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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

So, we've covered the bases on quality. The final two criteria we used in the screen were traditional valuation-related metrics, selected to ensure that we don't overpay for quality. We set the maximum price/cash flow and price/earnings ratios that we were willing to pay at a reasonable 15 times. For perspective, he S&P 500's trailing 12 month P/C and P/E ratios were about 6 and 15 times, respectively. We'd be more than happy to pay marketlike multiples for highly profitable firms with stable demand and favorable long-term prospects. Under the conservative assumption that earnings and cash flows simply keep up with inflation over the long haul, these metrics translate into a real earnings yield of approximately 7%.

And P/C Ratio <= 15
And P/E Ratio <= 15

This screen, which we ran at August month-end, produced seven ETFs. As might be expected, consumer staples and health care were well represented in the results, while financials and deep-cyclicals took a back seat. Here are four of the ETFs that passed our tests.

Consumer Staples Select Sector SPDR XLP
The cap-weighted structure of this ETF translates into relatively concentrated exposure to a few noncyclical consumer staples behemoths. About 75% of assets are allocated to consumer goods firms, with the remaining 25% invested in nondiscretionary retailers. Investors could view this satellite ETF as a defensive tilt to their portfolios. The industry stalwarts steering this ship include the usual suspects: Procter & Gamble PG, Coke KO, Philip Morris PM, and Wal-Mart WMT. More than 60% of this ETF's portfolio is invested in wide-moat firms and about 30% is allocated to narrow-moat firms.

iShares S&P Global Health Care IXJ
This ETF offers investors exposure to a portfolio of some of the finest health-care companies in the world. Similar to the overall health- care sector's industry breakdown, big pharma soaks up roughly two thirds of this cap- weighted fund. Rounding out the portfolio is a sprinkling of managed-care firms, mature biotech companies, and medical device firms. It is worth noting that investors can obtain similar sector exposure (with lower expense ratios) from funds like Vanguard Health Care ETF VHT and Health Care Select Sector SPDR XLV. However, neither of these ETFs contains firms domiciled outside North America. Thus, investors in this ETF would essentially be paying a slight premium (of 0.25% to 0.26%) on the net annual expense ratio here in order to gain exposure to foreign firms like Novartis NVS, Roche RHHBY, and Sanofi-Aventis SNY. Overall, international firms represent approximately 35% of the fund's assets. Health care is considered a classically defensive sector because of the noncyclical nature of the industry. That said, regulatory uncertainty is hanging over the sector like a dark cloud--consider your stance on the impact of health-care reform before diving in.

SPDR DJ Global Titans DGT
This fund tracks the Dow Jones Global Titans Index, which consists of 50 of the world's biggest companies based on market cap, assets, book value, revenue, and profits. To be included in the index, each firm must derive at least a portion of its revenue from outside of its home country. Technology and energy companies each soak up about 20% of total assets, with health care, financials, consumer staples, and telecom accounting for roughly 15%, 13.5%, 13%, and 9% of total assets, respectively. Our analysts have assigned wide economic moats to more than half of this ETF's portfolio (on an asset-weighted basis) and narrow moats to nearly 41% of assets. This fund brims with high-quality stocks.

Vanguard Dividend Appreciation ETF VIG
This ETF holds a diversified portfolio of high-quality U.S. large-cap equities that could easily serve as a conservative core U.S. equity position. The custom index used for this fund demands that companies increase their dividends for 10 consecutive years just to make the cut. It then imposes further tests for liquidity and financial strength to narrow the U.S. equity universe down to an exclusive list of nearly 200 names across a variety of sectors and industries. It is hard to find fault with the names that top this ETF's portfolio: stalwarts such as Procter & Gamble PG, International Business Machines IBM, ExxonMobil XOM, and McDonald's MCD. In fact, this portfolio has more than 90% of its  assets in companies that our analysts assign wide or narrow moats and an incredible 85% of assets in companies with low or medium uncertainty.

John Gabriel is an ETF analyst with Morningstar.

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