Hide in the Semiconductor Industry's Thick Pile of Cash With This ETF

| About: VanEck Vectors (SMH)

By our calculation, semiconductor companies are hoarding a thick pile of cash that is equal to 21% of their stock prices. That’s where investors want to hide when future is uncertain.

Companies can do a lot of things with cash to benefit investors in different situations. First of all, when times are right, companies can use cash to fund growth through capital expenditures on new plants and machinery. If growth opportunities are hard to locate, companies can return cash to investors by buying back shares or issuing dividends. When recessions hit, cash provides a cushion to any financial hardship. It also allows companies to buy competitors at attractive prices at the end of recessions and positions them better for futures.

When uncertainty is looming like nowadays, companies with more cash simply have more options than others and should fare better. Admittedly it is up to management teams’ discretion to make sound use of the cash. Sometimes their performance really disappoints investors no matter time is good or bad. But if we look at a basket of companies that are rich in cash, the differences on personality will be averaged away. Collectively the basket of companies should have an edge over peers and investors who stay with them should benefit.

Thus we come up with an idea to search for an ETF that is rich in cash.

Nonetheless, blindly embracing one with the highest cash ratio wouldn’t be a good idea. Investment is a sophisticated business. There are other criteria we want to consider for better potential and less risks. We designed a three-step procedure for this purpose:

  1. Pick industry ETFs that have abundant liquidity.
  2. Using our ETF ranking system to filter out ones with less sound fundamentals.
  3. Pick the one with the highest cash ratio.

Companies in the same industry often have similar business models. If a specific industry has more cash, it is more likely a structural opportunity associated to the industry. For liquidity, our criterion is the average daily dollar volume is more than $100 million. High liquidity means a lot of investors are trading it and hence paying attention to it. Given thousand eyeballs, any price error would be shallow. Thus we expect highly liquid ETFs to see less tracking errors. Another advantage is less bid-ask spread thus less trading costs.

We quantify fundamentals of ETFs by a newly devised ETF ranking system. For purpose of this discussion, we summarize below key attributes of the ranking system. Details can be found in our methodology article: “ETF Ranking: A New Fundamental Approach That Drives Short-Term Return."

  • The ranking system is based on fundamentals. Individual stocks are ranked by their valuation, financial condition and return on capital. We extended the ranking system to ETFs. The rank of an ETF is calculated to be the weighted average over the ranks of stocks in its portfolio.
  • It has predictive power. The ranking system drives short term return. We observed that stocks with higher ranks had a strong tendency to outperform those with lower ranks over a period of one week. The data show that moving up 10 rank points translates to an extra annualized return of 1.7% in the past 10 years, if ranks range from 0 to 100. As a mater of fact, the S&P 500 Index returned an annualized 2.5% in the same period.
  • It is bubble-proof. Growth is not fabricated into the ranking system. Stocks with rich valuation simply due to their growth potential are not going to have rosy ranks.

The cash ratio of a company is its cash per share number divided by its stock price. For an ETF we calculate the weighted average over all companies in its holdings. Listed below are ETFs that passed our liquidity check, together with their ranks and cash ratios. The cash ratio growth is the growth rate over the last three months.

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Cash Ratio

Cash Ratio Growth

Semiconductor HOLDRs (NYSEARCA:SMH)












SPDR S&P Metals and Mining (NYSEARCA:XME)








iShares Dow Jones Transport. Avg. (NYSEARCA:IYT)




SPDR S&P Oil & Gas Explore & Prod. (NYSEARCA:XOP)








iShares Dow Jones US Real Estate (NYSEARCA:IYR)




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Among all the listed ETFs, SMH is the top ranked one and with the second highest cash ratio. Although it doesn’t have the highest cash ratio, its cash ratio growth rate over the last three months is the highest. KBE, the ETF with the highest cash ratio, is ranked at only 24 by our ETF ranking system. A rank below 50 is expected to underperform the market. Indeed, banks were driving the latest sell off.

Ranked above 80, SMH has an expected annualized return that is three times market return. The aggregated rank of the entire market should be 50 since it is generally an average of all stocks whose ranks range from 0 to 100. Because in the past 10 years 10 rank points translated to an extra annualized 1.7%, a stock ranked above 80 would have outperformed the market (ranked at 50) by 1.7% x (80 – 50) / 10 = 5.1% annually. Plus a market return at an annualized 2.5%, the total annualized return would have been 7.6%, which is more than three times 2.5%, the market return in past 10 years. That said, historical returns do not guarantee future performance.

Thus SMH is highly liquid, has solid fundamentals and a thick pile of cash. It appears to be a safe choice for investors to hide in this trying time.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.