In a recent article, Chuck Jaffe wrote that when he considers a mutual fund or ETF, he looks at the ratings of three research firms: Morningstar, Lipper, and New Constructs. Morningstar and Lipper do an excellent job of tracking past price performance, but Chuck realizes that analyzing the past is not enough to make informed decisions, investors need due diligence on the holdings of a fund.
First Trust Utilities AlphaDEX Fund ETF (NYFXU) is in the Danger Zone this week due to its poor holdings. FXU might not have any obvious red flags on the surface, but a look at its holdings reveals a number of stocks with the potential to blow up, including some recent features in the Danger Zone. FXU has outperformed the market this year, gaining 14%, but its poor holdings make it a ticking time bomb that could blow up at any moment.
Proof That Holdings Matter
At the end of most of my articles, I include a section warning readers to avoid funds that allocate significantly to a stock that's in the Danger Zone that week. The performance of funds I recommended you avoid provides evidence of the excess risk of investing in funds with dangerous holdings.
On September 9, 2013, I warned investors to stay away from Morgan Stanley Institutional Small Company Growth Portfolio (MUTF:MSSLX) due to its significant allocation to Angie's List (NASDAQ:ANGI). MSSLX was also littered with companies we would put in the Danger Zone over the next several months, including Dunkin Donuts (NASDAQ:DNKN), NetSuite (NYSE:N), MercadoLibre (NASDAQ:MELI), and Zynga (NASDAQ:ZNGA). ANGI has dropped 60% since then, which has helped to tank MSSLX.
In the twelve months leading up to our recommendation to avoid it, MSSLX had been up 34%, outperforming the Russell 2000 by 5 percentage points. Since my recommendation, MSSLX and the Russell 2000 have diverged. The Russell 2000 is up 12%, and MSSLX is down by the same amount.
A month and a half later, I warned investors about 10 mutual funds that had significant allocation to Tangoe (NASDAQ:TNGO). Since then, TNGO has dropped 44%, and all of those 10 funds have lagged the Russell 2000's 4% gain. Only one has even managed positive performance. The worst performing fund has been John Hancock Small Cap Equity Fund (MUTF:SPVCX), which has lost 7%.
Both MSSLX and SPVCX had solid 1-, 3-, and 5-year track records, but in-depth research of their holdings enabled me to predict their future underperformance. Past performance is not always a good indicator of future performance.
The Issues With FXU
FXU allocates 11% of its value to three stocks that I've recently highlighted as high risk. AT&T (NYSE:T) is FXU's largest holding and accounts for 4.4% of its value. United States Cellular (NYSE:USM) is also in the top five and makes up 4.1% of FXU's portfolio. FXU allocates a further 2.5% to Hawaiian Electric (NYSE:HE). Both USM and HE are recent inductees to the Danger Zone.
All three of these companies have declining returns on invested capital (ROIC), significant debt, and major future cash flow growth baked into their valuations. Even if the rest of the portfolio were decent, the 11% allocated to these three stocks would probably keep me away.
Unfortunately, the rest of FXU's holdings are far from decent. Over 88% of its value is allocated to Dangerous-or-worse rated stocks, and only one Attractive stock, Consolidated Edison (NYSE:ED), makes it into FXU's portfolio. Admittedly, the pickings for this ETF are pretty slim, as Utilities ranked last in my Sector Rankings Report.
Still, FXU could have done much better. It fails to allocate any money to Attractive-or-better rated Utilities and Telecom stocks such Otter Tail Corp. (NASDAQ:OTTR), Verizon Communications (NYSE:VZ), and Neustar Inc. (NYSE:NSR).
Instead, FXU overweights overvalued companies with low ROICs. T, USM, and HE are all examples of FXU's poor holdings, as is Pepco Holdings (NYSE:POM), FXU's second largest holding. POM has not earned an ROIC above 4% since 2002. It has no excess cash, $9.4 billion in debt, deferred tax liabilities, and underfunded pensions, and has generated negative free cash flow in four out of the past seven years. Just like HE, POM is increasing its debt in order to fund $250 million in dividend payments each year. That is not a sustainable model. Tick-tock.
Making matters worse, POM's current valuation of ~$27/share implies that the company will grow after-tax profit (NOPAT) by 5% compounded annually for 26 years. Seeing as how POM has only grown NOPAT by 2% compounded annually for the past decade, the market's expectations appear overly optimistic.
One last issue with FXU: In addition to its poor stock-picking, FXU charges investors above average total annual costs of 0.78%. The slightly higher costs don't have a huge impact on performance, but investors should not be paying above average fees for an ETF with such poor holdings.
Need For Diligence
Superficially, FXU might look like a good pick. It has a decent dividend yield, it's been outperforming its benchmark (NYXLU), and the Utilities sector has been the best performer in 2014. However, a closer look reveals how overvalued FXU is. Combined, its holdings have a price to economic book value (PEBV) of 4.6. In other words, the current market valuation implies that the cash flows of its holdings are going to increase by 460%. That's a lot of growth baked in. Given that these are low-growth, low-ROIC companies, you have to be quite the gambler to bet Utility companies would exceed these high expectations.
Many Utility companies are following the same pattern as HE and POM, adding on debt every year in order to fund their dividend. In Barron's feature of my HE report, columnist Vito Racanelli wrote that HE's investor relations manager when asked to comment on our thesis said that the utility business is capital-intensive and regulated and that many utilities have negative free-cash flow. He would not provide cash flow guidance but offered up EPS estimates. Accounting results can disguise poor cash flows for only so long. Tick tock.
Sam McBride contributed to this report.
Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, or theme.
Disclosure: The author is short HE, ANGI, N. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.