We recommend investors short the KBW Bank ETF (KBE) and avoid or sell all other financial sector ETFs. We also rate the investment merit of the top nine financial sector ETFs.
Per our first-quarter-2011 review of U.S. Equity Sector ETFs, the financial sector is one of two sectors that gets our “dangerous” rating. Per Figure 2, the financial sector has only 95 stocks (17% of the value) that we rate attractive-or-better, compared to 323 stocks (66% of the value) that we rank dangerous-or-worse.
Some good stocks in the financial sector to buy individually or as part of an ETF are The Travellers Companies (TRV) and Capital One Financial (COF). Some stocks to avoid, sell or short in the financial sector are Morgan Stanley (MS) and Citigroup (C).
Investors eyeing financial sector ETFs should be careful. The sector offers more stocks with bad investment opportunity than good. The investment merit of each ETF derives from its constituents, so ETFs that overweight attractive-or-better-rated stocks-- like TRV and COF-- can be great investment opportunities, while ETFs that overweight neutral-or-worse-rated stocks-- like MS and C-- should be avoided.
Figure 1: Financial Sector – Capital Allocation & Holdings by Risk/Reward Rating
Sources: New Constructs, LLC and company filings
When analyzing the financial sector ETFs, we started by identifying those ETFs with acceptable structural integrity as measured by XTF, an ETF research firm. We chose the 6 ETFs whose XTF rating was above the sector average XTF rating.
Figure 2: Financial ETFs With Acceptable Structural Integrity
Sources: New Constructs, LLC; XTF and company filings
Figure 2 shows clearly that not all financial ETFs are made the same. Different ETFs have meaningfully different numbers of holdings, and therefore, different allocations to holdings. Given the differences in holdings and allocations, these ETFs will likely perform quite differently.
After determining the structural integrity, we analyzed the investment merit of each ETF based on how it allocated value to each stock it held. Figure 3 shows how the 6 financial sector ETFs stack up versus eachother and the overall sector based on their overall risk / reward ratings and the allocation of their holdings by rating.
Figure 3: Investment Merit Based on Holdings and Allocations
Sources: New Constructs, LLC; XTF and company filings
We find no attractive-or-better-rated financials sector ETFs.
We also find no neutral-rated financials sector ETFs. We recommend investors buy the very attractive and attractive stocks in this sector before buying any of the financials ETFs we cover in this report. Contact us for the full list of 95 financials companies that earn an attractive-or-better rating.
The overall financials sector outperforms KIE in quality of earnings ratings. The sector earns a very attractive economic vs. reported earnings ratings compared to KIE’s neutral rating.
KIE outperforms the overall financials sector in valuation ratings. KIE has a price-to-EBV of 0.6, earning it a very attractive rating compared to the financials sector’s price-to-EBV of 1.4. KIE’s GAP of 47 years earns it a dangerous rating while the financials sector’s GAP of 65 years earns it a very dangerous rating.
Click to enlargeKIE allocates capital more effectively than the overall financials sector. Per Figure 3 above, KIE allocates 35.6% of its value to attractive-or-better-rated stocks while the sector only allocates 16.6%. KIE also only allocates 43.7% of its value toward dangerous-or-worse-rated stocks compared to the sector’s dangerous-or-worse weightings of 65.8%.
For explanation and details behind our risk/reward rating system, see one of our Company Valuation reports, which are available for free here.
The S&P 500 significantly outperforms KIE in all components of the Overall Risk/Reward Rating except for Price-to-EBV. KIE’s relatively low Price-to-EBV does not offset its significantly worse quality of earnings ratings and other valuation ratings.
The S&P 500’s market-weighted average ROIC is 18.3%, earning it a very attractive rating compared to a dangerous-rated 7.1% for KIE. The S&P 500 also has a very attractive economic vs. reported earnings rating because its economic earnings are positive and rising while KIE’s economic earnings are negative.
Click to enlarge
The S&P 500 allocates capital more effectively than KIE. Per Figure 3 above, the S&P 500 allocates 42.3% of its value to attractive-or-better-rated stocks while KIE only allocates 35.6%. The S&P 500 also only allocates 23.7% of its value toward dangerous-or-worse-rated stocks compared to KIE’s dangerous-or-worse weightings of 43.7%.Methodology
This report offers recommendations on Financials sector ETFs and benchmarks for (1) investors considering buying financials sector ETFs and for (2) comparing individual ETFs to the financials sector and the S&P 500. Our analysis is based on aggregating results from our models on each of the companies included in every ETF and the overall sector (531 companies) based on data as of April 19th, 2011. We aggregate results for the ETFs in the same way the ETFs are designed. Our goal is to empower investors to analyze ETFs in the same way they analyze individual stocks.
To make an informed ETF investment, investors must consider:
1) The structural integrity of the ETF and its ability to fulfill its stated objective. We use XTF, an ETF research firm, to find the top nine ETFs with the best structural integrity rating.
2) The quality of the ETF’s holdings. We determine an ETF’s quality using our stock ratings.
Disclosure: I am long TRV.