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

It's been about seven months since we first used Morningstar's ETF price/fair value measure to take the temperature of the market and various sectors. As 2005 draws to a close, the song remains the same: Energy and basic-materials ETFs still look expensive, while consumer-goods and financial ETFs look undervalued.

Before we tackle the specifics, let's review the mechanics of the price/fair value ratio. This statistic is Morningstar's way of tapping the research of its 85 in-house equity analysts who research and estimate fair values on more than 1,600 stocks to help evaluate the attractiveness of ETF fund portfolios. The measure basically tries to offer a bottom-up assessment of whether an ETF portfolio is cheap or expensive by gauging whether its holdings, on average, are trading above or below their Morningstar fair value estimates.

To get the price/fair value ratio, we calculate the market value of all the holdings in the ETF for which we have fair value estimates. Then we use the fair value estimates of those stocks to calculate what we believe is the fair value of the same portfolio. Finally, we compare the two numbers and calculate the percentage premium or discount of the market value relative to the fair value estimate. When that difference is expressed as a ratio, a number more than one means the ETF's portfolio is overvalued; less than one indicates it is undervalued.

Morningstar does not estimate a fair value for every stock an ETF might own, so the relevance of the results of the price/fair value depends on how many stocks in a given portfolio have received a fair value estimate and the percentage of that portfolio's assets these stocks represent. Our coverage is pretty comprehensive for the vast majority of domestic large-cap ETFs: Morningstar analysts have assigned fair value estimates to stocks representing 75% or more of the asset values of most ETFs in that space.

Broad Market vs. Large Growth
At the end of November 2005, the price/fair value ratio showed broad-market index ETFs were fairly valued.  Vanguard Total Stock Market VIPERs ,  iShares Dow Jones Total Market ,  StreetTracks Total Market , and  iShares Russell 3000 Index  all had fair values within shouting distance of the total market values of their holdings.

Broad-Market ETFs
ETF	% of Assets w/ FV Estimates	Price/Fair Value
iShares Russell 3000 Index	90.0	0.99
iShares DJ US Total Market Idx	93.3	0.99
Vanguard Total Stk Mkt VIPERs	88.0	0.99

Surprisingly, large-cap growth ETFs looked fair, too. Given the way large-growth stocks have lagged the rest of the market in recent years, one might expect ETFs focused on them, such as  Vanguard Growth VIPERs ,  iShares S&P 500/Barra Growth Index  , and  StreetTracks Dow Jones Wilshire Large Cap Growth , to look relatively undervalued. Despite this group's underperformance, however, the funds actually are mixed bags valuation-wise. There are some attractively priced stocks in there, such as software giant Microsoft , heart device maker Boston Scientific , and computer maker Dell . To even things out, though, there are a good number of richly priced shares, such as Internet search firm Google , health insurer UnitedHealth Group , and oil services company Schlumberger , which have all enjoyed very strong runs in the past year.

Energy
As they were in the spring, the differences are more obvious among sector funds. Energy ETFs, which were the most overvalued funds when we first applied the price/fair value measure in May 2005, still look overvalued. Though energy prices moderated somewhat in the fall and took some of the wind out of the stocks' sails, the energy sector is still up smartly for 2005. Large integrated oil companies, such as ExxonMobil  and BP , which usually gobble up a lot of natural-resources ETFs' assets, look neither cheap nor expensive. But oil-services companies, such as Schlumberger and Halliburton , as well as refiners and exploration and production companies, such as Valero Energy , are way over their fair values after posting eye-popping returns in the past year. These stocks are big constituents of iShares Goldman Sachs Natural Resources ,  Energy Select Sector SPDR ,  Vanguard Energy VIPERs , and iShares S&P Global Energy Sector  . Each of these ETFs was among the most overpriced large- cap ETFs at the end of November 2005, with their shares trading about 20% higher than the value of their underlying components.

Overvalued ETFs
ETF	% of Assets w/ FV Estimates	Price/ Fair Value
iShares GS Natural Resources	96.5	1.29
Energy Select Sector SPDR	100.0	1.24
Vanguard Energy VIPERs	94.1	1.23
iShares S&P Global Energy	64.7	1.22
iShares DJ US Energy	99.3	1.20

Materials
Robust global demand for copper, gold, coal, and other commodities has boosted performance and valuations of mining and other hard-asset stocks, such as Phelps Dodge , Newmont Mining , and Peabody Energy . That, in turn, has kept the prices of basic-materials ETFs--iShares Dow Jones US Basic Materials , Vanguard Materials VIPERs , and Materials Select Sector SPDR --above their fair values.

