and Florida, and the only way it can pay
back TARP is through a lifeline from Bank of Montreal (
BMO
).
In one sign of good news, Bank of America (
BAC
) reached a settlement with the government-sponsored enterprises
regarding mortgage buybacks. Not only does this remove an unknown,
it sets a standard for any future private settlements that is
perhaps lower than what markets at one time feared. On the
larger-cap financials, James Sinegal, Morningstar's associate
director covering financials states that "the high-quality, narrow-
and wide-moat names we typically favor ... have worked through many
of their problems and are set to go on the offensive again, perhaps
by acquiring troubled peers." On the other hand, there is still
some concern about small-cap banks, many of which have not repaid
TARP money. You can read more from James Sinegal here.
The investment thesis for financials is that large-cap banks
have an attractive valuation and are resolving their problems. As
for how to implement this financials idea with an ETF, we like SPDR
KBW Bank (
KBE
), which owns 24 of the largest banks in the United States. Its
market-cap weighting results in a large exposure to J.P. Morgan
Chase (JPM), Citigroup (C), Bank of America and Wells Fargo (WFC),
all of which we believe are significantly undervalued. Because we
find the value of smaller banks less compelling, we would avoid
SPDR KBW Regional Banking (KRE), which equal weights 50 smaller
regional banks. The average market cap for KRE is about $1 billion
compared with $22 billion for KBE.
Health Care: One of the Few Sectors Adding Jobs
Few sectors of our economy have experienced consistent growth, but
one of them is health care. While total nonfarm payrolls are
essentially flat over the past 10 years, employment in the
health-care industry is up 30%. Alex Morozov, Morningstar's
associate director covering health care, said patient admission
rates are starting to improve and the removal of co-pays for
preventative care should boost demand. He goes on to say that "the
marketplace appears to be extrapolating near-term suppressed
revenue growth onto long-term projections for the sector." M&A
activity should remain an important driver of valuations in
2011.
A number of health-care ETFs trade at attractive price/fair
values, including Health Care Select Sector SPDR (XLV), which
trades at a price to fair value of 0.84, iShares Dow Jones US
Medical Devices (IHI), which trades at 0.88, and iShares S&P
Global Healthcare (IXJ), which trades at 0.89 and benefits from
some international diversification. Pharmaceutical HOLDRs (PPH) is
the cheapest health-care related ETF, thanks in part to its
concentration in "big pharma." It owns several 5-star stocks,
including Pfizer (PFE), and Abbott Laboratories (ABT). However, the
fund is not very well diversified, as it has 24% of its assets in
Johnson & Johnson (JNJ).
Energy and Materials: Fairly Priced and Facing Rising
Commodities Prices
Two of the more expensive sectors on a price/fair value basis are
materials and energy. There is little doubt that strong economic
growth in emerging markets is fueling demand for commodities. And
while the higher prices would benefit materials and energy
companies that produce the underlying commodities, it would likely
hurt refiners' margins, as U.S. consumers are less able to afford
those products.
According to the U.S. Energy Information Administration, between
2000 and 2009, petroleum consumption in the United States was down
by about 1 million barrels a day, but total world consumption was
up by about 10 million barrels a day. Petroleum consumption in
China has nearly doubled in just 10 years. To meet that growing
demand, prices have to rise to justify the higher marginal cost of
production of digging for harder-to-reach resources. A firm that
derives a large part of its revenues and has a large part of its
assets tied to the underlying commodity should benefit, while a
firm that has to buy the commodity on the open market only to
resell it to the cash-strapped American consumers will see margins
squeezed.
Thus, we like firms such as ExxonMobil (XOM), which trades at a
price/fair value of around 0.86, while we would avoid a firm such
as Valero (VLO) or Sunoco (SUN), which are both overvalued at 1.11
and 1.32, respectively. Allen Good, Morningstar equity analyst
covering refiners sees limited upside left in refiners, as he notes
in this report.
To implement our thesis on rising oil prices, we examined two
different energy-themed ETFs. IShares Dow Jones US Oil & Gas
Exploration & Production Index (IEO) has a price/fair value of
1.01 and has none of its assets in wide-moat stocks, while iShares
Dow Jones US Energy (IYE) has a price/fair value of 0.96 and 24% of
its assets in wide-moat stocks. While energy-stocks funds are not
very compelling, we see oil prices rising. In this research note,
Eric Chenworth makes the case for higher prices, and he summarizes
his thesis by saying "record global demand, falling inventories,
and a shrinking supply cushion bodes well for oil prices entering
2011."
We might be tempted to go long the commodity through an ETF.
However, there are a number of problems with ETFs that attempt to
track oil, such as the contango, which results from factors such as
high storage costs. Despite posing capital markets risk, equities
can be a better way to invest in oil for the long term, as a firm
like XOM owns vast oil reserves with virtually no storage costs.
So, despite the fact that the equity ETFs are not particularly
cheap on a price/fair value basis, a bullish outlook on oil prices
may make sticking with the equity ETFs a good idea.
The strong global demand and tight supply dragging oil prices
higher also applies to materials. iShares Dow Jones US Basic
Materials (IYM) is one of the more expensive ETFs on a price/fair
value basis, trading at 1.14. However, there are some attractive
areas, such as Market Vectors Steel ETF (SLX). Morningstar
associate director Elizabeth Collins gives a good summary of the
materials sector here.
While ETFs make a great tool for building portfolios and gaining
both passive and active exposure, it is still important to conduct
a fundamental review of the underlying holdings in your portfolio.
Morningstar offers a variety of research tools to get you
started.
Disclosure:
Morningstar licenses its indexes to certain ETF and ETN providers,
including Barclays Global Investors ((BGI)), First Trust, and
ELEMENTS, 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
Morningstar indexes.
See also
Which Non-U.S. Countries Have the Highest and
Lowest Forward P/E Multiples?
on seekingalpha.com