ITOT: Strong Potential Returns In 2022

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Summary

  • ITOT is a diversified source of equity beta, investing in small-caps right through to the mega-caps.
  • At the moment, from a valuation perspective based on earnings projections roughly in line with the consensus, the implied equity risk premium is well above what I would consider normal.
  • Therefore, recent share price declines are likely to be met with a continued resurgence. I would not rule out all-time highs being achieved in 2022 once again.
  • However, we will need to continue to monitor equity markets for the possibility of tighter valuations and/or recession risk (in the later stages of the business cycle).
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iShares Core S&P Total U.S. Stock Market ETF (NYSEARCA:ITOT) is an exchange-traded fund that provides investors with exposure to the "total" U.S. equity market, which means that the portfolio spreads far and wide, including both mega-cap companies as well as small-cap stocks. The fund had assets under management of $41.1 billion as of May 27, 2022, making it very popular, while the expense ratio is reported as being just 0.03%, making the fund also very cheap (presumably in part enabled by the wide popularity of ITOT).

ITOT had 3,626 holdings as of May 27, 2022, however the fund was still reasonably concentrated at the top as you might expect with practically any large equity fund. Nevertheless, the fund is less concentrated than conventional U.S. equity ETFs that track indices like the S&P 500. The top 10 holdings of ITOT represented 22.33% of the fund as of May 27, 2022.

ITOT Top 10 Holdings

Data from iShares.com

ITOT's chosen benchmark index, which it is designed to roughly track, is the S&P Total Market Index. A recent factsheet for the fund, as of April 29, 2022, revealed a trailing price/earnings ratio of 22.28x, a forward price/earnings ratio of 18.91x, a price/book ratio of 3.79x, and an indicative dividend yield of 1.48%. Based on this information, I know the forward projected ROE for ITOT's underlying portfolio is roughly 20% (almost exactly), and its dividend distribution rate (of earnings) is about 33%.

An ROE of 20% is strong. However, among the S&P 500, the buyback rate (of earnings) is roughly 50%, which is on top of dividend distributions. I will assume a lower 30% due to the lesser concentration of larger-cap stocks in the ITOT portfolio and hold this constant for now (we can play with adjustments shortly, after a base estimate to work with). Therefore, the strong ROE of 20% could even increase, as distributions (in dividends and buybacks) decrease net asset values (the retained balance sheet sizes) of companies, decreasing the denominator (equity) in the equation. Nevertheless, I will try to be conservative by tailing off earnings growth to 2% by year five.

The result of my estimates is that my three- and five-year average earnings growth rates are 13.82% and 9.77%, respectively, which are just below Morningstar's consensus estimate (over three to five years) of 13.92%. So, my projections are not unrealistic, apparently. I also assume the price paid in share buybacks is similar to the current prevailing price/earnings ratio on average, although I have decided to drop the forward price/earnings ratio down over time slightly.

The end result is that the current price of ITOT implies an IRR of 9.15-11.37%, depending on whether you are valuing the total earnings power or just distributions (plus terminal value).

ITOT IRR Estimate

Author's Calculations

Assuming a risk-free rate of about 3%, the implied equity risk premium is between 6.15% and 8.37%, which is high. I would consider 4.2-4.5% fair the U.S. equity risk premium without any beta adjustment (beta is a measure of relative volatility, or risk, and ITOT is basically just beta given its wide level of diversification, hence no adjustment is important here although a five-year estimate is 1.04x). An elevated ERP might be up to 5.5% (pre-adjustment for beta). So, the current range of 6.15-8.37% per my estimations implies potential upside of 7.6-34% for ITOT shareholders (depending on which cost of equity you use; the more favorable model is valuing ITOT on its total earnings power). The upside range is more like 22-52% if we assume a more "normal" ERP of 4.5% instead of targeting the elevated 5.5%.

If I adjust the buyback rate to 0%, or 50%, and hold these constant in each scenario, my projected IRR changes to roughly 7.57-11.37% (in the no-buybacks model) and 10.23-11.37% (in the higher-buybacks model).

As ITOT is so diversified, my view is basically a bullish view not just on ITOT but also on the wider U.S. equity market in aggregate. ITOT itself is exposed to all sorts of sectors, including Technology (24%), Healthcare (14%), and Financial Services (14%).

ITOT Sector Exposures

Morningstar.com

There are some risks of a recession apparently growing, but based on reasoned research from Fidelity, the U.S. still isn't in the later stages of its current business cycle. It is probable that markets have got well ahead of themselves.

Business Cycle Update for U.S. Equity Market

Fidelity.com

I am betting on all-time highs at present, before a "real top" is formed in the later stages of the current business cycle. Markets are thought to price in major events like earnings recessions about 6-9 months ahead of time, but not by much more. You also tend to see major yield curve inversions ahead of time, but yield curve inversions have been weak at best (the most credible indicator is the spread between the U.S. 10-year and the U.S. 3-month yields, and this has not even inverted yet). All I see at present is a good opportunity for risk premiums to contract again, i.e., for valuations to lift, and for stocks to hit higher highs before we should worry about a recession and bear market.

Therefore, in summary, ITOT is a diversified source of beta, with exposure to the entire U.S. equity market. It is low-cost to hold, and seems to be undervalued, based on historical measures of equity risk. In a low-rate world, an IRR of around 8-11% is excellent. Following recent market declines, I would buy the dip.

This article was written by

Hedge Insider profile picture
1.48K Followers
Providing commentary and analysis, principally focused on global macro, foreign exchange, and equities as an asset class. Primary interests include equity investing from an international perspective, and FX fair values.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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