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Morningstar
Stock Strategist

ETFs on Our Buy List

We make our picks from the bottom up.

Jeffrey Ptak

One of the many benefits that we accrue from covering 2,000 stocks is the ability to tap our research to value ETFs. Where others might use notoriously imprecise methods like top-down macro forecasting to gauge an ETF's fundamental attractiveness, we're able to go bottom-up, stock-by-stock.

To understand how, consider the largest ETF in the world, SPDRs Trust (SPY), which tracks the S&P 500 Index. We can roll up the fair value estimates that we've placed on more than 470 of the S&P's 500 constituent stocks (representing roughly 98% of the index) in order to derive a fair value estimate for the SPDR. Once we've estimated an ETF's fair value, we can compare it with the fund's price, just as we do in our stock research. The lower an ETF's market price relative to our fair value estimate, the more-attractive we'd consider it, and vice versa. (The SPDR was trading at a 7% discount to our fair value estimate as of Oct. 19, 2007, in case you were wondering.)

Which ETFs are in the bargain bin these days? Here's a short list that we've drawn from the nearly 300 stock ETFs for which we have comprehensive coverage of the underlying equities (defined as coverage on stocks accounting for at least 70% of the fund's assets).

Financial-Services ETFs

Consumer-Related ETFs

Diversified ETFs

Financial-Services ETFs
You have plenty to choose from in this sector, which has been waylaid by cascading fears over higher interest rates, a slumping real estate market, and shoddy lending. The typical financial-services stock that we cover was trading at a 6% discount to its fair value estimate as of Oct. 19.

That's reflected in the valuation of the broad financials-market funds that we cover, which are typically trading at 10%-20% discounts to our fair value estimate. Rydex S&P Equal-Weight Financials (RYF) (13% discount) and iShares Dow Jones U.S. Financial Sector (IYF) (17% discount) are two such examples.

But to find some of the biggest bargains, square your sights on the financials subsector ETFs, a number of which have gotten battered amid the sell-off. Here are our favorites at the moment:

  • KBW Bank (KBE) (0.76 price/fair value)

This fund teems with values--all but a handful of the portfolio's 25 stocks were trading at a discount to our fair value estimates as of Oct. 19. And many of those discounts were steep, with many of the fund's global bank ( Citigroup (C),  Bank of America (BAC),  J.P. Morgan Chase (JPM)) and super-regional ( Wachovia ,  Fifth Third (FITB), among others) holdings trading at 25% or larger discounts to fair value. The fund's narrow focus means we'd ordinarily demand a 15% discount to fair value before recommending it. By that standard, it screams "buy."

  • Regional Bank HOLDRs  (0.78 price/fair value) and
  • iShares Dow Jones U.S. Regional Banks (IAT) (0.79 price/fair value)

Don't let the names fool you--with top holdings including giants like J.P. Morgan Chase, Wachovia, and  US Bancorp (USB), these funds are hardly a dumping ground for toaster-peddling community savings banks or rinky-dink S&Ls. In some cases, such as  Regions Financial (RF), these firms have been punished by investors concerned about contracting net interest margins or mounting loan losses, subprime mortgage exposure in particular. To our eyes, the selling looks overdone, and many look cheap, explaining these regional bank funds' compelling valuations.

  • iShares Dow Jones U.S. Financial Services (IYG) (0.78 price/fair value)

This is the most-diversified of the four financials ETFs profiled, spanning virtually every financials subsector. You won't have to squint hard to figure out why: Its top three holdings--Citigroup, Bank of America, and J.P. Morgan Chase--recently soaked up nearly 30% of assets, and all three of those stocks are trading well below fair value, in our estimation.

Consumer-Related ETFs
Is the U.S. consumer rolling over? That question has bedeviled consumer stocks in recent months, as investors weighing the prospects of an economic slowdown or resurgent inflation have seemed to sell first and ask questions later. Housing-related concerns (think  Home Depot (HD) and  Lowe's (LOW)) and firms believed to be heavily leveraged to a vibrant, unburdened consumer (apparel makers, restaurants, etc.) have been hit especially hard.

