ETF Picks to Put Our Market Outlook into Action

Our stock analysts recently provided their quarterly stock market outlook, including a sector-by-sector summation of the best opportunities and a short list of compelling stock picks in each area.

Building off of that, we've prepared our own short list of exchange-traded funds that you can use to play some of the ideas and themes mentioned in the various sector outlooks.

Consumer

• Outlook: "The decline within the consumer goods and services sector has been so broad-based that we don't think investors should be focused on one or two industries that have fallen from favor. Although we believe a portfolio of some of our lower-quality 4- and 5-star stocks would do well over the long term, we think that a more judicious approach for the individual investor would be to focus on higher-quality companies that have more exposure to consumer staples than to discretionary purchases. Given the strong effects that operating leverage can have on restaurants and retailers, and given that we aren't counting on a loosening of the credit markets, we'd also emphasize firms that have strong balance sheets and sufficient cash flows to meet their capital needs over the next couple of years."
• ETF Pick:  Vanguard Consumer Staples ETF  and  Consumer Select Sector Staples SPDR   fit this profile almost to a tee. Though the Vanguard portfolio is wider-ranging and a tad less concentrated in its top holdings, the two funds cover roughly the same ground. That means defensive consumer bulwarks like  Procter & Gamble ,  Altria ,  Coca-Cola ,  Pepsi ,  Wal-Mart ,  Kraft , and  Colgate-Palmolive , to name a few, loom large. Generally speaking, these firms tap recurring sources of demand to churn out gobs of free cash flow year-in and year-out, with traits like iconic brands, switching costs, and hard-to-replicate scale cementing demand. And both funds look cheap--the Vanguard and SPDR portfolios were trading at 9% and 8% discounts to what our analysts think their holdings are worth in the aggregate.

Energy

• Outlook: "We thought that exploration & production (E&P) master-limited partnership (MLP) valuations looked rich this past summer, helped by a lot of hype and excitement over their prospects to make many accretive acquisitions in short order. The credit crunch, combined with a failure for retail investors to materialize as quickly as institutional investors had hoped, drove E&P MLP share prices down considerably in the first quarter of 2008. We think some opportunities have finally surfaced here given the recent pullback."
• ETF Pick: If you like a nice game of "Where's Waldo?" then you'll love trying to find an ETF that invests in MLPs. Try as you might, you'll probably come up empty, as most ETFs don't own them for tax reasons (among others). However, there is an exchange-traded note (ETN) that invests in nothing but MLPs: BearLinx Alerian MLP Select . Now before you jump headlong into the ETN, a number of caveats are in order. First, an ETN is a debt instrument, not a legal trust as with the typical ETF. As such, if the issuer of that instrument defaults, you could lose all or part of the capital you invest. Second, this ETN wasn't issued by just any firm--it was issued by  Bear Stearns . One would think that  J.P. Morgan's  acquisition of the firm, with Fed backing, would mitigate the risk of a default. But Bear's implosion is a sobering reminder that the risk is anything but academic. Third and finally, while a number of the MLPs that our analysts cover look cheap, a slew of others remains under review as our analysts reassess their assumptions in light of more-challenging capital markets conditions.

Financials

• Outlook: "We respect the weakness in the near-term outlook for financials firms. But we are still trying to look five to 10 years out and don't expect the recent trials to prove permanently intractable. We retain our basic faith in the productive potential of higher-performing firms within the financial-services sector. Our challenge (and yours) involves sorting out the long-term winners from marginal enterprises. The survivors and winners will thrive in the long run, while the losers are getting pummeled, and some won't survive."
• ETF Pick: Given the considerable uncertainty that banks and capital-markets firms of all stripes face in this climate, we'd make caution the better part of valor (if such a thing is possible these days) and go with an ETF that runs the gamut of the various financials subsectors.  Financial Select Sector SPDR ,  iShares Dow Jones U.S. Financial Sector , and  Vanguard Financials ETF  are all good places to start, as they provide exposure to the full panoply of commercial banks, thrifts, diversified financials, broker/dealers, insurers, and REITs that comprise the sector. From a valuation standpoint, it's pretty much a toss-up, as the three ETFs are within spitting distance of each other--all were recently trading at 15%-17% discounts to what we think they're worth. For those seeking maximum diversification, go with the Vanguard fund, which spreads its assets across more than 500 stocks.

