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Cheap, Local, and On a Roll

Use this screen to find focused funds with stellar risk/reward profiles.

Timothy Strauts, 08/30/2011

This article first appeared in the August/September 2011 issue of Morningstar Advisor magazine. Get your free subscription today!

U.S. stock market has been on a great run over the past two years. Since the March 2009 low, the S&P 500 is up just more than 100%. If your clients have been fully invested these past two years, they should be pretty happy, but there are many investors who still have cash on the sidelines. For those investors looking to put money to work, where should they invest today?

For this screen, we will focus on the domestic-tock exchange-traded fund universe.

Security Type = ETF
And Morningstar Category = Domestic Stock
And Holding Average Star Rating > 3.30
And Total Return 12 Month > 28.0%

To find areas of the market that are still undervalued, we will lean on Morningstar's equity analysts for guidance. The average star rating for an ETF's holding is an asset-weighted average of the Morningstar Rating for stocks in the portfolio. This average star rating offers the insight into the valuation of the equity holdings in a portfolio and draws on the research of Morningstar's stable of in-house equity analysts. Many people are familiar with the ETF and mutual fund star rating methodology, which ranks funds based on risk-adjusted returns for three-, five-, and 10-year time periods. So an ETF's star rating is a backward-looking measure. A stock's star rating, however, is forward-looking.

The Morningstar Rating for stocks has nothing to do with the stock's historical performance and is calculated by comparing a stock's current market price with Morningstar's estimate of the stock's fair value. The rating system also includes a risk adjustment, so it's more difficult for a company with above-average business risk to earn a 5-star rating. The margin of safety our analysts demand before giving a stock 5 stars is determined by their assessment of business risk. Our analysts assign stocks to one of three business-risk ratings.

Each of the five star-rating levels is defined based on expected returns, which assume that the stock's market price and our fair value estimate for the stock eventually converge. Under the system, 3-star stocks are those that should offer a "fair return," one that compensates for the risk of the stock, or a rate of return that's comparable to the stock's cost of equity. (The cost of equity is often called a "required return" because it represents the return an investor requires for taking on the risk of owning the stock.)

Momentum investing is a strategy of buying investments that have had strong returns over the past six to 12 months, and it's based on the idea that markets aren't random and trends exist. Research has shown that momentum generates outperformance in almost every market and asset class tested. Momentum's profitability seems to contradict the fact that many retail-level performance-chasers underperform the market. There is no contradiction. They lose out because they hold on to hot investments for far too long, riding collapsing trends down.

By looking for an average stock rating greater than 3.3, we're going to find the areas of the market that Morningstar equity analysts think are most undervalued. Then, looking at ETFs with one-year returns greater than 28% will take advantage of momentum trends. By combining a value metric and a momentum metric, our goal is to find undervalued securities with good momentum. The screen, performed in Morningstar Principia and run in mid-July, came up with 54 results out of 517 U.S.-equity ETFs. On a sector basis, there are five health-care, four large-value, four large-blend, three large-growth, one energy, two technology, and one natural-resources offerings in the results. Here are four of the resulting ETFs that could make sense in the current environment.   

iShares Dow Jones US Pharmaceuticals IHE
This ETF offers investors exposure to a high-quality portfolio of domestic pharmaceutical companies. Given the health-care sector's lack of sensitivity to the overall economic climate, investors may consider this fund as a defensive tilt for their portfolios. The healthcare sector has hit a lull in recent years, as key blockbuster drugs have lost exclusivity and a blitz of competition ensued from generic drug firms. The overhang weighing on large pharmaceutical firms has partly dissipated, with investor focus having returned to industry-specific, nonregulatory issues that drive pharmaceutical profitability. The secular growth story is incredibly appealing, given that the United States is home to approximately 78 million baby boomers who will presumably require increased levels of medical treatment and care going forward. Studies have shown that the majority of the average person's total medical costs over his or her lifetime are spent in the last few years of life.

iShares Dow Jones US Oil Equip. Index IEO
Unlike vertically integrated oil companies such as ExxonMobil XOM and Chevron CVX, the companies held by this fund are primarily focused on the exploration and production of oil and natural gas. This gives the fund more exposure to price changes in oil and gas and less revenue diversification than those of other oil- and gas-themed funds that hold large integrated energy companies. The top 10 holdings of this ETF are all constituents of the S&P 500, and represent 60% of fund assets.

Exploration and production is a risky and highly capital-intensive industry in which fortunes are largely determined by volatile crude oil and natural gas prices. An investment in IEO should be made with the expectation that oil prices will stay elevated and will continue to rise in the future.

Market Vectors Steel SLX
With its narrow industry focus, investors should treat SLX as a tactical satellite investment to complement a broadly diversified portfolio. In terms of overlap with the standard core holdings, there isn't much. Only four stocks from Market Vectors Steel are in the S&P 500 as well as having only four different common holdings with the MSCI World Index. The low correlation and overlap with core indexes provides significant diversification power to a standard portfolio. SLX also could be a good fit for investors with a negative outlook or wanting to hedge against dollar exposure, given that nearly 60% of the fund's assets are invested in international companies, and given that steel by nature is a commodity whose price generally moves in a direction inverse to the dollar.

Over the longer term, Morningstar's equity analysts believe that captive raw materials and efficient operations are among the keys to solid profits in steelmaking, with vertical integration less important and input prices now displaying greater volatility than in the past. Given the volatility of this index over the past few years, any investor looking to buy this ETF should be prepared for a bumpy ride.

Vanguard Information Technology VGT
VGT holds mostly large, well-established technology firms--the average market capitalization of the fund's holdings is around $41 billion--so investors who want exposure to more-speculative small- and mid-cap tech firms should look elsewhere. Although VGT holds a large number of stocks (418), it's nonetheless very top-heavy; its 10 largest holdings account for a significant 52% of the portfolio. VGT also has a very high-quality portfolio--wide-moat and narrow-moat firms account for about 46% and 35% of the portfolio, respectively, meaning that Morningstar's equity analysts believe that more than 80% of the firms that VGT holds have sustainable competitive advantages.

In this current technology environment, investors are focused on a number of trends that are expected to drive earnings in the near term. In our view, an overwhelming majority of companies included in this ETF have displayed resiliency and should continue to be nimble enough to succeed in the face of rapid innovation, short product cycles, and unpredictable consumer and corporate spending--issues that drive volatility in the tech sector. Still, we'd stress the importance of monitoring valuation when investing in the intensely competitive, maturing tech sector.

Timothy Strauts is an ETF analyst with Morningstar.

Timothy Strauts is an ETF analyst at Morningstar.

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