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Leave the 'Junk Rally' Behind and Look for Quality at a Reasonable Price

Use this screen to uncover ETFs comprising industry-leading businesses with relatively stable returns and decent valuations.

John Gabriel, 10/20/2009

With the stock market up impressively off its March lows, it can be tempting--especially for those currently underweight in equities-- to pile in on fear of being left in the market's dust. But before they allocate fresh capital into the market, we'd urge investors to not only focus on finding equities that trade at attractive valuations, but to also pay particular attention to the quality and sustainability of the underlying businesses. After being deeply undervalued throughout 2008 and into 2009, the market--as a whole--currently looks to be about fairly valued, according to our analysts' fair value estimates. That's not to say that pockets of opportunity don't still exist, however.

Signs of economic stabilization have certainly helped buoy the equity markets this year, but we'd be remiss to not recognize that much uncertainty still abounds in our fragile economy. In our view, investors should exercise prudence by sticking with stable companies with proven business models, while avoiding many of the high-beta stocks that led the surge in the market's recent "dash for trash." Indeed, quality and valuation go hand-in-hand. The "cheapest" stocks out there might be depressed for good reason (that is, declining demand, unsustainable leverage, obsolescence, etc.). Similarly, a great business can be a poor investment if bought at too dear a price. Warren Buffett summed up the general idea behind the screen we designed for Advisor Workstation users when he stated that, "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."

With quality on our minds, we narrowed the universe of ETFs down by first screening for funds that earn an asset-weighted return on assets of at least 10%. Using this metric, as calculated by dividing net income by total assets, we can weed out funds with big stakes in firms (or sectors) that tend to employ aggressive leverage to boost returns. When times are good, highly leveraged firms enjoy amped-up performance. However, sizable debt liabilities also leave these firms with less of a margin for error. With looming fears of a "double-dip recession," we want to steer clear of excessive leverage and favor profitable firms with manageable debt loads.

ROA % TTM >= 10

As another determinant of quality, we also screened for a minimum return on equity. ROE can be calculated by multiplying ROA by financial leverage, or by dividing net income by shareholders' equity. To think about it another way, we can think of this metric as a proxy for how much profit a company generates on the money shareholders have invested in the firm. As a point of reference, in the trailing 12 months through Aug. 31, the S&P 500 showed an ROA and ROE of about 7% and 18%, respectively.

And ROE % TTM >= 10

In our quest to uncover funds that have shown relatively stable performance we looked at the total risk as measured by the standard deviation, or variation of the fund's returns over the past three years. We set the cut-off for the maximum amount of risk we were willing to assume by using the S&P 500 benchmark as our proxy. In the three years up to Aug. 31, the S&P 500 had a standard deviation of about 19.5%. Screening for funds with less volatility than the overall market gives us some comfort in the quality of the screen results.

And Standard Deviation 3 Yr <= 20

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