Hardware

• Outlook: "In light of these macro- and microeconomic issues, we have considered what chip firms would serve as the best safe havens for investor capital. In general, we tried to find firms that have relatively less exposure to U.S. consumer markets, offer generous dividends, are exposed to countercyclical demand, or have strong economic moats that might be further strengthened in a downturn. A few of the stocks that meet these criteria from our coverage list are  Analog Devices ,  Microchip Technology , and  Texas Instruments ."
• ETF Pick: This one was pretty easy-- Semiconductor HOLDRs  holds these very types of names in spades. Consider that Texas Instruments,  Intel ,  Applied Materials , and Analog Devices recently soaked up more than two thirds of assets alone. Of course, with concentration comes volatility, and this fund has certainly experienced its fair share of bumps over time, a trend we'd expect to continue. However, as we've said before, provided investors have a suitably long time horizon and are disciplined about valuation, volatility can create inviting opportunities. Such is the case with this portfolio, which was recently trading at a hefty 27% discount to our fair value estimate, which more than affords the margin of safety we'd seek to compensate for the fund's risk. All told, 11 of the 16 portfolio holdings that our analysts cover were at least 20% undervalued as of March 28. (Investors should bear in mind that HOLDRs are a very quirky type of ETFs. It pays to read the fine print before investing.)

Health Care

• Outlook: "With the first quarter wrapping up, the health-care sector as a whole has become slightly undervalued. Physicians, research services, home health, managed care, and medical goods and services are all trading just at or a hair under their fair value estimates. But diagnostics, drugs, hospitals, assisted living, and medical equipment valuations are all becoming more attractive. As the market downturn ripples its way across the health-care sector, we've seen a number of companies with economic moats go on sale. We see this as an opportunity to buy some high-quality companies at appealing prices"
• ETF Pick: So where's the bargain-bin for high-quality health-care firms these days? Take your pick-- Health Care Select Sector SPDR ,  iShares Dow Jones U.S. Healthcare , and  Vanguard Health Care ETF  are chock-full of wide-moat businesses, many of them huge drugmakers. Investors seem to be adopting a sell-first-ask-questions-later approach in their appraisal of these businesses, which we expect to remain handsomely profitable by any reasonable definition of the term. True, nettlesome issues like generic encroachment, thinning pipelines, and regulatory action loom on the horizon. But our analysts think the market is discounting those negatives--and then some--into the prices of these firms' shares, creating some very compelling bargains in the process. Which is the pick of the litter? The portfolios are very similar on the whole, though the Vanguard ETF spans more names and treads a bit less heavily in pharma than the SPDR and iShares offerings. Differences notwithstanding, each fund invests heavily in wide-moat stocks (upwards of 55% of assets) and looks cheap (15%-plus discounts to our fair value estimates). Penny pinchers that we are, we'd probably just go with the Vanguard fund, which levies a paltry 0.22% expense ratio.

Industrials

• Outlook: "We think diversified multinational industrial companies will benefit from two powerful trends: robust industrial expansion from emerging markets and the weakening U.S. dollar. In addition, we think a robust aerospace market and demand for international shipping will drive strong earnings among companies serving those markets. We think multi-industrials  General Electric  and  Emerson Electric  are well positioned to benefit from these trends. We think  Terex  should benefit from strong construction demand and  Boeing  should thrive due to continued robust global demand for aircraft. Finally, we think that the weak dollar will stimulate international shipping and international shipper  Expeditors International of Washington  will be a major beneficiary of the trend."
• ETF Pick:  Vanguard Industrials ETF  and  Industrial Select Sector SPDR  are your best bets for gaining inexpensive, one-stop exposure to the industrial behemoths likely to benefit from global infrastructure and aerospace spending. These funds hold many of the same names, most notably General Electric, which accounted for 21.2% and 19.2% of assets, respectively. Obviously, our outlook for General Electric will go a long way toward explaining our take on these funds. But as of now GE's valuation looks attractive, as the stock was trading at a 13% discount to our fair value estimate as of March 28. But it's not as if GE is alone in that regard: For instance, 32 of the 50 Industrial Select Sector SPDR holdings that our analysts cover were recently at least 10% undervalued. All told, both the Vanguard and SPDR funds were trading at 11%-plus discounts to our fair value estimates, which puts the funds in bargain territory.