If not always deep, the selling has been fairly widespread, leaving roughly one in every two consumer stocks that we cover trading at least 10% below our fair value estimate. That, in turn, has put a number of consumer-related ETFs on sale, with the following being the cheapest of the bunch.

  • SPDR S&P Retail (XRT) (0.78 price/fair value)

Given that this portfolio is more-or-less equally weighted across 60 or so stocks, a few bargains does not a cheap ETF make. But with consumer stocks pulling back en masse lately, this fund finds itself flush with values. Roughly half of the 49 portfolio holdings that we cover were trading at 10% or better discounts to fair value, with apparel retailers
( Coldwater Creek ,  Chico's ,  Foot Locker (FL)), department stores
( J.C. Penney ,  Macy's (M)), discount chains ( Sears ,  Wal-Mart (WMT)), and grocers ( Whole Foods ,  SuperValu ) looking particularly cheap.

  • Powershares Dynamic Retail  (0.81 price/fair value)

Since we cover a lesser percentage of this fund's underlying stocks--71% to be precise--than we do the other ETFs on our buy list, it's worth noting that our fair value estimate should be taken with the proverbial grain of salt. That said, there's nothing on the surface to suggest that our 0.81 price/fair value ratio is unrepresentative of the whole. This ETF's bargain price owes mainly to a clutch of cheap discount retailers (Sears), auto suppliers ( Advance Auto Parts (AAP),  AutoNation (AN)), clothing stores ( Collective Brands ,  Gap (GPS),  Ann Taylor ), and home supply giants (Home Depot, Lowe's).

  • Retail HOLDRs  (0.82 price/fair value)

Here's an ETF where it pays to scan the holdings list. True, it looks cheap, even when we account for the 15% or so discount to fair value that we'd demand for an offering as narrowly targeted as this one. However, the portfolio is crammed into just a handful of names, with the top-five holdings recently soaking up around 55% of assets. Thus, our call turns to an unusually large extent on the precision of our fair value estimates on the five stocks in question--Wal-Mart, Home Depot, Target, Lowe's, and  Walgreen (WAG). For that reason, we'd probably opt for the two better-diversified offerings mentioned above over this one.

Diversified ETFs
And then there are the handful of diversified ETFs where nicked financial-, consumer-, and homebuilder-related names converge. What's the common thread? Usually, it's a record of strong historical earnings growth, which is abundant in the financial-services and retail realms, though the market has apparently soured on many of these firms' growth prospects for now.

  • Claymore/Great Companies Large-Cap Growth  (0.84 price/fair value)

This fund tracks an index that seeks firms with strong earnings growth, sane price multiples, and the traits of "great companies," the telltale of which include a global orientation. While those criteria are on the murky side ( Research in Motion (RIMM) passes the index's valuation screen despite the fact that, by our estimate, it's trading at nearly twice its intrinsic value), the upshot is that financials, homebuilders, and retailers figure prominently, with many of those names trading comfortably in 5-star territory. Given the portfolio's respectably high quality (nearly half of the names boast wide economic moats), moderate risk profile (our analysts consider only a handful to be above-average risks), and wide diversification across sectors, we wouldn't demand an especially large margin of safety before investing here, with an 8% discount to fair value sufficing.

  • Powershares High Growth Rate Dividend Achievers  (0.84)

This fund tracks an index that targets firms that have raised their annual dividend at least 10 years consecutively. Not surprisingly, stock quality is high--wide-moat stocks account for nearly 70% of assets--with mega-cap global banks (Bank of America, Citigroup), insurers ( American International Group (AIG)), drugmakers ( Johnson & Johnson (JNJ),  Pfizer (PFE)), and industrial conglomerates ( United Technologies (UTX)) filling out the portfolio's upper ranks. In short, these businesses have been able to exploit their manifold competitive advantages to churn out gobs of free cash year after year, returning a slug of that cash to shareholders each year in the form of dividends. In addition to the usual suspects in the banking, retail, and home improvement realms, this offering also prominently features a clutch of cheap health care ( Medtronic (MDT), Pfizer, Johnson & Johnson) and capital-markets-related names ( Legg Mason ,  Lehman Brothers ).

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