Eight Cheap ETFs Loaded with Wide-Moat Stocks

A key prong in our equity analysis method is the concept of economic moat. The term, which was originally coined by Warren Buffett, refers to a firm's competitive positioning. A company with an economic moat has a durable advantage that helps it keep competitors at bay and thereby generate outsized returns for shareholders.

For a firm to earn a wide-moat rating, our analyst must believe that the company's competitive advantage is sustainable over the long haul. Thanks to its enduring competitive edge, a wide-moat firm is likely to generate returns in excess of its cost of capital for several years into the future. Accordingly, a wide-moat company is far more likely than a no-moat firm to create value for the business and for its shareholders.

Those are the kinds of stocks we love to own. But it's not enough for a firm to enjoy the protection of an economic moat to earn our recommendation. We're willing to buy a stock only if it is trading at a discount to our fair value estimate.

We apply similar thinking to our analysis of ETFs. We tend to gravitate to ETFs that own a lot of wide-moat stocks. But we'll only consider investing in an ETF if it's trading at a discount to its aggregate fair value estimate.

With those ideas in mind, I recently screened the ETF universe for cheap funds with big stakes in wide-moat stocks. Specifically, I looked for ETFs that dedicate at least 60% of their assets to wide-moat stocks and with price/fair value ratios of 0.90 or below. Here's what I came up with:

Cheap ETFs with Plenty of Wide-Moat Stocks
	% Wide Moat Stocks*	Price/ Fair Value*	Expense Ratio
Pharmaceutical HOLDRs	90.90	0.87	**
DIAMONDS Trust (DIA)	70.99	0.89	0.17
iShares DJ US Financial Services (IYG)	69.66	0.73	0.48
PowerShares High Gr Rate Div Achiev	68.39	0.82	061
Consumer Staples Select Sector SPDR (XLP)	64.65	0.89	0.24
Health Care Select Sector SPDR (XLV)	64.60	0.90	0.24
PowerShares Dividend Achievers (PFM)	64.56	0.87	0.60
iShares NYSE 100 Index	63.06	0.88	0.20
Data as of 11-08-2007 * Based on weighted average of underlying stocks. ** HOLDRs charge an $0.08 per share annual custody fee.

Given the beating financial stocks have taken lately, it's not surprising that  iShares Dow Jones U.S. Financial Services (IYG) is the cheapest ETF on the list. In fact, financial ETFs have some of the lowest price/fair value ratios out there, but this ETF has one of the most diversified and highest-quality portfolios of the group. Not only does it include bargain-priced multinational banks like  Bank of America (BAC) and  J.P. Morgan (JPM), but it also owns credit card companies like  American Express (AXP), and investment firms like  Lehman Brothers . It's likely that we are still in the early innings of the subprime credit crisis, and these stocks could face some near-term challenges. So if you are intrigued by the bargains in the sector but would like to blunt volatility somewhat, this ETF represents an intriguing alternative to purchasing an individual stock.

Another favorite pick in this group is  Consumer Staples Select Sector SPDR (XLP). I purchased this for one of the model portfolios in Morningstar ETFInvestor back in late May, and it has gotten a tad cheaper since then. With rising oil prices, a weakening dollar, and falling housing prices, investors are understandably worried about the staying power of the U.S. consumer, and that has taken a toll on a number of consumer-related stocks. But I like the consumer-staples segment because it includes companies that provide products and services that consumers are reluctant to give up even during lean times, such as tobacco ( Altria (MO)), beverages ( Coca-Cola (KO) and  Anheuser-Busch (BUD)), food ( Kraft (KFT) and  Kroger (KR)), and health-care products ( CVS Caremark (CVS) and  Walgreen (WAG)).

Because the demand for these products is relatively stable, these stocks tend to be less economically sensitive and less volatile. Consequently, this ETF has the lowest standard deviation among all ETFs, as measured over both three- and five-year time spans. Given this ETF's high-quality, mild-mannered profile, I think it's an intriguing bargain at current valuation levels.

Sure, given the murky economic outlook and continued turmoil in the financial industry, it could take some time for these ETFs to return to their fair values. But the worries that are plaguing the market now are giving us the opportunity to pocket bargain-priced ETFs loaded with wide-moat firms that we think will create shareholder value for years to come.

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