This Low-Cost, High-Yielding ETF Looks Like a Bargain

As you might have heard, we recently retooled the content and format of our ETF Analyst Reports and introduced a host of innovative data points, such as the new "valuation rating" for ETFs. You can get an overview of these enhancements elsewhere, along with a more detailed walk-through. But you have to be a Morningstar.com Premium Member to access the enhanced  ETF Analyst Reports themselves.

With that in mind, we thought we'd give those of you who haven't yet subscribed to Morningstar.com a taste of our enhanced ETF research. Below you'll find an excerpted report sample. As you can see, we've expanded the scope of our analysis to better address a stock ETF's attractiveness based on the quality, risk, and valuation of its underlying holdings. What's more, we're now providing a host of new data points, such as the ETF fair value estimate and ETF expected return, that add granularity and context to our ETF research.

WisdomTree High-Yielding Equity DHS
by Sonya Morris CPA

Rating/Data 02-20-08

• Valuation Rating -- Undervalued
• ETF Market Price -- $50.97
• ETF Fair Value Estimate -- $66.41
• ETF Expected Return -- 20.5% annualized (three-year time horizon)

Analyst Note 02-20-08
Given  WisdomTree High-Yielding Equity's (DHS) focus on high-quality, moderate-risk stocks and diversification across holdings and industries, we wouldn't require a large discount to our fair value estimate to recommend it. An 8% discount would suffice. By that standard, the fund looks like a steal, as it was trading at a hefty 23% discount to our fair value estimate as of Feb. 20, 2008.

What's so grossly undervalued in the portfolio? The fund's top holdings include a clutch of megabanks, such as  Bank of America (BAC),  J.P. Morgan Chase & Co. (JPM), and  Citigroup (C) (all three of which are trading at 30%-plus discounts to intrinsic worth), which have gotten crushed amid the subprime-related carnage in the financial sector. The fund also owns a number of cheap drugmakers ( Pfizer (PFE),  Bristol-Myers Squibb (BMY), and  Eli Lilly (LLY)), chemical companies ( DuPont  and  Dow (DOW)), and tobacco concerns ( Altria (MO) and  Reynolds American ).

Thesis 02-20-08
We're comfortable recommending WisdomTree High-Yielding Equity at a modest margin of safety.

This fund's dividend payout is well above that of the typical equity exchange-traded fund and almost twice that of the S&P 500. That fat yield comes by way of its benchmark's unique methodology. Specifically, it isolates those stocks in the WisdomTree Dividend Index that rank in the top 30% in terms of dividend yield (dividends divided by stock price). Then it weights those stocks by projected cash dividends over the next 12 months.

Because it focuses on firms with the wherewithal to pay sizable cash dividends, this ETF's portfolio skews decidedly toward financially stable, established firms that frequently have enduring competitive advantages. Not surprisingly, roughly half of this fund's assets are staked in stocks that our analysts believe possess wide economic moats, many of them in the financial-services sector. Consider the likes of top holdings Bank of America, Citigroup, and J.P. Morgan. All three are financially sturdy banks with massive geographic footprints that dwarf most of the competition.

The fund's dividend focus spurs sector biases. It sports oversized financials and utilities weightings, for example, because those sectors are home to more companies that pay dividends. By the same token it treads lightly in the technology sector, as many tech companies reinvest in their businesses rather than pay dividends.

However, given the high-quality nature of this portfolio, we don't think these sector tilts significantly heighten risk. Furthermore, because this portfolio is broadly diversified across 350 dividend-paying stocks--only a small fraction of which warrant above-average risk ratings from our equity analysts--we wouldn't expect it to exhibit excessive volatility. Accordingly, we'd feel comfortable recommending this ETF with only a modest margin of safety. We'd be buyers at an 8% or greater discount  to our fair value estimate.

Portfolio Construction
This ETF is tethered to the WisdomTree High-Yielding Equity Index. To construct the index, WisdomTree ranks the stocks in the WisdomTree Dividend Index by dividend yield and isolates the top 30%. It then weights those highest-yielding stocks by projected cash dividends. Thus, whereas relatively low-yielding realms like technology make the cut in the broader Dividend index, this fund is virtually devoid of such fare; instead, financial-services and industrial stocks abound. In addition, this fund is more concentrated among holdings, with the top 10 stocks soaking up nearly half of assets.

Fees
This isn't the cheapest large-cap ETF, but its 0.38% expense ratio is reasonable and well below that of comparable mutual funds.

Though not an explicit cost, each of this fund's holdings courts risk. We can express that risk as a percentage cost of equity. The COE represents the minimum return that an investor would accept for investing in a particular stock. It's also the rate at which our analysts discount a firm's forecasted cash flows in estimating its fair value. Thus, the riskier a firm, the higher its COE and, thus, the lower its fair value.

This ETF's fair value estimate is based on a weighted-average cost of equity of 10.34%, which is slightly below average owing largely to this ETF's higher-quality bent. We arrive at this fund's 10.72% hurdle rate by adding this COE to its 0.38% expense ratio.

Bulls Say

• Hefty dividend payout is likely to please income-minded investors.
• Reasonable expenses means most of the ETF's dividend yield flows through to shareholders.
• This fund boasts a portfolio of high-quality stocks. It allocates about half its assets to wide-moat firms. Because such firms are more valuable given that they boast defensible competitive advantages of some sort, they burnish the portfolio's overall value.

Bears Say

• This ETF's focus on yield exposes it to substantial sector biases. Most notably, it dedicates roughly half its assets to the financials sector.
• Not the least expensive ETF of its kind.

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