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ETFs: The Cheap, the Dear, and the Fairly Valued

An update on funds our stock analysts would and wouldn't buy today.

Dan Culloton, 04/11/2006

Looking for bargains in a fairly valued market? Look beyond Asian and real-estate stocks and toward mega-cap equities. And though energy stocks don't seem as overvalued as they were at the end of 2005, they still aren't a great deal.

So says Morningstar's price/fair value ratio for exchange-traded funds. At the start of 2006's second quarter, we revisited the measure that uses the fair value estimates set by Morningstar's 90 equity analysts for 1,700 stocks to determine if ETFs' underlying holdings are, on average, trading above or below their worth. To make sure we were getting an accurate reading, we focused on ETFs that had Morningstar fair value estimatess for more than 80% of their holdings. Here's what we found.

Broadly Speaking

The broad market, as defined by the all-encompassing stock indexes tracked by Vanguard Total Stock Market VIPERs VTI, StreetTRACKS Total Market ETF TMW, and other offerings, looked fairly valued at current levels.

The valuations of the energy ETFs, on the other hand, don't look quite as lofty has they did a few months ago. This reflects recent price retreats of a few of the sector's biggest winners of recent years, such as Southwestern Energy SWN, as well as the reality that burgeoning Asian demand, steady consumption in the United States, and the need to spend more money on oil and gas exploration and production underpin the rally. A lot of that optimism is already baked into energy-stock valuations, though. Many of the largest holdings in energy-heavy ETFs such as iShares Goldman Sachs Natural Resources IGE are trading above their fair value estimates, including oil-services giants Schlumberger SLG and Halliburton HAL. That suggests that the future of these ETFs might not be as bright as their recent past.

 Broad Market ETFs
% of Assets w/ Fair Value Estimates
Fair Value
iShares R3000 Index IWV
iShares Dow Jones Total Market IYY
streetTRACKS Total Market TMW
Data as of 04-06-06

Airy Asia

Energy ETFs were not the most overvalued at the start of the second quarter. As of April 6, BLDRS Asia 50 ADR Index ADRA, which tracks an index of Asian stocks that list their shares on American stock exchanges, had the highest price/fair value ratio among the ETFs we examined.

Although it notched lackluster gains in this year's first quarter, the Japanese stock market has rallied strongly in the past three years, and this ETF keeps more than 60% of its assets in the shares of Japanese companies. Furthermore, the fund concentrates more than 15% of assets in just two mega-cap Japanese stocks that are currently trading above their Morningstar fair value estimates: Toyota Motor TM and Mitsubishi UFJ Financial Group MTU. Large helpings of a few richly valued industrial stocks, such as miner BHP Billiton BHP, also make this ETF look frothy.

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