Media

• Outlook: "Our average star rating for the entire media industry is 3.44, indicating that we think the overall industry is slightly undervalued. We think some of the most attractively priced stocks are in the media conglomerates segment ( News Corp. ,  Time Warner ,  Walt Disney )."
• ETF Pick: There's not much artistry to our approach here--if you want unadulterated exposure to media, big media in particular, then PowerShares Dynamic Media  is the only game in town. Yes, you could invest in a slug of media names via a consumer-related (e.g.,  Consumer Discretionary SPDR ), telecom (PowerShares Dynamic Telecom & Wireless ), or even Internet ETF ( Internet HOLDRs ). But not without pulling in a wide variety of other businesses in the process. As for PowerShares Dynamic Media, though we don't cover it currently, we can still estimate its fair value based on our coverage of virtually every one of its underlying stock holdings. The verdict? The portfolio was trading at a 12% discount to our fair value estimate, with Walt Disney (22% undervalued), Time Warner (45% undervalued), and  CBS  (39% undervalued) among its more attractive holdings.

Software

• Outlook: "With concerns over the near-term performance of the U.S. economy, we think this is an ideal time to call attention to software companies that are well positioned to weather a potential U.S. economic downturn. In our opinion, wide-moat software companies that generate stable revenues and benefit from economies of scale should continue to perform well and perhaps even consolidate their dominance of their respective markets. Companies such as  Autodesk  and  Microsoft  sell software that is essentially a "must-have" for their customers, and while their near-term growth in the U.S. may be tempered, revenues and profits are not going to tank."
• ETF Pick: There are a few ETFs that invest exclusively in software firms--Software HOLDRs , iShares S&P GSTI Software , and PowerShares Dynamic Software . Software HOLDRs is extremely concentrated--it packs practically all of its assets into its top few holdings. By contrast, the iShares and PowerShares funds are better diversified by name, making them preferable in that respect. However, we'd opt for the iShares offering for a few reasons. First, its portfolio's quality--as measured by the percentage of assets it invests in software firms that boast intractable competitive advantages, or wide moats (43% of assets)--is superior to the PowerShares ETF's (20% of assets). Indeed, its top holdings include a number of marquee names--Microsoft,  Oracle ,  Adobe , and  Electronic Arts , to name a few--that boast formidable advantages and throw off cash flow by the bucketful. Second, it's a bit less expensive to own--it levies a 0.48% expense ratio versus 0.60% for the PowerShares fund. We don't currently cover the iShares fund, which was recently trading at an 11% discount to what our analysts think its portfolio is worth.

Telecom

• Outlook: "In volatile economic times like these, the cash flow from a needed service is particularly nice to have. Ultimately, the value of a firm is the present value of its future cash flows. The value of a company that has more predictable cash flows should increase relative to other firms with less predictable cash flows when markets are concerned about economic issues and the sustainability of revenues, margins, and cash flows. In addition, international companies are less likely to be as directly affected by the weak U.S. economy."
• ETF Pick:  IShares Dow Jones U.S. Telecom  is our choice here. The fund is chock-full of telecom providers, with big weightings in the incumbent carriers like  AT&T  and  Verizon . These firms are hardly glamorous--and, in fact, the fixed-line telecom business is in the throes of secular decline. But they're dependably cash-generative and, in our book at least, cash is king. That doesn't make the fund an automatic "buy." But at a 20% discount to our fair value estimate--which is where the portfolio was recently trading--it's hard to pass up.

Utilities

• Outlook: "We would urge investors seeking the relative stability of regulated utility investments to stick with companies in areas with historically favorable regulatory environments, such as  Southern Company (SO). As we see it, Californian utilities that have blended regulated and competitive investments also offer compelling valuations today. Apart from value-eroding inflation fears amidst massive capital spending plans, an investment in  Edison International (EIX) or  Sempra (SRE) seems compelling to us."
• ETF Pick: Our utilities team has been very bullish on nuclear power, a business that's protected by huge barriers to entry. Investors in  Vanguard Utilities ETF (VPU) won't have to squint hard to find a leader in nuclear power--its top holding is  Exelon  (EXC), the largest nuclear plant operator in the U.S. While investors will be hard-pressed to find ETFs that offer surgical exposure to, say, utilities that operate in benign regulatory environments, they can get exposure to some of the aforementioned names--Southern Company, Edison International, and Sempra--through this fund. It's not the most undervalued utilities ETF that we cover--it was recently trading at a 9% discount to our fair value estimate versus a 10% discount for  iShares Dow Jones U.S. Utilities (IDU)--but it's the lowest cost, as it levies a 0.22% expense ratio. That price tag should ensure that most of the income that the fund's underlying holdings throw off ends up where it belongs--in your pocket.