An ETF for the Recession

The market may have rallied substantially in the past week, but investors and speculators everywhere still ask whether these gains are the end of the bear market or just another brief rally. Few clues exist to point us to the right conclusions; those small scraps we do have seem to contradict one another.

On one hand, the economic outlook remains bleak. Consumer spending has ceased its collapse, but for how long? With unemployment rates still rising and consumer debt at record levels, households will need to cut back again soon. Banks seem in less danger of sudden implosion, but the S&P 500's financial stocks still sit at a quarter of their 2007 peak and dividends have been slashed to a fraction of their former size. Even with less fear of insolvency, banks still refuse to take on any risk by issuing new large loans. The venerable pharma firm Roche had to resort to new bond issuance when no banks would supply bridge loans for its takeover of  Genentech . Without new loans, corporate growth and investment remains hamstrung.

On the other hand, the government has stepped in to support the credit markets and spending in a big way. An $800 billion stimulus package will find its way into infrastructure investment and squeezed household pockets over the next two years. Just last Wednesday, the Fed announced a further $300 billion infusion into the credit markets in the critical two to 10 year maturities where most corporate and mortgage-backed debt lies. The market seemed to respond well to this announcement and welcomed the news of slower declines in housing and retail markets.

We know that markets turn around before the economy does, and early March may well have produced the final investor capitulation that allows a sustained bull market. Then again, the S&P 500's fall from 935 in early January to 667 in early March left plenty of room for a dead cat bounce. We probably won't know whether this rally is sustainable until after the fact, when it's too late to invest in the bargains currently available.

So for those of us eager to put some available cash back into the market, we needed to identify an investment that should perform well whether or not the final recovery has arrived. Our ETF team thought through our expectations of the economy for the next year or so, identified the major risks in case events turn out worse than we thought, and searched our database for a fund that would provide the best possible portfolio to make it through intact no matter what may come. Our desired portfolio would be dominated by companies with:

1) Strong businesses that have large, reliable cash flows. As consumer spending and business investment deteriorate in 2009, we expect revenues to fall substantially. Any company with high fixed costs and narrow profit margins will probably see their earnings vanish in a poof of red ink as they find it impossible to cut costs fast enough. Only very profitable businesses with large moats or industries with extremely stable revenues will make it through the slump while staying in the black.

2) Low leverage, and particularly little exposure to financials. We believe the credit crunch will continue for a while longer, and lower sustainable leverage ratios will diminish the profitability of nearly all financial companies even if they survive the crisis intact. Other leveraged companies face substantial risk in the coming period of unprofitability, especially as they find it harder to roll over debt due to banks pulling back on corporate loans. A couple bad quarters and debt coming due could drive even very solid businesses with too much leverage into bankruptcy, and there is no better way to permanently impair the value of equity than for debtholders to seize it all.

3) Broad diversification. This goes not only for the stocks and sectors, but also the underlying revenues of the companies. In this global downturn, we cannot say which region will recover fastest or which may stay in a slump for years, so we want businesses that draw their profits from around the globe. Similarly, we did not want to pick specific sectors to outperform. Although consumer staples and health-care companies showed most of our desired attributes due to their respective steady revenues and lucrative intellectual property rights, we wanted to pick up some of the excellent names in the industrials, technology, materials, and consumer discretionary sectors at the same time.

4) A sizable discount to fair value. After all, what's the point of getting back into the market in such risky times if we don't expect considerable price appreciation?

After digging through the more than 840 U.S. ETFs in our database, a clear winner emerged:  Vanguard Dividend Appreciation (VIG). Don't let the name fool you; this fund has an average dividend yield lower than the S&P 500's, but the security of its yield and quality of its holdings are unmatched. To make the first cut for this ETF, U.S. companies need to have increased their dividends for at least 10 years running. After that, Vanguard and Mergent apply extra screens to ensure the holdings have fortresslike balance sheets and enough earning power to keep those dividends growing into the future.

The result is a who's who of the best-run corporations in this country, stalwart names such as  Coca-Cola (KO),  Proctor & Gamble (PG),  Wal-Mart (WMT),  Abbott Labs (ABT), and  International Business Machines (IBM). Further down the list, we find the smaller companies that delivered value by dominating their niches for years: Morningstar favorites such as  Automatic Data Processing (ADP),  Stryker (SYK), and  Illinois Tool Works (ITW).

An incredible 90% of the assets in VIG's portfolio boast either a wide or narrow moat according to our equity analysts, and 85% of assets are invested in companies with low or medium uncertainty. These statistics beat out nearly every other non-sector ETF in our database. Only the Dow Jones Industrial Average tracker DIAMONDS (DIA) approaches the same quality of names, but with far less diversification. As for leverage, Vanguard Dividend Appreciation's portfolio has a debt/capital ratio lower than all other ETFs' of similar quality except health-care sector-specific funds.

Finally, this ETF provides surprising diversification among these world-beaters, with the top 10 companies taking up only 40% of assets and sizable stakes in each of the consumer goods, consumer services, health-care, and industrial materials sectors. As of March 18, this fund traded at a 30% discount to our analysts' fair value, which is a slight premium to the market as a whole but still provides plenty of room for capital gains. With harsh times for business as the only certainty ahead, it helps to have the cream of American industry in your portfolio, and Vanguard Dividend Appreciation supplies them for a pleasantly cheap 0.28% a year.

 

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