Technology
A glance at broad technology ETFs, such as  Technology Select Sector SPDR  and the  Vanguard Information Technology VIPERs , reveals a fairly valued sector. Drill down, however, and you find bigger disparities. ETFs focused on chip and communications-equipment makers, such as iShares Goldman Sachs Networking  and iShares Goldman Sachs Semiconductor , were about 15% overvalued on Nov. 30, 2005. Speculative names, such as network chipmakers Marvell Technology  and Broadcom , were trading far above their fair values. Meanwhile, uncertainty about information technology spending and the product cycles of individual companies has restrained the performance and valuations of software stocks in iShares Goldman Sachs Software Index  . Some of its biggest components--Microsoft, Oracle , and Symantec --were trading at steep discounts to their fair values, which helped make the software ETF look undervalued as well.

Consumer Goods
Concerns about the effect of rising energy prices on sales and raw materials costs, as well as stock-specific worries about competition and earnings growth, have kept a lid on returns in the consumer-goods sector. Nevertheless, a number of leading companies, such as Procter & Gamble , have still managed to generate decent earnings. As a result, consumer-goods ETFs still showed the biggest discounts to their fair values among large-cap ETFs.

About three fourths of the 115 consumer-goods stocks covered by Morningstar analysts carried ratings of 3 or more stars (3 stars indicates the stock is trading near its fair value, 4 or 5 stars means the stock is priced below fair value). Shares of Wal-Mart , which is trying to expand already-thin margins; Coca-Cola , which is still trying to re-energize growth; Anheuser-Busch , which is contending with slower beer consumption and price competition; and Avon Products , which is still quaking from series of summer earnings warnings; look particularly cheap. These are big positions in  Consumer Staples Select Sector SPDR  and  Vanguard Consumer Staples VIPERs , so it's not surprising that the ETFs' shares were trading about 10% below their portfolios' fair value. IShares Dow Jones US Consumer Goods  showed a smaller discount, in part, because it doesn't include Wal-Mart.

Undervalued ETFs
ETF	% of Assets w/ FV Estimates	Price/ Fair Value
Consumer Staples Sector SPDR	98.9	0.91
Vanguard Cons Staples VIPERs	89.7	0.91
iShares DJ US Consumer Goods	89.7	0.92
streetTRACKS Global Titans	92.9	0.92
iShares DJ US Telecom	91.8	0.93

Telecom
Telecommunications ETFs also showed varying levels of discounts to fair value, depending on how much they packed into traditional phone-service providers, such as Verizon Communications , which has taken a beating in 2005 as it tries to restructure its business and update its network to compete with high-tech competitors.  IShares Dow Jones US Telecommunications  and iShares S&P Global Telecommunications , both of which have significant stakes in Verizon and other Baby Bells, were trading about 8% below their fair values. The shares of  Vanguard Telecom Services VIPERs , which also owns a big helping of the Bells, were closer to the fund's fair value because the portfolio devotes more money to more richly valued wireless services stocks, such as American Tower  and Crown Castle International (CCI).

Financial Services
Finally, worries about rising interest rates and a peaking real estate market have pressured stocks, such as National City , that make their living off of spread income and mortgages. That and the still-modestly valued insurance giant American International Group (AIG) have kept financial-services ETFs, such as iShares Dow Jones US Financial Services (IYG),  Financial Select Sector SPDR (XLF), and  Vanguard Financials VIPERs (VFH), below the fair value of their holdings.

What to Do?
The data still paints a risky picture for energy and materials ETFs. The funds continued to gain ground after we last said they were overvalued, and there's no telling how long the momentum will last. Nevertheless, it still could be time to reap some winnings and redistribute the money among more attractive priced offerings in the financial and consumer-staples areas. Because cheap stocks can stay that way for a while, it is best to make these moves in a small part of a diversified portfolio.

Disclosure: Barclays Global Investors (BGI), which is owned by Barclays, currently licenses Morningstar's 16 style-based indexes for use in BGI's iShares exchange-traded funds. iShares are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in iShares that are based on Morningstar indexes.