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Gains in Momentum

Use this screen to find ETFs that hold strengthening companies that are still undervalued.

Timothy Strauts, 12/06/2012

This article originally appeared in the December/January 2013 issue of MorningstarAdvisor magazine.  To subscribe, please call 1-800-384-4000. 

The strongest and most persistent factor strategy is momentum. Stocks that have performed best over the past year have higher returns than stocks that have performed worst. Momentum strategies have consistently outperformed standard long-only market strategies. We’ll use this screen to find exchange-traded funds that hold companies whose returns are gaining strength.

( U.S. Broad Asset Class = U.S. Stock
Or U.S. Broad Asset Class = Sector Stock
Or Leveraged Fund =  No
Or Net Assets Share Class > 250 million)

For this screen, we will focus on the domestic stock ETF universe. We’re not interested in leveraged products, so we’ll remove those from the search. When looking at potential ETF investments, you want adequate liquidity. One of the easiest ways to make sure you’ll be able to buy and sell with reasonable bid/ask spreads is to only consider ETFs with more than $250 million in assets.

And Total Return 1 Yr (Mo-End) > 32%

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

Why does momentum work? A stylized version of the story goes like this: In light of surprising or extreme news, investors “anchor” new price estimates to old prices. They are also loath to realize losses, preferring to keep dogs until they break even, and they are too quick to sell winners. Both biases also keep prices from instantly reflecting new information. Instead, prices slowly adjust to fair value, creating sustained price movements, up or down. Once an upward (or downward) trend is established, investors over extrapolate recent performance and herd in (or out) of the asset, further accentuating the trend. Over the medium term, the trend collapses after the market realizes it has overshot.

To find areas of the market that are still undervalued, we will lean on Morningstar’s equity analysts for guidance. Morningstar has 125 equity and credit analysts who conduct fundamental analysis and derive fair value estimates for more than 1,800 companies worldwide. Because this data can be aggregated to the fund level, we can form an estimate of intrinsic value for equity ETFs, which are simply worth the sum of their constituent parts. So a price/fair value less than 1 is undervalued. By combining a value and momentum metric together, our goal is to find undervalued securities with good momentum.

And Price/Fair Value < 1

We performed this screen using Morningstar Office in October. The screen comes up with 15 results out of 548 U.S. equity ETFs. On a sector basis, there are five funds that are financials, three that are large growth, two health care, two consumer cyclical, two large blend, and one technology. Here are four results that we think investors might consider in the current environment.

Technology Select Sector SPDR XLK
XLK holds mostly large, well-established technology firms—the average market capitalization of the fund’s holdings is around $115 billion—so investors who want exposure to more speculative small- and mid-cap technology firms should look elsewhere. This fund is very top-heavy; is top 10 holdings account for more than 67% of the portfolio’s assets. XLK also has a very high-quality portfolio—wide-moat and narrow-moat firms account for about 46% and 48% of the portfolio, respectively, meaning that Morningstar’s equity analysts believe that more than 93% of the firms that XLK holds have sustainable competitive advantages.

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.

Vanguard Mega Cap 300 Growth Index MGK
The MSCI US Large Cap 300 Growth is a subset of the MSCI US Large Cap 300, a market-weighted index of the 300 largest publicly traded U.S. companies. The index has ample buffer zones in its size and style criteria to avoid frenetic turnover. MSCI indexes are fully reconstituted semiannually, with quarterly reviews that have much looser rebalancing criteria than the competition from Russell and S&P. As a fully physically replicated fund, the ETF has tracked its index very closely. The ETF charges 0.12% per year, making it one of the cheapest mega-cap growth ETFs.

One possible reason to overweight this fund is that large-cap growth companies tend to hold up a tad better during bear markets than their value counterparts do (a notable exception is the tech bust). Some academics argue that the modest protection during bear markets lowers the expected return of growth stocks, explaining away growth stocks’ poor performance worldwide over long periods. We think the behavioral explanation makes more sense: Investors tend to extrapolate recent growth, bidding up glamour stocks above fair value. However, even if growth tends to underperform value, we expect any underperformance for this fund to be modest over the long run. Much of growth’s underperformance comes from smaller, more-speculative ventures.

SPDR S&P Pharmaceuticals XPH
This ETF offers investors exposure to a high-quality portfolio of domestic pharmaceuti- cal companies. And given the health-care sector’s lack of sensitivity to the overall economic climate, investors may consider this fund as a defensive tilt for a portfolio.

Investors need to pay special attention to the impact that health-care reform will have on drugmakers, given that pharma and biotech companies make up the lion’s share of this fund. Morningstar’s equity analysts believe that health-care reform will weigh on the health-care industry’s earnings per share by as much as 5% a year during the first few years of reform, followed by earnings gains of about 2% a year later in the decade. This will occur, our equity analysts think, because by 2014, volumes created by increases in the number of patients insured will begin mitigating cost pressures.

Consumer Discretionary Select Sector SPDR XLY
This low-cost, highly liquid ETF holds 81 companies and is fairly concentrated with 47% of assets in its top 10 holdings. It owns a variety of names that are tied to consumer spending, including retail companies, restaurants, media companies, apparel and luxury goods companies, automobile manufac- turers, and leisure firms. This is a high-quality portfolio, with 81% of assets invested in companies with economic moats, a designation assigned by Morningstar’s equity analysts to firms that possess significant and durable competitive advantages.

Before investing, however, investors should have a strong view on the macroeconomic climate. Given that about two thirds of econom- ic activity is fueled by consumer spending, investors should closely examine the economic backdrop and try to understand what the market presumably already is pricing into consumer-discretionary-related stocks.

Timothy Strauts is an ETF analyst at Morningstar.

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