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Originally published on June 30, 2010

By Michael Rawson, CFA

With the S&P 500 down about 7% in the second quarter, those investors who sold during the market crash and were hesitant to reinvest as the market rallied in 2009 might want to use the recent sell-off as a buying opportunity. What segments of the market are currently attractive? In this article, we discuss a valuation measure called the price/fair value ratio and highlight several ETFs that look attractive.

Morningstar has an army of 100 equity analysts covering more than 1,700 companies. Our analysts forecast revenue growth, profit margins, and capital investment (and all of the numbers that go into them) for each firm they cover. While measuring past performance is straightforward, forecasting future performance is much more difficult and requires an assessment of a firm's economic moat or sustainable competitive advantage. All of this work culminates in a discounted cash flow model from which a fair value estimate is derived. Stocks that sell at a discount to fair value offer the best potential for share price appreciation.

ETF investors can take advantage of the broad coverage of Morningstar's stock analysts by aggregating the price/fair value estimates of the components of an ETF. We can then gauge the attractiveness of each ETF by looking at the size of the discount to fair value. Morningstar has developed an ETF screening tool that allows users to screen for ETFs based on a number of criteria. By widening the upper and lower limit on the price/fair value criteria, we can see that Morningstar has a price/fair value estimate on 246 ETFs. Morningstar currently sees the market as somewhat undervalued, which is reflected in the fact that 206 ETFs were returned when setting the upper limit of the price/fair value to 1. Clicking on the price/fair value column heading sorts the results. Among the results are a number of ETF analyst picks such as Vanguard Dividend Appreciation ETF (NYSEARCA:VIG). This fund seeks out stocks that have a 10-year track record of increasing dividends.

Morningstar analysts currently see the best opportunities in the large and value side of the Morningstar Style Box. Vanguard Value ETF (NYSEARCA:VTV) trades at a price/fair value of 0.79 while Vanguard Growth ETF (NYSEARCA:VUG) trades at a slightly more expensive 0.87. While most small-cap ETFs do not have enough stocks under coverage to support a fair value estimate, we can see that large is preferred to mid-cap from the fact that Vanguard Mega Cap 300 Index ETF (MGC trades at a price/fair value of 0.80, while Vanguard Mid-Cap ETF (NYSEARCA:VO) trades at 0.95.

Additional criteria can also be used to narrow the results. For example, select Add Criteria and under the Valuation group, select % Wide Economic Moat. This criteria will allow us to search based on the percentage of assets underlying the ETF that analysts feel have a wide economic moat, or a sustainable competitive advantage relative to its peers. There are 27 ETFs that trade at a discount to fair value and have at least 50% of their assets in wide economic moat stocks. A number of health-care ETFs were returned by this screen, including Vanguard Health Care ETF (NYSEARCA:VHT) and Health Care Select Sector SPDR (NYSEARCA:XLV). Another fund that stands out in this screen is WisdomTree LargeCap Dividend (NYSEARCA:DLN). Firms that pay a consistently large dividend often have a wide economic moat because they have stable, defensible market positions and they have reached a stage in their life cycle that allows them to pay out a large portion of their cash flow to shareholders.

We have summarized some of the results below, but invite you to give the screening tool a try yourself. Price/fair value is but one lens from which you can tactically find ETFs that fit your investment needs. We believe that you will find other perspectives useful as well.

Vanguard Value ETF follows the more beaten-down, deeper-value half of the MSCI Prime Market 750 Index. While over long periods of time, value stocks tend to outperform, funds that concentrate on factors such as style can be more volatile in the short term. The fund charges an expense ratio of just 0.14% and holds about 420 stocks.

Vanguard Mega Cap 300 Index ETF follows a full replication strategy of the MSCI US Large Cap 300 Index, which tracks 300 of the largest U.S. stocks. This fund could serve as a suitable core holding, as it is diversified across names and sectors and large-cap stocks tend to be less volatile than small caps. However, its lack of exposure to small-cap stocks could cause the fund to underperform in periods when small-caps stocks do well, as they did over the past decade. The fund charges just 0.13%.

Vanguard Health Care ETF is an appropriate satellite holding for tactical investors who want to place a bet on health-care stocks. The fund charges just 0.25% and tracks about 300 stocks. This broad approach ensures that no matter what segment within health care does well, this fund will be sure to participate.

Health Care Select Sector SPDR tracks just 52 stocks, so it is more concentrated and larger in market cap than VHT, but it charges just 0.21% and has much greater assets under management and trading volume, which should result in better liquidity. Whereas VHT draws health-care stocks from a pool of the 2,500 largest U.S. stocks, the SPDR approach invests in health-care stocks that are also constituents of the S&P 500.

WisdomTree LargeCap Dividend tracks an index of 300 large-cap stocks weighted not by market cap but by dividend payout. This results in a large-cap and value tilt. Although the aggregate dividend yield may will be lower than an approach that weights stocks by dividend yield, this approach helps avoid overweighting distressed stocks which are likely to cut their dividend in the future. The fund charges 0.28% which is reasonable among dividend focused ETFs.

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.