Bargain Hunting in ETF Land

The past few weeks have seen a wild ride in financial markets, as investors worried that the mess in sub prime mortgages would lead to an overall credit crunch and, eventually, a recession. Don’t worry—we’re not going to debate that issue here. This article is about bargain hunting.

Although stocks have recovered some of their losses since the market hit a recent low on August 15th, all but two of the 58 ETFs we cover—the iShares FTSE/Xinhua China 25 (FXI) and Hong Kong (EWH) funds—are still lower than they were in mid-July when the correction began. And as with any market panic, sometimes the baby gets thrown out with the bath water, creating opportunities down the road. What follows is a discussion of three ETFs we think are bargains, one from each fund category: Broad Market, Sector, and International.

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Broad Market pick: iShares Russell 1000 Value (IWD). Yes, yes, we know: conventional wisdom says that after years of underperformance Growth stocks will start to shine and that Value’s time in the spotlight is past. Indeed, the iShares Russell 1000 Growth fund (IWF) did start to outperform the Russell 1000 Value fund (IWD) in July.

However, this is due mostly to differences in sector balance: Growth is overweight Tech while Value favors Financials—clearly the right and wrong places to be, respectively, during the mini-correction. But we do not think this will persist. Nervousness over the sub-prime mess will dissipate, and investors will remember that Tech stocks are not immune to disappointments on the earnings front (discount iPhone, anyone?).

However at the end of the day we think it’s about valuations. Stocks in IWD are only slightly less profitable, on average, than stocks in IWF, earning a Return on Equity of 15.7% and 18.7%, respectively, over the course of the business cycle. However, for this Growth stocks are fetching 4.0x estimated book value for this year, compared to less than half that (1.9x) for Value stocks. That kind of premium simply doesn’t seem justified to us.

Sector pick: Financial Sector SPDR (XLF). Despite all the media attention focused on financial firms, XLF was not the worst performing sector during the correction. In fact, four other Sector SPDRs fared worse, and XLF has since recovered somewhat. Still, for the reasons we discussed at length last month—estimates are rising and valuations are compelling—we think XLF remains a bargain. Currently stocks in XLF trade at just 11.2x this year’s anticipated earnings, the cheapest of any Sector SPDR, and enjoy a 3.0% yield, just a fraction below that of Utilities (XLU).

International pick: WisdomTree Emerging Markets High Yield (DEM). DEM is an excellent way for more conservative investors to get emerging market exposure with its whopping 5.9% yield. And we think Emerging Markets in general remain an attractive asset class: firms in DEM and other emerging market ETFs we follow are in fact world-class competitors, with profitability on par with or exceeding that of their counterparts in developed economies, and are unlikely to catch the bird-flu because America sneezes—credit-crunch or not. As a result, we do not think these emerging markets funds deserve the valuation discount they typically get. DEM is trading at just 11.5x expected earnings per share this year, compared with 15.5x for the S&P 500 SPDR (Figure 1). And lest you think that this high yield fund is full-up on crusty old slow-growers, companies in DEM have collectively grown earnings 21.6% per year over the past five years, compared with 15.7% for the S&P 500 (Figure 2). Good earnings growth at a discount: seems like a bargain to me!

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Comments

[Elliott:]

As a fan of closed end funds I'll say with a grin that there are no bargain ETFs because they always trade at NAV :-)

2007 Sep 11 11:56 PM

[Moshe:]

Dear Mr. Krause

"all but two of the 58 ETFs we cover—the iShares FTSE/Xinhua China 25 (FXI) and Hong Kong (EWH) funds—are still lower than they were in mid-July"

FXI - July high - $142. 58
Sept 11 - $151.18


Moshe

2007 Sep 12 03:10 PM